| Pub. 535, Business Expenses |
2005 Tax Year |
1.
Deducting Business Expenses
This chapter covers the general rules for deducting business expenses. Business expenses are the costs of carrying on a trade
or business and they
are usually deductible if the business is operated to make a profit.
Topics - This chapter discusses:
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 Daycare Providers)
-
925
Passive Activity and At-Risk Rules
-
936
Home Mortgage Interest
Deduction
-
946
How To Depreciate Property
See chapter 14 for information about getting publications and forms.
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted
in your industry.
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 distinguish business expenses from:
If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and
end of each tax year
to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost
of goods sold is deducted
from your gross receipts to figure your gross profit for the year. If you include an expense in 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 freight.
-
Storage.
-
Direct labor (including contributions to pension or annuity plans) for workers who produce the products.
-
Factory overhead.
Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain 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—Publication 538 and section 263A of the Internal Revenue Code and the related regulations.
You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called
“capital
expenses.” Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.
You can elect to deduct or amortize certain business start-up costs. See chapters 8 and 9.
Cost recovery.
Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount
you spend through depreciation,
amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are able
to recover your capital
expense. See Amortization (chapter 9) and Depletion (chapter 10) in this publication. You may also be allowed a section 179
deduction. For information on the section 179 deduction and depreciation, see Publication 946.
There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and
franchise rights. You
must fully capitalize the cost of these assets, including freight and installation charges.
Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules.
See section 1.263A-2 of
the regulations for information on these rules.
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. Improvements are generally major expenditures. Some examples are:
new electric wiring, a new
roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements.
However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business
expense. Treat as repairs
amounts paid to replace parts of a machine that only keep it in a normal operating condition.
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.
Capital versus Deductible Expenses
To help you distinguish between capital and deductible expenses, different examples are given below.
Motor vehicles.
You usually capitalize the cost of a motor vehicle you 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.
Generally, repairs you make to your business vehicle are currently deductible. However, amounts you pay to recondition
and overhaul a business
vehicle are capital expenses and are recovered through depreciation.
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 or their cost is minor.
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, but 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 versus Business 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 the business
part.
For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you can deduct 70%
of the interest as a
business expense. The remaining 30% is personal interest and 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 both of the following tests.
-
The business part of your home must be used exclusively and regularly for your trade or business.
-
The business part of your home must be:
-
Your principal place of business, or
-
A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or
-
A separate structure (not attached to your home) used 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 either for
the storage of inventory or
product samples, or as a daycare 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.
If you have more than one business location, determine your principal place of business based on the following factors.
-
The relative importance of the activities performed at each location.
-
If the relative importance factor does not determine your principal place of business, consider the time spent at each location.
For more information, see Publication 587.
Business use of your car.
If you use your car exclusively 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 actual mileage.
You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups,
insurance, and
registration fees. Or, 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 2005, the standard mileage rate is 40.5 cents a mile for all business miles driven before September 1, 2005.
The rate is 48.5 cents a
mile for business miles driven after August 31, 2005, and before January 1, 2006.
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.
For more information on car expenses and the rules for using the standard mileage rate, see Publication 463.
You can deduct the cost of a business expense if it meets the criteria of ordinary and necessary and it is not a capital expense.
Recovery of amount deducted (tax benefit rule).
If you recover part of an expense in the same tax year in which you would have claimed a deduction, reduce your current
year expense by the amount
of the recovery. If you have a recovery in a later year, include the recovered amount in income in that year. However, if
part of the deduction for
the expense did not reduce your tax, you do not have to include that part of the recovered amount in income.
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 limited to your out-of-pocket costs.
You cannot deduct the cost of
your own labor.
Similarly, if you pay a business expense in goods or other property, you can deduct only what 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 loss.
There may be limits on how much
of the loss you can deduct.
Not-for-profit limits.
If you carry on your business activity without 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.
-
The money and adjusted basis of property you contribute to the activity.
-
Amounts you borrow for use in the activity if:
-
You are personally liable for repayment, or
-
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,
or a rental activity.
In general, deductions for losses from passive activities only offset income from passive activities. You cannot use any excess
deductions to offset
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. Suspended passive losses are fully deductible in the year you completely dispose of the activity. 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.
When Can I Deduct an Expense?
When you can deduct an expense depends on your accounting method. An accounting method is a set of rules used to determine
when and how income and
expenses are reported. The two basic methods are the cash method and the accrual method. Whichever method you choose must
clearly reflect income.
For more information on accounting methods, see Publication 538.
Cash method.
Under the cash method of accounting, you generally deduct business expenses in the tax year you pay them.
Accrual method.
Under an accrual method of accounting, you generally deduct business expenses when both of the following apply.
-
The all-events test has been met. The test is met when:
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All events have occurred that fix the fact of liability, and
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The liability can be determined with reasonable accuracy.
-
Economic performance has occurred.
Economic performance.
You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is
for property or services
provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the
property is used. If your
expense is for property or services you provide to others, economic performance occurs as you provide the property or services.
Example.
Your tax year is the calendar year. In December 2005, the Field Plumbing Company did some repair work at your place of business
and sent you a bill
for $600. You paid it by check in January 2006. If you use the accrual method of accounting, deduct the $600 on your tax return
for 2005 because all
events have occurred to “fix” the fact of liability (in this case the work was completed), the liability can be determined, and economic
performance occurred in that year.
If you use the cash method of accounting, deduct the expense on your 2006 return.
Prepayment.
You generally cannot deduct expenses in advance, even if you pay them in advance. This rule applies to both the cash
and accrual methods. It
applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create
an asset with a useful
life extending substantially beyond the end of the current tax year.
Example.
In 2005, you sign a 10-year lease and immediately pay your rent for the first 3 years. Even though you paid the rent for 2005,
2006, and 2007, you
can only deduct the rent for 2005 on your 2005 tax return. You can deduct the rent for 2006 and 2007 on your tax returns for
those years.
Contested liability.
Under the cash method, you can deduct a contested liability only in the year you pay the liability. Under the accrual
method, you can deduct
contested liabilities such as taxes (except foreign or U.S. possession income, war profits, and excess profits taxes) either
in the tax year you pay
the liability (or transfer money or other property to satisfy the obligation) or in the tax year you settle the contest. However,
to take the
deduction in the year of payment or transfer, you must meet certain conditions. See Contested Liability in Publication 538 for more
information.
Related person.
Under an accrual method of accounting, you generally deduct expenses when you incur them, even if you have not yet
paid them. However, if you and
the person you owe are related and that person uses the cash method of accounting, you must pay the expense before you can
deduct it. Your deduction
is allowed when the amount is includible in income by the related cash method payee. See Related Persons in Publication 538.
Not-for-Profit Activities
If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset
other income.
Activities you do as a hobby, or mainly for sport or recreation, are often not entered into for profit.
The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not
apply to corporations
other than S corporations.
In determining whether you are carrying on an activity for profit, several factors are taken into account. No one factor alone
is decisive. Among
the factors to consider are whether:
-
You carry on the activity in a businesslike manner,
-
The time and effort you put into the activity indicate you intend to make it profitable,
-
You depend on the income for your livelihood,
-
Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
-
You change your methods of operation in an attempt to improve profitability,
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You (or your advisors) have the knowledge needed to carry on the activity as a successful business,
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You were successful in making a profit in similar activities in the past,
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The activity makes a profit in some years, and
-
You can expect to make a future profit from the appreciation of the assets used in the activity.
Presumption of profit.
An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including
the current year. Activities
that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced
a profit in at least 2 of
the last 7 tax years, including the current year. The activity must be substantially the same for each year within this period.
You have a profit when
the gross income from an activity exceeds the deductions.
If a taxpayer dies before the end of the 5-year (or 7-year) period, the “ test” period ends on the date of the taxpayer's death.
If your business or investment activity passes this 3- (or 2-) years-of-profit test, the IRS will presume it is carried
on for profit. This means
the limits discussed here will not apply. You can take all your business deductions from the activity, even for the years
that you have a loss. You
can rely on this presumption unless the IRS later shows it to be invalid.
Using the presumption later.
If you are starting an activity and do not have 3 (or 2) years showing a profit, you can elect to have the presumption
made after you have the 5
(or 7) years of experience allowed by the test.
You can elect to do this by filing Form
5213. Filing this form postpones any determination that your activity is not carried on for profit until 5 (or 7) years
have passed since you started the activity.
The benefit gained by making this election is that the IRS will not immediately question whether your activity is
engaged in for profit.
Accordingly, it will not restrict your deductions. Rather, you will gain time to earn a profit in the required number of years.
If you show 3 (or 2)
years of profit at the end of this period, your deductions are not limited under these rules. If you do not have 3 (or 2)
years of profit, the limit
can be applied retroactively to any year with a loss in the 5-year (or 7-year) period.
Filing Form 5213 automatically extends the period of limitations on any year in the 5-year (or 7-year) period to 2
years after the due date of the
return for the last year of the period. The period is extended only for deductions of the activity and any related deductions
that might be affected.
You must file Form 5213 within 3 years after the due date of your return for the year in which you first carried on the activity,
or, if earlier,
within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable
to the activity.
If your activity is not carried on for profit, take deductions in the following order and only to the extent stated in the
three categories. If you
are an individual, these deductions may be taken only if you itemize. These deductions may be taken on Schedule A (Form 1040).
Category 1.
Deductions you can take for personal as well as for business activities are allowed in full. For individuals, all
nonbusiness deductions, such as
those for home mortgage interest, taxes, and casualty losses, belong in this category. Deduct them on the appropriate lines
of Schedule A (Form 1040).
You can deduct a casualty loss on property you own for personal use only to the extent it is more than $100 and exceeds 10%
of your adjusted gross
income. See Publication 547 for more information on casualty losses. For the limits that apply to mortgage interest, see Publication
936.
Category 2.
Deductions that do not result in an adjustment to the basis of property are allowed next, but only to the extent your
gross income from the
activity is more than your deductions under the first category. Most business deductions, such as those for advertising, insurance
premiums, interest,
utilities, and wages, belong in this category.
Category 3.
Business deductions that decrease the basis of property are allowed last, but only to the extent the gross income
from the activity exceeds the
deductions you take under the first two categories. Deductions for depreciation, amortization, and the part of a casualty
loss an individual could not
deduct in category (1) belong in this category. Where more than one asset is involved, allocate depreciation and these other
deductions
proportionally.
Individuals must claim the amounts in categories (2) and (3) as miscellaneous deductions on Schedule A (Form 1040). They
are
subject to the 2%-of-adjusted-gross-income limit. See Publication 529 for information on this limit.
Example.
Ida is engaged in a not-for-profit activity. The income and expenses of the activity are as follows.
Ida must limit her deductions to $3,200, the gross income she earned from the activity. The limit is reached in category (3),
as follows.
The $800 of depreciation is allocated between the automobile and machine as follows.
The basis of each asset is reduced accordingly.
The $1,600 for category (1) is deductible in full on the appropriate lines for taxes and interest on Schedule A (Form 1040).
Ida deducts the
remaining $1,600 ($1,300 for category (2) and $300 for category (3)) as other miscellaneous deductions on Schedule A (Form
1040) subject to the
2%-of-adjusted-gross-income limit.
Partnerships and S corporations.
If a partnership or S corporation carries on a not-for-profit activity, these limits apply at the partnership or S
corporation level. They are
reflected in the individual shareholder's or partner's distributive shares.
More than one activity.
If you have several undertakings, each may be a separate activity or several undertakings may be combined. The following
are the most significant
facts and circumstances in making this determination.
-
The degree of organizational and economic interrelationship of various undertakings.
-
The business purpose that is (or might be) served by carrying on the various undertakings separately or together in a business
or investment
setting.
-
The similarity of the undertakings.
The IRS will generally accept your characterization if it is supported by facts and circumstances.
If you are carrying on two or more different activities, keep the deductions and income from each one separate. Figure separately
whether each is a
not-for-profit activity. Then figure the limit on deductions and losses separately for each activity that is not for profit.
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