During tough economic times, everyone always tries to reduce expenses and increase savings. Believe it or not — one government agency actually rewards you for spending. The reward comes in the form of more tax savings — not increased income, mind you, but more savings. Okay, you are probably reading the foregoing sentences again as if there was something you missed or perhaps, a typo error on my part. Well, you heard it — rather, read it right. The more you spend, the more of your money you can save (after taxes and expenses), thanks to my favorite government agency, the IRS, and its backbone, the Internal Revenue Code (Title 26 of the United States Code).
The More Expenses You Have, The Higher Your Tax Deductions
The Tax Code allows deductions for ordinary and necessary expenses. Section 162 of the Tax Code allows deductions for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. So theoretically, the more business expenses one incurs, the more deductions. More deductions result in more tax savings.
Let’s run through that once again. If you have more expenses to deduct, then your tax base upon which the IRS will determine or peg a tax rate, becomes smaller. This translates into the taxpayer paying less taxes and keeping more of his income (after expenses).
Image from GetACoder.com
Most of us understand the basic principle of deductions or deductible expenses. But let’s dissect what it takes to consider a business expense as a tax deduction. To be deductible, the expense must be ordinary and necessary, according to the TC (the nickname of the Tax Code above). Take note of the use of the conjunction “and” as distinguished from “or.”
When Is A Business Expense A Tax Deduction?
Ordinary expenses are those that are accepted and common.
Now if one habitually incurs a certain expense in the course of operating a business, does that mean the expense is ordinary? (Thus, meeting half of the formula to make it deductible?) Not so. The inquiry employed here in determining ordinariness is not subjective (or based on what one actually does in his business) but rather, objective (or taking into account the norms, customs and what is common among those engaged in a particular business or industry).
Here’s an interesting case study: In one US Supreme Court case, a taxpayer worked for a company that was engaged in the grain business. The company went bankrupt. Its suppliers and creditors were naturally upset. Then the taxpayer was later hired by another company engaged in a similar business as the bankrupt company. In order to reestablish his association with the previous creditors of the bankrupt grain company, the taxpayer decided to pay them back from his personal funds. He paid them the amount equivalent to the claims they had against the defunct grain business to make them whole.
The taxpayer now sought to deduct such payments as business expenses. Care to surmise what happened next? Well, the IRS overruled these tax deductions, and this ruling was affirmed by the US Supreme Court. The court reasoned that the payment of debts of others may be performed, but these were not ordinary expenses. They were more like extraordinary expenses. In fact, since these payments were done to reestablish good relations, they were more akin to purchasing goodwill, which is treated like a capital asset. Money spent in acquiring capital assets are not ordinary expenses.
Necessary expenses are those that are appropriate and helpful.
This is the other half of the formula to turn an expense into a deductible one. This particular condition is actually easier to establish. An expense is necessary if it is appropriate and helpful. What makes this easier to prove is that only the activities of the particular business are considered. There’s no need to prove customs or norms generally accepted in the industry. Businesses rarely make expenditures that are not appropriate and helpful.
Examples of expenses that exemplify the appropriate and helpful factors are those made to prolong the life of a capital asset, increasing its value or making it adaptable to a different use. Repairs and maintenance expenses are among the common types of necessary expenses.
Another case study: In one US Supreme Court case, a meat packing company situated near an oil refinery was adversely affected by the seepage of oil into its basements from the refinery. The meat company lined the basement walls with concrete to prevent further seepage. Consequently, the meat company claimed the expenses to fix its walls as deductions. But the IRS overruled the claim: they reasoned that this was a capital improvement and should be recovered through depreciation. But what did the US Supreme Court rule? They found in favor of the meat packing company. They found that the expenses were made for the purpose of restoring property to a sound state, or for keeping the property in an ordinarily efficient operating condition.
Well this explains the fundamentals of business deductions. Good luck with figuring out which of your business expenses are tax deductible!
Contributing Writer: Earl Fischer
Copyright © 2011 The Digerati Life. All Rights Reserved.
{ 7 comments… read them below or add one }
This is a good example of getting the facts right but coming to the wrong conclusion. I sincerely apologize to the author of the above article. You are not alone. Unfortunately.
Beware that if you spend money just to reduce your taxes, you end up with less money in your pocket.
Let’s put some numbers to the scenario where “the more you spend, the more money you can keep.”
Start with taxable income of $100 and a 15% tax bracket. I calculate tax at $15 and I keep $85 in my pocket. Remember that. $85. Write it down, we’ll need it later. We have $85 in our pocket after taxes.
As an astute, but misguided business owner who just read the above piece, I back up and spend $25 out of my pocket on an ordinary and necessary business expense. Taxable income goes to $75, and the tax bill is now $11.25 instead of $15. You spent $25 to save $3.75.
But now I only have $63.75 in my pocket! 25% less than before the action you prescribe.
Sincerely,
Earl Kelly, econtrol.cc
@Earl Kelly,
Thank you for your comment!
The writer of this article is an attorney, albeit NOT a tax attorney (yet). Although I sort of understood what he meant, or what I think he meant. You won’t necessarily have more money than you started with. But you could increase your tax savings (not income). I think there were some problems with the wording. I fixed it, so hopefully it has been clarified. Your example is much appreciated as it provides clarification.
As business owners, we have to spend anyway. If we did NOT take deductions, we’d have bigger expenses. So in that sense, by taking deductions, we are increasing the money in our pocket via tax savings. Another way to look at it: your business expenses are on a discount.
In my mind, it’s really just reducing expenses, not earning more income. There is a lot of terminology here that can cause confusion. How people get money back from taxes or how much they’re paying in taxes — these are areas of confusion that should be dissected more carefully. I hope to do it more in the future.
C’mon, if one had the choice of paying more tax or less tax, then the difference will be a “savings” of some sort, regardless of whether I see it in my pocket/wallet today. I think that is true of the energy savings credit that I am availing of from last year when I did some upgrades on my home (where I had to shell out money to fix the windows to more energy efficient ones). To avail of the tax credit/break, I had to spend. If I did not want to spend, then no tax break for me too.
I totally get what Mr. Fischer is referring to. I do this also on the business expense portion of my itemized tax filing. I do not get to keep money per se but rather I do not pay as much tax to the IRS which in some sense is a “savings”. Also, when all is said and done, it may lead to a larger refund from the IRS after itemizing—the delta between the larger refund and the smaller refund is the “income”. I found it funny reading the discrepancy between what the IRS ruled as “unnecessary” and what the US Supreme Court upheld as a “necessary” expense. Of course it is all point of view but what I want is more money for me/business rather than some other entity.
The real key for expensing is recognizing all of the deductible expenses that are out there, not increasing your expenditures for the sake of reducing your taxable income. One example, expenses related to job interviewing, travel/miles, printing, telephone, resume/writing can be deducted in certain circumstances. Many people aren’t aware of this. So, just being aware of all deductible expense items, including those lesser-known deductions can really add up.
What confuses me about business deductions is the line between business and personal, when it comes to small part-time businesses. For example, if you can’t run your small business without a computer, but you’d have a computer even if you didn’t have a small business, but not as nice a one… That kind of thing.
@ Steve, spot on, the key is recognizing the deductables that you can apply. Many individuals and small businesses dont have much of an idea what they can claim. Hopefully, their Bookkeeping/Accounting service will provide the right advise, but sadly many don,t. We always spend time in the details with our clients with this in mind and not just in Tax season…. for us its an all year round process as it should be.
I am in the small business of selling TV & home security. How much can I claim as an expense re my own Tv & home security bills per year, as these are demos of my products ?