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Deductible or a Capital Expense?

Is an amount paid by a business an expense that is currently deductible, or is it a capital expenditure that should be depreciated,, amortized or depleted?  This issue is one of the most common issues in a tax audit with the Internal Revenue Service, as well as one of the most litigated issues in United States Tax Court.  The article below has been prepared by a tax attorney to provide additional information related to this common issue.  Please remember that this article is for informational purposes, and you should consult directly with your tax attorney and advisors related to your specific issues.

A currently deductible expense is an ordinary and necessary expense that is paid or incurred by the business during the taxable year in the ordinary course of operating the trade or business.  Please reference Internal Revenue Code Section 162.  In comparison, a capital expenditure would be the cost to acquire, improve or restore an asset that is expected to last more than one year.  These capital expenditures are not allowed a deduction, but rather are subject to amortization, depreciation or depletion over the useful life of the property. See Internal Revenue Code Section 263.

That being said, how does one determine whether an expenditure is an expense to be deducted or a capital expenditure?  The answer is, it is a question of fact.  The Courts have applied the principles of deductibility versus capitalization on a case by case basis, and the facts and circumstances of each case will likely determine the outcome.

An example may help illustrate the difference between an expense that would be deductible versus one that would be capitalized.  If a business owner bought certain office supplies such as pens and paper, they would be deductible.  If the same business owner, purchased a building to operate the business, the building would be capitalized.  Let’s look at a different example that might not be as obvious.  Assume a business owns and rents property.  In one property a hole was placed in the wall when a tenant moved.  In another property, the owner decided to replace the walls with new drywall and paint.  It is likely the fixing of the hole in the wall would be deductible as a repair or maintenance, whereas the cost to replace the walls would be capitalized by the business.

One further issue to consider beyond the matters discussed above is that the Internal Revenue Code requires books and records to be maintained to verify and substantiate the expense whether it be a deduction or capital expense.  If the item or amount of the expense cannot be verified and substantiated by the taxpayer, the IRS may disallow the deduction or the capital expense.

If you have questions related to a deduction or capital expense, you can speak with a tax attorney by contacting The McGuire Law Firm.   The McGuire Law Firm offers a free consultation with a tax attorney to discuss your questions and issues.

Denver Tax Attorney

Is Your Business a Hobby?

Is your business considered a hobby by the Internal Revenue Service?  One of the key questions or issues is whether or not your business is an activity engaged in for profit.  While you may feel your business is established and engaged in for a profit, the IRS may feel otherwise, and the Internal Revenue Code can impact your deductions.  This article has been prepared by a tax attorney to provide additional information regarding this issue.  Please consult with your tax advisors or tax attorney regarding any questions you have.

The pertinent section relating to activities engaged in for profit is section 183, which is often referred to as the “Hobby Loss Rule.”  IRC Section 183 limits deductions that a business may anticipate they can claim when the business is not engaged for a profit.  As a business owner you can deduct ordinary and business expenses when conducting your business activity.  However, if your business activity is deemed to not be engaged in for the production of income (a profit), you may not be able to deduct some or all of the expenses.

The IRS will consider certain facts and circumstances when determining whether your activity or business is a hobby, or an activity engaged in for profit. Some of these issues are stated below.

 

  • Do you depend upon the income? Do you rely upon the activity or business to provide income that supports you?
  • What amount of effort and time do you put into the activity, and does the amount of time and effort show you intended to make a profit?
  • What is your knowledge base in regards to the activity and does such knowledge provide you with the ability to make a profit?
  • Have you been successful in making a profit with the applicable activity or a like activity in the past?
  • Has the activity made a profit in some of the taxable periods?
  • What actions or methods have you implemented to improve profit or allow the activity to be profitable?
  • If the activity has sustained losses, are the losses explained by circumstances beyond the taxpayer’s control?
  • If the activity has sustained losses, are the losses due to reasonable or anticipated start up expenses?

 

If an activity makes a profit in at least three of the last five years, then the IRS should validate the business as an activity engaged in for profit.  If the activity is deemed a hobby (not for profit), the losses from the activity cannot be used to offset other income.  In short, the activity cannot produce a loss.  Thus, the allowable deductions and expenses for the activity cannot exceed the gross income (gross receipts) of the activity.

If you have questions related to your business income, deductions and related matters, speak with a tax attorney at The McGuire Law Firm.  Free consultation with a tax attorney in Denver or Golden Colorado.

Deducting Business Expenses

Can I deduct my meals as a business expense?  Can I deduct this flight as a business expense?  Can I deduct the cost of my clothes or uniform as a business expense?  As a tax attorney, these are common questions I am asked, and rightfully so as everyone wants to take advantage of all potential deductions allowed by the Internal Revenue Code.  Not only is the deductibility of certain business expenses a hot topic with business owners, it is a hot topic and highly litigated topic with the Internal Revenue Service.  In fact, I recall reading a recent annual report to Congress by the Taxpayer Advocate Service whereby the deductibility of trade or business expenses he been one of the top ten most litigates issues for a very long time.  Furthermore, the same report stated that the courts affirmed the position taken by the Internal Revenue Service (the dissallowance 0f the deduction) in the vast majority of cases and that the taxpayer only prevailed (in full) about two-percent (2%) of the time.  The article below is not intended to be legal advice, but rather to provide general information regarding this issue.

First and foremost, we should start with the current law regarding deductions for business expenses.  Internal Revenue Code (the “Code”) Section 162 allows deductions for ordinary and necessary expenses incurred in a business or trade.  What actually constitutes ordinary and necessary may better be understood through an analysis of the case law, which is significant, surrounding the question.  Generally, the determination is made based upon a court’s full review of all facts and circumstances.

Based upon the black and white law under the Code, what constitutes a trade or business for purposes of Section 162.  Perhaps it is ironic that the term “trade or business” is so widely used in the Code, but yet, neither the Code nor the Treasury Regulations provide a definition for Trade or Business.  Personally, I think it would be quite hard to provide a definition for trade or business, especially under the auspices of income tax.  The concept of trade or business has been refined and defined by the courts more so than the Code.  The United States Supreme Court has held and stated that a trade or business is an activity conducted with continuity and regularity, and with the primary purpose of earning a profit.  Albeit broad, I would agree this definition would be sufficient for the majority of businesses I work and assist.

Now that we have an idea of what may constitute a trade or business, what is “ordinary and necessary?”  Again, the Supreme Court has helped provide definitions for these broad, but important terms.  Ordinary has been defined as customary or usual and of common or frequent occurrence in the trade or business.  Necessary has been defined as an expenses that is appropriate and helpful for the development of the business.  Further, it should be noted that some courts have also applied a level of reasonableness to each expense.

John McGuire is a tax attorney and business attorney at The McGuire Law Firm focusing his practice on issues before the IRS, tax planning & analysis and business transactions from formation to sale.

Denver Tax Attorney