Understanding Home Business Deductions con't...

Business vs Personal Expenses

IRC section 162 allows for:

A deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. It continues by giving these examples:

• A reasonable allowance for salaries or other compensation for personal services actually rendered.
  
• Traveling expenses while away from home in the pursuit of a trade or business. This does not include lunch during the average day. The IRS feels that is an expense at home or on the road. Meals mean while away from home for an overnight, and the meals and lodging must not lavish or extravagant under the circumstances.
  
• Rental payments for equipment or real estate.

An 'ordinary' expense generally is one that is normal, customary, or usual for a business under the facts and circumstances of its situation. An expense can be ordinary even if it does not occur on a continuing basis but only occurs once in the life of the business (for example, legal expenses for defending against a patent infringement). Ordinary really means ordinary in the course of running a business. Not ordinary for you.

A 'necessary' expense is one that is appropriate and helpful for the trade or business. This requirement helps distinguish between business and personal expenditures. A necessary expenditure need not be vital, but it may be appropriate for that line of business and helpful to the operation of the business. Think of it as a good thing to have but if you didn’t have it you could still operate. A good example would be property insurance. It may not be necessary in order to operate a business, but it is appropriate.

A final requirement is that the expense be 'reasonable' in amount. This is an issue that arises often in family-owned businesses. Salaries paid to family members must be appropriate for the amount and complexity of their work. That means you can’t pay Grandma $80,000 a year for moral support. Other expenses, such as travel and entertainment, may be disallowed by the IRS if the expenses are judged to be unreasonable for the circumstances, or if they appear personal in nature. So, that weeklong trip to Vegas to check out a supplier might be denied by the IRS.

Personal and family living expenses are not deductible unless specifically authorized by the IRC. Examples of deductible personal expenditures include the following:

• Prescription medicine and most medical expenses
• State and local taxes
• Home mortgage interest and property taxes
• Charitable contributions
• Many investment expenses

Some other expenditures might seem to be deductible business expenses but are actually nondeductible personal expenditures. For example, the costs of commuting to and from work and the cost of business attire are nondeductible personal expenditures. Here is how it breaks down:

If you have a gift shop downtown, your drive in to work in the morning and your return home that night are not allowable deductions. But if you work from home, your first call drive time is deductible as well as your return drive time home that night. BUT, upon returning home that night, you must go immediately to your home office, not to the kitchen. The reason is that your walk to the office in the morning and your walk at night from the office to the kitchen are not deductible expenses. In case this isn't clear, when you leave home in the morning make sure your first stop is a business stop, but if it’s Starbucks, make a business contact while there. That keeps it all legal.

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