How tax savvy a businessperson you are has a great effect on how much money is in your pocket at the end of the year. You probably know that the tax code allows you to deduct costs of doing business from your gross income. What you are left with is your net business profit. This is the amount that gets taxed.
So knowing how to maximize your deductible business expenses lowers your taxable profit. To boot, you may enjoy a personal benefit from a business expenditure -- a nice car to drive, a combination business trip/vacation, a retirement savings plan.
However, to benefit from the business deductions available to you and avoid trouble with the IRS, you need to understand when an expense is (or isn't) deductible.
The key to determining whether an expense is legitimate is found in Section 162 of the tax code, which states that a business expense must be "ordinary and necessary." Otherwise, it can't be deducted. Unfortunately, the tax code doesn't define either ordinary or necessary. Luckily, in many cases whether a business expense is ordinary and necessary is obvious. For instance, office equipment and supplies used in the business are clearly deductible.
Here are some other ways to determine if an expense is ordinary and necessary:
IRS publications and regulations. In some cases, such as travel expenses, the IRS provides specific instructions for determining whether or not an expense is ordinary and necessary. This is often done through IRS publications and regulations.
Court decisions. When there is no guidance on whether an expense is ordinary and necessary, it's up to the courts to figure it out. Generally, courts agree that ordinary and necessary refers to the purpose for which an expense is made. For example, renting office space is an ordinary and necessary expense for many businesses. However, the space must actually be used for the business or the expense won't qualify. Ordinary has been held by courts to mean "normal, common, and accepted under the circumstances by the business community." Necessary has been interpreted to mean "appropriate and helpful."
Given these broad guidelines, it is not surprising that people have tried to push the envelope on what qualifies as a business expense; and the IRS has pushed back. Sometimes a compromise is reached, and sometimes the issue is thrown into a court's lap.
Mr. Henry, an accountant, deducted his yacht expenses, contending that because the boat flew a pennant with the numbers "1040," it brought him professional recognition and clients. The matter ended up before the tax court. The court ruled that the yacht wasn't a normal business expense for a tax professional, and so it wasn't ordinary or necessary." In short, the yacht expense was personal and thus nondeductible. (Henry v. CIR, 36 TC 879 (1961).)
The laugh test. Tax professionals frequently rely on the so-called laugh test: Can you put down an expense for business without laughing about putting one over on the IRS? In the example above, the tax court laughed the accountant and his yacht out of court.
While the tax code itself contains no "too big" limitation, courts have ruled that it is inherent in Section 162. For example, it might be reasonable for a large apparel company to lease a jet to travel between manufacturing plants, but not for a corner deli owner to fly to New York to meet with her pickle supplier.
The number one concern of the IRS when auditing business deductions is whether purely personal expenditures are being claimed as business expenses. For instance, you can't deduct the cost of commuting to work, because the tax code specifically says this is a personal, not a business, expense. Ditto with using the business credit card for a vacation or cruising the beach in the company car. Because such shenanigans are common, IRS auditors are ever watchful.
Fortunately, you can often arrange your affairs -- legally -- in a way that lets you derive considerable personal benefit and enjoyment from business expenditures.
Be careful if you deal with relatives. An IRS auditor will look askance at payments to a family member or to another business in which your relatives have an ownership interest (in tax code parlance, these are known as related parties). An auditor may suspect that taxable profits are being taken out of your business for direct or indirect personal benefit in the guise of deductible expenses. For example, paying your spouse's father, who is in prison, $5,000 as a consultant's fee for your restaurant business would smell bad to an auditor.
To learn more about tax deductions for your business, see Home Business Tax Deductions: Keep What You Earn, by Stephen Fishman (Nolo).