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Deductible and Non-Deductible Business Expenses

The Internal Revenue Code (IRC) imposes a two-prong test that business owners must satisfy for every expense that’s deducted on a tax return – otherwise it’s treated as a personal expense. These two prongs require that an expense be ordinary in that it’s commonly incurred by similar businesses, and that it also be necessary or helpful to business operations.

Common Business Expenses

There are many types of business expenses that are deductible in the year in which you actually pay the expense, or if your business utilizes an accrual method of accounting, the year in which you or the business became legally liable to pay the expense. Expenses that typically satisfy the ordinary and necessary requirement without too much analysis are rent, employee wages, office or other supplies, state and local taxes, insurance premiums and a wide range of others.

Depreciating Business Assets

Expense deducting won’t apply to assets purchases you make for the business, such as cars, real estate and machinery. With business assets, you can’t immediately deduct the entire cost in the year it’s paid or legally incurred. For these types of asset costs, which are known as “capital expenses,” deductions are permitted over time through depreciation. For example, if you purchase equipment for your business, you can take a depreciation deduction each tax year until you’ve deducted the equipment’s full acquisition cost. This requires that you use the appropriate class life for the asset category the equipment falls under in the IRC. Class life is the number of tax years that you need to spread the depreciation deductions over. However, IRC Sec. 179 does allow you to bypass depreciation and deduct certain capital expenses in full in the year the asset is placed in service in your business. Section 179 does, however, limit the amount you can deduct each year.

Cost of Goods Sold (COGS)

Small business owners who operate a retail establishment that purchases wholesale inventory can deduct the costs associated with purchasing products is deductible – but only after they are sold to customers. On business returns, this is deducted as cost of goods sold, or COGS. Calculating your annual COGS deduction is done by determining the value of remaining inventory on hand one the first day of the year, adding the cost of all purchases made during the year to it and then subtracting the value of the ending inventory available on the final day of your business’ tax year.

For expenses that can’t satisfy the “ordinary and necessary” criteria of deductibility – you’ll have to assume that it’s not a deductible business expense. This is normally the case when expenses are predominantly personal in nature.

IRS Reference:
Publication 334