This is one of a series of Legal Log entries concerning the organization of business income and expenses for federal income tax purposes. In part 1, we reviewed the treatment of income. This month, we examine the general treatment of expenses for tax purposes.
Expenses
To reduce the amount of net income on which income taxes are paid, the business
must prove that its expenditures were legally permitted to be deductible business
expenses. As a rule of thumb, most expenses that are deductible business expenses
for corporations, partnerships and limited liability companies and partnerships are also
deductible for proprietorships. Still, due to the need to show that the expense is not for
personal, family, or living purposes, the individual proprietor has a greater
recordkeeping burden to satisfy the tax authorities that the expense has a bona fide
legitimate business purpose. Although there is an equivalent burden upon incorporated
businesses to show the proper expenditure of corporate funds, it is assumed for tax
purposes that funds were spent for corporate purposes, unless the facts show that no
business purpose was served by the expense.
Basic tax law principles that govern all types of deductions apply to all taxpayers: Anyone who seeks a deduction must show the specific tax code provision or regulation that supports the deduction. Further, all deductible expenses must be substantiated, and the taxpayer must show that the expense qualifies for a particular deduction. This includes travel and entertainment expenses, local travel expenses, gifts, and the purchase or use of computers, and transportation equipment like automobiles and aircraft (i.e., one’s hot air balloon). Where there is a mixture of personal and business use, the records must clearly document the actual and proportionate business and personal use. (In fact, the deduction will fail unless the business use exceeds fifty percent.) To be safe, all businesses should maintain thorough records and document as many expenditures as possible.
These substantiating records must show the amount, the circumstances of the expense, such as time and place, the specific business purpose, and the business relationship of the other persons involved in the expense. The following records can sufficiently collaborate a business expenditure, especially if the business maintains these records routinely whether as a paper or electronic record: (1) account books, (2) appointment dairies, (3) logbooks, (4) receipts and paid bills, (5) trip sheets, (6) expense and reimbursement reports, and when necessary, (7) recorded statements by other people involved in the expense.
While a manual recordkeeping system is perfectly valid if carefully maintained, various software packages have come into the retail marketplace in recent years that are well suited to this task. As will be discussed in an upcoming Legal Log, computerized records, routinely maintained and stored on electronic media, should satisfy the substantiation recordkeeping requirement. All records also must be "contemporaneous," that is, they must have been created at the time the expense is incurred, or the time the use of an item occurred, or soon after that.
Ordinary and Necessary
To be a business deduction, a business expense must be both ordinary
and necessary. An "ordinary" expense is one that is common and accepted
in the particular trade, business, or profession. A "necessary" expense is one that is
helpful and appropriate in the particular field. The expense must be
reasonable and be connected with the taxpayer’s specific business; the
degree of reason and connection will vary according to the circumstances of the
expense. Such expenses must be distinguished from expenses related to the costs of
selling goods, such as acquiring, producing or storing goods that are deducted in
computing the income of the business, and from expenses related to capital
investment, which must be depreciated or amortized as part of the investment.
Costs of Goods Sold
There are various expenses that are treated as part of computing the cost of
goods sold. These include: (1) the cost of products or raw materials, including
their shipping costs; (2) the cost of storage of the raw materials, incomplete products,
and completed products awaiting shipment; (3) direct labor costs for production
workers; (4) depreciation expense for machinery used in production or storage; and (5)
overhead cost of management and administration for production or storage. For those
ballooning businesses that make accessory products, records of these expenses
should be maintained carefully. (Although these expenses are not specifically listed as
deductions from net income, they are deducted from the gross revenue of the business
to compute net income.)
Capital Expenditures
Capital expenses are those that have a long term impact on the
business; whose costs must be treated as an investment in the business. These costs
are deducted over the estimated lifetime of the expense. There are three basic type of
capital expenditures:
In Part 3, we will look at how to organize usual expenses to simplify reporting deducible business expenses.