There are so many different kinds of business operating expenses that the tax code couldn’t possibly list them all. Instead, if you want to deduct an item as a business operating expense, you must make sure the expenditure meets certain requirements. This post is aimed to cover basic rules for deducting business operating expenses—expenses virtually every business incurs for things like rent, supplies, and salaries. If you don’t maintain an inventory or buy expensive equipment, these day-to-day costs will probably be your largest category of business expenses (and your largest source of deductions). Read on…
To be deductible qualified, the expense must be:
- Ordinary and necessary
- A current expense
- Directly related to your business, and
- Reasonable in amount (IRC 162)
We are going to discuss those requirements in details. But before that, it is worth mentioning a basi requirement should be met; your business must have begun. Read on…
Your Business must Have Begun
You must be carrying on a business to have deductible operating expenses. Costs you incur before your business is up and running are not currently deductible operating expenses, even if they are ordinary and necessary. However, up to $5,000 in start-up expenses may be deducted the first year you’re in business, with the remainder deducted over the next 15 years.
Below exhibit may help you to map the requirement easier:
Requirement-1. Ordinary and Necessary
The first requirement is that the expense must be ordinary and necessary. This means that the cost is common and “helpful and appropriate” for your business. The expense doesn’t have to be indispensable to be necessary; it need only help your business in some way—even if it’s minor. A one-time expenditure can be ordinary and necessary.
Example: Marilyn, a dentist, buys a television set and installs it in her dental office waiting room so patients can watch TV while waiting for their appointments. Although having a TV set in her waiting room is not an indispensable item for Mari’s dental business, it is helpful; some patients might prefer to see Connie instead of another dentist because they can watch TV while they wait. Therefore, the TV is an ordinary and necessary expense for Mari’s dental practice.
It’s usually fairly easy to figure out whether an expense passes the ordinary and necessary test. Some of the most common types of operating expenses include:
- Rent for an outside office
- Employee salaries and benefits
- Equipment rental
- Legal and accounting fees
- Car and truck expenses
- Travel expenses
- Meal and entertainment expenses
- Supplies and materials
- Repair and maintenance
- Business taxes
- Interest on business loans
- Banking fees
- Advertising costs
- Home office expenses
- Business-related education expenses
- Professional association dues
- Business liability and property
- Health insurance for employees
- Office utilities, and
- Software used for business
Generally, the IRS won’t second-guess your claim that an expense is ordinary and necessary, unless the item or service clearly has no legitimate business purpose.
The following exhibit lists the 15 most common operating expenses claimed by sole proprietor small business owners earning between $25,000 and $100,000 (2001).
15 most Common Operating expenses for Small Businesses
1. Car and truck expenses 81%
2. Utilities 68%
3. Supplies (other than office supplies) 60%
4. Office supplies 60%
5. Legal and professional services 60%
6. Insurance 54%
7. Taxes 51%
8. Meals and entertainment 47%
9. Advertising 43%
10. Repairs 40%
11. Travel 31%
12. Rent on business property 26%
13. Home office 21%
14. Rent on equipment and machinery 21%
15. Interest 18%
Note: % is percentage of business owners who claimed the expense
[Source: Information on Expenses Claimed by Small Business Sole Proprietor ships, General Accounting Office 04-304; January 2004].
Requirement-2. Current Expenses
Only current expenses are deductible as business operating expenses. Current expenses are costs for items that will benefit your business for less than one year. These are the costs of keeping your business going on a day-to-day basis, including money you spend on items or services that get used up, wear out, or become obsolete in less than one year.
A good example of a current expense is your business’s monthly phone bill, which benefits your business for one month. In contrast, buying a telephone for your business would be a capital expense (not a current expense) because the phone will benefit your business for more than one year. Other common current expenses include office supplies, repairs, and monthly rent.
Current expenses are currently deductible—that is, they are fully deductible in the year in which you incur them. Because all business operating expenses are current expenses, they are also all currently deductible. However, the annual deductions for some operating expenses (notably home offices) are limited to the amount of profits you earn from the business in that year. Items you buy for your business that last for more than one year (capital expense items) must be depreciated over several years or deducted in one year under section 179.
An expense must be directly related to your business to be deductible as a business operating expense. This means that you cannot deduct personal expenses. For example, the cost of a personal computer is a deductible operating expense only if you use the computer for business purposes; it is not deductible if you use it to pay personal bills or play computer games. if you buy something for both personal and business use, you can deduct only the business portion of the expense. For example, if you buy a cellular phone and use it half of the time for business calls and half of the time for personal calls, you can deduct only half of the cost of the phone as a business expense.
A business expense for one person can be a personal expense for another, and vice versa. For example, a professional screenwriter could probably deduct the cost of going to movies—he needs to see movies for his screenwriting business. But a salesperson could not deduct this type of expense.
Many expenses have both a personal and business component, which can make it difficult to tell if an expense is business-related. Because of this, the business-related requirement is usually the most challenging factor in determining whether an expense qualifies as a deductible business operating expense.
Even the most straightforward costs can present difficulties. For example: it’s usually easy to tell whether postage is a personal or business expense. If you mail something for your business, it’s a business expense; if you mail something unrelated to your business, it’s a personal expense. But even here, there can be questions. For example: should a doctor be allowed to deduct the postage for postcards he sends to his patients while he is on vacation in Europe? (yes—the tax court said the postage was deductible as an advertising expense; Duncan v. Commissioner, 30 TC 386 (1958)).
The IRS has created rules and regulations for some of the more common operating expenses that often involve a difficult crossover of personal and business. Some of these rules help by laying out guidelines for when an expense is and isn’t deductible. Others impose record -keeping and other requirements to prevent abuses by dishonest taxpayers. Most of the complexity in determining whether an expense is deductible as a business operating expense involves understanding and applying these special rules and regulations.
The expenses that present the most common problems (and are subject to the most comprehensive IRS rules and regulations) include:
- home office expenses
- meals and entertainment
- car and truck expenses
- business gifts
- bad debts
- employee benefits
- interest payments
- health insurance
- casualty losses
- taxes, and
- education expenses
Trough these rules and regulations, the IRS provides guidance on the following types of questions:
- If you rent an apartment and use part of one room as a business office, should you be allowed to deduct all or a portion of the rent as a business operating expense? How much of the room has to be used as an office (and for what period of time) for it to be considered used for business rather than personal purposes?
- Can you deduct the money you spend on a nice suit to wear to your office?
- Can you deduct the cost of driving from home to your business office?
- Can you deduct the cost of a lunch with a former client or customer? Does it matter whether you actually talk about business at the lunch?
Subject to some important exceptions, there is no limit on how much you can deduct, as long as the amount is reasonable and you don’t deduct more than you spend. as a rule of thumb, an expense is reasonable unless there are more economical and practical ways to achieve the same result. If the IRS finds that your deductions are unreasonably large, it will disallow them or at least disallow the portion it finds un-reasonable. Whether a deduction is reasonable depends on the circumstances.
In one case, the IRS found that it was unreasonable for an aircraft controller to spend over $17,000 to buy a plane to learn to fly, when he could have learned to fly just as well (but far more cheaply) by renting a plane. On the other hand, it was reasonable for a shopping center developer to pay to keep a charter plane on 24-hour standby when the plane had to be available at a moment’s notice to transport prospective tenants to a building site.
Certain areas are hot buttons for the IRS—especially car, entertainment, travel, and meal expenses. There are strict rules requiring you to fully document these deductions. The reasonableness issue also comes up when a business pays excessive salaries to employees to obtain a large tax deduction. For example, a business owner might hire his 12-year-old son to answer phones and pay him $50 an hour—clearly an excessive wage for this type of work.
For some types of operating expenses, the IRS limits how much you can deduct. These include:
- The home office deduction, which is limited to the profit from your business (although you can carry over and deduct any excess amount in future years)
- Business meals and entertainment, which are only 50% deductible
- Travel expenses, which are limited depending on the length of your trip and the time you spent on business while away, and business gifts, which are subject to a $25 maximum per individual per year.
Operating expenses That Are Not Deductible
Even though they might be ordinary and necessary, some types of operating expenses are not deductible under any circumstances. In some cases, this is because congress has declared that it would be morally wrong or otherwise contrary to sound public policy to allow people to deduct these costs. In other cases, congress simply doesn’t want to allow the deduction.