Just like professional track athletes try to drop unnecessary weight, taxpayers should try to keep their tax liability as low as possible. However, in taxes, as in sport, there can be a fine line between maximizing your performance and cheating -- in other words, between tax mitigation and tax evasion. Understanding the principles that determine which expenses are deductible and which are out-of-bounds will help you rein in your taxes without getting on the wrong side of the IRS.
Ordinary and Necessary
The IRS allows you to deduct any ordinary and necessary expenses you encounter in conducting your trade or business. For the IRS to consider an expense as ordinary and necessary, it must be commonly accepted in your line of work, as well as useful and relevant to your business. For instance, the IRS will probably not buy your explanation that a helicopter is an ordinary and necessary expense for your plumbing business; but you're probably safe if you're the owner of a TV station.
Current vs. Capital Expenses
The IRS regulates both the type of expenses you may deduct and when you may deduct them. Everyday expenses that are required for your business, such as rent or utility bills, are straightforward; you simply deduct the expense from your gross income. However, expenses you use to generate income, such as a vehicle, are considered investments and cannot be entirely deducted in the year they're incurred. Instead, they must be capitalized, or deducted gradually, over the life of the asset. The rule of thumb to differentiate current from capital expenses is that if the expense has a useful life of more than a year, it is a capital expense. A handy exception to this rule are computers, furniture and equipment. Under Section 179 of the tax law, you can deduct the entire cost of tangible personal property, up to a limit of $500,000.
Gone are the days when you could claim all the expenses related to wining, dining and entertaining your clients and customers. However, it can still be a large -- and fun -- deduction, if you can afford it. As of 2013, you could deduct half of entertainment expenses, regardless of how many cocktails you drank, football games you attended or gourmet meals you wolfed down, as long as you can provide proof the expense was directly related to your business.
Regardless of whether they're deductible or not, certain expenses are red flags for the IRS because of the high incidence of fraud in tax returns that include them. A home office deduction is a classic red flag, because it is so easy, and tempting, to deduct the cost of a home office that doesn't meet IRS minimum requirements. Taxpayers who have a side business that consistently loses money are particularly suspicious because it could look as though they are using their side business as a front to absorb the cost of a hobby. Other examples of red-flag deductions are business entertainment expenses, excessive travel expenses and casualty losses.
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