We are often asked by our clients if they can deduct particular expenses. The key provision that governs any deduction of expenses against business income is that they are ‘ordinary & necessary’ expenses to operate the business. Of course, these are both subjective words. The IRS has taken “ordinary” to mean usual, customary, accepted or habitual, while “necessary” has been given a more loose definition. An expense does not have to be indispensable to be considered “necessary” – it only has to be convenient, useful, or appropriate. For example, expenses for employee recreation may not be mandatory, but they can be considered “necessary” if they are undertaken “for the improvement of the morale and well-being of employees.”[i] The case below of a manufacturing company referred to as FAA reflects an IRS interpretation of how those words apply:
A large, family-owned corporation engaged in manufacturing was founded many years ago by the family patriarch who discovered a trove of some sort of material essential for the company’s manufacturing. In a tax year not at issue, descendants of the patriarch traveled to the area, retrieved artifacts from the discovery site, and set up an exhibit relating to the find. The artifacts and exhibit wound up at the company headquarters. The corporation deducted the expenses of the trip, and the deduction wasn’t challenged by IRS.
In the tax year at issue in the memo, descendants of the company’s founder, led by the company president, made another trip to find other artifacts relating to the family patriarch’s establishment of the company. Company officers made the trip along with family members. The trip involved expenses for travel, rentals, security, public relations, and cinematography. An exhibit at the company headquarters displays photos, video, and artifacts retrieved. The company deducted the trip costs on its tax return, reasoning that the retrieved artifacts were “company icons holding particular significance” to the company, its employees and the surrounding community, and were “vital elements” of the company’s culture that “enhance and create opportunities” for the company to tell its story and promote itself. The expenses of the family members who came along on the trip were paid by the family and weren’t deducted by the corporation.
The IRS denied the deduction of the trip expenses for 2 reasons: 1) They did not show how the exhibit provided a direct benefit to the company; and 2) The trip included activities that provided significant personal enjoyment to the participants.
In order to secure the deduction, the company should have laid out a written plan (prior to undertaking the venture) of how they were going to use the exhibit to increase sales. Beyond just showing that the trip would have some intangible benefit to the company, they needed a concrete plan for how this was going to benefit them. Those benefits could include increased sales, increased efficiency, expanded capacity, reduced stress on the workforce, reduced expenses or extended life of assets employed in the business. (Note that there is always increased scrutiny when an expense only benefits the portion of the workforce that is related to the owners.) They also should have laid out what portions of the trip were business-related and what portions were more vacation in nature and reported a percentage of income to the employees based on that ratio.
The IRS distinguishes business expenses from (a) expenses used to figure cost of goods sold, (b) capital expenses, and (c) personal expenses. The first category would include things like raw materials costs. These costs are deducted from your gross revenue to calculate your gross profit, so they cannot also be included in business expenses. The second category includes business start-up costs and expenses for business improvements and assets such as equipment. These costs are considered an investment in the business and show up on your balance sheet rather than in expenses. The last category, personal expenses, is where you might allocate a portion of costs for a business trip such as the one FAA undertook. An example presented by the IRS has been that you borrow money and use 70% of it for business and the other 30% for a family vacation. In that case, you would generally deduct 70% of the interest as a business expense, and the other 30% would generally be nondeductible personal interest.[ii]
The key thing for any expense whose business nature is not obvious is to always document beforehand the details of the projected expense and the specific benefits it will bring to the business.
For further advice please consult your Wealth Advocate at Mackey Advisors.