Deductible vs. Nondeductible Business Expenses

Jeff Franco for Demand Media/AZ Central writes:  The Internal Revenue Code provides a fairly general two-pronged test that taxpayers must satisfy for each business expense for which they take a deduction on a tax return. These two requirements are that the expense be ordinary, or that it’s commonly incurred by other business owners within the same industry, and that it be a necessary expense, meaning it’s helpful to your business.

Immediately Deductible

There are a large number of business expenses that can be deducted on the tax return covering the year in which the expense was paid, or if you are accounting under the accrual method, the year in which it was incurred. These expenses typically cover items such as rent, employee salaries, utilities, office supplies, state and local taxes, insurance payments as well as a long list of others. Generally, expenses that are immediately deductible tend to cover goods and services that are used or consumed in the short term.

Deductible Over Time

When you purchase assets for your business, such as vehicles, equipment or even real property, you can’t take a deduction for the entire acquisition cost in the same year the expense is paid or incurred. Instead, these types of expenses, which are referred to as “capital expenses,” are deducted over time as required under the revenue code for the particular category of assets. For example, when you purchase business equipment, you will report a depreciation deduction on your return each year for a portion of its acquisition cost. Moreover, this requires referencing the class life for the asset in the revenue code, which is the number of years you can allocate the cost over. However, Internal Revenue Code Sec. 179 may allow you to fully deduct a certain amount of asset purchases in a single tax year rather than through multi-year depreciation deductions.

Related Reading: Can You Deduct Business Expenses for a Board of Directors?

Deductible When Sold

For small-business owners who manufacture products or purchase wholesale inventory for resale, the cost of manufacturing or purchasing your products isn’t deductible until they are sold to consumers. On business tax returns, you’ll see this referred to as “Cost of Goods Sold” or COGS. Calculating your COGS can be somewhat intricate, but you essentially determine your annual deduction by taking the value of your inventory at the beginning of the year, adding manufacturing costs and purchases to that amount and then subtracting the value of your ending inventory value as of the last day of the tax year.

Nondeductible Personal

Whenever an expense doesn’t satisfy the “ordinary and necessary” requirements of deductibility, it’s probably safe to assume that it’s nondeductible. But if you’re still unsure, you should consider whether you benefit personally by the expense. If an expense is purely for personal purposes, such as the purchase of a family car that you don’t use in the business, the cost won’t be deductible as a business expense. However, if it’s the only car you own and you use it for both business and personal purposes, you can deduct the portion of car expenses that you can allocate to business use based on the ratio of business miles driven to the total number of miles you put on the car during the year.