The Federal Income Tax laws are vast, complex and ever changing. This contributes to misunderstandings and errors. Here are a few common misconceptions relating to business expenses.
Entertainment:
A common misconception for a taxpayer is that entertaining a client, supplier or business associate (i.e. lunch, dinner, sporting event) is a fully deductible expense. The truth is that if the expense qualifies at all, generally only 50% of it is deductible.
An entertainment expense only qualifies as a deduction if “the entertainment expense is directly related to or associated with the active conduct of a trade or business, or for the production or collection of income.”
Generally, the criteria to meet the above definition are as follows:
- “directly related” means the entertainment takes place in a clear business setting, or at a different setting, but with the main purpose of the event being business; and it must include having more than a general expectation of getting income or other specific business benefit in the future.
- “associated with” means the entertainment is directly before or after substantial business discussions.
Once a taxpayer has a business expense that meets one of the above criteria, thus qualifying the activity as a business expense, they are subject to a 50% limit. For example, if a taxpayer incurs $200 of qualified expenses to entertain a client only $100 would be deductible.
The expenses must also be “reasonable”. Expenses that are “lavish” or “extravagant” are not deductible even if they might otherwise qualify. So, for example, a skybox or private luxury box may be considered lavish and extravagant if the box is rented for more than one event in the same sports arena. For lavish or extravagant expenses, a taxpayer can generally deduct 50% of the cost of the price of a non-luxury box seat ticket, but not more. That is, they reduce it down to what a non-lavish version of the same activity might cost.
There are also certain expenses that are not allowed at all such as certain club dues (golf or country clubs) or membership fees to an organization whose principal purpose is to entertain members or guests. However, while the membership itself is not deductible, 50% of the cost of a “qualified” business lunch could be deducted.
Deductible Business Costs and Mileage:
Taxpayers often misunderstand what portion of their costs incurred and/or mileage getting from home to work, work to home, home to a client, etc. qualify as deductible business costs.
The most common mistakes relate to “commuting” (e.g. going from home to work and from work back home). Under the Federal Income Tax laws a commuting expense is not an “ordinary and necessary” expense of business. Accordingly, mileage put on a car for traveling from home to work, and back again, is considered to be “commuting” and thus, not business mileage.
However, there are some exceptions and nuances to the commuting rules:
Home Office:
If the taxpayer has his principal place of business it his, the cost for going between home and another work location for business purposes is generally deductible.
Temporary Work Site:
Travel expenses from the taxpayer’s home to a temporary work site outside the metropolitan area where the taxpayer lives and normally works is generally deductible.
Multiple Work Locations:
Travel expenses between home and a temporary work location for business purposes is generally deductible if the taxpayer has a regular work location.
However, if a taxpayer goes from home to the regular work place and then to the temporary work location, only the cost from the regular work place to the temporary work location is deductible. The costs relating to the trip from home to the regular work place are not deductible.
It should be noted that for people who drive, business mileage is significant whether the taxpayer is deducting based upon “actual expenses” or is deducting based upon the “Standard Mileage Rate”.
Here is an example:
Frank is an attorney who has a regular office 5 miles from his residence. Normally, Frank drives from home to his office and then back at the end of the day. No part of those 10 mile round-trips are deductible as a business expense (i.e. none of the mileage is considered to be business mileage).
However, from time to time, Frank has to stop by at a client’s store (3 miles from his residence) before going on to his office. The store is 8 miles from his office since it is in the complete opposite direction from his office. The mileage driving from Frank’s home to the client’s store (3 miles) can qualify as a business expense because the client’s store qualifies as a “temporary work location”. The mileage driving from the client’s store to Frank’s office (8 miles) can also qualify as a business expense. The ride home at the end of the day from Frank’s office to his residence (5 miles) is not business mileage and thus, not deductible.
Work Clothing:
Taxpayers often misunderstand what portion of their clothing purchases and cleaning costs qualifies as deductible business costs.
The most common mistakes relate to whether clothing purchased primarily to wear for work is deductible and whether laundering costs for that clothing is deductible. Often, there is even a “dress code” that makes it even more appealing to try to deduct the costs of clothing.
In general, clothing (or costs of maintaining clothing) is not deductible as a business expense even if required for work.
However, there are some exceptions where certain items do qualify as deductible where they are required for use during work:
- Uniforms required for work (e.g. Police or Fire uniforms);
- Safety Equipment (e.g. Kevlar vests or HAZMAT suits)
- Clothing with company logos.
The examples provided above are work specific, meaning that they are required as part of the job and would not generally be worn outside of work. A policeman, for instance, would not wear his uniform while off duty. However, even where a business suit is required by a law firm, or to appear before a Court, the cost of purchasing or cleaning business suits is not deductible as a business expense.
Conclusion
Taxpayers and tax return preparers must understand these laws. In some situations, clients may assume nothing is deductible and miss valid business deductions. In other situations, they may assume more is deductible than can be supported by the law. It is a best practice for tax return preparers to advise their clients of these rules before their clients provide their tax information. This may save their client the effort of assembling information that is not needed or having to go back and re-assemble that information. It may also allow a client to validly reduce their income tax.
5/2012
Copyright ©, Keith B. Baker – 2012
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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