Business Expense Deductions
Business expenses may be deducted from gross income, but the law governing deductions can be intricate, and both taxpayers and the IRS may make mistakes in applying these rules. See IRC §§ 162, 183, 274(d); see also IRS Publication 535 (http://www.irs.gov/pub/irs-pdf/p535.pdf). To be entitled to a deduction for business expenses, the expenditure must be ordinary and necessary and paid or incurred in carrying on a trade or business.
The IRS occasionally questions whether the taxpayer is conducting a business claiming that the taxpayer instead is engaged in a “hobby.” If this is proved, deductions may be disallowed under § 183. This occurs generally when there is no documenting information sent to the IRS supporting the income such as a Form 1099 . The student attorney should work with the client to substantiate the business activity and the claimed expenses. The student attorney should also review the applicable law or speak with a supervisor to ensure that the deduction is proper and that the client was engaged in a business.
The student attorney should exercise due diligence before submitting a claim for business deductions. The IRS is concerned that a taxpayer may exaggerate business losses to offset income from other sources (such as the wages of a spouse). The reduction in reported income may increase the size of tax credits such as the Earned Income Tax Credit (EITC).
Deductions under IRC § 162 (arising from a trade or business) are distinct from § 212 (arising from the production of income such as an investment activity).
To substantiate claimed business expense deductions, the student attorney will prepare a notebook for the IRS. The notebook should include:
- A copy of any correspondence from the IRS, especially notices explaining changes to the return
- A copy or transcript of the tax return
- A memorandum
- Exhibits to substantiate the claimed expenses
- A mileage log or odometer readings
- Calendar of daily business activities
- Profit/Loss statements
- Bank statements indicating business income
- Receipts for expenses
- Customer rosters
A sample memorandum is available below. A good example of a Tax Court discussion of business expense deductions contained in Delima v. Commissioner, T.C. Memo. 2012-291 (October 16, 2012) (linked below).
While the specific rules for deductions vary depending on the type of expense, here are four things to keep in mind:
- The expense must be connected with a business (discussed below);
- The expense must be both commonly incurred in the type of business in which the taxpayer is engaged and appropriate and helpful in that business;
- The expense must be paid;
- Generally, the expense must be substantiated with documentary evidence.
The IRS may challenge the existence of a business. A business must have the opportunity for profit, and not be merely a source of deductions used to offset other income. IRC § 183(a). The IRS will presume that an activity is not a business if the client reports losses from the activity for three out of five years. IRC § 183(d). This presumption can be rebutted with evidence that the client had a bona fide belief that her activity would produce a profit, and the student attorney should seek evidence of this belief (e.g., the client had no other source of income, had prior success, etc.).
If the client is unable to establish that a business exists, under limited circumstances the client may still deduct expenses up to the amount of income from the activity. IRC § 183(b)(2). This is normally presented as an alternative argument for claiming the deductions.
The IRS may also disallow a deduction for expenses even though a business exists. Often, these disallowances arise because the IRS believes the expense is personal in nature (especially clothing, meals, or travel to popular vacation spots).
The IRS usually requests substantiation of claimed expenses. IRC § 274(d). In these cases, the student attorney should work with the client to gather documentary evidence. Help the client create a system for organizing documents, but have the client sort through receipts. You may want to prepare a spreadsheet on which the client can insert the claimed expenses and supporting evidence The spreadsheet may become an Appendix for the notebook. A client may no longer have their business records. There are limited circumstances when the taxpayer is allowed to reconstruct the records. If this issue arises, first discuss the situation with your supervisor.
In certain cases, the IRS may challenge the existence of business income reported on the client’s return but that was not reported on a Form 1099. Taxpayers with very low income, especially those with children, may benefit from higher income which increases the EITC. Any self-employment tax due on the non-existent income will be offset by the increased credit. In these cases, the IRS may request bank statements or business records indicating receipt of the reported income. If these records are not available (and it is not unreasonable for a very small business to operate on an entirely cash basis; e.g., informal childcare, day labor, etc.), the student attorney should ask the client to collect signed statements from customers attesting to the business and the value of any payments to the client.