On the Horns of a Dilemma
If you listened to last week’s audio version of this blog, you heard a brief discussion of what it means to have a business. Well, I wanted to expand on that because it is the basis of the ideas that make deducting business expenses from income legal. It goes directly to the reason that entrepreneurs seek the help and advice of tax preparers and accountants.
Typically clients will joke with me about using their dog as a dependent, or writing off the cost of daily travel as advertising, or some other idea that would benefit them by lowering their taxes. Well, you can only reduce your income by transactions that have a purpose other than reducing your taxes.
The topic is what’s called the Doctrine of Economic Substance. I’m going to indulge my internal geek and refer to the Internal Revenue Code Sec 7701(o). There is a two pronged (the horns) test that any transaction must meet to be considered. A transaction will be sustained only if both of the following are true (the dilemma):
(1) It changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position.
(2) The taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.
This is a paraphrase of the language in the Code, but please feel free to read the original.
Notice the identical phrase “apart from Federal income tax effects.” This is where we get the idea of “serious business purpose.” The code goes on to define specifically what constitutes a substantial purpose which includes this (quoting now):
The potential for proﬁt of a transaction shall be taken into account … only if the present value of the reasonably expected pre-tax proﬁt … is substantial in relation to the present value of the expected net tax beneﬁts that would be allowed if the transaction were respected
In other words, if you don’t expect that the transaction will increase your profits, it’s not a deductible transaction. A serious business purpose, remember.
OK. Geek satisfied.
What does this mean in practical terms? Well, it means that if you are in business every dollar you spend that promotes the profitability of that business is deductible from your business income. It also means that nothing is deductible that is not related to the profitability of the business.
So, if you stop for breakfast every morning on your way to your machine shop, you cannot deduct the price of the meal. After all, everyone eats breakfast (or should) so there is no aspect of this experience that promotes your business profitability. However, if you invite a business prospect to join you for breakfast as you explain to him or her the benefits of becoming a customer of yours, then that becomes a deductible transaction (within the rules of meal expenses). Even if the prospect in fact does not become a customer, your purpose in the transaction was to induce them to buy, and so you had an expectation of increased profitability.
For tax purposes, preparers like me work hard to maximize the deductions your business can take so as to minimize the tax liability. We may even be able to demonstrate that your business experienced a loss–expenses in excess of income. And there are various tax benefits for this situation, some immediate and some long term.
But this is for tax purposes. Continued losses will mean the eventual demise of the activity. And that sometimes comes at a cost. If it can’t be made clear that the deductions and tax savings were done with a legitimate profit expectation, you may actually have to pay back-taxes to make up the difference.
This is the primary proof of the existence of a business–the expectation of profit.
Clearly this is different from an employee’s expectation of income via wages or salary. And it is the reason that the Code only allows a minimum number of specific deductions for individuals. The employee cannot suffer the consequences of a loss either financially or due to retrospective tax penalties.
I am asked by many business owners, “What business expenses can I deduct?” The answer is, “All of them.” Then they ask, “Can you give me a list?” And the answer is, “It depends.”
The IRS has another test for business expenses: whatever is necessary and ordinary for the operation of your business, trade or profession. Don’t get me wrong. There are details related to specific expense items, but assuming it is necessary and ordinary, it is deductible.
Some examples. As an office worker you may be expected to wear a suit everyday. Is the expense of cleaning the suit deductible? Nope. Everyone is responsible for their own clean clothes. However, if you operate an auto repair shop you may be expected to wear a uniform which identifies the garage and maybe even you. The maintenance of those uniforms is a business expense. It is necessary (can’t have naked people working on cars) and ordinary (most garages have similar uniforms).
Or, the owner of a shop keeps his dog with him for companionship. Is the dog’s food a business expense? No, because presence of the dog does not increase the expectation of profitability. However, if the business is an auto salvage yard and the dog is a Doberman which is let out into the lot overnight to defend against theft, then the dog food is a business expense. It is necessary (security is needed to keep people from stealing parts from cars in the lot) and ordinary (many salvage yards utilize guard dogs for security).
One more, a bit more complicated. Let’s say you remodel your business office. You really want to live in luxury so you buy an antique oak desk and cover the walls with silk brocade and add really expensive knick-knacks. So your total remodel amounts to $150,000. Is this deductible? Maybe. Remember above when we mentioned that the test is whether the present value of expected profit is substantial in relation to the tax benefit received. So, if your business is the sale of high value items where your profits are in thousands for each sale, this cost might pass that test. You need to be able to favorably impress potential clients, and the sumptuous office helps improve your image and makes a sale more likely. However, if you run a candy store, the increase in sales due to your office’s appearance is going to be difficult to show.
This is a more technical discussion than usual, I admit. But these articles are aimed to help you increase your profits. So you need to understand the importance of profits and how to deal with those profits at tax season.
So the best advice I can offer is to work with your tax preparer closely throughout the year to make sure you are covering all your bases–both for profits and for taxes. And I invite you to contact me with questions about your own situation. And I hope you’ll consider using me to prepare your taxes (if you don’t already).
Maybe you could leave a comment with experiences you have had or questions you have about the deductibility of certain items.