Allowable Tax Deductions for Business Expenses

As a tax attorney in California with tax season right around the corner, business owners and entrepreneurs regularly ask me which expenses can be deducted on their taxes as “business expenses” and which cannot. The basic question of whether an expense is personal or business is answered by the tax code under a three part test. Generally, an expense is deductible if (1) it is related to a trade or business, (2) it is ordinary and necessary, and (3) it is paid or incurred in carrying on a trade or business. (Internal Revenue Code section 162(a), 26 U.S.C. § 162(a).)

First, for an expense to be related to a trade or business, your activities must rise to the level of a trade or business and there must exist a connection between the activities and the expense. For your activities to constitute a trade or business, you must enter into the activity for the purpose of making a profit, and your activities must be substantial and sustained.

Second, the expense must be an ordinary and necessary expense. An expense is ordinary if it is normal, usual or customary in the type of business in which it is incurred. An expense is necessary if it is appropriate or helpful to the business. In addition, the expense must be reasonable.

Third, the expense must be incurred in carrying on a trade or business. An individual is carrying on a trade or business only if he is actively engaged in the trade or business. Consequently, expenses relating to looking for a new trade or business, preparing for a new trade or business, or investigating the potential success of a new business are not deductible as ordinary and necessary business expenses.

While these rules may sound simple, they can get quite complex, especially in the area of personal versus business expenses. Often times, questions have very clear answers, and violations of those answers can result in penalties. If you’re not sure whether an expense is proper to deduct, contact an attorney that focus on tax law to prevent the costs of tax penalties for non-compliance. If you’re already facing a proposed tax increase and/or penalties and think you may be in the right, a tax lawyer is your best option to assess whether you have a case and advocate for your interpretation of the tax code.