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Lesson 1: Introduction, Background, and Review
Limitations on Deducting Business Expenses
In addition to having to satisfy the requirement to be ordinary, necessary, and reasonable, business expenses will not be deductible for taxes if they are contrary to public policy. Capital expenditures, expenses associated with earning tax-exempt income, personal expenditures, or another person’s or entity’s expense are also not deductible for tax purposes. Click on each button below to learn more about these limitations.
Contrary to Public Policy
Any business expenses that break the law in some way will not be deductible on the business’s tax returns. For example, fines paid for speeding tickets by a trucking company would not be deductible because public policy states they should have been driving at no more than 55 miles per hour. Similarly, bribes, kickbacks, and penalties are not deductible. The Foreign Corrupt Practices Act of 1977 prohibits the payment of bribes to foreign officials. That creates the public policy that renders such payments not deductible for taxes. The passage of IRC §280E addresses the efforts to combat sales of illegal drugs. This code section prohibits the deduction of any expenses incurred in the selling of illegal drugs.
Capital Expenditures
If a business incurs expenditures to acquire or improve assets with useful lives of more than 1 year, those expenditures can’t be deducted on the tax return for the year of the expenditure. Instead, the expenditure must be capitalized. Capitalizing an expenditure means the costs and useful lives will be recorded in the tax records of the business. The business will then allocate a portion of that expenditure to each year of the assets’ useful lives. If the asset is a tangible asset, such as a machine or building, then the business should allocate the asset using the depreciation methods permitted for tax purposes. If the asset is an intangible asset, such as a copyright or patent, then it should amortize the asset to allocate the expenditure. If the asset is a natural resource, such as a forest or coal mine, then it should use the depletion method to allocate the expenditure.
Associated With Earning Tax-Exempt Income
The IRS will not permit any expenditure that doesn't help a business generate taxable income to offset that taxable income. Put another way, if the government doesn’t have the right to tax the income generated, the business doesn’t have the right to deduct the expenses incurred in generating that nontaxable income. The most common example of tax-exempt income is interest earned by investing in state and local bonds. If a business has excess cash and invests it in a state or local bond, the interest earned will not be taxable, so any commissions they may have paid to buy the bond will not be a tax-deductible expense.
Personal Expenditures
A business can’t deduct expenditures that are incurred for personal benefit. For example, a business can’t deduct payments for the business owner’s car if that car is strictly for personal use.
Another Person’s/Entity’s Expense
Expenses incurred by another entity or person are not tax-deductible business expenses for the business in question. The entity or person who incurred the expenses must deduct them. Using the example of a building with a retail store and an apartment occupied by the store owner for personal use, the store owner would incur the electricity used to light the apartment, so it would not be a tax-deductible business expense. There are some exceptions on personal tax returns, where a taxpayer may be able to deduct a dependent’s medical expenses or education expenses.