Mary Carollo: Small Business Tax Deductions

If you own a small business, you probably already know about how your small business gets taxed at the end of the year. Just how much you are able to deduct as a “cost of doing business” is part of how much you will get taxed. Remember that whatever you are left with (your profit) after making your small business tax deductions is what you will get taxed on.

So, in order to minimize your taxes on your small business, it is always best to maximize your small business tax deductions. By doing so, you will lower your small business profit and minimize your taxes. In addition, by maximizing your tax deductions, you could get some personal benefits as well — perhaps a new business car, a business trip/vacation, or even a retirement plan. However, you must always be careful to play by the rules that the Internal Revenue Service (IRS) has set out. You could land in hot water if you don’t!

Internal Revenue Code Section 162 – The “Ordinary and Necessary” Expenses of Doing Business

In general, it is painful to read the actual tax code. However, section 162 is so important when it comes to figuring out a small business’ tax deductions that it is worth putting in here (at least a portion of it).

Internal Revenue Code Section 162 – In general – There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business…

Section 162 goes on for quite some time listing examples (and exceptions) of what are considered “ordinary and necessary” business expenses. However, what you should take away from this is that any expenses you deduct from your small business profits must be ordinary and necessary.

What exactly is ordinary and necessary, though? Many of the best legal minds often struggle with this question. What is important for you is that many of the things that you would call ordinary and necessary (such as a business computer, or a desk) are also defined as ordinary and necessary by the IRS.

Publications and Regulations

— There are other expenses that are in a grey area, however. For example, travel expenses may not always be “ordinary and necessary.” However, in many such grey areas, the IRS provides some guidance through publications (“pubs”) and regulations (“regs”).

Courts Have Made Decisions on Tax Deductions

— In addition to the guidance that the IRS provides through publications and regulations, courts also sometimes weigh in on what is considered an ordinary and necessary business expense. Generally, courts apply the notion that “ordinary and necessary” refers to the purpose for which the expense was made.

As an example, renting office space for your business is an ordinary and necessary business for a business that actually uses the office as an office. However, if a business rents an office just for the purpose of spending money and it does not use the office in its business, then it is not an ordinary and necessary business expense and cannot be deducted. The courts have generally found that “ordinary” means “normal, common, accepted under the circumstances by the business community,” and “necessary” means “appropriate and helpful to the business.”

As you can clearly see, the courts have left a lot of wiggle room for businesses to try to sneak in “ordinary and necessary” business expense deductions. On the other side, the IRS pushes to try to contain what is “ordinary and necessary.” When something falls outside of what the IRS has defined, it often finds its way into court.

For example, suppose that John is a self-employed accountant. One year, the IRS notices that Frank has a big deduction listed on his taxes. Taking a closer look, the IRS sees that John has decided to deduct his speed boat as an ordinary and necessary business expense. John says that the boat is ordinary and necessary because he places his business cards on other boats and cars when he takes the boat out for a ride. If this situation were to go to court, the court would probably find that the speed boat was not an ordinary and necessary business expense for an accountant. Right?!?

The “laugh” test

— One way that you can weed out many expenses as not being ordinary and necessary to your business is to employ the laugh test. Basically, if you can put down the expense as an ordinary and necessary deduction on you tax return without laughing, then it passes the laugh test. The hot air balloon above would not pass the laugh test.

Enlarged Expenses Can Hurt You

The people that work at the IRS are pretty smart, despite what you may mutter under your breath when filling out your tax return. They know that, by and large, people try their best not to overpay for anything. Because of this, the amount of a business expense is not generally questioned. However, there are occasions when the IRS will look more closely into very large business expenses (ones that are deemed unreasonably large).

Although the tax code itself does not contain any term relating to a business expense that is “too large,” the courts have generally ruled that Section 162 contains an inherent size exception. For example, while it may be ordinary and necessary for an executive of a multi-national company to rent a private jet to fly to meetings, it is ordinary and necessary for the owner of a start-up homemade crouton business to rent the same jet.

Personal Expenses are a No-No

Out of all of the concerns that the IRS has when it comes to Section 162 business expense deductions, there are none larger than the IRS’s concerns over personal expenses that are claimed as business expenses. As an example, you cannot deduct the cost of commuting to and from work as a business expense (the tax code specifically defines this as a personal expense). The same rules apply to situations where a business credit card is used on a personal vacation. Trying to claim personal expenses as business deductions happens more that you may think. Because of this, the IRS auditors are always checking.

However, there are certain arrangements that can be put in place that allows you to get personal benefits from your business expenses. You should ask your accountant about this if you are interested.

Stay Away From Relatives

You should always be careful when your business deals directly with your family. There have been many situations in the past where a small business owner would “pay” a family member, or a business that a family member has an ownership interest in. Although these transactions could be honest, there are other times when the payments are being made to hide business profits and use them for personal use. As an example, if you have your father-in-law on your business’ payroll at $20,000 a year as a consultant, it would be fine if he was your actual consultant. However, if your father-in-law has been in a coma for the past 10 years, the IRS is going to come down on you hard.

Free Consultation with a Utah Small Business Lawyer

If you are here, you probably have a business law issue you need help with, call Ascent Law for your free small business law consultation (801) 676-5506. We want to help you.