Complicated deductions

Note: this article is intended primarily for taxpayers who file a schedule C. Partnerships (form 1065) and Corporations (form 1120 or 1120S) generally have deductions that are similar to these but often work a little differently. If you operate a Partnership or a Corporation your best course of action is to contact our office for information on how these deductions work for those entity types.

Where deductions to your business get complicated is when money is spent on something that is both for you, personally, and for your business. The amount spent on your, personally is not deductible. Only the business portion. For many expenses this is easy to differentiate. Below are some deductions where the separation is more difficult, and how the IRS has resolved this difficulty.

Meals and Entertainment (minus entertainment)

The IRS understands that taking a client or colleague out to lunch or dinner is for many businesses an important part of networking and business communications. So, businesses, including self employed individuals, are allowed to take a deduction for certain meals. (Note, as of the Tax Cuts and Jobs Act entertainment costs are no longer deductible. “Meals and Entertainment” remains in colloquial usage because this deduction was called that for so long, but only meals are allowed as of the writing of this article.)

The IRS allows a 50% deduction for Meals, as long as it meets the following criteria:

  1. The expense is an ordinary and necessary expense paid or incurred during the taxable year

  2. The expense is not lavish or extravagant

  3. The taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages

  4. The food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact

  5. In the case of food and beverages provided with entertainment, the food or beverages are purchased separately or otherwise isolated from the entertainment cost (so that only the food can be deducted)

Items 3 and 4 are the most relevant to the majority of taxpayers. Be sure that when you are including a meals in your business deductions, that you or an employee is present with a current or potential customer, or business contact. In the event of an audit, the IRS may ask you to prove this. The easiest way to create evidence to support this deduction is, each time you spend money on a meal that you intend to deduct, take the receipt and on the back write who was present at the meal, and a summary of what was discussed (even a very short one, like “payroll” or “new client”)

Special rules for 2021 and 2022. The 50% limitation is suspended for 2021 and 2022, allowing a 100% deduction for meals with a business purpose. Please note that the rules that you or an employee be present, and with a client or business contact still apply.

Home Office Deduction

Do you work from home all or some of the time? You may qualify for the home office deduction. That would mean deducting a portion of all your home expenses including:

  • Mortgage interest or rent

  • RE taxes

  • Repairs and Maintenance

  • Utilities

  • Other

Obviously, in this scenario you use your home both to live in and to work in. As we learned above we can’t deduct the money you spend on yourself. So how to we break the amount of money spent on the above into the amount that was for your business and the amount that was for your personal use?

The answer is by square footage. Measure or estimate that area of your home that you use for business and the total square footage of the home. Divide the business portion by the total and you’ll get a percentage. Multiply that percentage by the expenses listed above and you’ll get the deductible portion. If our office is preparing your tax return all this means is that if you are interested in taking the home office deduction you’ll need to provide us with total square footage of the home and the square footage of the area used for business, and the totals of each of the expense categories above. We’ll handle the rest.

Three special notes about the home office deduction:

  • The home office deduction can’t reduce your income from your business to a loss. So if you earned $5 and have $10 of home office deduction, your business income will be $0 not -$5. This is important because if you could reduce your income below zero, you could use that negative income to offset other income on your return, like income from a W2 or another business.

  • The IRS regulations require that the business area of the home must be used exclusively for business purposes. The IRS doesn’t even allow you to use the area for another purpose during off hours. You may think, “how could the IRS prove I used the area for something else and disallow this deduction under audit” and you’d be right that it would be difficult for the IRS to prove. However, consider a home office that has exercise machines in it, or a home office that is rented part of the time as an Air BNB. In these scenarios it would be easy for the IRS to prove you were not using the area exclusively for your home office.

  • Part of this deduction is taking depreciation on your home- expensing the value of the business use portion of the home over time. Ordinarily, when you sell your home you do not pay taxes on any capital gains except in very rare cases. If you take the home office deduction, and then sell your home for a capital gain, you will pay taxes on the amount of depreciation taken as part of the home office deduction. Most often the taxes saved via the home office deduction outweigh the taxes paid upon selling the home.

Special note for Partnerships/LLC’s (Not S Corps) you can take the home office deduction as unreimbursed partnership expenses on Schedule E if the partnership agreement requires you to pay those expenses and specifies that you will not be reimbursed for them. If your partnership agreement does not currently specify this and you would like to make yourself eligible for this deduction, you can amend your partnership agreement.

Health Insurance

You can deduct the cost of your health insurance and dental insurance against your self employment income with two caveats:

  1. You must not be eligible for health insurance coverage provided by an employer. This includes coverage you are eligible for through your spouse. This means if you have another job or your spouse has a job and they offer you coverage even if you do not accept the offer you can’t take the Self Employed Health Insurance Deduction

  2. The Self Employed Health Insurance Deduction can’t reduce your taxable income from the business below $0. So if you earned $5 and you have $10 in deductible Self Employed Health and Dental Insurance, your taxable income would be $0 not -$5. This is important because if you could reduce your income below zero, you could use that negative income to offset other income on your return, like income from a W2 or another business.

Business Gifts

You can deduct the cost of business gifts to clients or vendors throughout the year with the following limitation:

  1. Gifts per year to each individual cannot exceed $25*

*The $25 does not include things like gift wrapping.

You can gift items costing more than $25, but only the first $25 will be deductible.

Uniforms

The IRS allows deductions for uniforms or work clothing only if the clothing is unsuitable for use outside of work. So for example, a mascot or cheerleader’s costume would be unlikely to be worn outside of work, and so those are deductible. Work attire such as suits, dresses, T shirts for a construction worker that are intended to get very dirty, none of these qualify because they are suitable for wearing outside of work. It does not matter if you never wear such clothing outside of work, only the suitability (possibility) of wearing outside of work matters.