The goal of most tax planning is to defer the taxation of income into future tax years, while at the same time, accelerating deductions to the current year. Unlike individuals, a business can deduct most expenses it incurs; however, not all expenses can be deducted in full in the year the expense is incurred. In order for an expense to be deductible in full in the tax year it is incurred, it must meet the requirements of Section 162 of the Internal Revenue Code for a trade or business expense.
This post summarizes briefly the guidelines for determining whether expenses are deductible as trade or business expenses.
In general, an expense is deductible if (1) it is related to a trade or business, (2) it is ordinary and necessary, and (3) it is paid or incurred in carrying on a trade or business.
First, for an expense to be related to a trade or business, your activities must rise to the level of a trade or business and there must exist a connection between the activities and the expense. For your activities to constitute a trade or business, you must enter into the activity for the purpose of making a profit, and your activities must be substantial and sustained.
Second, the expense must be ordinary and necessary. An expense is ordinary if it is normal, usual, or customary in the type of business in which it is incurred. An expense is necessary if it is appropriate or helpful to the business. In addition, the expense must be reasonable and not lavish.
Third, the expense must be incurred in carrying on a trade or business. An individual is carrying on a trade or business only if he or she is actively engaged in the trade or business. Consequently, expenses relating to looking for a new trade or business, preparing for a new trade or business, or investigating the potential success of a new business are not deductible as ordinary and necessary business expenses. However, such expenses may, through an election, be deducted up to $5,000 and then amortized over a 15-year period as start-up expenditures.
Certain trade or business expenses are not deductible even if they satisfy these tests. For example, expenses that violate public policy, such as bribes, are not deductible. In addition, expenditures for capital assets are not deductible, though a depreciation, amortization, or depletion deduction may be allowed.
Some of the deduction rules are complex and require informed judgment to determine whether a particular expense is deductible. For this reason, the facts of your situation should be carefully reviewed. Please feel free to contact me anytime to arrange a meeting in which we can further discuss the tax consequences of your transactions during the preceding tax year.