Home > Taxes > What Expenses Can Be Considered As Business Related?
What expenses can generally be considered as business related and what are not?
In other words, what areas might get me into trouble if I try to write them off?
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In this audio snippet, you'll hear about:
- General rule is that any ordinary and necessary business expense is deductible.
- Must be both A. Ordinary and B. Necessary
- The IRS wants you to make money. And they know that in order to make money you have to spend money.
- A business that has been around for years with huge travel meals and entertainment expenses, they'll start to disallow it
- At the end of the day, if you're making money and have reasonable expenses, the IRS will allow it
- Certain costs are real expenses, and certain expenses are cost of good sold – important to segregate them appropriately
- Better to put expenses where they should be, because often IRS won't even inquire about cost of good sold, but they will inquire about inappropriate expenses
Audio Transcript
Travis:
What expenses can generally be considered as
business–related, and what are not? In other words, what are areas that
might get me in trouble legally if I try to write them off?
Yosef:
That's so interesting you asked that question. In fact, today, I just got an email from the IRS.
There
are a number of IRS online publications that I read through and follow
very closely for my own practice. But actually, they just published
what's called Revenue Ruling 2007–28, about disallowance of certain
entertainment expenses. Which I thought was interesting, because pretty
much, they're telling you that if you go to a convention outside of
North America, there are certain limitations, under Section 247,
subsection H, as to how much you can deduct for taxation purposes.
But
again, that's not something that a really small business owner is
really going to encounter. The reason that I mention it is because, the
general rule, under section 162 of the Internal Revenue Code is that
any ordinary and necessary business expense is deductible.
Travis:
Ordinary and necessary.
Yosef:
It has to be both A: ordinary, and B: necessary.
Travis:
OK.
Yosef:
Most business expenses easily fit that category. There was a clip on MSN.com
from another very famous tax practitioner named Jeff Schnipper. He's
also an attorney and a CPA, I believe. And he was talking about how he
has a big–screen TV in his office which he uses to record wills on. And
he says the full big–screen TV is tax–deductible, because it's an
ordinary and necessary expense for his business. And he had no problem
publicizing that to the entire world.
Travis:
All right.
Yosef:
That being said, if I were to take a step back. And again, this is
definitely more an art than a science. I've done now a number of audits
where I feel comfortable saying this and that is: the IRS wants you to
make money. And the IRS knows that in order to make money, you have to
spend money.
What
the IRS also knows is that, if you're in business, and you're just
spending money and not making money, then something is going wrong. Now
certain businesses, when they first start, are not going to make money.
If
you've been in business for a while, you have to start making money or
go out of business, because it just doesn't make any sense otherwise.
So when they start seeing a business that's been around for a number of
years with huge travel, meals, and entertainment expenses, they're
going to arbitrarily just disallow it. Saying, "This is ridiculous."
Just
to give you some more insight, I'm actually representing a taxpayer
right now who was developing a certain line of fashionable products,
shall I say. And she devoted an entire year traveling around the world,
trying to put together these fashionable products.
Travis:
All right.
Yosef:
Now, she also happens to have had six little kids at home that were being watched by a nanny while she was doing this.
Travis:
Oh, wow.
Yosef:
Now, I know that my poor client was innocently working very, very hard,
traveling all over Europe, Asia, the Middle East, putting this
together. The auditor was a little jealous, I think, and didn't like
the fact that the client was doing that much travel. The point, though,
is that it was ordinary and necessary for what the client was doing.
Again, if you're in the business of fashion, you will have such
expenses.
Travis:
Sure.
Yosef:
Now, if you're a notary public, you're not going to be traveling around
to other countries. Similarly, if you're a web designer, you're not
going to be wining and dining clients in very fancy restaurants. I
mean, maybe you could be, but you'd have to explain why. Or you
wouldn't have to be driving around in a Porsche to entertain your
clients.
Travis:
[laughs] Right.
Yosef:
It's got to make sense. And I think, at the end of the day, if you're
generating income and you have a reasonable amount of expenses, the IRS
will understand.
Travis:
OK. One quick follow–up: was her nanny a tax deduction?
Yosef:
The nanny was only partially deducted as a dependent care expense.
Travis:
OK.
Yosef:
That allows up to $5,000 a year. Actually, depending on how you
structure it, it could be up to $5,000 a year if you have a section 125
plan; it gets complicated. But there is a certain credit, called
dependent care expense credits, for that nanny, provided, of course,
that you fill out Schedule H and attach it to your tax return, whereby
you're withholding taxes from which you're paying your nanny.
Travis:
OK. Well, $5,000 is at least something. It doesn't seem like you could
probably hire a nanny for six kids for a year for anywhere near $5,000.
Yosef:
Well, that's true.
Travis:
But that's a different question.
Yosef:
Typically, you're not going to be able to justify your child–care
expense beyond what the IRS allows for the dependent care credits.
Travis:
OK. Great. I have some questions about, unless you have something more to add there.
Yosef:
Yeah, I wanted to talk a little more about the section 162 ordinary and necessary expenses.
Travis:
Please.
Yosef:
I think a lot of taxpayers don't realize something. And it surprises
me, because I think any savvy businessperson should keep this mind: in
business, certain costs are real expenses, and certain costs are costs
of goods sold.
In
other words, if you're in an inventory–intensive business, you're going
to have materials and labor to manufacture your goods, or you're going
to be buying your inventory from somewhere else. And then you'll have
certain other expenses for selling and administrative, or overhead,
expenses. And it's very important to segregate them appropriately.
Travis:
Why is that?
Yosef:
Why is that? Well, there are two reasons for that. First of all, the
IRS, when they review your tax return, depending on what kind of
industry you're in, they are looking for certain benchmark ratios.
Travis:
All right.
Yosef:
For example, let's say you're in the grocery business. I know I keep
coming back to that, but it's a really simple business. The average
grocer works on five to 10 percent markups. So if you have a grocer
that has $3 million in sales and $2.7 million in cost of goods sold,
the IRS is not going to flinch, because they know how the industry
works. They're not going to red flag that, because again, it's very
typical.
If
you're a wholesale diamond dealer, your margins could be three percent.
So again, if you show that, let's say you've got $10 million a sale and
$9–point–something million in cost of goods sold; it's going to pass
muster, at least initially, for the IRS. At least, that's been my
experience.
Now, the reason you want to segregate out your
costs is, because the IRS is using certain benchmarks to look at your
tax return, you want to have certain costs that play into your gross
profit number. Again, your gross profit is your gross revenues less
your cost of goods sold. And you'll have certain expenses then that
have been deducted from your gross profits before you get your net
income.
I think it's important that these expenses be
classified appropriately, both so that you make the IRS's job easier,
and it's also easier for you to substantiate the nature of those
expenses as well.
I have had cases whereby the IRS won't
even inquire about your cost of goods sold, but they will inquire about
the nature of certain expenses. So sometimes, I think it's better for
taxpayers to put the expenses where they should be than to just
arbitrarily put everything as expenses without considering the impact
of reporting your gross profit appropriately.
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