Tax FAQ Series – What is considered a business expense/deduction?

During this upcoming tax season, we are hosting a Tax FAQ series on the blog to answer many of the frequently asked tax questions we consistently receive from our small business owning clientele. We hope you find this information helpful!

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Our first question of the series is “What is considered a business expense/deduction?”

A: According to Section 162 of the tax code, a business deduction is anything that’s Ordinary, Necessary and Reasonably Related to the Production of Income.

“Ordinary” refers to those expenses that are typical for your industry. If you’re in the real estate profession where it’s typical to provide “house warming” incentives as a means of securing ongoing client loyalty, then “incentives” would be an ordinary expense. However, if you’re in a profession where bribes and gratuitous gestures are considered unethical then expenses for “incentives” would be viewed in a far more skeptical light.

“Necessary” expenses are those that support the operation of your business and potentially result in income. Be careful not to apply the personal budgeting concept of “wants” vs. “needs” with needs being equivalent to necessary items in business because this would be an “apples to oranges” comparison. A want in a personal budget (like internet, travel, etc.) would very likely be necessary in a business context. But make sure that the business expense is truly applicable to your business.

“Reasonably Related” speaks to the necessity that an expense be connected to producing income. And here the tax courts have provided some clarity. In doing so, the court introduces a concept that is embodied in the term “inherently personal.” When an expense is inherently personal in nature, it is generally NOT considered a business expense, even though it’s tangentially related to the production of income. Groceries, used for yourself and your family in your own home, are a good example. Even though you can’t work if you’re starved, the food you eat (and the basic cleaning supplies, light bulbs, A/C filters, etc.) is considered inherently personal in nature because it is primarily related to your personal well-being, not the production of income. However, groceries you purchase to host a client appreciation event at your residence would clearly be reasonably related to the business. So, in this area, it’s often easiest to determine what’s reasonably related to the production of income but considering what the primary purpose of the expense would be.

Still have more questions? Give us a call at (480) 888-7111 to schedule your free tax consultation!