Business and special deductions

Business expense deductions

Accounting methods are used to determine when revenue is recognized, directly impacting reported earnings and financial ratios such as gross and net profit margins. Investors and lenders rely on these figures to assess a company’s stability and growth potential.

The cash accounting method income when paid or constructively received by the taxpayer even if actual cash is not yet under the physical control of the taxpayer and expenses at the time when they are actually paid. A business deducts an expense in the tax year when it is actually paid, not when the expense is incurred or the service is used. There are some exceptions, such as for long-term prepaid expenses i.e., rent or insurance, which may be subject to a 12-month rule, requiring them to be deducted over the period they benefit rather than when paid.

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example, interest credited to a bank account is considered constructively received even if the funds have not yet been withdrawn.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 recognizes income when earned or taxpayer have a right to receive it, regardless of whether paid. 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. However, it must be applied consistently and approved by the IRS. However, it is not used in filing a tax return.

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. The common deductible expenses that a business can incur include but are not limited to, are inventory, 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 uniquely necessary to the trade or business.

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. See IRS pub. 463 for details.

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. In 2020, the Consolidated Appropriations Act (CAA) was signed into law, allowing food and beverage expenses purchased directly from restaurants in 2021 and 2022 to become 100% deductible.

100% Deductible meal expenses

• On-site dining for employees
• Holiday parties for employees
• Employee events to boost productivity and retention
• Meals served during a company’s business presentation
• Food and beverages purchased from restaurants
• If taxpayer is on an overnight business trip

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.

Per diem rates, business use car, gift, and travel expenses
Either the standard mileage or the actual expense method can be used to deduct the business use percentage of a car or truck. The standard mileage rate is usually changed by the IRS every year. Gifts are limited to $25 deduction for each gift given by the giver. Amounts given that exceeds $25 is income to the recipient. 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 daily allowance provided to employees or self-employed taxpayers to cover lodging, meals, and incidental expenses incurred while traveling away from home for business. The IRS publishes annual per diem rates that may be used in lieu of tracking actual expenses.

Other nondeductible expenses:
Illegal activities, penalties and fines, political contributions, commuting costs, gifts exceeding $25, entertainment expenses (see IRC section 274 for details), life insurance premiums, and work clothes required by the employer, and demolition costs of business-use property are not tax deductible.