When Is A Business Expense A Tax Deduction?

During tough economic times, everyone always tries to reduce expenses and increase savings. Believe it or not — one government agency actually rewards you for spending. The reward comes in the form of more tax savings — not increased income, mind you, but more savings. Okay, you are probably reading the foregoing sentences again as if there was something you missed or perhaps, a typo error on my part. Well, you heard it — rather, read it right. The more you spend, the more of your money you can save (after taxes and expenses), thanks to my favorite government agency, the IRS, and its backbone, the Internal Revenue Code (Title 26 of the United States Code).

The More Expenses You Have, The Higher Your Tax Deductions

The Tax Code allows deductions for ordinary and necessary expenses. Section 162 of the Tax Code allows deductions for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. So theoretically, the more business expenses one incurs, the more deductions. More deductions result in more tax savings.

Let’s run through that once again. If you have more expenses to deduct, then your tax base upon which the IRS will determine or peg a tax rate, becomes smaller. This translates into the taxpayer paying less taxes and keeping more of his income (after expenses).



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Most of us understand the basic principle of deductions or deductible expenses. But let’s dissect what it takes to consider a business expense as a tax deduction. To be deductible, the expense must be ordinary and necessary, according to the TC (the nickname of the Tax Code above). Take note of the use of the conjunction “and” as distinguished from “or.”

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When Is A Business Expense A Tax Deduction?

Ordinary expenses are those that are accepted and common.

Now if one habitually incurs a certain expense in the course of operating a business, does that mean the expense is ordinary? (Thus, meeting half of the formula to make it deductible?) Not so. The inquiry employed here in determining ordinariness is not subjective (or based on what one actually does in his business) but rather, objective (or taking into account the norms, customs and what is common among those engaged in a particular business or industry).

Here’s an interesting case study: In one US Supreme Court case, a taxpayer worked for a company that was engaged in the grain business. The company went bankrupt. Its suppliers and creditors were naturally upset. Then the taxpayer was later hired by another company engaged in a similar business as the bankrupt company. In order to reestablish his association with the previous creditors of the bankrupt grain company, the taxpayer decided to pay them back from his personal funds. He paid them the amount equivalent to the claims they had against the defunct grain business to make them whole.

The taxpayer now sought to deduct such payments as business expenses. Care to surmise what happened next? Well, the IRS overruled these tax deductions, and this ruling was affirmed by the US Supreme Court. The court reasoned that the payment of debts of others may be performed, but these were not ordinary expenses. They were more like extraordinary expenses. In fact, since these payments were done to reestablish good relations, they were more akin to purchasing goodwill, which is treated like a capital asset. Money spent in acquiring capital assets are not ordinary expenses.

Necessary expenses are those that are appropriate and helpful.

This is the other half of the formula to turn an expense into a deductible one. This particular condition is actually easier to establish. An expense is necessary if it is appropriate and helpful. What makes this easier to prove is that only the activities of the particular business are considered. There’s no need to prove customs or norms generally accepted in the industry. Businesses rarely make expenditures that are not appropriate and helpful.

Examples of expenses that exemplify the appropriate and helpful factors are those made to prolong the life of a capital asset, increasing its value or making it adaptable to a different use. Repairs and maintenance expenses are among the common types of necessary expenses.

Another case study: In one US Supreme Court case, a meat packing company situated near an oil refinery was adversely affected by the seepage of oil into its basements from the refinery. The meat company lined the basement walls with concrete to prevent further seepage. Consequently, the meat company claimed the expenses to fix its walls as deductions. But the IRS overruled the claim: they reasoned that this was a capital improvement and should be recovered through depreciation. But what did the US Supreme Court rule? They found in favor of the meat packing company. They found that the expenses were made for the purpose of restoring property to a sound state, or for keeping the property in an ordinarily efficient operating condition.

Well this explains the fundamentals of business deductions. Good luck with figuring out which of your business expenses are tax deductible!



Contributing Writer: Earl Fischer

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