Understanding Tax Deductions & Credits
Business taxes are governed by a large volume of tax codes, rules, regulations and procedures. Knowing the ins and outs of these various requirements can make the difference between a tax refund or a large tax bill. The most often misunderstood of these are the ones governing business deductions and business credits. This report will help clarify these two areas.
As a precursor to discussing each area, it is important to understand that the requirements for business returns are different (VERY different) from those for individual tax returns. And in fact, this may be the most common of the myths about business taxes. Taxpayers are regularly told what they can’t do regarding business deductions because the “rules” don’t allow it. But in fact, these “rules” are only applicable to personal returns and do not apply to business returns.
A sister myth applies when it comes to business credits. Business credits are designed to soften the pain of the tax a business has to pay on it’s income. These range from benefits for investing in inventory to hiring more employees. But the large majority of businesses file tax returns that are informational in nature (forms 1120S or 1065 for example). So the business doesn’t pay taxes at all – just passes the information to the individual owners/shareholders who use the information at the personal tax return level. When this is the case, business credits don’t apply because there is not business tax. So be careful when you hear about business credits – they may sound good but if they don’t apply to your situation, they’re irrelevant.
With that framework, here are the details about business deductions.
What is a Business Deduction?
According to Section 162 of the tax code (with a little help from the Tax Court) a business deduction is anything that’s Ordinary, Necessary and Reasonably Related to the Production of Income. Unfortunately, that’s a definition that doesn’t really help much when it comes to categorizing expenses. But with a little review it’s not as complicated as it might seem.
“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” gifts as a means of securing ongoing client loyalty then “Gifts” would be an ordinary expense. However, if you’re in a profession where bribes and gratuitous gestures are considered unethical then expenses for “Gifts” would be viewed in a far more skeptical light. But don’t let this definition dissuade you from considering approaches to business that are innovative and not necessarily the norm in your industry. Years ago, charges for e-fax services would have been considered cutting-edge. Now they’re absolutely main stream. If you see a better way to run your business, then pursue it. But recognize that if the IRS gets involved, you may need to provide some justification as to how ordinary some of your unorthodox approaches may be.
“Necessary” expenses are those that support the operation of your business and are appropriate in order to 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 as a whole. For example, life insurance sponsored by the company for you as the owner would NOT be necessary if it were not provided to your 15 employees. However, if life insurance were provided by the business to you and these 15 employees, then the expense would qualify as necessary. Insurance is both an employee benefit (that helps you attract and keep good employees) and a risk mitigator (reduces the chance that a deceased employee’s family will feel financial motivation to sue the company for wrongful death, justified or not). But this would be the case only if it’s applied to all employees, or a defined group of employees. It wouldn’t be considered necessary if it’s just for the owner.
“Reasonably Related” speaks to the necessity that an expense be primarily related 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 wellbeing, 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.
The table below provides a simple tool for determining what does and doesn’t constitute a business expense in your particular circumstances. Evaluate the expense in each of the four criteria (Ordinary, Necessary, Reasonably Related, and Paid in the Current Year). So long as the expense has all “Yes” responses, it can be considered a business expense. However, if the expense has any “No” responses then the expense may not qualify.
There are volumes of IRS regulations, rules and guidelines associated with the area of business deductions. But keep in mind, that the IRS does not make the final determination on what is or is not a business deduction. That decision is made by Congress or the Tax Court. It’s worth knowing these guidelines, rules and regulations, but you should make your own determination regarding whether or not an expense is reasonably related, necessary, and ordinary. And so long as you have a rational basis for doing so, you have good grounds for the business claim. If you have questions, this is another excellent area to seek guidance from your tax advisor.
Inherently Personal Expenses
There are a few expenses which can generally be excluded just by virtue of their nature when it comes to identifying business expenses. These expenses have been identified by the Tax Court as being inherently personal in nature, and include:
• Groceries consumed in your own home by yourself and your taxpayer
• Necessary Utilities (generally electricity, water, sewer/trash)
• Underwear and Personal Hygene
• Primary Residence Mortgage or Rent
• Charitable Contributions
Note that exceptions apply. For example, if you use your primary residence for business purposes, then a portion of the necessary utilities and rent expense may be a business deduction. If you’re an underwear model then underwear purchases may be considered a business deduction as well. But in most cases, these expenses won’t be business deductions.
Any other deduction which doesn’t fall in the inherently personal ones identified above should be examined for inclusion as a business deduction. And when you’re managing your finances, it is probably a good idea to have all but these specific categories of expenses paid for from the business account. This maximizes the opportunity for inclusion as a business expense.
Business taxes are vastly different from personal taxes. And business deductions in particular, are an important and effective way of reducing overall taxation for the taxpayer. On the other hand, business credits rarely provide any benefit except in those situations where the business will also be taxed. Business deductions are those that are ordinary, necessary, reasonably related to the business purpose, and occur in the tax year. By paying attention to these definitions and handling the business finances properly, the taxpayer can successfully use both deductions and any applicable credits to reduce their overall tax liability.
If you have questions about what deductions or credits may apply to your specific situation, give us a call to schedule your free consultation today. Call (480) 888-7111 or submit a web request here.