What Are Non-deductible Business Expenses?
According to the IRS, a deductible business expense must be both ordinary and necessary. Therefore, any expense that isn’t ordinary and necessary to your business’s operation is non-deductible. In addition to this broad definition, the IRS provides guidance on specific business expenses that cannot be deducted. This article gives more information about each of these non-deductible business expenses, along with examples.
The 2017 Tax Cuts and Jobs Act has eliminated the deduction for entertainment expenses, which means you can’t deduct the cost of entertaining clients at sporting events, concerts, or private clubs. It doesn’t matter whether you invite and discuss business with a client or employee, any expenses related to entertainment aren’t deductible. However, business meals at entertainment events are deductible if you have an itemized receipt that states the cost of the meals separately from the entertainment event.
Let’s say you invite your favorite client to a baseball game. You purchase tickets for both of you in advance and treat your client to hot dogs and drinks while at the game. Because the baseball game is considered entertainment, it isn’t deductible. The cost of the hot dogs and drinks, which are purchased separately from the tickets, isn’t an entertainment expense and isn’t subject to the disallowance. Therefore, you may deduct 50% of the expenses associated with the hot dogs and drinks purchased at the game as a meal expense.
50% of Business Meals
You can generally deduct only 50% of your food and beverage costs, with the caveat that they can’t be “lavish or extravagant” and the business owner or employee must be present. In 2021, the Consolidated Appropriations Act allowed for a full 100% deduction for business meals in 2021 and 2022 as long as they are provided by a restaurant.
Here are some of the most common 50% deductible expenses that are 100% deductible if purchased from a restaurant before the end of 2022:
- A meal with a client where work is discussed (that isn’t lavish)
- Employee meals while traveling
- Employee meals at a conference, above the ticket price
- Food for a board meeting
- Dinner provided for employees working late
Taxes that cannot be deducted as business expenses include: :
- Federal income taxes
- 50% of self-employment taxes are non-deductible, and 50% are deductible as an adjustment to income for the sole proprietor or partner
- Estate, inheritance, legacy, succession, and gift taxes
- Taxes on real property apportioned at the time of closing
Employers are allowed to deduct employment taxes, such as social security and unemployment tax, that they must pay on the wages of their employees.
Penalties & Fines
Fines and penalties that a business pays to the government for violation of any law are never deductible. For example, you can’t deduct an underpayment penalty, late payment penalty, or late filing penalty. However, interest paid to the IRS is deductible if the underlying income tax liability is business-related.
Nondeductible penalties and fines aren’t limited to tax-related items. Any fine or penalty is nondeductible. For instance, no matter how much you argue that speeding is an ordinary and necessary thing for your business, the fine for your speeding ticket isn’t deductible.
Gifts and contributions that are made to political parties are generally not deductible as are expenses incurred to participate in any political campaign of a candidate for public office. The rule applies to indirect contributions as well, such as advertising in a program for a political party’s convention or tickets to an inaugural ball that is identified with a political party. In both cases, if the proceeds from the program or event are for the party’s or candidate’s use, the associated expenses are non-deductible.
Payments made to officials or employees of a foreign government aren’t deductible if the payments are unlawful under the Foreign Corrupt Practices Act of 1977. Additionally. payments made to officials or employees of any government other than a foreign government aren’t deductible if the payments constitute an illegal bribe or kickback.
A kickback is a payment for referring a client, patient, or customer. It commonly occurs when money is given to someone to influence a third party to purchase from, use the services of, or otherwise deal with the person who pays the kickback.
Interestingly, ordinary and necessary business expenses of an illegal business are deductible against the income from the illegal business. An example would be the security expense for an illegal gambling hall or bribes of government officials.
It sounds odd to think of a tax return being filed for an illegal business and the ordinary and necessary expenses being deducted. These returns are usually filed after the suspect is arrested and the IRS learns of the untaxed income.
Business Expenses of Drug Trafficking
Unlike most illegal activities, the ordinary and necessary expenses of drug trafficking aren’t deductible. You can’t, for example, deduct the money you paid for smuggling illegal substances into the country, money laundering, or other illegal activities like bribes and kickbacks.
When someone in the drug trade is arrested, the IRS can include all estimated income they earned in taxable income without allowing any deductions against that income. This is much harsher than for other illegal activities where business deductions are allowed.
Purchases of Property, Plant & Equipment
One of the principles underlying the tax rules for deductions is that your income for the year should only be offset by those expenses that contributed to earning that income. Capital expenditures to acquire or improve a business asset that will last longer than a year aren’t deductible as business expenses.
The IRS considers capital expenditures for purchasing long-term business assets—like vehicles, equipment, and buildings—as investments in your business, not expenses. In this case, you might be able to deduct the entire purchase price under Bonus Depreciation or Section 179.
The IRS has adopted new rules designed to help classify whether an item is a “repair,” which is generally deductible in the year it’s made, or an “improvement” that must be added to the property’s basis and deducted over a period of years. Because these rules are complex and could have huge tax ramifications, it’s a good idea to consult with an accountant before making any substantial repairs or improvements to your property.
The following items have been considered as capital expenditures by the IRS:
- Burglar alarm installation charges
- Flood protection costs
- Business facility improvement costs, such as replacing a roof
- Insulation costs
- Display cases, remodeling costs
- Cable replacement costs upon sudden failure
- Office, cost of changing location and equipment
- Electrical system replacement costs
Determining whether a payment is a deductible expense versus a capital expenditure can be difficult. Bench provides unlimited tax advice in its Premium bookkeeping plan.
What Is an Ordinary & Necessary Business Expense?
Unless an expense falls into one of the nondeductible expenses listed above, it can be deducted if it’s ordinary and necessary. Ordinary is usually interpreted by the courts to mean an expense that’s common within a specific trade or business while necessary means helpful and appropriate. If you run a delivery business, ordinary and necessary expenses would be the fuel, maintenance, and tolls associated with your vehicles.
Here are some examples of ordinary and necessary business expenses that are deductible:
- Administrative expenses like licenses, insurance, and bookkeeping
- Office supplies to support your business
- Attorney and accountant fees
- Employee compensation
- Employee-sponsored retirement plans, such as 401(k)
- Rent for office space
- Bank charges
- Commissions and sales costs
- Contract labor costs
- Dues and subscriptions
- Postage and delivery fees
- Equipment rentals
- Advertising and promotion
- Internet subscriptions, domain names, and hosting
Simply stated, business expenses that aren’t ordinary and necessary for your business cannot be deducted. In addition, in the broad ordinary and necessary test, there are several expense types that are explicitly made nondeductible in the tax code, including entertainment, taxes, penalties and fines, political contributions, and capital expenditures.