Expenses related to carrying on your trade or businesses are generally deductible if the business is operated to make a profit. To qualify as a deduction, a business expense must be reasonable and “ordinary and necessary”.
An ordinary expense 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.
Separate Business & Personal Expenses
It is important to separate your business expenses from other expenses such as personal expenses. Generally, you cannot deduct your personal expenses. However, if an expense for something used for both personal and business purposes, you can deduct expenses related to the business portion of its use. For example, if you borrow money and use three quarters of it for your business and the other quarter for personal use, you can deduct three quarters of the interest paid that tax year as a business expense.
Costs and Capital Expenses
Costs related to your investment in your business must also be treated differently than business expenses. Capital expenses are considered assets and must be capitalized rather than deducted. There are generally three types of costs that are capitalized:
- business start-up costs related to creating or acquiring an active trade or business (including franchise fees);
- business assets including equipment and land;
- and improvements to your business.
Another set of expenses that should not be included in your business deductions are expenses for the cost of goods sold. Businesses that manufacture products or purchase them for resale must value inventory at the beginning and end of each tax year to determine the cost of goods sold. This cost is deducted from gross receipts to figure the gross profit for the year. Cost of goods sold expenses include:
- the costs of raw materials and their storage and transportation;
- direct labor to produce the product(s);
- and factory overhead.
These expenses have already been deducted and therefore cannot be deducted again as a business expense.
The uniform capitalization rules indicate that the direct costs and part of the indirect costs for certain production or resale activities must also be capitalized. This rule does not apply to personal property acquired for resale for taxpayers with an average gross income of less than $10 million for the preceding 3 tax years.
The following are some of the most common types of business deductions:
- Business Use of Your Car & Home;
- Employees’ Pay;
- Retirement Plans;
- Rent Expense;
- Interest, Taxes and Insurance.
Some other less common types of expenses qualify as deductions. For example, bad debts directly related to sales or services provided by your business and previously reported as income qualify as business deductions.
Note however, that if such an expense is deducted but the amount is subsequently recovered, that amount must be then considered as income for the tax year in which it was collected. Other qualified business expense deductions include amortization of the costs of pollution-control facilities, research and experimentation, other intangibles including goodwill, and Gulf Opportunity Zone clean-up costs.
Additional information can be found at www.irs.gov in Publication 535 (Business Expenses).
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