I. Introduction to Business Expenses
A. According to the Internal Revenue Code (IRC), “a business expense must be both ordinary and necessary,” to be deductible. The IRC further states, “an ordinary expense is one that is common and accepted in your trade or business. 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.”
Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.
II. Common Business Expenses/Topics/Issues
A. Home Office Deduction:
Generally, to deduct the business use of a home, four tests have to be met: (1) Part of the home is used in connection with a trade or business; (2) Not using the part of home as an employee; (3) The use of the home is regular and exclusive; and (4) The home is the principal place of business
1. To qualify under the trade-or-business-use test, you must use part of your home in connection with a trade or business. If you use your home for a profit-seeking activity that is not a trade or business (e.g., research on stocks and financial planning for personal investments), you cannot take a deduction for its business use.
2. To qualify under the regular use test, you must use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use.
You must consider all facts and circumstances in determining whether your use is on a regular basis.
3. To qualify under the exclusive use test, you must use a specific area of your home only for your trade or business. The area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition.
You do not meet the requirements of the exclusive use test if you use the area in question both for business and for personal purposes. For example, a playwright composes her work and communicates with performance artists from a laptop at her kitchen table. The playwright also eats her meals at the kitchen table. She cannot deduct the use of her entire kitchen because she uses the kitchen for personal, domestic purposes and not exclusively for her trade and business as a playwright. She could possibly deduct the size of the kitchen table as a home use office if she does not eat her meals there or use it for any other personal reasons.
4. To qualify to deduct the expenses for the business use of your home under the principal place of business test, your home must be your principal place of business for that trade or business. To determine whether your home is your principal place of business, you must consider:
(a) The relative importance of the activities performed at each place where you conduct business, and
(b) The amount of time spent at each place where you conduct business.
Your home office will qualify as your principal place of business if you meet the following requirements.
B. Business Travel:
According to the IRC, “travel expenses are the ordinary and necessary expenses of traveling away from home for your business, profession, or job. You can't deduct expenses that are lavish or extravagant, or that are for personal purposes.” Furthermore, the IRC states, “you're traveling away from home if your duties require you to be away from the general area of your tax home for a period substantially longer than an ordinary day's work, and you need to get sleep or rest to meet the demands of your work while away.”
1. Generally, your tax home is the entire city or general area where your main place of business or work is located, regardless of where you maintain your family home. In determining your main place of business, take into account the (1) length of time you normally need to spend at each location for business purposes, (2) the degree of business activity in each area, and (3) the relative significance of the financial return from each area. However, the most important consideration is the length of time you spend at each location.
For example, a soprano maintains a residence with her girlfriend in Los Angeles. The soprano also rents an apartment in Houston, where she has a multi-year contract to perform at a symphony in the city for nine months out of the year. The income earned from this contract represents 90% of her annual income. She travels back and forth from Los Angeles to Houston at least a couple of times a month to spend time with her girlfriend.
In this scenario, the soprano’s tax home is Houston, not Los Angeles, even though she maintains a residence in Los Angeles with her girlfriend. This determination was made because: (1) she’s in Houston primarily to work; (2) she works in Houston for nine months out of the year; and (3) a substantial portion of her income is earned in Houston. As such, the money spent for travel between Los Angeles and Houston, rent on the apartment in Houston, and food consumed in Houston is not deductible. In essence, the soprano is maintaining two personal residences in two different cities and the travel between the two cities is deemed to be a personal expense, not a business expense.
The 2017 Tax Cuts and Jobs Act (TCJA) eliminated the deduction for any expenses related to activities generally considered entertainment, amusement, or recreation. Taxpayers may continue to deduct 50 percent of the cost of business meals if the taxpayer (or an employee of the taxpayer) is present and the food or beverages are not considered lavish or extravagant. The meals may be provided to a current or potential business customer, client, consultant, or similar business contact.
Food and beverages that are provided during entertainment events will not be considered entertainment if purchased separately from the event.
Prior to 2018, a business could deduct up to 50 percent of entertainment expenses directly related to the active conduct of a trade or business or, if incurred immediately before or after a bona fide business discussion, associated with the active conduct of a trade or business.
For example, a financial advisor takes out potential clients to a Chicago Bulls game. He pays for all the tickets and food and beverages consumed at the game. After the game, the financial advisor and potential clients meet up at a restaurant for dinner to discuss business.
Here, the tickets to the game and the food and beverages consumed at the game are considered entertainment expenses and not deductible. However, the dinner is deductible since it is considered to be a business meal.
D. Work Clothing:
Work clothes are deductible if the following two tests are met: (1) the clothes are worn as a condition of employment and (2) the clothes are not suitable for everyday wear. Most taxpayers will fail the second test. For example, consider a trial attorney who is required to wear a suit to work every day because courts require attorneys to wear suits. (FYI, it does not matter whether the trial attorney is employed or self-employed). Even though a suit is required for work, the suit is still suitable for everyday wear. The attorney can wear the suit to a party, funeral, formal event, etc. It does not matter that the trial attorney would not be caught dead wearing a suit outside of work. If the clothing is suitable for everyday wear, it’s not deductible. An example of work clothing that would be deductible is someone who works as a clown. A clown is required to work as a clown, and the clown suit is not suitable for everyday wear (i.e., you would not wear it to a funeral or go grocery shopping in it.)
E. Business Start-Up and Organizational Costs:
Business start-up and organizational costs are generally capital expenditures. However, you can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs paid or incurred after October 22, 2004. The $5,000 deduction is reduced by the amount your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized.
Start-up costs include any amounts paid or incurred in connection with creating an active trade or business or investigating the creation or acquisition of an active trade or business. Organizational costs include the costs of creating a corporation or partnership.
F. Business Use Vehicle Deduction:
Business owners can use either the standard mileage rate or actual car expenses when calculating their business use vehicle deduction. The standard mileage rate is a fixed amount deduction per mile set by the IRS. Actual car expenses include depreciation, licenses, lease payments, registration fees, gas, insurance, repairs, oil, garage rent, tires, tolls, and parking fees. Generally, the standard mileage rate offers a great business deduction.
Keep in mind, if you want to use the standard mileage rate for a car you own, you must choose to use it in the first year the car is available for use in your business. Then, in later years, you can choose to use either the standard mileage rate or actual expenses.
G. Self-Employed Retirement Plan Contribution and Deduction:
If you are self-employed (a sole proprietor or a working partner in a partnership or limited liability company), you must use a special rule to calculate retirement plan contributions for yourself.
Retirement plan contributions are often calculated based on participant compensation. For example, you might decide to contribute 10% of each participant's compensation to your SEP plan. This formula works to determine employees' allocations, but your own contributions are more complicated. You cannot simply multiply your net profit on Schedule C by 10%.
Total limits on plan contributions depend in part on your plan type. A limit also applies to the amount of annual compensation you can consider for determining retirement plan contributions.
Plan contributions for a self-employed individual are deducted on Form 1040 (on the line for self-employed SEP, SIMPLE, and qualified plans) and not on the Schedule C. If you made the deduction on Schedule C, or made and deducted more than your allowed plan contribution for yourself, you must amend your Form 1040 tax return and Schedule C.
H. Self-Employed Health Insurance Deduction:
You may be able to deduct the amount you paid for medical and dental insurance and qualified long-term care insurance for yourself, your spouse, and your dependents. One of the following statements must be true:
(1) You were self-employed and had a net profit for the year reported on Schedule C (Form 1040 or 1040-SR) or Schedule F (Form 1040 or 1040-SR).
(2) You were a partner with net earnings from self-employment for the year reported on Schedule K-1 (Form 1065), box 14, code A.
(3) You used one of the optional methods to figure your net earnings from self-employment on Schedule SE.
(4) You received wages in 2019 from an S corporation in which you were a more-than-2% shareholder. Health insurance premiums paid or reimbursed by the S corporation are shown as wages on Form W-2.
I. Business or Hobby Deductions:
The main difference between a business and a hobby is that people who start a business set out to make a profit. On the other hand, people engage in a hobby for sport or recreation, not to make profit. As such, hobby deductions are not considered a business expense and they cannot be deducted on a business return.
To distinguish whether you have a legitimate business or hobby, consider all facts and circumstances with respect to the activity. A hobby activity is an activity not done for profit. This includes activities done mainly for sport, recreation, or pleasure. No one factor alone is decisive. You must generally consider these factors in determining whether an activity is a business engaged in making a profit:
(1) Whether you carry on the activity in a businesslike manner and maintain complete and accurate books and records.
(2) Whether you have personal motives in carrying on the activity.(3) Whether the time and effort you put into the activity indicate you intend to make it profitable.
(4) Whether you depend on income from the activity for your livelihood.
(5) Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
(6) Whether you or your advisors have the knowledge needed to carry on the activity as a successful business.
(7) Whether you were successful in making a profit in similar activities in the past.
(8) Whether the activity makes a profit in some years and how much profit it makes.
(9) Whether you can expect to make a future profit from the appreciation of the assets used in the activity.