I’m often asked if a particular expense is tax deductible. Everyone is looking for a deduction! In general, only expenses incurred in a trade or business (IRC §162) or those incurred in the production of income (IRC §212), will be deductible on an individual tax return. I once had someone ask me if a new washer and dryer was deductible. It would be if it were used in a trade or business, for example in a hair salon to wash towels. This taxpayer was using the appliances at her home, so the cost would not be deductible. (Hard to believe someone would ask, but true story.) The IRS has criteria an expense must meet in order to be considered deductible for tax purposes. The expense must be ordinary, necessary, reasonable, and incurred by the taxpayer.
An expense is ordinary if it is normally incurred in the type of business the taxpayer is involved in. For example, let’s say Jim Jones owns ABC Newspaper and he is sued for liable based on a story he ran on the front page. ABC Newspaper has never been sued for liable before, but the legal fees involved in defending the paper would certainly be considered an ordinary expense for the newspaper business.
The Supreme Court has held that an expense is “necessary” if it is “appropriate and helpful” in the taxpayer’s business. Again, what may be appropriate and helpful in one line of business may not be in another. Dump fees are appropriate and helpful for a tree trimming business but are not appropriate and helpful for a CPA firm.
In practice the reasonable standard is most often applied in situations involving salary payments made by a closely held corporation to a shareholder/employee. This is a frequent abuse of the tax system, the shareholders pay themselves a very large salary, in an effort to avoid the corporation paying a dividend. But, it doesn’t apply just to salary expense. Overdraft fees are an ordinary expense of doing business, and may be necessary to keep the checking account open. However, if overdraft fees occur daily, they may fail the reasonableness test and not be considered a deductible expense.
Expense Must be Incurred Directly by the Taxpayer
If a taxpayer pays an expense on behalf of someone else, it’s considered a gift and not a deductible expense. When the sales tax deduction was first enacted, people would go to retailers’ parking lots and find receipts so they could use them for their sales tax deduction. This rule prohibits such behavior. The one exception is for medical expenses paid for a dependent, and those are deductible.