1. Deducting Business Expenses

Introduction

This chapter covers the general rules for deducting business expenses. Business expenses are the costs of carrying on a trade or business. These expenses are usually deductible if the business is operated to make a profit.

Topics

This chapter discusses:

• What you can deduct
• How much you can deduct
• When to deduct
• Not-for-profit activities

Useful Items You may want to see:

Publication

• 334   Tax Guide for Small Business
• 463   Travel, Entertainment, Gift, and Car Expenses
• 525   Taxable and Nontaxable Income
• 529   Miscellaneous Deductions
• 536   Net Operating Losses (NOLs) for Individuals, Estates, and Trusts
• 538   Accounting Periods and Methods
• 542   Corporations
• 547   Casualties, Disasters, and Thefts
• 587   Business Use of Your Home (Including Use by Day-Care Providers)
• 925   Passive Activity and At-Risk Rules
• 936   Home Mortgage Interest Deduction
• 946   How To Depreciate Property

Form (and Instructions)

• Sch A (Form 1040)   Itemized Deductions
• 5213   Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit

See chapter 14 for information about getting publications and forms.

What Can I Deduct?

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

It is important to separate business expenses from the following expenses.

• The expenses used to figure the cost of goods sold.
• Capital expenses.
• Personal expenses.

If you have an expense that is partly for business and partly personal, separate the personal part from the business part.

Cost of Goods Sold

If your business manufactures products or purchases them for resale, some of your expenses may be included in figuring cost of goods sold. You deduct cost of goods sold from your gross receipts to figure your gross profit for the year. If you use an expense to figure the cost of goods sold, you cannot deduct it again as a business expense.

The following are types of expenses that go into figuring cost of goods sold.

• The cost of products or raw materials, including the cost of having them shipped to you.
• The cost of storing the products you sell.
• Direct labor costs (including contributions to pension or annuity plans) for workers who produce the products.
• Factory overhead expenses.

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.

For more information, see the following sources.

• Cost of goods sold - chapter 6 of Publication 334.
• Inventories - Publication 538.
• Uniform capitalization rules - section 263A of the Internal Revenue Code and the related regulations.

Capital Expenses

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called capital expenses. There are, in general, three types of costs you capitalize.

1. Going into business.
2. Business assets.
3. Improvements.

Recovery.   Although you generally cannot take a current deduction for a capital expense, you may be able to take deductions for the amount you spend through depreciation, amortization, or depletion. These allow you to deduct part of your cost each year over a number of years. In this way you are able to recover your capital expense. See Amortization (chapter 9) and Depletion (chapter 10) in this publication. For information on depreciation, see Publication 946.

Going Into Business

The costs of getting started in business, before you actually begin business operations, are capital expenses. These costs may include expenses for advertising, travel, or wages for training employees.

If you go into business.   When you go into business, treat all costs you had to get your business started as capital expenses.

Usually you recover costs for a particular asset through depreciation. Generally, you cannot recover other costs until you sell the business or otherwise go out of business. However, you can choose to amortize certain costs for setting up your business. See Going Into Business in chapter 9 for more information on business start-up costs.

If you do not go into business.   If you are an individual and your attempt to go into business is not successful, the expenses you had in trying to establish yourself in business fall into two categories.

1. The costs you had before making a decision to acquire or begin a specific business. These costs are personal and nondeductible. They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility.
2. The costs you had in your attempt to acquire or begin a specific business. These costs are capital expenses and you can deduct them as a capital loss.

If you are a corporation and your attempt to go into a new trade or business is not successful, you may be able to deduct all investigatory costs as a loss.

The costs of any assets acquired during your unsuccessful attempt to go into business are a part of your basis in the assets. You cannot take a deduction for these costs. You will recover the costs of these assets when you dispose of them.

Business Assets

The cost of any asset you use in your business is a capital expense. There are many different kinds of business assets, such as land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must capitalize the full cost of the asset, including freight and installation charges.

If you produce certain property for use in your trade or business, capitalize the production costs under the uniform capitalization rules. See section 1.263A-2 of the regulations for information on those rules.

Improvements

The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. You can deduct repairs that keep your property in a normal efficient operating condition as a business expense.

Improvements include new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements.

Restoration plan.   Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. This applies even if some of the work would by itself be classified as repairs.

Replacements.   You cannot deduct the cost of a replacement that stops deterioration and adds to the life of your property. Capitalize that cost and depreciate it.

Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition. However, if your equipment has a major overhaul, capitalize and depreciate the expense.

Capital or Deductible Expenses

To help you distinguish between capital and deductible expenses, several different items are discussed below.

Business motor vehicles.   You usually capitalize the cost of a motor vehicle you buy to use in your business. You can recover its cost through annual deductions for depreciation.

There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. See Publication 463.

Repairs you make to your business vehicle are deductible expenses. However, amounts you pay to recondition and overhaul a business vehicle are capital expenses.

Roads and driveways.   The costs of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. The cost of maintaining a private road on your business property is a deductible expense.

Tools.   Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year.

Machinery parts.   Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition and not add to its life is a deductible expense.

Heating equipment.   The cost of changing from one heating system to another is a capital expense.

Personal Expenses

Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct as a business expense only the business part.

For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, generally you can deduct as a business expense only 70% of the interest you pay on the loan. The remaining 30% is personal interest that is not deductible. See chapter 5 for information on deducting interest and the allocation rules.

Business use of your home.   If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation.

To qualify to claim expenses for the business use of your home, you must meet the following tests.

1. The business part of your home must be used exclusively and regularly for your trade or business.
2. The business part of your home must be one of the following.
   1. Your principal place of business.
   2. A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business.
   3. A separate structure (not attached to your home) you use in connection with your trade or business.

You generally do not have to meet the exclusive use test for the part of your home that you regularly use in either of the following ways.

• For the storage of inventory or product samples.
• As a day-care facility.

Your home office qualifies as your principal place of business if you meet the following requirements.

• You use the office exclusively and regularly for administrative or management activities of your trade or business.
• You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

For more information, see Publication 587.

Business use of your car.   If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on mileage. Only your expenses for the miles you drove the car for business are deductible as business expenses.

You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. Instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. For 2002, the standard mileage rate is 36½ cents a mile for all business miles driven.

If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate. You can use the nonbusiness part of the personal property tax to determine your deduction for taxes on Schedule A (Form 1040) if you itemize your deductions.

For more information on car expenses and the rules for using the standard mileage rate, see Publication 463.

How Much Can I Deduct?

You cannot deduct more for a business expense than the amount you actually spend. There is usually no other limit on how much you can deduct if the amount is reasonable. However, if your deductions are large enough to produce a net business loss for the year, the tax loss may be limited.

Recovery of amount deducted.   If you recover part of an expense in the same tax year for which you would have claimed a deduction, reduce your expense deduction by the amount of the recovery. If you have a recovery in a later year, include the recovered amount in income. However, if part of the deduction for the expense did not reduce your tax, you do not have to include all the recovery in income. Exclude the part that did not reduce your tax.

For more information on recoveries and the tax benefit rule, see Publication 525.

Payments in kind.   If you provide services to pay a business expense, the amount you can deduct is the amount you spend to provide the services. It is not what you would have paid in cash.

Similarly, if you pay a business expense in goods or other property, you can deduct only the amount the property costs you. If these costs are included in the cost of goods sold, do not deduct them as a business expense.

Limits on losses.   If your deductions for an investment or business activity are more than the income it brings in, you have a net loss. There may be limits on how much, if any, of the loss you can use to offset income from other sources.

Not-for-profit limits.   If you do not carry on your business activity with the intention of making a profit, you cannot use a loss from it to offset other income. See Not-for-Profit Activities, later.

At-risk limits.   Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment you have at risk in the activity. You are at risk in any activity for the following items.

1. The money and adjusted basis of property you contribute to the activity.
2. Amounts you borrow for use in the activity if:
   1. You are personally liable for repayment, or
   2. You pledge property (other than property used in the activity) as security for the loan.

For more information, see Publication 925.

Passive activities.   Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate during the year, or a rental activity. In general, deductions for losses from passive activities only offset your income from passive activities. You cannot use any excess deductions to offset your other income. In addition, passive activity credits can only offset the tax on net passive income. Any excess loss or credits are carried over to later years. For more information, see Publication 925.

Net operating loss.   If your deductions are more than your income for the year, you may have a net operating loss. You can use a net operating loss to lower your taxes in other years. See Publication 536 for more information. See Publication 542 for information about net operating losses of corporations.

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