Table of Contents
This chapter covers the general rules for deducting business expenses. Business expenses are the costs of carrying on a trade or business, and they are usually deductible if the business is operated to make a profit.
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What you can deduct
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How much you can deduct
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When you can deduct
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Not-for-profit activities
Publication
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334 Tax Guide for Small Business
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463 Travel, Entertainment, Gift, and Car Expenses
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525 Taxable and Nontaxable Income
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529 Miscellaneous Deductions
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536 Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
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538 Accounting Periods and Methods
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542 Corporations
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547 Casualties, Disasters, and Thefts
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587 Business Use of Your Home
(Including Use by Daycare Providers) -
925 Passive Activity and At-Risk Rules
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936 Home Mortgage Interest
Deduction -
946 How To Depreciate Property
Form (and Instructions)
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Sch A (Form 1040) Itemized Deductions
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5213 Election To Postpone
Determination as To Whether the Presumption Applies That an
Activity Is Engaged in for Profit
See chapter 12 for information about getting publications and forms.
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. 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.
It is important to distinguish business expenses from:
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The expenses used to figure cost of goods sold,
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Capital expenses, and
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Personal expenses.
If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.
The following are types of expenses that go into figuring cost of goods sold.
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The cost of products or raw materials, including freight.
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Storage.
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Direct labor (including contributions to pension or annuity plans) for workers who produce the products.
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Factory overhead.
Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.
This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.
For more information, see the following sources.
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Cost of goods sold—chapter 6 of Publication 334.
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Inventories—Publication 538.
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Uniform capitalization rules—Publication 538 and section 263A of the Internal Revenue Code and the related regulations.
You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenses.” Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.
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Business start-up costs (See Tip below).
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Business assets.
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Improvements.
You can elect to deduct or amortize certain business start-up costs. See chapters 7 and 8.
The costs of getting started in business, before you actually begin business operations, are capital expenses. These costs may include expenses for advertising, travel, or wages for training employees.
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The costs you had before making a decision to acquire or begin a specific business. These costs are personal and nondeductible. They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility.
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The costs you had in your attempt to acquire or begin a specific business. These costs are capital expenses and you can deduct them as a capital loss.
There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must fully capitalize the cost of these assets, including freight and installation charges.
Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. See Regulations section 1.263A-2 for information on these rules.
The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. Improvements are generally major expenditures. Some examples are: new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements.
However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition.
To help you distinguish between capital and deductible expenses, different examples are given below.
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.
For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and generally is not deductible. See chapter 4 for information on deducting interest and the allocation rules.
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The business part of your home must be used exclusively and regularly for your trade or business.
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The business part of your home must be:
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Your principal place of business, or
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A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or
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A separate structure (not attached to your home) used in connection with your trade or business.
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You use the office exclusively and regularly for administrative or management activities of your trade or business.
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You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.
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The relative importance of the activities performed at each location.
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If the relative importance factor does not determine your principal place of business, consider the time spent at each location.
You can deduct the cost of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense.
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The money and adjusted basis of property you contribute to the activity.
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Amounts you borrow for use in the activity if:
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You are personally liable for repayment, or
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You pledge property (other than property used in the activity) as security for the loan.
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When you can deduct an expense depends on your accounting method. An accounting method is a set of rules used to determine when and how income and expenses are reported. The two basic methods are the cash method and the accrual method. Whichever method you choose must clearly reflect income.
For more information on accounting methods, see Publication 538.
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The all-events test has been met. The test is met when:
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All events have occurred that fix the fact of liability, and
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The liability can be determined with reasonable accuracy.
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Economic performance has occurred.
Example.
Your tax year is the calendar year. In December 2008, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $600. You paid it by check in January 2009. If you use the accrual method of accounting, deduct the $600 on your tax return for 2008 because all events have occurred to “fix” the fact of liability (in this case the work was completed), the liability can be determined, and economic performance occurred in that year.
If you use the cash method of accounting, deduct the expense on your 2009 return.
If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit.
The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:
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You carry on the activity in a businesslike manner,
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The time and effort you put into the activity indicate you intend to make it profitable,
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You depend on the income for your livelihood,
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Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
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You change your methods of operation in an attempt to improve profitability,
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You (or your advisors) have the knowledge needed to carry on the activity as a successful business,
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You were successful in making a profit in similar activities in the past,
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The activity makes a profit in some years, and
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You can expect to make a future profit from the appreciation of the assets used in the activity.
If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. If you are an individual, these deductions may be taken only if you itemize. These deductions may be taken on Schedule A (Form 1040).
Example.
Ida is engaged in a not-for-profit activity. The income and expenses of the activity are as follows.
Gross income | $3,200 | |
Subtract: | ||
Real estate taxes | $700 | |
Home mortgage interest | 900 | |
Insurance | 400 | |
Utilities | 700 | |
Maintenance | 200 | |
Depreciation on an automobile | 600 | |
Depreciation on a machine | 200 | 3,700 |
Loss | $(500) |
Ida must limit her deductions to $3,200, the gross income she earned from the activity. The limit is reached in category (3), as follows.
Limit on deduction | $3,200 | ||
Category 1: Taxes and interest | $1,600 | ||
Category 2: Insurance, utilities, and maintenance | 1,300 | 2,900 | |
Available for Category 3 | $ 300 |
The $800 of depreciation is allocated between the automobile and machine as follows.
$600 $800 | x | $300 | = | $225 | depreciation for the automobile |
$200 $800 | x | $300 | = | $75 | depreciation for the machine |
The basis of each asset is reduced accordingly.
Ida includes the $3,200 of gross income on line 21 of Form 1040.The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Ida deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted- gross-income limit.
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The degree of organizational and economic interrelationship of various undertakings.
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The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting.
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The similarity of the undertakings.
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