The First Principle of Small Business Deductions

The first rule of small business deductions is that no tax deduction strategy is ever going work for you if the Internal Revenue Service ends up disallowing your tax deductions. This may sound like too obvious of a statement, but once you think about it you'll realize its importance. Many people simply forget the important fact that just because they have been getting away with claiming a certain expense on their tax return, there is no guarantee that the IRS will continue to allow that tax deduction in the future.

People sometimes ask their tax accountant "Can I deduct this or expense for business purposes?....Or, what about this one?" referring to some business related transactions or expenses. If the accountant asked knows anything at all about the tax code, the correct response to such a question would be "Well, all depends on the circumstances!"

It is not the transactions or expenses by themselves that determine whether or not small business deductions are tax deductible; it is the circumstances surrounding the transactions. The Internal Revenue Service refers to this as "form over substance" (don't worry if you don't understand what that means!) Put differently, would you feel comfortable claiming all the small business deductions in the world knowing that an IRS auditor could disallow your deductions with the stroke of a pen? Not only would you loose your small business deductions; you would also have incurred additional penalties and interest. Not to mention all the stress of going through an IRS audit, and the embarrassment of having your "business expenses" disallowed!

Taking this view, you realize that the best question to ask yourself or your accountant is not about which small business deductions you could possible claim, it is about which small business deductions you could legally defend if your tax return is ever audited by the IRS.

To answer that question, it is necessary for you to know something about how the IRS determines whether or not certain small business deductions may be deducted on a tax return. A good start would be to consider what the Internal Revenueconsiders to be a legitimate, bona fide tax deduction.

Understanding "Ordinary and Necessary" Small Business Deductions

According to the IRS, any small business deductions you claim on your tax return have to be ordinary and necessary. What does ordinary and necessary mean? Well, the IRS (and the tax courts) interpret "ordinary and necessary" to mean "reasonable and customary." So what does this mean for you, the taxpayer and small business owner? That really depends a whole lot on which line of business you are in and the business customs and practices of your specific industry. To help you understand this important concept, here are two examples:

Example #1.

A successful commercial real estate agent invites a potential client to inspect a property and claims a $655 tax deduction to pay for the client's airfare and accommodations. The real estate agent's yearly business income is in range of hundreds of thousands of dollars. The IRS, if it were to examine the return, would probably not argue with the reasonability and necessity of such a tax deduction. This would be true even if the agent had not been able to close this particular deal. In order to generate this kind of income, it would be to be expected that it was necessary to incur expenses in anticipation of making a profit. Furthermore, the real estate agent could argue that it is customary in commercial real estate to pay for a potential client's travel expenses. The IRS would most likely agree that not only is such a deduction necessary, but also customary for the taxpayer's line of business.

Example #2.

The owner of an auto repair shop in a small town reports his first year's business income to be $25,000 and claims a $5,560 tax deduction for client entertainment expense. The taxpayer argues that this was a necessary expense, since he expects that the money he has spent on business lunches for potential clients will pay off in the long term by providing him with a thankful, loyal customer base. However, the IRS would probably disallow these small business deductions, arguing that it is not customary for auto repair shop owners to treat their potential clients to expensive lunches and dinners (when was the last time your auto mechanic treated you for lunch?). Common sense? You bet!

Applying "Ordinary and Necessary" to Your Business

Before claiming small business deductions, always ask yourself:

Question #1: "Are these small business dedcuctions necessary expenses of doing business,ie. how will they allow my business to increase it's income?"

Question #2: "Are these small business deductions customary for my line of business?"

Keep in mind that the taxcourts have defined "necessary" as "appropriate" and "helpful" as opposed to "absolutely essential" to a taxpayer's business (Blackmer v. Comissioner, 70 F.2d 255). This means that it there is some room for interpretation.

Examples of Interpretation

For example, a Mary Kay sales person inviting potential customers to lunch to dosales presentations of her cosmetics line would probably be allowed her small business deductions because it could be argued that the expenses would be helpful in generating customer loyalty and future sales. Furthermore, such a tax deduction is considered to be ordinary in the taxpayer's line of business. The IRS and the Tax Courts would most likely allow the small business deductions.

On the other hand, a financial planner could argue that he considers his telephone calls to a psychic hotline a necessary business deduction since he feels it would give him a competitive edge in the financial markets. In this case, however, his small business deductions would almost certainly be disallowed because calls to a psychic hotline would not be considered appropriate nor customary for the taxpayer's business. Remember the terms "Reasonable" and "Necessary."

In addition to being reasonable and necessary, the IRS requires that your small business deductions be paid or incurred during the tax year for which you are claiming the deduction and that the expense was connected with the conduct of a trade or business.

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