As a tax preparer the inevitable question comes up as I meet with clients, “Why can’t I deduct that?” Sometimes there is an easy answer, other times it tends to be more complicated. A simple answer is that deductions are often tied to a specific purpose. For instance, the Residential Energy Credit was designed to give a credit when households did something that was energy-efficient for the home thus reducing the strain on the energy infrastructure. The IRA contribution credit allows people to deduct their contributions because they are saving for retirement on their own rather than relying, again, on the social security system. When it comes down to it there are some basic questions to consider when wondering if you can deduct something.
Four items to review before you deduct an expense
1. Is it materially required to generate a profit?
As a self-employed person you can take many deductions for expenses incurred for your business. Often times it can become a free for all in the things that are deducted because it “can” be construed as a business expense. The question to always ask yourself is if it is materially required to generate a profit? If the answer is no then you probably cannot deduct it.
2. Think in percentages.
By using personal items such as a vehicle, home or cell phone for business use you need to think in percentages. What percentage is being used for personal and what for business? Use a legitimate percent otherwise it may raise a red flag.
3. The odds are if you derive any joy out of it you probably cannot deduct it.
I always use the example of a business meeting over lunch for this. You are only allowed to deduct 50% of a business meal. Why? Because you are considered half of the party. You are required eat whether you are at a business meeting or not. The true expense here is you taking out a business associate or prospect for a meal.
4. Because they said so.
Do you remember asking your parents when you were younger why you couldn’t do something and they replied, “because I said so.” When it comes to deductions on your tax return it often comes down to this simple statement. You cannot deduct everything to diminish your tax liability and in turn reducing the amount of money going into the coffers. What you get to do is deduct certain things because the laws on the books said that you could.