Chapter 5: Business Deductions

5-1 OVERVIEW OF BUSINESS DEDUCTIONS

The Code does explicitly allow the deduction of expenses incurred in a trade or business, but only if those expenses are ordinary, necessary, and reasonable in amount.

5-1a Ordinary and Necessary Requirement

Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. To understand the scope of this provision, it is critical to understand the meanings of the terms ordinary and necessary. Since these terms are not defined in the Code or Regulations, the courts have dealt with these terms on numerous occasions.

An expense has been held to be ordinary if it is normal, usual, or customary in the type of business conducted by the taxpayer.  Note that an expense need not be recurring to be considered ordinary. For example, a business may incur an expense related to a rare and unusual event. However, if other businesses in a similar situation are likely to incur a similar expense, the expense can be considered ordinary, even though it is not recurring.

An expense has been held to be necessary if a prudent businessperson would incur the same expense and the expense is expected to be appropriate and helpful in the taxpayer’s business.  But as Example 2 shows, no deduction will be allowed unless a necessary expense is also ordinary.

Example 2

Pat purchased a business that had just been adjudged bankrupt. Because the business had a poor

financial rating, Pat wanted to restore its financial reputation. Consequently, he paid off some of

the debts owed by the former owners that had been canceled by the bankruptcy court. Because

Pat had no legal obligation to make these payments, the U.S. Supreme Court decided that he was

trying to generate goodwill. Although the payments were necessary (i.e., appropriate and helpful),

they were not ordinary and their deduction was not allowed.

5-1b Reasonableness Requirement

An expense must also be reasonable to be deductible. Although the Code applies the reasonableness requirement solely to salaries and other compensation for services, the courts have held that for any expense to be ordinary and necessary, it must also be reasonable in amount. If an expense is unreasonable, any amount in excess of what is reasonable is not deductible.

The question of reasonableness usually arises with respect to closely held corporations where there is little or no separation of ownership and management. For example, excessive salaries, rent, and other expenses paid by a closely held corporation to its shareholders may be deemed unreasonable. What constitutes reasonableness is determined by the facts and circumstances surrounding a situation.8 Courts will view the reasonableness of a salary paid to a shareholder of a closely held corporation in light of all relevant circumstances. For example, a court may find that an unusually large salary is reasonable despite its size if the shareholder has unusual or unique expertise. Amounts paid to shareholders that are deemed unreasonable are generally held to be dividends.9 Because dividends

are not deductible by the corporation, the disallowance results in an increase in corporate taxable income.

Example 3

Return to the facts of The Big Picture on p. 5-1. The small engine service and repair business, a closely

held C corporation, is owned by Michael Forney, his spouse (Kathleen) and his mother (Terry). The

company has been highly profitable over the years and has never paid dividends. Michael is the

key employee of the business, while his mother plays a very minor role. Assuming that their current

salaries of $55,000 and $3,000 are comparable to what they could earn at similar companies for the

work they do, they are likely to be considered reasonable and, therefore, deductible.

If Mr. Forney’s plan to more than double his salary and increase his mother’s salary by tenfold

is implemented, the amounts in excess of their current salaries may be deemed unreasonable;

if that is the case, the excess would be disallowed as deductible salary. The disallowed amounts

would then be treated as dividends rather than salary income to Michael and Terry. Although both

salaries and dividends are taxable to the shareholders, salaries are deductible by the corporation

while dividends are not.

5-2 TIMING OF DEDUCTION RECOGNITION

5-2a The Cash Method

The expenses of cash basis taxpayers are deductible only when they are actually paid, either with cash or other property. Although promising to pay or issuing a note does not satisfy the actually paid requirement, a payment made with borrowed funds is deductible. Taxpayers using the cash method are also allowed to claim a deduction at the time they charge expenses on credit cards. Effectively, they borrowed money from the credit card issuer and simultaneously paid the expenses. 

Although a cash basis taxpayer must actually or constructively pay an expense for the expense to be deductible, payment does not ensure a current deduction. The Regulations require capitalization of any expenditure that creates an asset having a useful life that extends substantially beyond the end of the tax year. The courts have clarified that expenditures that provide a benefit beyond the end of the tax year following the year of payment generally create an asset with a useful life that extends substantially beyond the end of the tax year and must be capitalized.16 Thus, even cash basis taxpayers can only deduct such expenditures through amortization, depletion, or depreciation over the tax life of the asset.

Example 4

Redbird, Inc., a calendar year and cash basis taxpayer, rents property from Bluejay, Inc. On July 1,

2021, Redbird pays $24,000 rent for the 24 months ending June 30, 2023.

The prepaid rent extends 18 months after the close of the tax year—substantially beyond the

year of payment. Therefore, Redbird must capitalize the prepaid rent and amortize the expense on

a monthly basis. Redbird’s deduction for 2021 is $6,000.

Assume that Redbird is required to pay only 12 months’ rent in 2021 and pays $12,000 on July 1,

2021. The entire $12,000 is deductible in 2021, as the benefit does not extend beyond the end of 2022.

5-2b The Accrual Method

An accrual basis taxpayer may deduct an expense when both the all events test and the economic performance test are met. The all events test is met when (1) all of the events have occurred to establish the existence of a legal liability and (2) the amount of the liability can be determined with reasonable accuracy. The economic performance test is met when the party obligated to do something (i.e., to perform) to satisfy the liability does so. In situations in which a liability arises as a result of services being provided or property being transferred to the taxpayer, economic performance occurs when the service is provided or ownership of the property is transferred. If the liability is the result of the taxpayer being required to provide services or transfer property, economic performance occurs when the taxpayer provides the service or transfers the property.

Example 5

Robin, Inc., a concert promoter, sponsored a jazz festival in a rented auditorium at City College.

Robin is responsible for cleaning up after the festival, which took place on December 22, 2021, and

reinstalling the auditorium seats. Because the college is closed over the Christmas holidays, the

company hired by Robin to perform the work did not begin these activities until January 3, 2022.

Robin cannot deduct its $1,200 labor cost until 2022 when the services are performed.

An important consequence of the economic performance test is that many expenses that are estimated for financial reporting purposes, often by employing reserves or allowance accounts, are not immediately deductible for tax purposes. These expenses typically require estimation precisely because there has been no economic performance. Instead, deductibility is deferred until economic performance has occurred.

Example 6

Oriole Airlines is required by Federal law to test its engines after 3,000 flying hours. Aircraft cannot

return to flight until the tests have been conducted. An unrelated aircraft maintenance company

performs the tests. Oriole estimates that the tests will cost approximately $1,500 per engine.

For financial reporting purposes, the company accrues an expense based upon $0.50 per hour

of flight ($1,500 4 3,000 hours) and credits an allowance account. The actual amounts paid for

maintenance are offset against the allowance account.

For tax purposes, the economic performance test is not satisfied until the work has been performed.

The amount accrued for financial reporting purposes cannot be deducted for tax purposes.

Note that the economic performance test does not require that an expense be paid before it is deductible. In Example 6, the economic performance test is met when the engine tests are performed, even if the expense is not paid until the following year.

Note: The book makes it seem as if the all events test and economic performance test are separate things. In fact, economic performance is part of the all events test. See Section 461(h) and Regulation Section 1.461-1(a)(2)(i).

Tax Geek Tuesday: Demystifying The Deduction Rules For Accrued Liabilities (forbes.com)

5-2c Expenses Accrued to Related Parties

Regardless of the taxpayer’s general method of accounting, the Internal Revenue Code places restrictions on the deductibility of expenses accrued to related parties. Without these restrictions, related taxpayers who have control over both sides of a transaction would have the ability to enter into transactions that allow the immediate deduction of an expense by an accrual basis taxpayer while allowing the deferral of the related income by a cash basis taxpayer on the other side of the transaction. For example, an accrual basis, closely held corporation might borrow funds from a cash basis individual shareholder. At the end of the year, the corporation would accrue and deduct the interest expense, but the cash basis lender would not recognize interest income because no interest had been paid.

Section 267 specifically addresses related-party transactions, deferring the deduction of an expense accrued to a related party until the related party is required to recognize the item in income. Note that deferral is not required if both parties use the same general method of accounting. Likewise, deferral will not be required if the party reporting income uses the accrual method and the party taking the deduction uses the cash method.

Relationships and Constructive Ownership

For purposes of § 267, related parties include the following:

• Family members, including brothers and sisters (whether whole, half, or adopted), spouse, ancestors (e.g., parents and grandparents), and lineal descendants (e.g., children and grandchildren) of the taxpayer.

• Corporations and shareholders who own more than 50 percent (directly or indirectly) of the corporation’s stock.

• Two corporations that are members of a controlled group (discussed in Chapter 12).

Constructive ownership provisions must be considered when determining whether taxpayers are related for purposes of § 267. Under these provisions, certain taxpayers are treated as if they own the stock directly owned by others. For example, for purposes of applying the tests of § 267, taxpayers are treated as owning any stock directly owned by family members as well as their proportionate share of any stock owned by a corporation or partnership of which they are an owner.

Example 7

The stock of Sparrow Corporation is owned 20% by Ted, 30% by Ted’s father, 30% by Ted’s mother,

and 20% by Ted’s sister. Although Ted actually owns only 20% of Sparrow Corporation, he is deemed

to own the stock owned by his father (30%), mother (30%), and sister (20%).

As a result, he directly and indirectly owns 100% of Sparrow, and Ted and Sparrow are related

parties. The same outcome (100% direct and indirect ownership) results for all of the shareholders

in this example.

Example 8

Continue with the facts presented in Example 7. On July 1 of the current year, Ted loaned $10,000 to

Sparrow Corporation at 3% annual interest, with principal and interest payable on demand. For tax purposes, Sparrow uses the accrual basis and Ted uses the cash basis. Both report on a calendar year basis. Because Sparrow and Ted are related parties, Sparrow cannot deduct any interest accrued to Ted

until Ted recognizes it as income. Because Ted is a cash basis taxpayer, the deduction is not available

to Sparrow until the interest is paid.

5-2d Prepaid Expenses—The “12-Month Rule”

A special rule allows taxpayers, including accrual basis taxpayers, to deduct certain prepaid expenses. A deduction is allowed if the benefit created by the payment doesn’t extend beyond the earlier of (1) 12 months after the first date on which the taxpayer realized the benefit or (2) the end of the tax year following the tax year in which the payment was made (the “12-month rule”). Although this rule applies to both cash and accrual method taxpayers, it does not supersede the economic performance test. Therefore, it does not apply to prepayments for services, property, or the use of property for accrual basis taxpayers unless economic performance has occurred. Nor does it apply to other expenses for which special rules regarding their timing exists (e.g., interest and taxes, discussed later in this chapter). Prepaid expenses eligible for the 12-month rule include insurance, dues, and licenses.

Example 9

On November 1, 2021, Nada, a calendar year and accrual basis taxpayer, pays $6,000 for a 1-year

premium on a catastrophic liability policy that takes effect December 15, 2021. Nada will receive

a benefit from this policy from December 15, 2021, through December 14, 2022. Her benefit does

not extend beyond 12 months after the benefit begins on December 15. It also does not extend

beyond the end of 2022. Therefore, this payment satisfies the requirements of the 12-month rule

and Nada can deduct the $6,000 in 2021.

Example 10

Assume the same facts as in Example 9, except that the benefit from the policy runs from

February 1, 2022, through January 31, 2023. Nada’s benefit now extends beyond the end of the tax

year following the tax year in which the payment was made (December 31, 2022), so the 12-month

rule requirements are not met. Nada must capitalize the $6,000 payment in 2021 and amortize it

over the benefit period.

5-3 DISALLOWANCE POSSIBILITIES

5-3a Expenses Incurred in the Investigation of a Business

Recall that § 162 allows a deduction for expenses incurred in carrying on a trade or business. However, expenses may be incurred to investigate the creation or acquisition of a business before the business is actually conducted by the taxpayer. Such costs might include travel, engineering and architectural surveys, marketing reports, and various legal and accounting services. How such expenses are treated for tax purposes depends on the following: 

• The current business, if any, of the taxpayer.

• Whether the business being investigated is actually acquired.

When the taxpayer is not in a business that is the same as or similar to the one being investigated, the tax result depends on whether the new business is acquired. If the taxpayer actually acquires the new business, the expenses must generally be capitalized as startup expenditures . However, the taxpayer may be able to immediately deduct up to $5,000 of startup expenses in the month in which business begins. (If an active business is acquired, the business is treated as beginning on the date of acquisition.) This deduction is reduced dollar-for-dollar by the amount total startup expenses exceed

$50,000. Any expenses not eligible for an immediate deduction are amortized over

180 months, again beginning in the month in which business begins

Example 11

Tina, a sole proprietor, owns and operates 10 restaurants located in various cities throughout the

Southeast. She travels to Atlanta to discuss the acquisition of an auto dealership. She incurs legal

and accounting costs associated with the potential acquisition. After incurring total investigation

costs of $52,000, she acquires the auto dealership on October 1, 2021.

Tina may immediately deduct $3,000 [$5,000 2 ($52,000 2 $50,000)] and amortize the balance

of $49,000 ($52,000 2 $3,000) over a period of 180 months. For calendar year 2021, therefore, Tina

can deduct $3,817 [$3,000 1 ($49,000 3 3/180)].

If the taxpayer is not already in the same or similar business and the business is not acquired, the investigation expenses generally are nondeductible.

Example 12

Lynn, president and sole shareholder of Marmot Corporation, incurs expenses when traveling

from Rochester, New York, to California to investigate the feasibility of acquiring several auto care

centers. Marmot is in the residential siding business. If no acquisition takes place, Marmot may

not deduct any of the expenses.

Startup expenses include the following:

• Expenses incurred to investigate the creation or acquisition of a business by the taxpayer (e.g., market studies).

• Expenses incurred in creating or acquiring a business (e.g., incurring professional fees, identifying suppliers, and obtaining licenses).

• Expenses incurred before the day the business begins that would otherwise have been deductible under § 162 (e.g., salaries, utilities, and advertising).

If the taxpayer is already in a business that is the same as or similar to that being investigated (i.e., the taxpayer is investigating the expansion of an existing trade or business), all such expenses are deductible in the year paid or incurred. The tax result is the same whether or not the taxpayer decides to follow through with the expansion

Example 13

Michael Forney believes that his mechanical and business

skills can be used to turn around other small engine businesses whose revenues have been declining. He

investigates Southside Small Engine Services LLC, a nearby competitor that is for sale. Expenses paid to consultants and accountants as part of this investigation totaled $6,000. After reviewing various materials, he determined that buying Southside Small Engine Services would not be a good idea.

The $6,000 spent to investigate this potential expansion is deductible as a business expense because

Mr. Forney is already in the small engine service and repair business. Investigating new business

opportunities in one’s current trade or business is an ordinary and necessary business expense.

5-3b Public Policy Limitations

Deduction of the following expenses is specifically prohibited.

• Bribes and kickbacks illegal under either Federal or state law.

• Two-thirds of the treble damage payments made to claimants resulting from violation

of antitrust law.

• Fines and penalties paid to a government or governmental entity for violation of law.

• Amounts paid to a government or governmental entity for the investigation into

the potential violation of any law.

For purposes of the above rules, any entity that regulates a national securities or commodities exchange (e.g., the Securities and Exchange Commission and the Commodity Futures Trading Commission) is considered a governmental entity.

Example 14

Michael Forney had not instituted proper procedures for disposing of used motor oil and other engine fluids from his business. During the current tax year, he was fined $2,500 by the city. Mr. Forney believes the fine should be deducted as an ordinary business expense. However, because the fine was assessed by and paid to a government for a law violation, the $2,500 is not deductible.

Interestingly, the expenses of operating an illegal business (e.g., a money laundering operation) that are not inherently illegal themselves are deductible as long as the expenses themselves are not illegal. While allowing deductions related to illegal activity may seem inappropriate, recall that the law taxes net income, not gross revenue. An exception applies to expenses incurred in illegal drug trafficking. Drug dealers are not allowed a deduction for ordinary and necessary business expenses even if those

expenses are themselves legal. However, drug dealers are nonetheless allowed to deduct their cost of goods sold, or the cost of the illegal drugs themselves

5-3c Political Contributions and Lobbying Activities
Political Contributions
No deduction is allowed for direct or indirect payments for political purposes. Nondeductible political contributions include payments made to support a political party or to support, participate in, or influence a campaign on behalf of a candidate for public office.

Lobbying Expenses
Lobbying expenses are not deductible. Lobbying expenses include those incurred in attempting to influence any existing or potential legislation at the Federal, state, or local level.  The disallowance extends to a pro rata portion of the membership dues of trade associations and other groups that are involved in lobbying activities.

Example 17

Mr. Forney’s business made contributions to the

Small Engine Repair Institute, a trade association for owners of similar-type businesses. The trade

association estimates that 70% of its dues are allocated to lobbying activities. Thus, the deduction

on the corporate tax return is limited to $3,000 ($10,000 3 30%).

There are two special rules related to the disallowance of lobbing expenses. First, the disallowance provision does not apply to activities devoted solely to monitoring legislation. Second, a de minimis exception allows the deduction of up to $2,000 of annual in-house lobbying expenditures incurred by the taxpayer.

5-3d Expenses Related to Entertainment, Recreation, or Amusement

Taxpayers may incur costs to entertain potential or existing customers, clients, suppliers, or employees. These costs can be incurred either during or in association with a business meeting and may be considered ordinary and necessary trade or business expenses. However, due to the element of personal enjoyment and the related potential for abuse the deductibility of such expenses might create, Congress limits the deductibility of these expenses.

Generally, no deduction is allowed for any costs related to entertainment, amusement, or recreation activities. Nor are costs related to any facilities (e.g., airplanes, yachts, stadium boxes, hotel suites, vacation houses) used in such activities deductible. Dues related to membership in any business, social, athletic, or sporting clubs are also nondeductible. Business meals, including those paid in connection with business meetings as well as those paid for employees, are generally deductible as long as they are not lavish or extravagant. However, any deduction is limited to 50 percent of the cost of the meals.33 The deduction for the cost of meals provided to employees on an employer’s business premises is also subject to the 50 percent reduction.34 There are several exceptions to the 50 percent cutback on the deductibility of meals. For example, the following are fully deductible:35

• Expenses for food or beverage provided by a restaurant (for 2021 and 2022 only);

• Expenses for meals or entertainment treated by the recipient as taxable income; and

• Expenses for recreational or social activities primarily for the benefit of non-highly

compensated employees.

Example 18

Peach, Inc., incurs the following expenses during 2021:

Meals with potential customers at various restaurants $ 20,000

Theater tickets and green fees for activities immediately preceding or following business meals 24,000

Rental of a luxury box at the baseball stadium for entertaining clients 30,000

Memberships in various country clubs and golf clubs 12,000

The costs of maintaining an on-site cafeteria where employees may dine for free so that they are accessible during the workday and can work during lunch 25,000

The costs of maintaining an on-site health facility so employees can work out before or after work or at lunch 27,000

The costs of an all-day summer party for employees and their families 10,000

Total $148,000

Peach may deduct $42,500 of the above expenses [$20,000 for business meals provided by restaurants plus $10,000 for the employee party and $12,500 (50%3$25,000) for the on-site cafeteria]. No portion of the $24,000 spent on events preceding or following business meals, the $30,000 to rent the stadium box, the $12,000 spent on club dues, or the $27,000 maintaining the health facility are deductible.

5-3e Business Interest Expense

Interest on business debt, or business interest, is generally deductible. However, taxpayers may use intercompany debt as a relatively easy way of artificially shifting income between related entities. This may be particularly useful if the two entities face different tax rates or one is exempt from U.S. tax (e.g., a foreign entity). Over time, Congress has imposed various limitations on the deductibility of business interest to prevent this kind of income shifting. 

Currently, a limitation on the deductibility of business interest expense applies to large businesses. The deduction is limited to a taxpayer’s business interest income plus 30 percent of adjusted taxable income. Adjusted taxable income is taxable income calculated without considering (1) nonbusiness income, gain, deduction or loss; (2) any business interest income or expense; (3) the net operating loss (NOL) deduction; and the deduction for qualified business income (§ 199A). In addition, for years beginning before 2022, adjusted taxable income is calculated without considering any depreciation, amortization, or depletion deduction. Any disallowed interest can be carried forward indefinitely. The business interest expense limitation only applies to taxpayers having annual average gross receipts in excess of $26,000,000 (for 2021; this amount is indexed annually for inflation) during the prior three taxable years.

Example 19

In 2021, Robin Corporation has $50,000,000 of adjusted taxable income, $1,000,000 of business interest income, and $20,000,000 of business interest expense. Robin’s 2021 deduction for business interest expense is limited to $16,000,000, the sum of its $1,000,000 of business interest income plus 30% of its adjusted taxable income (30% 3 $50,000,000 5 $15,000,000). The $4,000,000 of disallowed interest expense is carried forward to future tax years.

5-3f Excessive Executive Compensation