Determining whether an expense qualifies as a deducible business expense is challenging for the new business owner. Below, are summarized guidelines to help determine whether an expense qualifies as being deductible as a business expense.
In general, an expense is deductible if: (1) it is related to a trade or business, (2) it is ordinary and necessary, and (3) it is paid or incurred in carrying on a trade or business.
First, for an expense to be related to a trade or business, your activities must rise to the level of a trade or business and there must exist a connection between the activities and the expense. For your activities to constitute a trade or business, you must enter into the activity for the purpose of making a profit, and your activities must be substantial and sustained.
Second, the expense must be ordinary and necessary. An expense is ordinary if it is normal, usual, or customary in the type of business in which it is incurred. An expense is necessary if it is appropriate or helpful to the business. In addition, the expense must be reasonable and not lavish.
Third, the expense must be incurred in carrying on a trade or business. An individual is carrying on a trade or business only if he or she is actively engaged in the trade or business. Consequently, expenses relating to looking for a new trade or business, preparing for a new trade or business, or investigating the potential success of a new business are not deductible as ordinary and necessary business expenses. However, such expenses may, through an election, be deducted up to $5,000 and then amortized over a 15-year period as start-up expenditures.
Certain trade or business expenses are not deductible even if they satisfy these tests. For example, expenses that violate public policy, such as bribes, are not deductible. In addition, expenditures for capital assets are not deductible, though a depreciation, amortization, or depletion deduction may be allowed.
Some of the deduction rules are complex and require informed judgment to determine whether a particular expense is deductible. For this reason, the facts of your situation should be carefully reviewed. If you would like to have a detailed discussion about the guidelines for your specific situation, please feel free to contact us.