Business and Personal Expenses: Where to Draw the LineAug 22, 2020
If you ask a group of tax professionals about a business deduction, you may get several different answers. This is confusing and frustrating for business owners. Where do you draw the line on what is an allowable business deduction if the professionals cannot agree? Here is an easy to follow guide to help figure it out and actual court cases of taxpayers who took deductions too far.
Clear vs. subjective
It is important to note that some business deductions are clear and without question. For these items there is usually IRS guidance, a clear IRS tax code reference and/or tax court cases to support whether the expense is deductible or not.
Other deductions are subjective. There may be unclear, conflicting or no specific guidance. These deductions depend on the facts and circumstances. When taking a deduction that is subjective, it is best to have documentation and a well thought out reason supporting the deduction. It is also wise to consider the risk of taking a deduction that may be disallowed later.
You may have heard someone claim they took outrageous deductions such as "I entertain my business partners at my pool and that makes my pool a business deduction!" What happens here is that the IRS does not check every return as soon as it's filed and tax software does not stop you from deducting a disallowed expense. It is up to the taxpayer and their tax professional to only deduct those expenses which are permitted. The audit is the way in which outrageous and disallowed expenses are discovered, and when found, not only are the back taxes owed, but also interest and penalties.
When evaluating the deductibility of an expense, these three steps can help you make a good determination: 1) see if the IRS has specific guidance on the expense, 2) determine if the expense is ordinary and necessary for your specific business or industry and 3) assess whether the expense could be considered personal and therefore not deductible.
The IRS Tax Code is available online but can be challenging to navigate. It's does not make for a relaxing Sunday afternoon read. The IRS provides guidance on how they interpret the tax code, and these publications are a bit easier to get through. Though these are subject to change and your individual situation could be interpreted differently, these publications give a sense of what is and is not considered deductible by the IRS today.
- Publication 334: Tax Guide for Small Business
- Publication 463: Travel, Gift, and Car Expenses
- Publication 535, Business Expenses
The IRS offers the following explanation of a business deduction. The IRS states:
"To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary."
The IRS further provides that personal expenses are not allowed as business deductions:
"Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part."
Therefore, it is not sufficient to know that an expense is common and helpful for your business, it also needs to not be a personal expense. Generally personal expenses are going to be your home costs, commute to work, grooming, personal clothing, personal medical, self-care activities or anything that maintains your lifestyle, health or mental health.
In deciding what is deductible for those expenses that fall into a gray area, be aware there is a continuum. It spans from a risk taking perspective of, "If I jump through mental hoops and twist myself into a pretzel I can call this a business deduction" all the way to a risk aversion perspective such as, "I won't even take allowable deductions if I think it might trigger an audit."
Aim for the middle ground. The middle ground allows all reasonable deductions but doesn't push the envelope too far. The middle ground says, "If this expense relates to the operation of my business and is not for my personal benefit, then I will deduct it." The middle ground is never outrageous or ridiculous.
If a deduction falls into one of these three categories it is likely to be allowed:
- The expense helps you get clients or customers, involves office space, furniture, decor, computers, marketing, contracts, training and other infrastructure.
- It is directly related to the process of earning revenue such as supplies, cost of good sold, employee costs, client management systems, shipping costs and other expenses used when services or products are purchased.
- Involves administrative costs such as accounting, banking, record keeping, payroll costs and other activities that occur after revenue is earned.
As mentioned above, personal expenses are going to be your home costs, commute to work, grooming, personal clothing, personal medical, self-care activities or anything that maintains your lifestyle, health or mental health.
If an expense is considered personal then it cannot be a business deduction. You may ask, "But wait, I have a friend whose employer pays their gym membership, why can't I pay my gym membership and deduct it?!" Businesses can provide fringe benefits to their employees but the cost may be added to the employees wages and taxed as income. It would then be included in gross wages on the W2. See IRS Publication 15-B and Simple Profit Blog: Bonuses, Gifts & Fringe Benefits: Taxable and Deductible to learn more about employee fringe benefits.
Allocation between personal and business
When an item such as a phone, printer or computer is going to be used for personal and for business both, you can allocate it between personal and business and deduct the business portion. You can determine an allocation by tracking your usage for a period of time, if your usage will be consistent over time, or by keeping a log as evidence for the deduction. This is similar to how we keep a mileage log to deduct car expenses. For example, if you use your phone for personal and business, and after tracking it for a period of time determine your phone is used 55% for business, you can deduct 55% of the cost.
Items that are completely personal usually relate to clothing suitable for every day wear, personal grooming, commute to work, family care and medical care. One might ask, "How can I possibly work if my back hurts?" Or declare, "I can't show up to work if I'm not professionally dressed, I won't make any money!" Or exclaim, "I would not have paid for a manicure if I didn't have to work this week!" The IRS does not generally allow deductions that enable you to arrive safely, looking nice and well dressed at your office. Showing up ready to work is expected to occur at your own expense.
Splitting costs for self-employed
If your business is a sole proprietor or LLC, you have three options to pay a cost that is both personal and business, like a cell phone bill. You can either 1) pay from a personal account and have your business reimburse you, 2) pay just the business portion of the bill from the business account or 3) pay the bill from a business account and record the personal portion as an owners draw. The first two options are preferable as the last one includes running some of a personal expense through the business which is not ideal.
Splitting costs for Corp entities
If your business is an S-Corp or C-Corp it must pay all it's own bills. It's also more important to not run any personal expenses through the business. So the option is to have the business pay the business portion of the bill only, or pay the bill personally and have the business do an employee reimbursement under an accountable plan. An accountable plan is a policy that permits employee reimbursements to not be taxed as income.
Tax court cases
Below are some tax court cases where people tried to deduct personal expenses as business deductions. Note that when a case gets to tax court that means that the IRS auditor disallowed the deduction and the taxpayer decided to fight the IRS. Usually the taxpayer has hired an attorney to represent them and incurred additional cost to get the case heard by a tax court judge. Sometimes the taxpayer wins. In these cases they lost:
Hamper v. Commissioner
A television news anchor was denied deductions for business clothes, vision correction contacts, haircuts, manicures, teeth whitening, skin care products, gym membership and media subscriptions to stay up to date on the news. Professional memberships and dues were permitted. The tax court also agreed to let the IRS charge an additional 20% accuracy penalty on the disallowed deductions, in addition to the extra tax due.
Scott v. Commissioner
A flight attendant was denied the right to deduct hair and nail costs with the tax court noting, "Grooming expenses (i.e., hair and nail maintenance) are inherently personal expenses, and amounts expended for grooming are not deductible regardless of whether an employer requires an employee to be well groomed." She was also denied a deduction for her personal cell phone and clothing that she wore only for work purposes because it was every-day clothing.
Elverson v. Commissioner
The owner of an accounting business and was denied the right to claim a deduction for pants worn to work, postage that was not clearly established as used for business and the cost of the family cell phone plan because two of the lines were used exclusively for personal calls and texts.
Barnes v. Commissioner
A Ralph Lauren salesperson was required to purchase and wear Ralph Lauren clothing when representing the company. The tax court ruled that because the clothing was suitable for wear outside of work, it was not deductible as a business expense.
Drake v. Commissioner
The tax court ruled that haircuts are not deductible even when required by the Army to occur every two weeks, as haircuts are considered personal grooming.
Wheir v. Commissioner
In this case the tax court disallowed food and shakes a professional body builder deducted as business expense due to their protein and nutritional content. But the tax court did allow the body builder to deduct tanning and body oils that were only marketed to body builders, only used for body building and not generally used outside of body building activities. The products were deemed exclusively used for business and therefore allowed as deductions.
Although these tax cases show that in most cases clothing, makeup and other personal expenses cannot be deducted, there are times when the deductions are allowed. Clothing can be deducted if it involves protective wear or items that are not suitable for worn outside of work. A clear example would be safety boots and protective eyewear or a professional clown suit. Unlike a business suit, which can be worn at a personal event, protective wear and a clown suit cannot be adapted for every day wear. Makeup could be deducted if paying a makeup artist to apply makeup the day of a professional photoshoot, where the benefits are washed off that day. Purchase of makeup products that can be used after the photoshoot are not deductible.
Travel and commuting
When combining business and personal travel, the trip needs to be primarily for business. It is not permitted to deduct travel costs if you take a seven day vacation and spend one day in a business seminar. More days need to be dedicated to business than for personal. Additionally, the travel needs to be essential to the work. It is not permitted to deduct travel costs solely for change of scenery. See the Simple Profit blog Business Related Travel: What is Deductible for more details on deducting business travel expenses.
Commuting to and from work is generally considered personal. Parking costs at your main office are also considered a personal expense. See the Simple Profit blog Business Use of Your Car: Mileage and More for more details on car expenses.
Medical expense deduction
If you have a medical expense, those costs are sometimes permitted as a personal deduction if you itemize, not a business deduction. If you are self-employed, you may be able to deduct health insurance premiums if you meet certain rules, but this deduction occurs separately from your ordinary and necessary business deductions on your tax return. There are rules around medical expense deductions and limits regarding their deductibility. See Tax Topic No. 502 Medical and Dental Expenses for more information.
While there is a gray area and professionals do not always agree, navigating what is deductible is less daunting than it may seem. Be reasonable, consider the existing tax guidance, tax code and tax court rulings if they apply. Determine if the expense is exclusively used for business and if it is commonplace and helpful to earning revenue. Then consider if the expense could be considered personal, and do not deduct personal expenses as business deductions.
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