What types of expenses can’t be written off by your business?
Suppose you read the Internal Revenue Code (and you probably don’t want to!). In that case, you may be surprised that most business deductions aren’t specifically listed. For example, the tax law doesn’t explicitly state that you can deduct office supplies and other expenses. Some expenses are detailed in the tax code. Still, the general rule is contained in the first sentence of Section 162, which states you can write off “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
Generally, an expense is ordinary if considered common or customary in a particular trade or business. For example, insurance premiums to protect a store would be an ordinary business expense in the retail industry.
A necessary expense is defined as one that’s helpful or appropriate. For example, a car dealership purchases an automated external defibrillator. It may not be necessary for the operation of the business. Still, it might be helpful and appropriate if an employee or customer suffers cardiac arrest.
An ordinary expense can be unnecessary, but to be deductible, an expense must be ordinary and necessary.
In addition, a deductible amount must be reasonable concerning the expected benefit. For example, if you’re attempting to land a $3,000 deal, a $65 lunch with a potential client should be OK with the IRS. (Remember that the Tax Cuts and Jobs Act eliminated most deductions for entertainment expenses but retained the 50% deduction for business meals.)
Examples of taxpayers who lost deductions in court
Not surprisingly, the IRS and courts don’t always agree with taxpayers about what qualifies as ordinary and necessary expenditures. Here are three 2023 cases to illustrate some of the issues:
- A married couple owned an engineering firm. For two tax years, they claimed depreciation of $76,264 on three vehicles. Still, they didn’t provide the required details, including each vehicle’s ownership, cost, and useful life. They claimed $34,197 in mileage deductions and provided receipts and mileage logs. The U.S. Tax Court found they didn’t show any related business purposes. The court also found the mileage claimed included commuting costs, which can’t be written off. The court disallowed these deductions and assessed taxes and penalties. (TC Memo 2023-39)
- The Tax Court ruled that a married couple wasn’t entitled to business tax deductions because the husband’s consulting company failed to show that it was engaged in a trade or business. Invoices produced by the consulting company predated its incorporation. And the court ruled that even if the expenses were legitimate, they weren’t adequately substantiated. (TC Memo 2023-80)
- A physician specializing in gene therapy had multiple legal issues and deducted legal expenses of $360,295 for two years on joint Schedule C business tax returns. The Tax Court found that most legal fees were to defend the husband against personal conduct issues. The court denied the deduction for personal legal expenses but allowed a deduction of $13,000 for business-related legal expenses. (TC Memo 2023-42)
Proceed with caution
The deductibility of some expenses is clear. But for other expenses, it can get more complicated. Generally, if an expense seems like it’s not customary in your industry — or if it could be considered fun, personal, or extravagant — you should proceed with caution. And keep careful records to substantiate the expenses you’re deducting. Please consult with us for guidance on these complex issues. It is better to address the issue before the actual expense is incurred.