By Jason Watson, CPA
Posted Friday, November 3, 2023
Similar to the 185 reasons to not elect S corporation taxation, there aren’t 185 small business deductions that you cannot take. However, we want to start with the crazy things small business owners try to do since it is such a good springboard for discussion.
100% Cell Phone
Most small businesses operate on a cell phone. However, most small business owners also use his or her cell phone as a personal phone. The minute you get the “Hey honey… we need milk and eggs” text message to your cell phone, it drops from 100% business use to something else.
If you attempt to deduct 100% of your cell phone as a small business tax deduction, the IRS will claim 0% and then force you to demonstrate why it should be something else. Conversely, if you approach this from a position of being reasonable it is extremely challenging for the IRS to argue otherwise. What is reasonable?
We usually start with a single phone line cost of about $150 per month in 2020 dollars. While it might only take $10 to add another line, you would still need to spend $150 for yourself. From there it becomes a preponderance of the facts and circumstances. Some people say there are 40 hours in a work week and there are 168 available hours (24 x 7).
However, this calculus assumes your personal use “density” is the same as your business use “density.” For most business owners, this is not true. You probably talk longer with clients and business associates, than you do friends and family.
Anywhere from 50% to 80% is a good jumping off point. Since this is a mixed-use expense between personal and business, the cell phone charges should be paid by you personally and then reimbursed by the business for the business use portion through an Accountable Plan. See Chapter 10 on operating your S Corp for more details.
We feel compelled to hammer this point home- if the expense is mixed-use, such as cell phones, the bill is paid for with personal funds, and then the business portion is reimbursed to you by the business. Same with automobiles that are shared between personal and business use (we’ll remind you in a bit). Yes, it feels better using business funds, but No, you shouldn’t unless the expense is 100% business.
Automobiles
Automobiles will be discussed in nauseating detail later in this chapter, and there is a decision tree as well to help determine if you should own it or the business. In keeping with the business tax deductions that are disallowed, claiming your only automobile as 100% business use is a tough sell.
Home Office Improvements
You cannot spend $30,000, finish your basement, plop your desk in the middle of it and deduct the $30,000 for two reasons. First, the entire space must be regularly and exclusively used as a home office. This means the theater room must be a conference room, and the wet bar must be the office kitchen. Might be tough in the world of small business tax deductions.
Second, even if the entire basement is designated business use, the $30,000 represents an improvement. Therefore, it must be capitalized as an asset and subsequently depreciated over 39 years. From there, only the business use portion of mortgage interest, property taxes, insurance, HOA dues and utilities are deductible. And if you have an S corporation, then this business expense is reimbursed to you by the business through an Accountable Plan (and therefore deductible by the business as an employee reimbursement expense).
Don’t worry, the projection TV with the non-glare screen was still worth it. We’ll talk more about home offices especially with multiple locations later in this chapter.
Food
More bad news. You cannot deduct your business meals unless you fall under one of two situations-
- You are entertaining a client, prospect or other business associate (or a small group such as 12), and discussing business matters, or
- You are away from your tax home where you require substantial rest (such as an overnight trip), and that trip has a business purpose.
As such, if you cruise through the Starbuck’s drive-through and grab your triple grande vanilla breve on the way to your day meeting, no good. However, if you are traveling away from your tax home when on a business trip, then order the venti. Live a little.
Your small business tax deduction is limited to 50% under both circumstances (the 100% that we enjoyed for all meals was only for the 2021 and 2022 tax years, so we are back to the same old same old).
The theory on this is straightforward- you have to eat regardless of owning a business or not. In other words, your meal is not contributing directly to the operations or success of your business. The IRS is clever- they don’t mind giving you a tax deduction today on something that eventually will result in taxable business income through growth and profits in the future. Think of it this way- if you had a regular W-2 job, you wouldn’t be able to deduct your meals. Why would that change with your shiny new business or S corporation?
In reference to overnight travel or travel away from your tax home, your tax home is the location where you earn income. Here is the word for word description from IRS Publication 17–
To determine whether you are traveling away from home, you must first determine the location of your tax home.
Generally, your tax home is your regular place of business or post of duty, regardless of where you maintain your family home. It includes the entire city or general area in which your business or work is located.
If you have more than one regular place of business, your tax home is your main place of business.
If you do not have a regular or a main place of business because of the nature of your work, then your tax home may be the place where you regularly live.
If you do not have a regular or a main place of business or post of duty and there is no place where you regularly live, you are considered an itinerant (a transient) and your tax home is wherever you work. As an itinerant, you cannot claim a travel expense deduction because you are never considered to be traveling away from home.
Main place of business or work. If you have more than one place of business or work, consider the following when determining which one is your main place of business or work.
- The total time you ordinarily spend in each place.
- The level of your business activity in each place.
- Whether your income from each place is significant or insignificant.
There you have it. Overnight travel away from your tax home will create a nice business deduction for that beer sampler with pretzels and mustard dip. Spicy of course.
Here is a link to IRS Publication 17 (Your Federal Income Tax)-
Tax homes can get tricky especially if you travel a lot or have multiple job locations. More details are coming up in this chapter when we discuss home offices. Also, we can always help sort through it to find the best tax position.
Also, note the word “itinerant” above. Here is a snippet of the snippet-
If you do not have a regular or a main place of business or post of duty and there is no place where you regularly live, you are considered an itinerant (a transient) and your tax home is wherever you work. As an itinerant, you cannot claim a travel expense deduction because you are never considered to be traveling away from home.
WCG CPAs & Advisors have a lot of Certified Registered Nurse Anesthetists (CRNA) who travel all over the country putting people to sleep on short-term contracts, or stints if you are Formula 1 fan. Unless you return periodically to a place where you regularly live, you will not have a tax home. Without a tax home a lot of travel, lodging and meals deductions go away.
Sidebar: CRNAs certainly take the cake on fun business names like Sleepy Times Ahead LLC and Passing Gas with Class LLC. Either they are clever, or some of the gas meant for the patient was accidentally inhaled by the medical professional. Perhaps it wasn’t accidental. Who uses gas anymore? We digress…
Per Diem
Sole proprietors including single-member LLC owners, and partners are allowed to deduct the federal per diem rate for meals. Lodging can only be deducted using the actual cost of lodging. Where are S corporations? You are not going to like this. Employees of corporations are eligible for per diem allowances, reimbursements and deductions unless this same employee owns more than 10% of the corporation.
This means that most S corporation shareholders are hosed, and can only deduct (or get reimbursed) for actual meal costs. IRS Revenue Procedure 2011-47 has this limitation and IRS Publication 463 states in part “A per diem allowance satisfies the adequate accounting requirements for the amount of your expenses only if…you are not related to your employer.”
You are related to your employer if-
- Your employer is your brother or sister, half-brother or half-sister, spouse, ancestor, or lineal descendant,
- Your employer is a corporation in which you own, directly or indirectly, more than 10% in value of the outstanding stock, or
- Certain relationships (such as grantor, fiduciary, or beneficiary) exist between you, a trust, and your employer
Therefore, the question becomes, if you are an LLC being taxed as an S corporation, are you a corporation where you own stock or an limited liability company where you own a membership interest. We believe these are one in the same in this context. Don’t fret. You can still deduct 50% of your meals when traveling; you just need to use actual expenses and not per diem allowances.
Country Club Dues
Nope. The IRS does not care how many times or how much you entertain your clients, prospects and business associates at your country club. The membership dues are not allowed. However, the specific out-of-pockets expenses associated with qualifying meals incurred at your country club are deductible. There are some other devils in the details, but this is the general gist. Also, recall that since the Tax Cuts and Jobs Act of 2017, entertainment is no longer deductible.
Don’t confuse this with other types of dues such as Chamber of Commerce or other professional organizations such as BNI. Those dues are 100% deductible although there is some scuttle butt about BNI since a portion of the dues are likely for meals.
Client Gifts
Yuck, more IRS publications stuff on the way. In IRS Publication 463, here is the blurb on client gifts-
You can deduct no more than $25 for business gifts you give directly or indirectly to each person during your tax year. A gift to a business that is intended for the eventual personal use or benefit of a particular person or a limited class of people will be considered an indirect gift to that particular person or to the individuals within that class of people who receive the gift.
If you give a gift to a member of a customer’s family, the gift is generally considered to be an indirect gift to the customer. This rule does not apply if you have a bona fide, independent business connection with that family member and the gift is not intended for the customer’s eventual use.
If you and your spouse both give gifts, both of you are treated as one taxpayer. It does not matter whether you have separate businesses, are separately employed, or whether each of you has an independent connection with the recipient. If a partnership gives gifts, the partnership and the partners are treated as one taxpayer.
$25 is the maximum per year per person. The second paragraph explains you cannot give $100 to a family of four (as an example), unless you have a separate bona fide relationship with each family member. Here is the link to IRS Publication 463 (Travel, Entertainment, Gift, and Car Expenses)-
In a recent IRS audit that we represented, the client presented a $1,000 receipt for forty $25 VISA gift cards along with forty names of clients, prospects and business associates, including the business connection to each. Excellent documentation frankly. The IRS agent accepted the business deduction as is, yet quietly we wondered if any of those names actually received the gift cards. We didn’t bring it up. Interesting indeed.
Keep this in mind as well- note that the IRS refers to individuals in their little pontification above. Gifts to another business are limitless. So, if your client is a business and you want to express your gratitude, theoretically there is no limit provided an individual is not the designated recipient.
Promotional items that are under $4 in unit cost and have your business name or logo on them are not considered gifts and do not contribute to the $25 maximum.
Commuting Expenses
It is unfortunate, but expenses associated with your commute to work are not deductible. Tolls and parking are the common ones small business owners attempt to deduct. There is a subtle difference to be aware of- driving from a work location to your client’s place of business is not commuting. Commuting is driving from your home to your office or client’s place of business.
You can solve a lot of problems surrounding commuting expenses by qualifying for a home office. Then your commute is from the bedroom to the home office. If you shower, then the commute is from the bathroom to the home office.
All kidding aside, or least most of it, the tax benefit of the home office deduction is not too low, not too high. In our experience, about $250 or so of cash in your pocket benefit comes from the additional deductions associated with a home office. But! Where the big benefit comes from is the deduction of travel expenses; without a home office, your mileage or automobile expenses to your first client is not tax deductible. However, with a home office, this drive is now considered travel between work locations. Huge difference!
We do a deep dive into the home office deduction in a bit.
Professional Attire
The tax code is very clear on this. Anything that you can convert to everyday use is considered personal, and therefore not tax deductible. Many business owners want to deduct dry cleaning expenses or Men’s Warehouse purchases, but they usually cannot. We know you are rocking it in the double-breasted vest without a coat look, but the IRS doesn’t have fashion sense and therefore doesn’t care. However, there are some exceptions (of course there are).
WCG CPAs & Advisors prepares several tax returns for pilots, flight attendants, military personnel, nurses and firefighters. These uniforms are not suitable for everyday use and / or are protective in nature (such as steel-toed boots), and therefore are small business tax deductions. We also have a handful of models and actors as clients, and their clothing is considered theatrical costumes not suitable for everyday use.
Many small business owners will embroider a nice golf shirt or something similar. This can be deducted as either clothing not suitable for everyday use or advertising depending on the IRS agent who is bent out of shape about your tax returns.
The maintenance such as alterations and laundering of deductible clothing is also tax deductible. Shoes, socks, nylons, haircuts, watches and the like are all disallowed. Forget about it. In Mary A. Scott v. Commissioner (Tax Court Summary Opinion 2010-47), a Continental Flight Attendant was denied shoes, socks, nylons and hair product as unreimbursed employee business expenses. Here is the link-
It’s a fun case and a quick read.
Loan Payments
Many businesses have loans, either for automobiles, business equipment or lines of credit. However, having an expense category of “Loan Payment” is a dead giveaway that the business owner doesn’t understand that only the interest portion of the loan payment is deductible.
Think of it this way- if you lent your buddy $50,000 and he or she shockingly pays you back the $50,000 plus $10,000 in interest, only the $10,000 would be income to you. The $50,000 would be what we nerdy accountants call a return of capital.
Yet another way to look at this- your small business tax deduction must be recognized as income by another entity (either business or person), unless that entity is a charity. So, for the IRS to allow you to deduct mortgage interest on your home mortgage as an example, the lender must recognize the interest as income. Your deduction = someone else’s taxable income.
Zeus and Apollo
Let’s say you are a hotshot private investigator driving a red Ferrari 308 GTS in Hawaii. Can you deduct two Dobermans as business expenses? Possibly. We recently worked with a client who is a criminal defense attorney where we demonstrated that the need for security dogs was a bona fide occupational qualification. In other words, the dogs provided security to the criminal defense attorney so he was able to perform his job. Stop laughing, it was L-E-G-I-T. Not because of the creativity, but because of the argument’s position.
Another way to look at these obscure examples- the IRS allows you to deduct most things if they eventually lead to the generation of taxable income. Think of investment fees. Think of Zeus and Apollo who allowed the attorney to continue taking on high-risk, high-profit (taxable) defense cases.
Conclusion
Enough about the stuff you can’t do, or at least enough of the business deductions you need to carefully position yourself with, let’s talk about the stuff you can do. There are several small business tax deductions that are common, yet overlooked or misapplied.