Business and special deductions

Business expense deductions

Accounting methods determine when a business reports income and deductions for tax purposes - in other words, which tax year an item belongs to. The method a business chooses can shift taxable income between years, which is why the IRS requires it to be applied consistently once adopted.

The cash accounting method recognizes income when it is paid or constructively received, and deducts expenses in the tax year they are actually paid - not when the expense is incurred or the service is used. There’s an exception for certain prepaid expenses, such as rent or insurance, under the 12-month rule: if the benefit doesn’t extend beyond the earlier of 12 months after the benefit begins or the end of the tax year after the year of payment, the taxpayer can deduct the full prepayment in the year it’s paid. If the benefit extends beyond that window, the expense must instead be capitalized and deducted over the period it benefits.

Definitions

Constructive receipt

Constructive receipt occurs when income is credited to a taxpayer’s account or made available to them without restriction, even if the taxpayer has not physically received it. For example, interest credited to a bank account is considered constructively received even if the funds have not yet been withdrawn.

The accrual accounting method generally recognizes income when all events have occurred that fix the right to receive it and the amount can be determined with reasonable accuracy: the earliest of when payment is received, when it is due, or when it is earned, with special rules for advance payments. Under the accrual method, expenses are recognized and recorded in the accounting period when they are incurred (when goods are received or services are rendered), regardless of when cash is actually paid. This process is called an accrual and involves recording the expense on the income statement and creating a corresponding liability on the balance sheet, ensuring financial statements accurately reflect the economic activity and obligations of the period.

The hybrid accounting method combines elements of both the cash and accrual methods of accounting. Under this approach, a taxpayer uses the cash method for certain items of income and expense (recognizing them when received or paid) and the accrual method for others (recognizing them when earned or incurred). This method is often used when it more clearly reflects income, such as recognizing sales and cost of goods sold under the accrual method while using the cash method for other expenses. A taxpayer may use a hybrid method on a filed return as long as it clearly reflects income and is applied consistently from year to year.

A taxpayer who wants to change their accounting method from cash to accrual or vice versa must file Form 3115, Application for Change in Accounting Method, with the IRS. This form is required for changes in inventory valuation, depreciation adjustments, or any other method relating to a specific item.

Definitions

Form 3115

The IRS form used to request consent to change an accounting method. It is required when a taxpayer switches between cash and accrual accounting, changes inventory valuation methods, adjusts depreciation methods, or modifies any other accounting practice for a specific item.

Deductible expenses

Pursuant to IRC section 162, business expenses are ordinary and necessary costs incurred in the course of business which are subtracted from revenue to arrive at a company’s taxable net income. Cost of goods sold isn’t one of these expenses: it is subtracted from gross receipts to figure gross profit, before any business expense is deducted. Common deductible business expenses include, but are not limited to, advertising, car and truck, contract labor, payroll, insurance, legal and accounting fees, communication, rent or lease equipment, vehicles or property, and other expenses that are ordinary and necessary to the trade or business. A capital expenditure, such as the cost of buying or improving equipment, a vehicle, or a building, isn’t deducted as a current expense; its cost is capitalized and recovered over time through depreciation or amortization.

Definitions

IRC (Internal Revenue Code)

The primary body of federal statutory tax law in the United States, codified in Title 26 of the U.S. Code. It governs all aspects of federal taxation, including income, payroll, estate, and excise taxes. IRC section 162 specifically addresses the deductibility of ordinary and necessary business expenses.

Ordinary and necessary

An expense is “ordinary” if it is common and accepted in the taxpayer’s trade or business, and “necessary” if it is helpful and appropriate for the business. Both conditions must be met for an expense to be deductible under IRC section 162.

Either the standard mileage rate or the actual expense method can be taken. You must use actual expenses if you used five or more vehicles simultaneously in your business (such as in fleet operations). The actual expense method is not allowed for a leased vehicle if the standard mileage method was previously used for that vehicle. Under the actual expense method, a car must be used more than 50% for business to qualify for the Section 179 deduction, bonus depreciation, or accelerated MACRS depreciation; at 50% or less, it is depreciated by the straight-line method over 5 years. See IRS pub. 463 for details.

Work-related education is a deductible business expense for a self-employed taxpayer (on Schedule C or F) if it maintains or improves skills needed in the taxpayer’s present work, or is required by law or an employer to keep the taxpayer’s present salary, status, or job. Even when it meets one of those tests, education isn’t deductible if it’s needed to meet the minimum educational requirements of the present trade or business, or if it’s part of a program of study that will qualify the taxpayer for a new trade or business - even one the taxpayer doesn’t plan to enter (for example, law school for an accountant).

Meal and entertainment expenses

The Tax Cuts and Jobs Act (TCJA) of 2017 brought changes that eliminated the deduction for entertainment expenses, while still allowing for a 50% deduction on qualifying meal expenses. The Consolidated Appropriations Act (CAA), signed into law in 2020, temporarily raised the deduction to 100% for food and beverages purchased directly from restaurants in 2021 and 2022. That temporary rule expired after 2022, so for 2025 qualifying business meals are generally back to the standard 50% deduction (IRS Pub. 463). A meal eaten for personal reasons, with no business purpose, is a personal expense and isn’t deductible at all (IRC section 262).

100% deductible meal expenses

• Free food and beverages provided to the general public as advertising or to promote goodwill
• Holiday parties for employees
• Employee events to boost productivity and retention
• Meals served during a company’s business presentation

50% deductible meal expenses

• Meals provided by restaurant
• Meals provided to taxpayer and taxpayer’s client while talking about business
• Meals consumed while taxpayer is traveling for business
• Meals given to client - Example: client is given a coupon or voucher for meal

Examples of nondeductible entertainment expenses
Tickets for seating at sporting events, theatre concerts, golf outings, museums, sightseeing tours, or cultural events even if related to business. Food and beverages provided at an entertainment event are deductible as a meal (subject to the 50% limit) only if they are purchased separately from the entertainment or their cost is stated separately on the bill, invoice, or receipt; otherwise the entire cost is nondeductible entertainment.

Per diem rates, business use car, gift, and travel expenses
The IRS updates the standard mileage rate annually (see the car and truck expense rules above). Gifts are limited to a $25 deduction per recipient per year for the giver. Any amount above $25 per recipient per year is simply nondeductible to the giver; the $25 limit doesn’t determine whether the recipient has income. There are certain rules for foreign business travel, tax home, family home, and recordkeeping to substantiate business expenses. Refer to the IRS website for more details.

Definitions

Per diem

Latin for “per day.” A fixed daily amount an employer pays an employee for lodging, meals, and incidental expenses while traveling away from home for business, at the IRS-published rates, in place of reimbursing actual costs. A self-employed taxpayer can use only the meal and incidental part (the standard meal allowance); there is no standard lodging amount, so lodging is deducted at actual cost.

Other nondeductible expenses:
Illegal bribes and kickbacks, penalties and fines, political contributions, commuting costs, gifts exceeding $25, entertainment expenses (see IRC section 274 for details), life insurance premiums on a policy of which the business is directly or indirectly a beneficiary, clothing that is suitable for everyday wear (even when the work requires it), and demolition costs of business-use property are not tax deductible. An employee’s unreimbursed cost of a uniform or other work clothes isn’t deductible for 2025 either, except in a few categories of employment such as qualified performing artists, who can deduct theatrical clothing that isn’t suitable for everyday wear. For an illegal business, the Code disallows illegal bribes and kickbacks (IRC section 162(c)) and, if the business traffics in Schedule I or II controlled substances, all deductions (IRC section 280E); its other ordinary and necessary expenses, such as rent, wages, and legal fees, remain deductible.