Business Expenses and Deductions
What Can I Deduct?
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. 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.
Even though an expense may be ordinary and necessary, you may not be allowed to deduct the expense in the year you paid or incurred it. In some cases you may not be allowed to deduct the expense at all. Therefore, it is important to distinguish usual business expenses from expenses that include the following.
The expenses used to figure cost of goods sold.
Cost of Goods Sold
If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.
The following are types of expenses that go into figuring cost of goods sold.
The cost of products or raw materials, including freight.
Direct labor (including contributions to pension or annuity plans) for workers who produce the products.
Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.
This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.
For more information, see the following sources.
Cost of goods sold—chapter 6 of Pub. 334.
Uniform capitalization rules—Pub. 538 and section 263A of the Internal Revenue Code and the related regulations.
You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenses.” Capital expenses are considered assets in your business. In general, you capitalize three types of costs.
Business start-up costs (See Tip below).
You can elect to deduct or amortize certain business start-up costs. See chapters 7 and 8.
Cost recovery. Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount you spend through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are able to recover your capital expense. See Amortization (chapter 8) and Depletion (chapter 9) in this publication. A taxpayer can elect to deduct a portion of the costs of certain depreciable property as a section 179 deduction. A greater portion of these costs can be deducted if the property is qualified disaster assistance property. See Pub. 946 for details.
Going Into Business
The costs of getting started in business, before you actually begin business operations, are capital expenses. These costs may include expenses for advertising, travel, or wages for training employees.
If you go into business. When you go into business, treat all costs you had to get your business started as capital expenses.
Usually you recover costs for a particular asset through depreciation. Generally, you cannot recover other costs until you sell the business or otherwise go out of business. However, you can choose to amortize certain costs for setting up your business. See Starting a Business in chapter 8 for more information on business start-up costs.
If your attempt to go into business is unsuccessful. If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories.
The costs you had before making a decision to acquire or begin a specific business. These costs are personal and nondeductible. They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility.
The costs you had in your attempt to acquire or begin a specific business. These costs are capital expenses and you can deduct them as a capital loss.
If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss.
The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. You cannot take a deduction for these costs. You will recover the costs of these assets when you dispose of them.
There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must fully capitalize the cost of these assets, including freight and installation charges.
Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. See Regulations section 1.263A-2 for information on these rules.
Improvements are generally major expenditures. Some examples are new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements.
Generally, you must capitalize the costs of making improvements to a business asset if the improvements result in a betterment to the unit of property, restore the unit of property, or adapt the unit of property to a new or different use.
However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition.
Restoration plan. Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. This applies even if some of the work would by itself be classified as repairs.
Capital Versus Deductible Expenses
To help you distinguish between capital and deductible expenses, different examples are given below.
Motor vehicles. You usually capitalize the cost of a motor vehicle you use in your business. You can recover its cost through annual deductions for depreciation.
There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. See Pub. 463.
Generally, repairs you make to your business vehicle are currently deductible. However, amounts you pay to recondition and overhaul a business vehicle are capital expenses and are recovered through depreciation.
Roads and driveways. The cost of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. The cost of maintaining a private road on your business property is a deductible expense.
Tools. Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor.
Machinery parts. Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense.
Heating equipment. The cost of changing from one heating system to another is a capital expense.
Personal Versus Business Expenses
Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.
For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you generally can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and generally is not deductible. See chapter 4 for information on deducting interest and the allocation rules.
Business use of your home. If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation.
To qualify to claim expenses for the business use of your home, you must meet both of the following tests.
The business part of your home must be used exclusively and regularly for your trade or business.
The business part of your home must be:
Your principal place of business; or
A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business; or
A separate structure (not attached to your home) used in connection with your trade or business.
You generally do not have to meet the exclusive use test for the part of your home that you regularly use either for the storage of inventory or product samples, or as a daycare facility.
Your home office qualifies as your principal place of business if you meet the following requirements.
You use the office exclusively and regularly for administrative or management activities of your trade or business.
You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.
If you have more than one business location, determine your principal place of business based on the following factors.
The relative importance of the activities performed at each location.
If the relative importance factor does not determine your principal place of business, consider the time spent at each location.
Optional safe harbor method. Individual taxpayers can use the optional safe harbor method to determine the amount of deductible expenses attributable to certain business use of a residence during the tax year. This method is an alternative to the calculation, allocation, and substantiation of actual expenses.
The deduction under the optional method is limited to $1,500 per year based on $5 a square foot for up to 300 square feet. Under this method, you claim your allowable mortgage interest, real estate taxes, and casualty losses on the home as itemized deductions on Schedule A (Form 1040). You are not required to allocate these deductions between personal and business use, as is required under the regular method. If you use the optional method, you cannot depreciate the portion of your home used in a trade or business.
Business expenses unrelated to the home, such as advertising, supplies, and wages paid to employees, are still fully deductible. All of the requirements discussed earlier under Business use of your home still apply.
For more information on the deduction for business use of your home, including the optional safe harbor method, see Pub. 587.
If you were entitled to deduct depreciation on the part of your home used for business, you cannot exclude the part of the gain from the sale of your home that equals any depreciation you deducted (or could have deducted) for periods after May 6, 1997.
Business use of your car. If you use your car exclusively in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. Generally, commuting expenses between your home and your business location, within the area of your tax home, are not deductible.
You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. Or, instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. Beginning in 2015, the standard mileage rate is 57.5 cents per mile.
If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate.
For more information on car expenses and the rules for using the standard mileage rate, see Pub. 463.
How Much Can I Deduct?
Generally, you can deduct the full amount of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense.
Recovery of amount deducted (tax benefit rule). If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current year expense by the amount of the recovery. If you have a recovery in a later year, include the recovered amount in income in that year. However, if part of the deduction for the expense did not reduce your tax, you do not have to include that part of the recovered amount in income.
For more information on recoveries and the tax benefit rule, see Pub. 525.
Payments in kind. If you provide services to pay a business expense, the amount you can deduct is limited to your out-of-pocket costs. You cannot deduct the cost of your own labor.
Similarly, if you pay a business expense in goods or other property, you can deduct only what the property costs you. If these costs are included in the cost of goods sold, do not deduct them again as a business expense.
Limits on losses. If your deductions for an investment or business activity are more than the income it brings in, you have a loss. There may be limits on how much of the loss you can deduct.
Not-for-profit limits. If you carry on your business activity without the intention of making a profit, you cannot use a loss from it to offset other income. See Not-for-Profit Activities , later.
At-risk limits. Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have “at risk” in the activity. You are at risk in any activity for the following.
The money and adjusted basis of property you contribute to the activity.
Amounts you borrow for use in the activity if:
You are personally liable for repayment, or
You pledge property (other than property used in the activity) as security for the loan.
For more information, see Pub. 925.
Passive activities. Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate, or a rental activity. In general, deductions for losses from passive activities only offset income from passive activities. You cannot use any excess deductions to offset other income. In addition, passive activity credits can only offset the tax on net passive income. Any excess loss or credits are carried over to later years. Suspended passive losses are fully deductible in the year you completely dispose of the activity. For more information, see Pub. 925.
Net operating loss. If your deductions are more than your income for the year, you may have a “net operating loss.” You can use a net operating loss to lower your taxes in other years. See Pub. 536 for more information.
See Pub. 542 for information about net operating losses of corporations.
When Can I Deduct an Expense?
When you can deduct an expense depends on your accounting method. An accounting method is a set of rules used to determine when and how income and expenses are reported. The two basic methods are the cash method and the accrual method. Whichever method you choose must clearly reflect income.
For more information on accounting methods, see Pub. 538.
Cash method. Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them.
Accrual method. Under an accrual method of accounting, you generally deduct business expenses when both of the following apply.
The all-events test has been met. The test is met when:
All events have occurred that fix the fact of liability, and
The liability can be determined with reasonable accuracy.
Economic performance has occurred.
Economic performance. You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.
Your tax year is the calendar year. In December 2015, the Field Plumbing Company did some repair work at your place of business and sent you a bill for $600. You paid it by check in January 2016. If you use the accrual method of accounting, deduct the $600 on your tax return for 2015 because all events have occurred to “fix” the fact of liability (in this case, the work was completed), the liability can be determined, and economic performance occurred in that year.
If you use the cash method of accounting, deduct the expense on your 2016 return.
Prepayment. You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.
In 2015, you sign a 10-year lease and immediately pay your rent for the first 3 years. Even though you paid the rent for 2015, 2016, and 2017, you can only deduct the rent for 2015 on your 2015 tax return. You can deduct the rent for 2016 and 2017 on your tax returns for those years.
Contested liability. Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under the accrual method, you can deduct contested liabilities such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes) either in the tax year you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. However, to take the deduction in the year of payment or transfer, you must meet certain conditions. See Regulations section 1.461-2.
Related person. Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet paid them. However, if you and the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can deduct it. Your deduction is allowed when the amount is includible in income by the related cash method payee. See Related Persons in Pub. 538.
If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income. Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit.
The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.
In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone is decisive. Among the factors to consider are whether:
You carry on the activity in a businesslike manner,
The time and effort you put into the activity indicate you intend to make it profitable,
You depend on the income for your livelihood,
Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
You change your methods of operation in an attempt to improve profitability,
You (or your advisors) have the knowledge needed to carry on the activity as a successful business,
You were successful in making a profit in similar activities in the past,
The activity makes a profit in some years, and
You can expect to make a future profit from the appreciation of the assets used in the activity.
Presumption of profit. An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least 2 of the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period. You have a profit when the gross income from an activity exceeds the deductions.
If a taxpayer dies before the end of the 5-year (or 7-year) period, the “test” period ends on the date of the taxpayer's death.
If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried on for profit. This means the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years that you have a loss. You can rely on this presumption unless the IRS later shows it to be invalid.
Using the presumption later. If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption made after you have the 5 (or 7) years of experience allowed by the test.
You can elect to do this by filing Form 5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years have passed since you started the activity.
The benefit gained by making this election is that the IRS will not immediately question whether your activity is engaged in for profit. Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in the required number of years. If you show 3 (or 2) years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2) years of profit, the limit can be applied retroactively to any year with a loss in the 5-year (or 7-year) period.
Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2 years after the due date of the return for the last year of the period. The period is extended only for deductions of the activity and any related deductions that might be affected.
You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity, or, if earlier, within 60 days after receiving written notice from the IRS proposing to disallow deductions attributable to the activity.
Gross income from a not-for-profit activity includes the total of all gains from the sale, exchange, or other disposition of property, and all other gross receipts derived from the activity. Gross income from the activity also includes capital gains and rents received for the use of property which is held in connection with the activity.
You can determine gross income from any not-for-profit activity by subtracting the cost of goods sold from your gross receipts. However, if you determine gross income by subtracting cost of goods sold from gross receipts, you must do so consistently, and in a manner that follows generally accepted methods of accounting.
Limit on Deductions
If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the three categories. If you are an individual, these deductions may be taken only if you itemize. These deductions may be taken on Schedule A (Form 1040).
Category 1. Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all nonbusiness deductions, such as those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines of Schedule A (Form 1040).
You can deduct a casualty loss on property you own for personal use only to the extent each casualty loss is more than $100, and the total of all casualty losses exceeds 10% of your adjusted gross income (AGI). See Pub. 547 for more information on casualty losses.
For the limits that apply to home mortgage interest, see Pub. 936.
Category 2. Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your gross income from the activity is more than your deductions under the first category. Most business deductions, such as those for advertising, insurance premiums, interest, utilities, and wages, belong in this category.
Category 3. Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income from the activity exceeds the deductions you take under the first two categories. Deductions for depreciation, amortization, and the part of a casualty loss an individual could not deduct in category (1) belong in this category. Where more than one asset is involved, allocate depreciation and these other deductions proportionally.
Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). They are subject to the 2%-of-adjusted-gross-income limit. See Pub. 529 for information on this limit.
Adriana is engaged in a not-for-profit activity. The income and expenses of the activity are as follows.
Real estate taxes$700
Home mortgage interest900
Depreciation on an automobile600
Depreciation on a machine2003,700
Adriana must limit her deductions to $3,200, the gross income she earned from the activity. The limit is reached in category (3), as follows.
Limit on deduction$3,200
Category 1: Taxes and interest$1,600
Category 2: Insurance, utilities, and maintenance1,3002,900
Available for Category 3$ 300
The $800 of depreciation is allocated between the automobile and machine as follows.
$600 $800x$300=$225depreciation for the automobile
$200 $800x$300=$75depreciation for the machine
The basis of each asset is reduced accordingly.
Adriana includes the $3,200 of gross income on line 21 (other income) of Form 1040. The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040). Adriana deducts the remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form 1040) subject to the 2%-of-adjusted-gross-income limit.
Partnerships and S corporations. If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S corporation level. They are reflected in the individual shareholder's or partner's distributive shares.
More than one activity. If you have several undertakings, each may be a separate activity or several undertakings may be combined. The following are the most significant facts and circumstances in making this determination.
The degree of organizational and economic interrelationship of various undertakings.
The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business or investment setting.
The similarity of the undertakings.
The IRS will generally accept your characterization if it is supported by facts and circumstances.
If you are carrying on two or more different activities, keep the deductions and income from each one separate. Figure separately whether each is a not-for-profit activity. Then figure the limit on deductions and losses separately for each activity that is not for profit.