Business Expenses – What is NOT Deductible?
While it seems like a straightforward question, there can sometimes be confusion about what expenses can be deducted from your business for tax purposes and what expenses cannot be. Deductions are critical in helping to lower your tax bill, but knowing what expenses you can deduct is critical to keeping you out of trouble in the event of an IRS audit.
Let’s start with understanding how business expenses are defined according to the IRS. A business expense must be both “ordinary and necessary” to be tax deductible. An ordinary expense is one that is common and accepted in your industry, and a necessary expense must be helpful to your operations and appropriate for your business. An expense that is considered ordinary and necessary for a manufacturer might not be ordinary and necessary for a consultant, so it is important to focus on your specific industry and what is acceptable – there is not always a “one-size-fits-all” answer.
There are certain expenses that, in most cases, are tax deductible regardless of the industry. Some examples include advertising, accounting fees, bank charges, continuing education, legal fees, office supplies, rent expenses, payroll expenses/related, and so on. However, what are some expenses that are NOT deductible regardless of the industry or specific circumstances? The following expenses are generally off-limits for a business tax deduction:
- Capital costs: fixed asset expenses for your business (including equipment, furniture/fixtures, machinery, etc.) for such assets that have a long-term useful life and individually exceed $2,500 in cost. These costs generally cannot be deducted in the year of purchase, but rather must be “capitalized” (added to your balance sheet as an asset) and depreciated (deducted) over several years. However, there is a really great workaround called Section 179 that you can explore with your tax professional to see if it’s a good fit for you.
- Personal expenses: generally, you cannot deduct any personal, living, or family expenses (that’s right – no tax deduction for the dog’s braces!). However, if you have an expense that is used partly for business and partly for personal purposes, you can deduct the business portion.
- Fines and penalties: you cannot deduct fines and penalties, including estimated tax or underpayment penalties.
- Political contributions: contributions your business made to a political party or candidate, including lobbying or campaign event costs, are not deductible.
- Hobby losses: expenses that create a loss in an activity that is not deemed a business activity (which would then make it a hobby) are not deductible. There are specific IRS guidelines on whether your activity can be considered a business or not.
- Owner life insurance premiums: these costs generally are limited or completely non-deductible.
- Commuting costs: the IRS says that costs of traveling from home to work are not tax-deductible expenses. However, if you have a home office that is your primary business location where you do most of your work, you can potentially deduct costs associated with traveling to meet clients and run business-related errands.
- Business gifts over $25: you cannot deduct more than $25 for any business gift given to any one person during the tax year.
- Business clothing: costs of clothing you wear for work are not deductible. The only exception is for uniforms you are required to wear.
- Entertainment costs: these costs are completely non-deductible for Federal purposes after recent tax reform (previously they were 50 percent deductible). However, be aware that some states still allow a partial deduction.
Here’s the bottom line: as a business owner, imagine sitting in front of an IRS auditor, needing to explain how a deduction would be ordinary and necessary for your business. Would you be able to do it?