Navigating Non-Deductible Business Expenses

  • Accracy
  • 26th Nov, 2023

A tax deduction, often referred to as a "tax write-off," is an expense that can be subtracted from your taxable income, therefore reducing the amount of tax you owe. This article primarily focuses on business tax deductions, which are deductible on your business tax return, as opposed to personal tax deductions, which apply to your personal tax return. As we paddle down the river of finance, it's crucial to understand every current and undertow that influences our journey. One of the key elements that is often overlooked is non-deductible expenses. These are like the rocks beneath the surface—they might not be immediately visible, but they can significantly impact our financial health.

Navigating Non-Deductible Business Expenses
Tax Tips

What are non-deductible expenses?

Non-deductible expenses are costs that cannot be subtracted from your income before it's assessed for tax. They can take a bite out of your profits, making it essential to understand what they are, how they work, and most importantly, how they can affect your financial journey.

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Difference between deductible and non-deductible expenses

Imagine your business expenses as a triad of categories: tax-deductible, non-deductible, and context-specific deductions. Understanding which expenses get filed under each category means you've mastered a critical aspect of your financial health.

Like a puzzle, the financial world is a complex structure with different pieces fitting together to create the full picture. Non-deductible expenses are one such piece — not as flashy as revenue, but equally as important in understanding your business' tax situation. In simple terms, non-deductible expenses are the costs that you cannot subtract from your income when declaring your taxes. They stand in stark contrast to deductible expenses, which you can subtract, thereby reducing your taxable income and subsequently, your tax liability.

Certain expenses—like personal expenses, mortgage interest, vacation costs—are non-deductible and it all comes down to intended purpose of these expenses. The IRS doesn't allow deductions for expenses that are not directly tied to producing income. For example, personal expenses like home mortgage interest or vacation costs are considered non-deductible. The exact list of non-deductible expenses can vary based on your business situation and tax regulations.

The Consequences of Misclassifying Expenses

Misclassifying expenses can lead to serious consequences like penalties or additional tax payments.

The general rule is to be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. Anything beyond that is generally not deductible. So for example, if you wear street clothes while you work remotely, those clothes are not deductible. But if you wear protective clothing, work boots, a tool belt, and a helmet for your construction job, then that would be tax deductible. This is because that clothing is ordinary and necessary for that job and industry.

The determination of deductible and non-deductible expenses is rooted in a comprehensive legal framework established by regulatory agencies such as the Internal Revenue Service (IRS). The IRS governs and enforces the tax laws that dictate which expenses are eligible for deductions and which are not. This regulatory body provides clear guidelines on what constitutes deductible business expenses based on their relevance to generating income and the nature of the business. Understanding these criteria and the IRS's role in defining them forms the foundation for making informed decisions regarding your business's tax liability and financial strategy.

Common examples of non-deductible expenses

Let's look at some common non-deductible business expenses.

Personal expenses

  • Any ordinary expenses related to personal or family are considered personal expenses and will not be tax deductible for your business.
  • If it doesn't have anything to do with business activities or you don't need it to perform your work-related responsibilities, then it is usually a personal expense.
  • For example, if you buy business supplies (staplers, paper, pens/pencils, etc.) those will be deductible. BUT if you buy supplies for personal use (pencils for sketching in your past time) those will not be deductible.

Anything Illegal

  • It doesn't matter if they are business or personal expenses, any expenses that are incurred illegally or are for illegal activities will not be deductible

Commuting expenses

  • Any expenses that are incurred while commuting to and from work are not deductible because they are considered personal expenses and not business.

Political contributions

  • Contributing money to a political party/candidate is not deductible.

Entertainment

  • Entertaining clients (concert tickets, golf games, etc.) is not tax deductible.
  • You are no longer able to take tax deductions for expenses that are entertainment alone.

Life insurance

  • Unless this is something that you offer employees, then this is generally not deductible. Also, small businesses with a specific business structure (LLC, S-Corp, sole proprietors) can deduct the premiums they pay employees, typically through group life insurance.

Legal fees for property purchasing

Club membership

  • Sometimes clients will justify this by stating that the golf club is where they meet people and market their services. Unfortunately, it is still not deductible.

Child and Dependent Care

  • Child and dependent care often does reduce your tax bill but it is not a tax deduction. Instead it is a tax credit.
  • While this credit does require you to have expenses, the expenses are not actually deductible. Instead they help you qualify for the tax credit. Rather than recording it on your books as a deductible business tax expense, you'll need to attach Form 2441 to your Form 1040 to claim the credit.
  • If you pay someone to care for a child or another dependent while you work, you may be able to claim the Child and Dependent Care Credit. To qualify, the person receiving the card must be a child (under age 13) or a spouse or other dependent who is physically or mentally incapable of self-care.
  • The credit is worth between 20% and 35% of your allowable expenses, depending on your income. Allowable expenses are limited to $4,000 for the care of one dependent and $8,000 if you paid for the care of two or more dependents. IRS Publication 503 provides more information on the Child and Dependent Care Credit. You'll need to attach Form 2441 to your Form 1040 to claim the credit.

Research and Development (R&D) tax credit

  • R&D often does reduce your tax bill but it is not a tax deduction. Instead it is a tax credit.
  • While this credit does require you to have expenses, the expenses are not actually deductible. Instead they help you qualify for the tax credit. Rather than recording it on your books as a deductible business tax expense, you'll need to fill out IRS form 6765 to claim the credit.
  • The R&D tax credit is a tax incentive, in the form of a tax credit, for U.S. companies to increase spending on research and development in the U.S. A tax credit generally reduces the amount of tax owed or increases a tax refund.
  • The R&D credit is available to any business that incurs expenses while attempting to develop new or improved products or processes while on U.S. soil.

Try this four-part tax credit test

A simple, four-part test can help determine whether your business qualifies for the federal tax credit.

  1. Eliminate uncertainty. You must have carried on the research in order to eliminate uncertainty about the development or improvement of a product or process. In other words, changes solely for aesthetic purposes don't qualify.
  2. Process of experimentation. The activities must include some experimentation to resolve the technical uncertainty, such as modeling, simulation, systematic trial and error, or other methods.
  3. Technological in nature. The research must rely on the hard sciences, such as engineering, physics, chemistry, biology or computer science.
  4. Qualified purpose. The purpose of the activity must be to create a new or improved product or process, resulting in increased function, reliability, performance, or quality.

Health care expenses

  • Health care expenses are not deductible on your business tax return but they are deductible on your personal income tax return.
  • You can deduct other out-of-pocket medical costs, such as office co-pays and the cost of prescriptions. These costs are normally included on itemized deductions on Schedule A.
  • Self-employed business owners can also deduct health insurance premiums for themselves, their spouse, and dependents on Schedule 1 attached to their Form 1040. However, if you are eligible to participate in a plan through your spouse's employer, then the business can't deduct those premiums.

Charitable contributions

  • Charitable contributions are not deductible on your business tax return but they are deductible on your personal income tax return.
  • To qualify, the donation must be made to a qualified organization.
  • Starting with 2020 returns, taxpayers can claim up to $300 of cash contributions as an "œabove-the-line" deduction on Form 1040. To deduct more than that, the business owner has to itemize deductions on Schedule A attached to Form 1040.
  • Starting with 2020 returns, taxpayers can claim up to $300 of cash contributions as an "œabove-the-line" deduction on Form 1040.

Lean on the experts At Accracy

Navigating the intricacies of understanding the deductibility of expenses can sometimes feel overwhelming. But don't worry. As a bonus, Bench Tax clients have the added convenience of being able to connect with their tax advisor by scheduling a call within the Bench app.

Mastering the labyrinth of tax regulations and grasping the criteria outlined by the governing bodies like the IRS, empowers you to make well-informed decisions that directly affect your tax liability. Recognizing which expenses are eligible for deductions allows you to craft a financial strategy that optimizes resource allocation. If you ever find yourself needing further clarification on specific expenses, never hesitate to reach out to a tax professional or make use of the resources available to you. Always remember, your proactive approach towards understanding both deductible and non-deductible expenses will play a significant role in the success and longevity of your business.

Related reading
  • For a list of common business expenses that are tax deductible, check out this article.
  • If you're curious about above-the-line deductions, check out this article.
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