Business Expenses

Business expenses are the costs a business incurs to operate, and a business may deduct those that qualify under Internal Revenue Code section 162(a) as "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Deducting them reduces the business's taxable profit, so the rules on what qualifies decide a good deal of a small business's tax. The section 162 test is broad but not unlimited: several categories of spending are specifically capped or disallowed no matter how business-related they are.

The governing standard is the "ordinary and necessary" test. "Ordinary" means the expense is common and accepted in the taxpayer's line of business, and "necessary" means it is helpful and appropriate for the business, a lower bar than "indispensable." Rent on a shop, wages to employees, supplies, insurance, professional fees, and advertising are the uncontroversial core. The expense must be for the business rather than personal: section 262 disallows personal, living, and family expenses, which is why the commute from home to a regular workplace is not deductible even though it is plainly necessary to earn the income.

Several categories are limited or disallowed even when they are genuinely business-related. Business meals are generally deductible at only 50% of their cost, and entertainment expenses are disallowed altogether under section 274. Fines and penalties paid to a government for breaking the law are not deductible under section 162(f), and neither are illegal bribes and kickbacks under section 162(c) or, in most cases, lobbying expenses under section 162(e). Knowing these carve-outs matters because they are exactly the costs a business owner is tempted to treat as ordinary deductions.

A final line separates an expense from a capital cost. A cost that merely keeps the business running, this month's rent, this week's supplies, is deducted in the year it is paid. A cost that buys something with a useful life beyond the year, a vehicle, machinery, a building improvement, is generally capitalized and its cost recovered over time through depreciation rather than deducted at once. Certain rules let a business expense some of these purchases immediately, but the default is that lasting assets are depreciated, not written off in full the day they are bought. How and where all of this is reported, and the records that support it, are handled on the business's tax return and its books.

The mechanics are subtraction: qualifying business expenses come off revenue to reach the taxable profit the owner is taxed on. Two hypothetical items show how the limits work.

First, a business meal. The owner takes a client to lunch and the bill is $100. Because business meals are generally 50% deductible, only $50 reduces taxable profit, not the full $100. Second, a laptop bought for $2,000. Because it is a lasting asset rather than a consumed cost, the default treatment is to capitalize it and recover the cost through depreciation over several years, rather than deducting the whole $2,000 in the year of purchase, though special rules may allow more of it to be expensed up front. A $300 charge for the year's accounting software, by contrast, is an ordinary operating cost deductible in full that year.

This lists what the deduction does well and where it trips people up, rather than pros and cons of a choice.

Strengths

• Directly lowers taxable profit, so every qualifying dollar spent reduces the tax base.
• The "ordinary and necessary" standard is broad and covers most genuine costs of running a business.

Traps

• Personal and commuting costs are not deductible, even when they feel necessary to the work.
• Business meals are only half-deductible and entertainment is disallowed.
• Fines, illegal payments, and most lobbying are non-deductible regardless of business purpose.
• Lasting assets must generally be capitalized and depreciated, not expensed all at once.
• Weak records are the usual reason an otherwise valid deduction fails in an audit.