What is Deductible? 7 Points to Know
Can you deduct the cost of __________ (fill in the blank)? If you have been wondering what the answer is to this question, read on....
Tax Deductions, GenerallyOur tax laws are statutory, meaning, to be deductible, an expense has to be allowed by a specific Code section. There are a number of Code sections that provide for tax deductions. Most expenses fall under two Code sections. These Code sections provide for a tax deduction for ordinary and necessary business expenses and investment expenses.
Tax Deductions for Business ExpensesFor business expenses to be deductible for tax purposes, they have to be:
1. Ordinary and necessary,
2. Paid in carrying on a trade or business, and
3. Paid in the current year.
The implementing regulations and court cases clarify each of these requirements.
An *ordinary and necessary* expense is one that is common or frequent in the type of business in which the taxpayer is engaged. A *necessary* expense is one that is "appropriate and helpful" to the taxpayer's business.
The Code provides several examples of ordinary and necessary business expenses, including salaries for personal services rendered, non-lavish traveling expenses while away from home for work, and rental or lease payments for property used in a business.
The courts have addressed fact patterns that are less certain. For example, the courts have struggled with cases involving payments made by one company to protect its business reputation where the taxpayer did not have a legal obligation to make the payments. The courts have generally said that these discretionary payments can be ordinary and necessary expenses.
The courts have said that the *in carrying on* language imposes a higher standard that the looser *in connection with* language that is used for some other tax deductions. This higher standard requires the taxpayer actually have an active and identifiable business.
Even the requirement that the expense be paid in the current year has been litigated. Many of the more difficult cases in this area involve situations where the taxpayer was credited with payment, rather than making direct payment.
Tax Deductions for Investment ExpensesInvestment expenses can also be deductible. These tax deductions are limited to individuals, rather than corporations.
The law imposes similar requirements as those for business expenses. Specifically, the expense has to satisfying the following requirements to be a deductible investment expense:
1. Ordinary and necessary,
2. Paid for the production or collection of income or for the management, conservation, or maintenance of property held for investment, and
3. Paid in the current year.
These expenses often include investment, trustee, and other professional fees.
While the Code says that these expenses are deductible, the recent Tax Cuts & Jobs Act (*TCJA*) has had the impact of disallowing most of these expenses if they are not tied to a specific item of property.
Tax Deductions for Personal ExpensesPersonal, living, and family expenses are generally not deductible. While this rule seems self explanatory, it is hard to apply in practice. This often turns on the distinction as to whether an expense is a business or personal expense. The use of a personal cell phone for work is a prime example.
The Taxpayer Bears the BurdenRegardless of the type of tax deduction, the law puts the burden on the taxpayer to establish their entitlement to the deduction. This burden is one of producing records sufficient to enable the IRS to determine the correct tax.
The IRS expects these records to be created contemporaneously rather than after-the-fact on audit. The courts have also imposed a similar standard. They often note that the failure to keep and present contemporaneous records weighs heavily against a taxpayer's attempted proof.
Estimates May be PossibleBut what happens when it is clear that the taxpayer incurred a deductible expense, but the records have been lost or destroyed? Or what if the records were never created?
The courts have said that if a taxpayer has inadequate business records can prove that he paid certain expenses, but cannot substantiate the exact amount, the court has the discretion to estimate the amount allowable deduction. This is referred to as the Cohan rule, from the Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930) court case.
The Cohan rule has to parts:
1. The taxpayer can show that some deductible expense was incurred and
2. The taxpayer has some records or other evidence to provide the courts with a means to estimate the amount of the deduction.
This estimation rule is not mandatory on the IRS or courts; rather, the IRS or courts can use it as they see fit. In applying the rule, the courts often note that the court is to "bear heavily * * * upon the taxpayer whose inexactitude is of his own making."
No Estimates for Some ExpensesThere are some expenses that cannot be estimated using the Cohan rule. These expenses are those set out in Sec. 274(d). This Code section imposes strict substantiation requirement for some deductions, including travel expenses and gifts. It also applies to listed property, which includes any passenger vehicle.
With Sec. 274(d) expenses, the Code says that no tax deduction is allowed unless the taxpayer substantiates, by adequate records or by sufficient evidence corroborating his statements, the amount, time, place, and business purpose of each expenditure.
Even though the court cannot apply the Cohan rule to approximate these expenses, the implementing regulations provide an exception for cases in which the records were lost by fire, flood, or other casualty.