US Income Tax/Business Deductions
Business pay income taxes on their profit, whether the business is a major corporation or a self-employed individual. This is achieved by deducting trade and business expenses from gross income (which is revenue from a business's perspective) to find adjusted gross income.
- 1 Trade and business defined
- 2 "Ordinary and necessary" defined
- 3 Business assets
- 4 Excluded business expenses
- 5 Business vs. personal
Trade and business defined
Trade and business deductions are provided by Section 162 of the Internal Revenue Code, but that section does not define the terms "trade" and "business." The current definition is provided by the Supreme Court's ruling in Commr. v. Groetzinger, 480 U.S. 23 (1987):
- To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity. The taxpayer's primary purpose for engaging in the activity must be for income or profit.
The "continuity and regularity" requirement distinguishes trade and business deductions from profit-seeking deductions, which are provided under Section 212. Profit-seeking deductions can be claimed for any activity engaged in for income or profit, whether the taxpayer is actively involved or not. The key difference between the two classes is that profit-seeking deductions are below the line, meaning they are applied against AGI, while trade and business deductions are above the line, meaning they are applied against gross income. Profit-seeking expenses must also be itemized, which is described in more detail later in this text, but practically means that they may not always benefit the taxpayer. Trade and business deductions, on the other hand, always apply against the taxpayer's income, assuming the taxpayer has income to deduct against.
"Ordinary and necessary" defined
To be deductible, Section 162(a) requires that trade and business expenses be "ordinary and necessary." Like "trade or business," the phrase "ordinary and necessary" is not defined by the statute. The Supreme Court has also failed to provide a definition for the term.
It is clear that ordinary and necessary business expenses exclude personal expenses and capital expenditures. Some courts have gone further to indicate that strange or arbitrary expenses are also not deductible.
Many expenses in consideration of assets are classified as capital expenditures, and are not deductible as business expenses. Instead, capital expenditures give a basis to the assets purchased, and that basis reduces the amount of income realized when the asset is sold.
Generally, any expenditure that creates or adds value to an asset that will be held for over a year is a capital expenditure. This is not a strict rule: minor assets incidental to a business, such as supplies, materials, furniture and books, may simply be deducted when they are purchased. But all significant assets to be held in the long term must be treated as capital expenditures.
Capital expenditures may also be required for expenses incidental to the acquisition of assets. This was established by the Supreme Court's opinion in INDOPCO v. Commr., 503 U.S. 79 (1992), which held that the legal and consulting fees for a corporate acquisition are considered capital expenditures. The IRS later established so-called "INDOPCO Regulations," which require capitalization of expenditures to acquire, create or enhance an intangible asset, as well as all expenditures incidental to such activity.
Improvements to a property are capital expenditures and affect basis. Repairs to property are normal business expenses which do not affect basis.
Because capitalization affects the basis of the asset in question, classifying an expense as a capital expenditure does not remove all of the tax benefit for that expense: capitalization "shifts" the tax benefit forward in time, so that it will be recognized as part of the gain or loss upon sale of the asset.
Some assets have a limited lifespan: they are known as wasting assets because they lose value over time. Machinery and buildings are examples of wasting assets. Artwork and land, on the other hand, are not wasting assets because their value generally stays constant or goes up over time. Capital expenditures on wasting assets give rise to a type of deduction called cost recovery.
Depreciation is the typical form of cost recovery for wasting assets. It provides a system for gradually deducting the cost of the asset over a fixed period. In addition to being a business deduction, depreciation also deducts from the basis of the asset. This means that a fully-depreciated asset has a basis of zero.
Since 1981, the main method of depreciation has been accelerated cost recovery. Property placed into service after 1986 is depreciated by the Modified Accelerated Cost Recovery System (MACRS), while property placed into service between 1981 and 1986 is depreciated by MACRS' predecessor, the Accelerated Cost Recovery System (ACRS).
Under MACRS, each asset is given a recovery period based on its "midpoint life" as determined by the IRS. The recovery periods are 3, 5, 7, 10, 15, and 20 years for various forms of personal property, 27.5 years for residential buildings, and 39 years for nonresidential buildings.
Depreciation always starts and stops at the midpoint of each year. A 10-year asset, for instance, receives half a year's worth of depreciation in the year it is purchased, then depreciates normally until year 11, when it receives another half a year's worth of depreciation (which should equal its remaining basis). This half-year rule is intended to keep taxpayers from benefiting disproportionately if they purchase assets late in the year.
There are two methods for calculating the actual depreciation. The straight line method is mandatory for real property, but can be voluntarily applied to any depreciable asset. Under the straight line method, the same percentage of the asset's basis is deductible each year. So a 10-year asset with a basis of $100,000 would be deductible by $5,000 in the first year, $10,000 each year from year 2 to year 10, and $5,000 in year 11.
Other assets use the declining balance method, which provides higher depreciation in initial years but lower depreciation in later years. 15 and 20-year assets use 150-percent declining balance, while other assets use 200-percent (double) declining balance.
Section 179 allows a limited amount of machinery and equipment to be "expensed," or deducted immediately. Expensing can be performed in lieu of depreciation, or it can be applied against the basis of an asset and the remainder can then be depreciated normally.
Section 179 makes a separate cost recovery provision for many intangible assets, including covenants not to compete, franchises, goodwill, government licenses, and trademarks. Such assets are amortizable over 15 years. Other intangibles can be amortized if the taxpayer can prove that they have a limited useful life.
Depletion is essentially depreciation for natural resources. It applies to mining and lumber operations which are likely to reduce the value of land over time.
Leveraged tax shelters
From the mid-1960s to the mid-1980s, many investors took advantage of cost recovery to create leveraged tax shelters, investments that provided a high rate of return by generating high cost recovery deductions that were passed on to investors. The classic tax shelter was a piece of real estate financed through "nonrecourse debt"—a loan secured against the property, such as a mortgage. The investor would put up a tiny portion of the purchase price, and then take cost recovery deductions every year until the property was fully depreciated. Often, they would recover their investment in the form of lower taxes within a few years.
Congress eventually created two rules to block leveraged tax shelters. The at-risk limitation, passed in the Tax Reform Act of 1976, established that the deductible loss of a taxpayer cannot exceed the amount with respect to which the taxpayer is actually "at risk." The limitation applies to all business and investment activities except real estate.
Congress added the passive activity loss limitation in the Tax Reform Act of 1986. Codified at Section 469, the rule states that deductions from passive business activities cannot be used to offset income from other sources. The rule essentially forces taxpayers to separate their "passive" business activities from their personal and "active" business activities, and only apply passive business losses against passive business income.
Excluded business expenses
Section 162 renders several types of business expenses non-deductible for "public policy" reasons.
Fines and penalties for illegal conduct are not deductible under Section 162(f). This rule includes civil and criminal penalties of all kinds, as well as similar private payments such as settlements and restitution.
Lobbying expenses are not deductible under Section 162(e), which bars deductions of expenses to influence legislation, political campaigns, referenda and executive decisions.
Bribery is also not deductible as a business expense. Section 162(c) specifically prohibits businesses from deducting illegal bribes to government officials, although bribes to foreign officials are deductible if they are permitted under the Foreign Corrupt Practices Act.
Section 280G prohibits deduction of "excess parachute payments," defined as payments to an executive contingent upon a change in ownership or control of a corporation, when such payments exceed three times the executive's average annual compensation over the past five years.
Section 280E prohibits deduction of business expenses incurred in illegal drug trafficking.
Business vs. personal
Some types of business expenses can be construed as having both business and personal purposes. In such cases, their deductibility is often limited.
Section 280A generally disallows business deductions for home offices, with a number of exceptions. A home office is deductible if it is exclusively used on a regular basis as the taxpayer's principal place of business, or by the taxpayer's clients for meeting or dealing with the taxpayer.
If a home office meets one of these exceptions, its proportion of the total expenses of the home can be deducted as business expenses. For instance, if the office constitutes twenty percent of the house's floor area, then twenty percent of the utility bills and insurance premiums would be deductible.
Travel, meals and entertainment
Business travel, including lodging, transportation and meals, is deductible under Section 162(a)(2) when the taxpayer is "away from home." "Home" is considered to mean the taxpayer's principal place of business, so this rule disallows deductions for commuting expenses. If the taxpayer has no such place of business, their "home" is their residence.
Transport, lodging and meals are deductible whenever the taxpayer is spending the night away from home. For trips that do not involve an overnight stay, transportation expenses are deductible so long as they are not commuting expenses between the taxpayer's residence and principal place of business. A doctor, for instance, can deduct the cost of traveling between hospitals and clinics, but cannot deduct the cost of traveling between residence and hospital or residence and clinic. Rev. Rul. 90-23, 1990-1 C.B. 28.
However, there are many restrictions on what employees are allowed to expense and deduct. Most of these restrictions are found in Section 274, which states that the following are nondeductible:
- Tickets purchased above face value (only deductible at face value).
- Skybox tickets (only deductible to an amount equal to the cost of box seats).
- Luxury water travel.
Entertainment expenses not directly related to the taxpayer's trade or business are generally not deductible, as are operating and membership expenses for entertainment facilities, such as sporting and social clubs. But such expenses can be deducted if they are provided as employee compensation or made available to the general public.
Meals and entertainment provided by employers to their employees are only deductible to 50 percent of their cost under Section 274(n). This restriction does not apply if the meal is considered a de minimis fringe, or if it is supplied to transportation workers subject to federal hours limits (e.g. aircrews and long-distance bus drivers).
Vehicles, computers and phones
Section 280F deals with vehicles, computers and phones, three types of property that are often provided by businesses to their employees, or used by self-employed individuals for their business. Such items are not depreciable under the usual accelerated system unless more than fifty percent of their use is for business. Use by employees must be for the employer's convenience and required as a condition of employment in order for such use to count as business use. "Profit-seeking" use is also not counted as business use.
Automobiles are subject to additional rules which greatly decelerate their depreciation. However, trucks, vans, ambulances, hearses and all vehicles over 6,000 pounds are not counted as "automobiles" for the purpose of this rule. This means that while a Rolls-Royce must be depreciated over a very long period, a Hummer can be depreciated over a relatively brief period.
Business uniforms are only deductible if they are unsuitable for ordinary wear outside the course of business. This leads to some seemingly arbitrary distinctions. The cost of military uniforms, for instance, cannot be deducted when the uniforms can be worn off duty. Fatigues, on the other hand, cannot be worn off duty, and therefore the cost of military fatigues is deductible. By similar logic, a performer can deduct the cost of a unique tuxedo they wear on stage; a lawyer cannot deduct the cost of a suit.