One of the more significant expenses for the small business owners is income taxes. Since most small businesses are tax pass through entities, it is beneficial to the business to have the least amount of net income in order to reduce the tax obligations of the owner(s). This is achieved by making sure every dollar expensed is deductible for tax purposes. However, the Internal Revenue Service and the corresponding Tax Code identify what is allowable and what is not deductible. This article goes into more detail about the nondeductible expenses for a small business.
Most of these expenses are grouped into two sets. The first are the more common personal expenses, especially those that directly or indirectly benefit the owner of the business. The second set primarily benefit the business but are not deductible; however, they are deferred until termination or sale of the company. At that point in time, there is the ability to use this expense as an offset against the calculated taxable income to the owner.
This is one of the areas of business that as a professional I advise owners to be careful. Your goal as a business is to demonstrate profitability. If you take expenses that benefit you, it reduces the bottom line. Granted, you’ll pay less in income taxes. But the reality is that outside viewers and potentially the bank and other investors will frown upon the lower than possible profit. What I’m saying is this: It is a good business model to pay income taxes. It demonstrates that you are not only a legitimate operation, but you have credibility. Use your own money to pay your personal expenses. Let the business make a profit!
The first section of this article is a summary of those expenses that are nondeductible for business purposes. If you desire to learn more details or explore the marginal items and gain a better understanding, please read the two sections explaining these two sets of nondeductible expenses.
In general, for an expense of a business to be deductible, it must be ‘Necessary’ and ‘Ordinary’ as defined by the code. In general those expenditures made by the business that provide a more direct benefit to the owner, are not deductible. The following is short list of nondeductible expenses:
- Penalties and Fines charged by governmental authorities – examples include parking tickets and failure to timely file documents,
- Transportation expenses for the personal vehicle of the owner and/or dependents of the owner; however, those expenses for transportation of the owner related to actual work are deductible,
- Life insurance premiums unless they are a group policy ensuring all employees equally and the beneficiaries are the employees,
- Charitable contributions, for pass-through entities, these contributions flow directly to the owner via Form K-1,
- Depreciation and Amortization in excess of the amounts allowed under the Code,
- 50% of all meals,
- Travel expenditures if the travel involves personal leisure for any owner or employee; includes the pro-rated amounts for leisure on regular business trips,
- Membership and Club Dues,
- Lobbying and Political Contributions,
- Illegal activities including bribes,
- Personal cell phone bills.
The most common form of a nondeductible expense relates to expenditures that directly benefit the owner. The one I’ve encountered frequently is taking lunches as an expense for the business. The IRS uses the personal standard of life as the basic test. Individuals are not allowed to take lunch as an expense on their personal return; therefore, the business owner or the employee isn’t allowed either. This is premise for the 50% rule. Since most lunch meetings are one on one, the portion of value consumed by the owner or employee is nondeductible.
Some expenses are necessary and ordinary but the IRS requires the business to accrue the expenditure as a capital cost and either depreciate or amortize this cost over time. In some situations, the business must hold this expenditure as an asset on the books and is considered basis once sold. The perfect example is land.
The following sections go into more detail related to the nondeductible expenses.
Those expenses that create some form of personal benefit to any employee or owner of a company are not allowed as a deduction for tax purposes. The IRS wants this value taxed. The idea is to only allow those expenses that are ordinary and necessary. No untaxed value should inure to any individual without this benefit included in that individual’s compensation or income. There are about three very common expenses and several unusual expenses. The following describe them one by one. I illustrate how you document the expense to either make it deductible or allocate to the owner the nondeductible portion appropriately.
The number one frequently used nondeductible expense made by a business is the purchase of meals that benefit the owner or management. The IRS scrutinizes these expenses based on the nature of your business and industry. For those that do have the ability to deduct these meals, the IRS requires substantial documentation and demonstration that they benefit the company. In addition, it would behoove the small business to include this benefit in the owner’s income i.e. his direct portion of the cost of meals. The following is an example of best practices related to this particular expense:
Best Practices Tip – Owner’s Meals
George runs a law firm as managing member that specializes in zoning law modifications and compliance. The firm has several contracts as advisors to different local municipalities and towns. In addition, his best clients are developers. In general, George meets with the developers and their management team or with the zoning boards and often certain members. He does this via lunches at family style restaurants. After each meal, George sits in his car and makes notes of the meeting including attendance, discussion items, issues addressed and information exchanged. He carefully marks each receipt with what each individual ate at that meeting. He circles his meal cost and at the bottom multiples his respective meal cost along with the refreshment by the combined sales and meals tax. The value derived is noted as nondeductible and is included as income in George’s next paycheck.
Copies are stored electronically and matched up against the charge card value each week. Information is noted in the accounting entry and a spreadsheet is updated noting the exact date and place of the meeting, total amount expended, the amount charged back to George and the paycheck period George’s share of the meal is accrued to in the payroll.
By having George’s share included in his paycheck as income, his portion of the meal is deductible as wages paid to George.
In the tip above, George’s share is deducted via his paycheck and the balance is deducted as a normal expense for the firm. Because of the unique nature of the practice, these meals are deductible as ordinary and necessary. George has a documented background via contracts with some of the local governments and limits the practice to zoning law work. It is not unreasonable for him to use the lunch venue as his means of communication and marketing. Because George limits the form of meals to family style dining, he is reasonable in his expenditures for meals.
The deductibility would be arguable if George were to dine in upscale restaurants or failed to properly document the meetings. More importantly, George demonstrates to the IRS that his portion is taxed as wages to him via the payroll. In addition, George’s reasonable exercise of family style dining illustrates that the company is trying to control costs and not at the expense of paying taxes.
Another personal benefit commonly used by small business relates to transportation for the owner. This particular expense typically generates the greatest value to an owner. This is another area the IRS scrutinizes to a high degree. The key is to not provide a value to the owner in any form. If there is value to the owner, the owner picks this value up as income for tax purposes. As in the meals example above, the owner needs to document his transportation for the business. This is best done using a mileage log. In addition, it is much better if the company did not own the vehicle and simply reimbursed the owner for documented miles at the standard mileage rate (2015 Deduction Rate).
If you already have a company vehicle and it is driven by the owner or a family member, the mileage log is still the best defense for the deductibility of the expense.
Best Practices Tip – Personal Vehicle
When the owner drives a company car, the bookkeeper should track all the expenses for that particular vehicle in a separate spreadsheet, by month. The bookkeeper should get the log from the owner and document the beginning and ending mileage each month, review the actual miles driven for business and those driven for personal purposes by the owner. In each month’s tab on the spreadsheet, an allocation of the month’s total cost is created between the owner and the company.
Just as in the illustration above, the owner’s share is either included in his payroll making the entire vehicle costs of operations deductible or the owner reimburses the company via a personal check for his respective value derived. The total value should include all costs to operate the vehicle including depreciation and accrued expenses (insurance, interest and taxes).
The third most common nondeductible expense in the small business world is insurance that directly benefits the owner and his family. This one is really serious. The IRS doesn’t want management taking life insurance premiums as a deduction on the business return. If the business takes a premium as a deduction, then every dollar of benefit paid by the insurance company on behalf of deceased is included in income in the year of death.
Basically, life insurance premiums are nondeductible by absolutely everybody. In exchange for this rule, Congress exempts benefits paid by life insurance companies from income. The goal is to maximize value to the widow. Don’t do it!
It is still OK for the company to pay the premiums, but they must be documented as a nondeductible expense and reported appropriately to the IRS in the annual tax return. If you don’t know how; please consult with a CPA.
Other forms of nondeductible insurance include disability for the owner, personal umbrella policy and customized protection.
Other Nondeductible Expenses
Other nondeductible expenses include penalties, often directly related to infractions with the local government. For contractors, believe it not, the reinspection fee paid to Codes and Compliance is not deductible for tax purposes, but is still a cost in the construction of the project.
The remaining examples include:
- Personal interest
- Listed Property used by an owner
- Travel expenses that include leisure activities (I have a separate article on this subject in the income tax section)
- Membership Dues and Club Fees
- Lobbying and Political Party Contributions
In general, if the item isn’t deductible on the personal tax return, it is generally not deductible on the business tax return.
Some expenses are not deductible on the year to year operating tax returns, but are deductible once the particular asset is sold. The next section explains this type of cash outlay in more detail.
Deferred Expenses for Tax Purposes
One particular asset on the books for many small businesses is never deductible as an expense or via depreciation. This is land. In general, land will continue on forever and is never depreciated or amortized. Therefore, it is included in the basis at the time of sale of this asset. This rule is applicable to every business out there.
In general there is one exception to the land item. For those involved in mining, the land is comprised of two components. The first is the value of the underlying raw resource that will be mined while the balance is the value of the real estate as a piece of land. The portion of value as land is nondeductible and deferred as basis whereas the raw resource value is allocated over time using depletion accounting.
In some expenses; the tax basis of the equity section is adjusted instead of the cost being expended to the profit and loss statement. This is because the Code identifies these cash expenditures as more in line with a stock cost than as a business expense. Think of it like brokerage fees included in the basis of the stock at the initial purchase. Well, the same goes for a business.
The best example is a cost related to transferring assets into the name of the company in exchange for stock. A really good example would be an owner donating his vehicle to the company in exchange for an equity position. These costs are netted against the value received.
Those costs to purchase and prepare the stock certificates are not deductible either. As with the transfer of the truck example above, they are simply netted against the proceeds. As an example:
Jim pays $400 for 40 shares of his own company. The company purchases a stock certificate book for $10. On the books of record; the company increases the equity section by $400 and then decreases the equity section by $10 to net $390 as the balance in the stock section of equity. Jim’s personal basis is $400, but the company’s basis for the stock is only $390.
Conclusion – Nondeductible Expenses
It is important as the owner of business to track nondeductible expenses. They are reported each year on the tax return and should be tracked via a spreadsheet for the business’s set of books. Those expenses that generally benefit an owner or any employee and not included in that individual’s compensation package are not deductible. Other nondeductible items include illegal activities most notable penalties and fines, life insurance premiums that benefit the owner, and several others. When in doubt, talk with your CPA. Act on Knowledge.