When it comes to your federal income taxes, all expenses are not treated equal. Many of the expenses you incur related to your business are deductible and reduce your taxable income and, in turn, your tax bill. But not every business expense is deductible. Here’s what you need to know about how to treat various expenses that can come up in the course of your business.
What are the general rules regarding which expenses are deductible?
According to the IRS, a deductible business expense must be ordinary and necessary. An expense that’s common and accepted in your particular industry is ordinary; a necessary expense is one that’s helpful and appropriate for your business.
How do I handle expenses that mix business and personal?
Not surprisingly, personal, living, and family expenses are non-deductible business expenses. But sometimes, you might have expenses for items or services that serve both business and personal expenses — your cell phone, Internet, or car, for example.
The IRS permits you to allocate the costs between business and personal use and deduct the business share. This can be easier said than done in some cases and often requires close tracking. For a motor vehicle, for example, you must allocate your expenses based on actual mileage. You may want to consult with a CPA for advice on how to reasonably allocate such expenses.
I’m just starting a business — are any of my expenses non-deductible?
Unfortunately, yes. The IRS generally considers costs incurred before you actually begin operations — for example, advertising, travel, or wages for employees going through training — to be capital expenses. (Once you’re up and running, you may qualify for numerous deductions.)
You can’t deduct the full amount of capital expenses in the tax year that you incur them. Instead, you typically recover the cost over a period of years through either:
- Depreciation: For fixed assets, such as land, building, or equipment, and certain intangible property like patents, copyrights, and computer software or
- Amortization: For goodwill and certain other intangible assets.
With both depreciation and amortization, you deduct a percentage of the expense every year for a prescribed period commonly known as the recovery period.
Note: Some newly purchased capital assets may qualify for so-called bonus depreciation or Sec. 179 expensing, which allows the business to deduct all or part of the cost in the year the property is placed in service.
But the IRS permits a limited deduction for certain start-up costs — up to $5,000 of start-up costs and $5,000 of organizational costs (for example, the costs of creating a corporation or partnership). The deduction is reduced by your total start-up or organizational costs that exceed $50,000, and you must amortize any remaining costs.
To qualify for the deduction, a start-up cost must be:
- A cost a business could deduct if it was paid or incurred to operate an existing, active business in the same field as the one you entered.
- A cost a business pays or incurs before the business activity begins.
Examples include the costs for:
- An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.
- Advertisements for the opening of the business
- Salaries and wages for employees who are being trained and their instructors
- Travel and other necessary costs for securing prospective distributors, suppliers, or customers
- Salaries and fees for executives and consultants or similar professional services
Interest, taxes, and research and experimental costs are non-deductible start-up costs.
What if my attempt to launch a new business fails?
When an individual strikes out, the costs incurred before acquiring or starting a specific business are personal and therefore non-deductible. Those costs might include expenses related to a general search for, or a preliminary investigation of, a business opportunity.
Costs related to your attempt to acquire or start a specific business are capital expenses, and you can deduct them as a capital loss. Corporations that fail in an effort to go into a new business may be able to deduct all of their investigatory costs as a loss.
Did you purchase certain assets (for example, land, office furniture, or franchise rights) as part of an unsuccessful attempt to start a business? You can’t claim a deduction for the costs; you’ll recover them only when you sell the assets.
Depends on how you define “travel.” Your expenses for commuting to and from your workplace are non-deductible. But expenses associated with traveling to a work-related meeting held away from the workplace generally are deductible.
There are limits, though. For example, if you bring your spouse or a friend with you on a business trip, their expenses are non-deductible.
Are entertainment expenses non-deductible?
Generally, you can’t claim a deduction for an entertainment event. This includes expenses for entertaining guests at:
- Social, athletic, and sporting clubs
- Sporting events
The costs of entertaining on yachts or hunting, fishing, vacation, and similar trips are also non-deductible.
In addition, you can’t deduct any expense for the use of an entertainment facility you own, rent, or use(for example, a pool, tennis court, airplane, or vacation home). This includes depreciation and operating costs such as rent, utilities, maintenance, and protection.
Note: When assessing an item that might be considered either a gift or entertainment, the IRS generally will deem it entertainment.
What about meal expenses?
Meal expenses are partially non-deductible. You generally can deduct only 50 percent of food and beverage costs. These expenses can’t be “lavish or extravagant,” and the taxpayer or an employee must be present.
You can deduct half of the expenses for food and beverages provided to a customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective. That means the deduction is available for employer-provided meals.
Note: The Consolidated Appropriations Act of 2021 allows a full 100 percent deduction for business meals in 2021 and 2022, as long they’re provided by a restaurant.
The partial deduction is also available for food or beverages provided at an entertainment activity if:
- The items are purchased (or logged) separately from the entertainment costs on one or more bill(s), invoice(s), or receipt(s).
- The amount charged reflects 1) the venue’s usual selling cost for such items purchased separately from the entertainment, or 2) the approximate reasonable value of the items.
Let’s say you buy tickets to take a client to a baseball game. While there, you buy him hot dogs and drinks. The tickets are non-deductible entertainment expenses, but you can deduct half of the cost of the dogs and drinks (with proper documentation, of course).
Or maybe you purchase tickets to take a client to a suite at a basketball game, and the price includes food and drinks. The ticket price is non-deductible — unless the invoice breaks out the cost of the food and drinks.
The 50-percent limit on business meal deductions generally doesn’t apply to:
- Expenses treated as compensation
- Reimbursed food and beverage expenses
- Expenses related to recreational, social, or similar activities for employees, such as holiday parties, that don’t favor highly compensated employees
- Items available to the public, as long as more than 50 percent of the actual or reasonably estimated consumption is by the general public, including customers, clients, and visitors.
- Goods and services sold to customers. For example, food or beverage items that are purchased as part of preparing and providing meals to a restaurant’s paying customers, which also are consumed at the worksite by staff.
So you can fully deduct all of these expenses.
Are club or membership dues non-deductible?
These clubs are generally considered non-deductible entertainment, whether organized for business, pleasure, recreation, or other social purposes. Specifically, a organization’s membership dues are non-deductible if one of the organization’s principal purposes is either:
- To conduct entertainment activities for members or their guests, or
- To provide members or their guests with access to entertainment facilities.
In other words, you can’t deduct dues paid to:
- Country clubs
- Golf and athletic clubs
- Airline clubs
- Hotel clubs
- Clubs operated to provide meals under circumstances generally considered to be conducive to business discussions
What about motor vehicles?
You generally must capitalize the cost of motor vehicles used in your business. You’ll recover the costs through annual depreciation deductions. Certain limits apply to how much you can deduct for such appreciation every year.
You can, however, deduct repair expenses for business vehicles.
Is the treatment different for repairs versus improvements?
Repairs to business assets like motor vehicles or buildings are deductible if they are part of routine maintenance to keep that asset in normal working condition. Improvements are non-deductible and must be capitalized.
An “improvement” is something that improves the asset, restores it, or adapts it to a new or different use. Rewiring a building, replacing a roof, or replacing a major component of a machine would be an improvement. But painting a building, repairing broken windows, or changing the oil on a vehicle is a deductible repair.
Note: Several types of improvements to non-residential property currently qualify for Sec. 179 expensing (deducting the entire cost), including roofs, HVAC, fire protection systems, alarm systems, and security systems.[BN5]
Are gifts non-deductible?
Not completely. You can spend as much as you like to give a loyal client or business associate a token of appreciation, but you cannot deduct more than $25 per recipient. Gifts to a customer’s family member generally are considered gifts to the customer.
What about political contributions and lobbying expenses?
Contributions or gifts paid to political parties or candidates are generally non-deductible, as are expenses paid or incurred to participate in any political campaign of a candidate for public office. It doesn’t matter if your support is based on a party’s or candidate’s policies directly related to your industry.
The rule applies to “indirect” political contributions, too, such as:
- Advertising in a program for a political party’s convention or a publication if any of the proceeds are for the party’s or candidate’s use
- Tickets for galas, dinners, and other events if any of the proceeds are for the party’s or candidate’s use
- Tickets to an inaugural ball or similar event that’s identified with a political party or candidate
Lobbying expenses generally are non-deductible, as well.