This is a summary of rules on some of the most common business deductions that the IRS frequently examines during an audit. The summary below is a very condensed version of the rules, with details omitted for brevity. Other types of deductions are not discussed. If you have any questions about the deductions, contact us or visit www.irs.gov.
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business.
The law does not provide an exhaustive list of deductible expenses, but the general rule above is a guideline. For example, excessive amounts of expenses (like travel or meals) may call into question whether they are ordinary and necessary. The IRS may evaluate using facts and circumstances, such as the amount of business income and the type of business.
ORDINARY AND NECESSARY: The most important thing to know: personal expenses are not deductible. Just because the expense happens away from home, while traveling for business, does not automatically mean it is deductible. The expense must be deemed both: 1. Ordinary and necessary 2. Directly related to the trade or business
Let’s dig into that. What is an ordinary and necessary business expense? To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in the trade or business. A necessary expense is one that is helpful and appropriate for the trade or business. An expense does not have to be indispensable to be considered necessary. For example, an Internet connection is considered both ordinary and necessary for “knowledge” workers – like attorneys, consultants and advertising employees – when conducting work travel. Is the expense trade or business related?
The easiest way to think about this might be to talk about what is not covered. Any activity that is a hobby cannot qualify as being trade or business related. Any activity that is for personal enjoyment or entertainment will not qualify. A deductible expense must be engaged in for profit. Any deductible activity should be undertaken to improve the performance of the business on a continuing basis. Additionally, an expense for an additional night, such as if the business trip is over on Friday and the taxpayer returns home on Saturday, will still be allowed as business related expense if it can be shown that the additional expense will result in an overall savings to the taxpayer. This is sometimes referred to as the “hard headed businessman” rule.
Miles from one work location to another work location are deductible. Miles from your house to your work place, and vice versa, are not deductible. But if you have a home office (note, there are strict requirements to claim a home office), then miles from your house to another work location are deductible. To claim vehicle expenses, make sure to keep the following records:
- Documentation identifying the vehicle and proving ownership or a lease;
- Mileage log showing date, business purpose, description, location, destination and miles of each trip (you may use a paper log, a phone app, or other software). Certain vehicles are exempt from the mileage log requirement, such as trucks with loaded gross vehicle weight over 14,000 pounds and passenger buses;
- Receipts, invoices and bank statements proving payment for various expenses like gas, parking, toll, repairs, oil, etc.
- An independent 3rd party mileage reading (like a car repair shop) at the beginning or end of each year (to compute total miles driven for the year)
- Date vehicle is placed in service (i.e. first used for business)
- Cost of vehicle, if owned
MEALS AND ENTERTAINMENT
Meals that have historically been 50% deductible as part of operating a trade or business are generally still 50% deductible. This includes:
- Meals directly related to meeting with prospective or current business client, customer, consultant or similar business contact. The government has clarified that the expense must be ordinary and necessary, must not be extravagant and the taxpayer or an employee of the taxpayer must be present at the meal.
- Meals directly related to meeting with employees, partners, shareholders and directors.
- Meals during business travel.
With the new tax law, some meals that were 100% deductible prior to the new tax law, are now 50% deductible starting in 2018. This includes:
- Meals provided at a company cafeteria or dining room or meals provided for the convenience of the employer. These expenses will not be deductible after 2025.
- Office snacks provided to employees at the office. This may include coffee, soda, water, candy, donuts, and similar snacks. Stay tuned on this one as it is possible that the government may clarify that this was not intended to be changed from 100% deductible to 50% deductible in the new tax law.
Expenses associated with recreational or social activities for employees are 100% deductible. This includes the company holiday party, company picnic or other social events. There is no change to this in the new tax law.
Entertainment expenses no longer deductible.
Entertainment expenses use to be 50% deductible. Under the new tax law, starting in 2018, entertainment expenses are not deductible. This has created some confusion as to whether meals included in the entertainment are 50% deductible or not deductible at all.
The government recently clarified that if the meal expense is separately itemized on the receipt or invoice, then it will fall under the normal meal expense rules and not the entertainment rules. So, be sure to have your meal expenses separately itemized when entertaining.
BUSINESS TRAVEL EXPENSES
Deductible travel expenses consist of transportation and lodging expenses while way from tax home ON BUSINESS. To deduct travel expenses, taxpayers must be away from their tax home longer than an ordinary work day (usually at least overnight). The tax home includes the entire city or general area where the taxpayer regularly conducts business. Taxpayer must maintain an account book, diary, log, trip sheet or similar records, as well as documentary evidence (like receipts and canceled checks) to substantiate the amount, time, place, and business purpose of the expenditures. Examples include plane or bus fare, car rentals, and lodging.
Is the expense trade or business related? The easiest way to think about this might be to talk about what is not covered. Any activity that is a hobby cannot qualify as being trade or business related. Any activity that is for personal enjoyment or entertainment will not qualify. A deductible expense must be engaged in for profit. Any deductible activity should be undertaken to improve the performance of the business on a continuing basis. Additionally, an expense for an additional night, such as if the business trip is over on Friday and the taxpayer returns home on Saturday, will still be allowed as business related expense if it can be shown that the additional expense will result in an overall savings to the taxpayer. This is sometimes referred to as the “hard headed businessman” rule.
Can a taxpayer deduct expenses for business travel even if the trip includes personal activities? It depends. It is clear that taxpayers can deduct regular travel expenses when the trip is entirely business related. Additionally, if the taxpayer is on a domestic business trip and made personal side trips or stayed longer than the business purpose required, then the expenses must be allocated between business and personal. The portion of the trip dedicated to business activities is deductible. Any portion related to personal activities is not deductible.
Example: Luke travels to San Francisco to meet with a client Wednesday through Friday. He stays with a friend in the city on Saturday and Sunday. The expenses he incurred the first three days of the trip may be deductible business expenses. His personal activities on Saturday and Sunday cannot be included in the deduction.
What about international trips? If the taxpayer travels outside the United States, expenses for travel can be deducted if the trip is entirely for business purposes. Not only that, but all travel expenses are deductible in that case. However, it’s a different story if the trip is not entirely for business purposes. In order to deduct the travel, the taxpayer must meet one of the following exceptions. The trip will be considered entirely for business IF:
- The taxpayer did not have substantial control over arranging the trip. The taxpayer does not have substantial control when he or she is an employee who was reimbursed or paid a travel expense allowance; is not related to the employer; or when the taxpayer is not a managing executive.
- The taxpayer was outside the United States for a week or less and includes business and personal activities.
- The taxpayer was outside the United States for more than one week and spent less than 25% of the total time outside of the United States on personal activities.
- The taxpayer can establish that a personal vacation was not a major consideration even if the taxpayer had substantial control over arranging the trip. If the trip was primarily for business but the taxpayer did engage in personal activities, then the taxpayer must allocate travel time on a daily basis only deducting expenses for days spent on business activities.
Special rules for conventions and cruises
A taxpayer can deduct up to $2,000 per year of expenses for attending conventions, seminars or similar meetings held on cruise ships. All ships that sail are considered cruise ships. A taxpayer can deduct these expenses only if all of the following requirements are met.
- The convention, seminar or meeting is directly related to the taxpayer’s trade or business. • The cruise ship is a vessel registered in the United States.
- All of the cruise ship’s ports of call are in the United States or in possessions of the United States. • The taxpayer attaches to her return a written statement signed by an officer of the organization or group sponsoring the meeting that includes a schedule of the business activities of each day of the meeting and the number of hours the taxpayer attended the scheduled business activities.
- The taxpayer attaches to her return a written statement signed by the taxpayer that includes information about:
- The total days of the trip (not including the days of transportation to and from the cruise ship port),
- The number of hours each day the taxpayer devoted to scheduled business activities, and
- A program of the scheduled business activities of the meeting.
Click on this IRS link for more info: Business Travel Expenses
GIFTS IN GENERAL: You can deduct NO MORE THAN $25 for business gifts you give directly or indirectly to EACH PERSON during your tax year.
Tax Tip: Items that could be considered either a gift or entertainment expense normally are considered entertainment. If you give your business associates tickets to an entertainment activity and you DO NOT attend the event, you can choose which the most advantageous treatment is.
For each gift, keep a detailed record of the name of the recipient, and the occasion.
GIFTS FOR EMPLOYEES: If you give minimal benefits to employees, you can exclude the value from the employees’ wages. For example, turkeys, hams, or other items of nominal value given to employees at Christmas or other holidays are deductible business expenses, and not taxable to the employees. But a gift of cash, a gift certificate, or a similar item that can easily be exchanged for cash must be reported as wages of the employee/s regardless of the amount involved.
HOME OFFICE DEDUCTION
To qualify for home office deduction, the area in the home used for business must be used REGULARLY and EXCLUSIVELY:
- As the principal place of business (including administrative use); or
- As a place to meet with clients in the normal course of business; or
- In connection with the business if it is a separate structure not attached to the taxpayer’s personal residence.
REGULAR use means the area is used on a continuing basis. Occasional or incidental business use does not meet this test, even if the area is used for no other purpose.
EXCLUSIVE use means a specific part of the home is used ONLY for business purposes. This is a very strict and rigid rule – any indication of personal use, no matter how small, disqualifies the expense.
To document business use, take a picture of the office space, position a calendar in the background, and encode a date on the picture. Do this every tax year.
Click on this IRS link for more info: Home Office Deduction
Always keep proof and proper documentation for expenses claimed and any forms filed.
The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on your taxes, your investments, the law or any other business and professional matters that affect you and/or your business.