To be deductible, a Business Expense must be Ordinary, Necessary, and Reasonable in Amount. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.
Even though an expense may be Ordinary, Necessary, and Reasonable in Amount, you may not be allowed to deduct the expense in the year you paid or incurred it. In some cases, you may not be allowed to deduct the expense at all. Therefore, it is important to distinguish usual business expenses from expenses.
Deductible Miscellaneous Business Expenses include (not all inclusive):
Advertising Expenses: You generally can deduct reasonable advertising expenses that are directly related to your business activities. Generally, you can’t deduct amounts paid to influence legislation (for example, lobbying).
You can usually deduct as a business expense the cost of Institutional or Goodwill Advertising to keep your name before the public if it relates to business you reasonably expect to gain in the future.
The cost of advertising that encourages people to contribute to the Red Cross, to buy U.S. savings bonds, or to participate in similar causes is usually deductible.
Anticipated Liabilities: Anticipated liabilities or Reserves for anticipated liabilities are NOT deductible.
You can Deduct Expenses only when you Actually Pay or accrue them, depending on your accounting method.
Assume you sold 1-year TV service contracts this year totaling $50,000. From experience, you know you will have expenses of about $15,000 in the coming year for these contracts. You can NOT deduct any of the $15,000 this year by charging expenses to a reserve or liability account.
Bribes and Kickbacks: Engaging in the payment of Bribes or Kickbacks is a Serious Criminal Matter. Such activity could result in criminal prosecution. Any payments that appear to have been made, either directly or indirectly, to an official or employee of any government or an agency or instrumentality of any government aren’t deductible for tax purposes and are in violation of the law.
Payments paid directly or indirectly to a person in Violation of Any Federal or State Law (but only if that state law is generally enforced, defined below) that provides for a criminal penalty or for the loss of a license or privilege to engage in a trade or business are NOT allowed as a deduction for tax purposes.
Meaning of “Generally Enforced.” A state law is considered generally enforced unless it is never enforced or enforced only for infamous persons or persons whose violations are extraordinarily flagrant. For example, a state law is generally enforced unless proper reporting of a violation of the law results in enforcement only under unusual circumstances.
Kickbacks: A kickback is a Payment for Referring a Client, Patient, or Customer. The common kickback situation occurs when money or property is given to someone as payment for influencing a third party to purchase from, use the services of, or otherwise deal with the person who pays the kickback. In many cases, the person whose business is being sought or enjoyed by the person who pays the kickback isn’t aware of the payment.
For example, the Yard Corporation is in the business of repairing ships. It returns 10% of the repair bills as kickbacks to the captains and chief officers of the vessels it repairs. Although this practice is considered an ordinary and necessary expense of getting business, it is clearly a violation of a state law that is Generally Enforced. These expenditures aren’t deductible for tax purposes, whether or not the owners of the shipyard are subsequently prosecuted.
Car and Truck Expenses: The costs of operating a car, truck, or other vehicle in your business may be deductible.
Cell Phones and iPhones, etc: are deductible business expenses when used 100% for business.
Sole proprietors, partners in a partnership, or shareholders in an S corporation may be able to deduct charitable contributions made by their business on Schedule A (Form 1040).
You paid $15 to a local church for a half-page ad in a program for a concert it is sponsoring. The purpose of the ad was to encourage readers to buy your products. Your payment isn’t a charitable contribution. You can deduct it as an advertising expense.
You made a $100,000 donation to a committee organized by the local Chamber of Commerce to bring a convention to your city, intended to increase business activity, including yours. Your payment isn’t a Charitable Contribution. You can deduct it as a business expense.
Club Dues and Membership Fees: Generally, you can NOT deduct amounts paid or incurred for membership in any club organized for business, pleasure, recreation, or any other social purpose. This includes country clubs, golf and athletic clubs, hotel clubs, sporting clubs, airline clubs, and clubs operated to provide meals under circumstances generally considered to be conducive to business discussions.
Club Dues and Membership Fees Exception: The following organizations aren’t treated as clubs organized for business, pleasure, recreation, or other social purpose unless one of the main purposes is to conduct entertainment activities for members or their guests or to provide members or their guests with access to entertainment facilities.
- Boards of Trade,
- Business Leagues,
- Chambers of Commerce,
- Civic or Public Service Organizations,
- Professional Organizations such as Bar Associations and Medical Associations,
- Real Estate Boards, and
- Trade Associations.
Credit Card Convenience Fees: Credit card companies charge a fee to businesses who accept their cards. This fee when paid or incurred by the business can be deducted as a business expense.
Damages Recovered: Special rules apply to compensation you receive for damages sustained as a result of:
- Patent Infringement,
- Breach of Contract,
- Antitrust Violations, or
- Fiduciary Duty.
You must include this compensation in your income. However, you may be able to take a special deduction. The deduction applies only to amounts recovered for Actual Economic Injury, not any additional amount. The deduction is the smaller of the following:
- The amount you received or Accrued for Damages in the tax year reduced by the amount you paid or incurred in the year to recover that amount.
- Your Losses from the Injury you haven’t deducted.
Demolition Expenses or Losses: Amounts paid or incurred to demolish a structure are NOT deductible. These amounts are added to the basis of the land where the demolished structure was located. Any loss for the remaining undepreciated basis of a demolished structure wouldn’t be recognized until the property is disposed of.
Education Expenses: Ordinary and necessary expenses paid for the cost of the education and training of your employees are deductible. Deductible Business Expenses.
You can also deduct the cost of your own education (including certain related travel) related to your trade or business. You must be able to show the Education Maintains or Improves Skills required in your trade or business, or that it is required by law or regulations, for keeping your license to practice, status, or job.
An attorney can deduct the cost of attending Continuing Legal Education (CLE) classes that are required by the state bar association to maintain his or her license to practice law.
Education expenses you incur to meet the minimum requirements of your present trade or business, or those that qualify you for a New Trade or Business, aren’t deductible. This is true even if the education maintains or improves skills presently required in your business.
Franchise, Trademark, Trade Name: If you buy a Franchise, Trademark, or Trade Name, you can deduct the amount you pay or incur as a business expense only if your payments are part of a series of payments that are:
1) Contingent on Productivity, use, or disposition of the item;
2) Payable at least annually for the Entire Term of the Transfer Agreement; and
3) Substantially equal in amount (or Payable Under a Fixed Formula).
When determining the Term of the Transfer Agreement, include all renewal options and any other period for which you and the transferor reasonably expect the agreement to be renewed.
Trade Name: is generally considered the Name a Business uses for Advertising and Sales Purposes. A trade name is sometimes referred to as a “fictitious” or “doing business as (DBA)” title. For example, “McDonald’s” may be the trade name, but the legal name is “McDonald’s Corporation.”
A Franchise Includes an Agreement that gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities within a specified area.
- A Physical or Mental Disability (for example, blindness or deafness) that functionally limits your being employed.
- A physical or mental impairment that substantially limits one or more of your Major Life Activities.
- Your work clearly requires the expense for you to Satisfactorily Perform that work.
- The Goods or Services purchased are clearly not needed or used, other than incidentally, in your personal activities.
- Their treatment isn’t specifically provided for under other Tax Law Provisions.
You are blind. You must use a reader to do your work, both at and away from your place of work. The reader’s services are only for your work. You can deduct your expenses for the reader as a business expense.
Interview Expense Allowances (Job Interview): Reimbursements you make to job candidates for transportation or other expenses related to interviews for possible employment are NOT wages. You can deduct the reimbursements as a business expense.
Webmaster Consulting Costs: If you are starting a business, you may have to amortize these expenses as start-up costs.
Legal and Professional Fees: Fees charged by CPA’s and attorneys that are ordinary and necessary expenses directly related to operating your business are deductible as business expenses.
Legal and Professional Fees you pay to acquire business assets usually are Not deductible. These costs are added to the basis of the property.
Fees that include payments for Work of a Personal Nature are NOT allowed as a business deduction on Schedule C (Form 1040). Examples include:
- Drafting your Last Will and Testament, or
- Damages arising from a Personal Injury.
If the invoice includes Both Business and Personal Deductions, figure the business portion as follows: multiply the total amount of the bill by a fraction, the numerator of which is the amount attributable to business matters, the denominator of which is the total amount paid. The result is the portion of the invoice attributable to business expenses. The portion attributable to personal matters is the difference between the total amount and the business portion (figured above).
Certain payments made in Sexual Harassment or Sexual Abuse cases:
For amounts paid or incurred after December 22, 2017, new Section 162(q) Provides No Deduction is Allowed under section 162 for any settlement or payment related to sexual harassment or sexual abuse if it is subject to a nondisclosure agreement. In addition, attorney’s fees related to such a settlement or payment aren’t allowed as a deduction.
Tax Preparation Fees: The cost of hiring a tax professional, such as a certified public accountant (CPA), to prepare that part of your tax return relating to your business as a sole proprietor is deductible on Schedule C (Form 1040). Deduct expenses of preparing tax schedules relating to rentals or royalties (Schedule E), or farm income and expenses (Schedule F) on the appropriate schedule. Expenses for completing the remainder of the return are miscellaneous deductions and are no longer deductible.
You can also claim a Business Deduction for amounts paid or incurred in resolving asserted tax deficiencies for your business operated as a sole proprietor.
Licenses and Regulatory Fees: Licenses and regulatory fees for your trade or business paid annually to state or local governments are generally deductible. Some licenses and fees may have to be amortized.
- Influencing Legislation,
- Participating in or intervening in any Political Campaign for, or against, any candidate for public office.
- Attempting to influence the general public, or segments of the public, about elections, Legislative Matters, or referendums.
- Communicating directly with Covered Executive Branch Officials (POTUS) in any attempt to influence the official actions or positions of those officials.
- Researching, Preparing, Planning, or Coordinating any of the preceding activities.
Your expenses for influencing legislation and communicating directly with a covered executive branch official include a portion of your labor costs and general and administrative costs of your business. For information on making this allocation, see Regulation Section 1.162-28.
You can not claim a Charitable or Business Expense Deduction for amounts paid to an organization if both of the following apply:
If a tax-exempt organization, other than a Section 501(c)(3) Organization, provides you with a notice on the part of dues that is allocable to nondeductible lobbying and political expenses, you can’t deduct that part of the dues.
Covered Executive Branch Official: For purposes of this discussion, a “covered executive branch official” is any of the following:
1. The President of the United States (POTUS),
2. The Vice President of the United States,
3. Any officer or employee of the White House Office of the Executive Office of the President and the two most senior level officers of each of the other agencies in the Executive Office,
4. Any individual who serving in or for the White House:
a. Is serving in a position in Level I of the Executive Schedule under Section 5312 of title 5, United States Code;
b. Has been designated by the President (POTUS) as having Cabinet Level Status; or
c. Is an Immediate Deputy of an individual listed in item (a) or (b).
Exceptions to denial of deduction: The general denial of the deduction doesn’t apply to the following:
- Any in-house expenses for influencing legislation and communicating directly with a Covered Executive Branch Official if those expenses for the tax year don’t exceed $2,000 (excluding overhead expenses).
- Professional Lobbyists Expenses: incurred by taxpayers engaged in the trade or business of lobbying (Professional Lobbyists) on behalf of another person (but does apply to payments by the other person to the lobbyist for lobbying activities).
Moving Machinery: Generally, the cost of moving machinery from one city to another is a deductible expense. So is the cost of moving machinery from one plant to another, or from one part of your plant to another. You can deduct the cost of installing the machinery in the new location. However, you must capitalize the costs of installing or moving newly purchased machinery.
Outplacement Services: The costs of outplacement services you provide to your employees to help them find new employment, such as career counseling, resume assistance, skills assessment, etc., are deductible.
The costs of Outplacement Services may cover more than one deduction category. For example, deduct as a utilities expense the cost of telephone calls made under this service and deduct as a rental expense the cost of renting machinery and equipment for this service.
Penalties and Fines: Penalties paid for late performance or nonperformance of a contract are generally deductible.
You own and operate a construction company. Under a contract, you are to finish construction of a building by a certain date. Due to construction delays, the building isn’t completed and ready for occupancy on the date stipulated in the contract. You are now required to pay an additional amount for each day that completion is delayed beyond the completion date stipulated in the contract. These additional costs are deductible business expenses.
On the other hand, generally, No Deduction is Allowed for Penalties and Fines paid to a government or specified nongovernmental entity for the violation of any law except the following:
- Amounts that Constitute Restitution,
- Amounts Paid to Come into Compliance with the Law,
- Amounts paid or incurred as the result of certain Court Orders in which no government or specified nongovernmental agency is a party, and
- Amounts paid or incurred for Taxes Due.
On or after December 22, 2017, no deduction is allowed for the restitution amount or amount paid to come into compliance with the law unless the amounts are specifically identified in the Settlement Agreement or Court Order.
Also, any amount paid or incurred as reimbursement to a government for the costs of any Investigation or Litigation aren’t eligible for the exceptions and are nondeductible.
See section 162(f), as amended by P.L. 115-97, section 13306.
Examples of Nondeductible Penalties and Fines include the following (not all inclusive):
- Amounts paid because of a conviction for a crime or after a Plea of Guilty or No Contest in a Criminal Proceeding.
- Amounts paid as a penalty imposed by federal, state, or local law in a civil action, including certain additions to tax and additional amounts and assessable penalties imposed by the Internal Revenue Code.
- Amounts paid in settlement of actual or possible liability for a Fine or Penalty, whether civil or criminal.
- Amounts Forfeited as Collateral posted for a proceeding that could result in a fine or penalty.
- Fines paid for Violating City Housing Codes.
- Fines paid by truckers for Violating State Maximum Highway Weight Laws.
- Fines paid for violating Air Quality Laws.
Civil Penalties paid for violating federal laws regarding mining safety standards and discharges into navigable waters.
A Tax Fine or Penalty do not include any of the following:
- Legal fees and related expenses to Defend Yourself in a Prosecution or civil action for a violation of the law imposing the fine or civil penalty.
- Court Costs or Stenographic and Printing Costs.
- Compensatory Damages paid to a government.
Political Contributions: Contributions or gifts paid to political parties or candidates aren’t deductible. In addition, expenses paid or incurred to take part in any political campaign of a candidate for public office aren’t deductible.
Indirect Political Contributions: You can’t deduct indirect political contributions and costs of taking part in political activities as business expenses.
Examples of Nondeductible Expenses include the following:
- Advertising in a Convention Program of a political party, or in any other publication if any of the proceeds from the publication are for, or intended for, the use of a political party or candidate.
- Admission to a dinner or program (including, but not limited to, Galas, Dances, Film Presentations, Parties, and Sporting Events) if any of the proceeds from the function are for, or intended for, the use of a political party or candidate.
- Admission to an Inaugural Ball, Gala, Parade, Concert, or similar event if identified with a political party or candidate.
Repairs: The cost of Repairing or Improving Property used in your trade or business is either a deductible or capital expense. Routine maintenance that keeps your property in a normal efficient operating condition, but that doesn’t materially increase the value or substantially prolong the useful life of the property, is deductible in the year that it is incurred. Otherwise, the cost must be capitalized and depreciated. See Form 4562 and its instructions for how to figure and claim the depreciation deduction.
The Cost of Repairs includes the costs of labor, supplies, and certain other items. The value of your own labor isn’t deductible. Examples of repairs include:
- Reconditioning floors (but not replacement),
- Repainting the Interior and Exterior walls of a building,
- Cleaning and repairing roofs and gutters, and
- Fixing plumbing leaks (but not replacement of fixtures).
Repayments: If you had to repay an amount you included in your income in an earlier year, you may be able to deduct the amount repaid for the year in which you repaid it. Or, if the amount you repaid is more than $3,000, you may be able to take a Credit Against your Tax for the year in which you repaid it. In most cases, you can claim a deduction or credit only if the repayment qualifies as an expense or loss incurred in your trade or business or in a for-profit transaction.
Type of Deduction: The type of deduction you are allowed in the year of repayment depends on the type of income you included in the earlier year. For instance, if you repay an amount you previously reported as a capital gain, deduct the repayment as a capital loss as explained in the Instructions for Schedule D (Form 1040). If you reported it as self-employment income, deduct it as a business expense on Schedule C (Form 1040), or a farm expense on Schedule F (Form 1040).
If you reported the amount as wages, Unemployment Compensation, or other nonbusiness ordinary income, you may be able to deduct it as an other itemized deduction if the amount repaid is over $3,000.
Beginning in 2018, due to the Suspension of Miscellaneous Itemized Deductions subject to the 2% floor under section 67(a), your aren’t able to deduct the repayment as an itemized deduction if it is $3,000 or less.
Repayment—$3,000 or Less: If the amount you repaid was $3,000 or Less, deduct it from your income in the year you repaid it.
Repayment—Over $3,000: If the amount you repaid was More than $3,000, you can deduct the repayment as an other itemized deduction on Schedule A (Form 1040), line 16, if you included the income under a “claim of right.” This means that at the time you included the income, it appeared that you had an unrestricted right to it. However, you can choose to take a credit for the year of repayment. Figure your tax under both methods and use the method that results in less tax:
Method 1. Figure your tax for Claiming a Deduction for the Repaid Amount.
Method 2. Figure your tax for Claiming a Credit for the Repaid Amount. Follow these steps:
- Figure your tax Without Deducting the Repaid Amount.
- Refigure your tax from the earlier year without including in income the amount you repaid.
3. Subtract the tax in (2) from the tax shown on your return for the earlier year. This is the Amount of your Credit.
4. Subtract the answer in (3) from the Tax Figured without the Deduction (step 1).
If Method 1 results in less tax, deduct the amount repaid as discussed earlier under Type of Deduction.
If Method 2 results in less tax, Claim the Credit on Schedule 3 (Form 1040), line 12d, and write “I.R.C. 1341” next to line 12d.
Example. For 2019, you filed a return and reported your income on the cash method. In 2020, you repaid $5,000 included in your 2019 gross income under a Claim of Right. Your filing status in 2020 and 2019 is single. Your income and tax for both years are as follows:
Your tax under Method 1 is $5,685. Your tax under Method 2 is $6,185, figured as follows:
Because you pay less tax under Method 1, you should take a Deduction for the Repayment in 2020.
Repayment does not apply: This discussion doesn’t apply to the following:
- Deductions for Bad Debts,
- Deductions from Sales to Customers, such as returns and allowances, and similar items, and
- Deductions for legal and other expenses of Contesting the Repayment.
Year of deduction (or credit): If you use the cash method of accounting, you can take the deduction (or credit, if applicable) for the tax year in which you actually make the repayment. If you use any other accounting method, you can deduct the repayment or claim a credit for it only for the tax year in which it is a proper deduction under your accounting method. For example, if you use the accrual method, you are entitled to the deduction or credit in the tax year in which the obligation for the repayment accrues.
Supplies and Materials: Unless you have deducted the cost in any earlier year, you can generally deduct the cost of materials and supplies actually consumed and used during the tax year.
If you keep Incidental Materials and Supplies on hand, you can deduct the cost of the incidental materials and supplies you bought during the tax year if all the following requirements are met:
- You don’t Keep a Record of When they are Used.
- You don’t take an inventory of the amount on hand at the beginning and end of the tax year.
- This method doesn’t distort your income.
You can also Deduct the Cost of Books, Professional Instruments, Equipment, etc., if you normally use them within a year. However, if the usefulness of these items extends substantially beyond the year they are placed in service, you must generally recover their costs through depreciation.
Utilities: Business Expenses for Heat, Lights, Power, Telephone Service, and Water and Sewerage are Deductible. However, any part due to personal use isn’t deductible.
Telephone Services: You can’t deduct the cost of basic local telephone service (including any taxes) for the first telephone line you have in your home, even if you have an office in your home.
However, charges for Business Long Distance Phone calls on that line, as well as the cost of a second line into your home used exclusively for business, are deductible business expenses.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.