March 1, 2016
By Craig W. Smalley, EA
Small-business owners often have questions about what expenses they can deduct on their taxes. But allowable business-expense deductions vary based on the type of business you are in.
The IRS states in tax code IRC §162(a) that deductions are allowed “for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
‘Ordinary and necessary’ But what exactly do “ordinary and necessary expenses” include? This, of course, also depends on your business. For instance, if you own a retail store, the IRS wouldn’t expect to see meals and entertainment expenses, travel expenses or auto expenses taken as tax deductions. However, if you are in sales, those expenses could be expected, based on the assumption that you would regularly take clients out to lunch, drive to meet with potential clients and perhaps even travel out of town. Additionally, if you are in construction, you might have higher contract-labor expenses than, say, a business that operates out of an office. That’s because companies with office workers typically pay employees a salary and withhold payroll taxes, whereas construction firms often use day labor.
In IRC §162, the following are listed as examples of ordinary and necessary business expenses: (1) a reasonable allowance for salaries or other compensation for personal services actually rendered; (2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and (3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.”
But further guidance from the IRS — stating that an expense that “enhances your business” is also deductible — adds a wrinkle. It might not be easy to tell a necessary or ordinary expense for your business from one that enhances it. Things that enhance your business may include continuing education; assets and equipment such as computers, desks and telephone systems; advertising; and, for some businesses, vehicles. (But, of course, some of those also could be considered necessary or ordinary for certain businesses.)
Common deductions
This can be murky territory for business owners. Naturally, there are different variables and thus different deductible expenses depending on the type of business you have. But the most common business-expense tax deductions are for vehicle expenses, office supplies, Internet costs, cell phone bills, home offices and meals. The type of business that you are in would determine the amounts that would be ordinary and necessary.
To deduct these expenses, you must make sure to keep very good records. For vehicle expenses, you have to keep a mileage log detailing the mileage used for business purposes. Many smartphone apps can help you track mileage. For meal expenses, keep the receipt and jot down the name of the client with whom you dined and what was discussed. For other deductions or for those you are uncertain about, it might be best to consult a tax advisor.
Questionable deductions But what happens if you deduct something that is questionable for your particular type of business? It doesn’t necessarily mean the IRS will audit you. Rather, a return may be selected for examination based on its Discriminant Function System (DIF) score, a computer-generated number given to each return. A DIF score essentially measures your tax return against other tax returns in your industry, comparing it with industry norms. The thought is that the higher the DIF score, the higher your chances are of being audited. So while you won’t automatically get audited for questionable deductions, it’s important to be as accurate as possible when deducting business expenses on your tax return. As a small-business owner, you must keep excellent records. And if you seek help from a tax professional, make sure to work with one who fully understands your line of business.
Craig Smalley is an enrolled agent and the founder of CWSEAPA LLP and Tax Crisis Center LLC.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.