Deducting Expenses from your Taxes
Income tax is nothing more than a tax on income. Income, on the other hand, is, for tax purposes, a complex concept that forms the basis of many tax disputes. Additionally, understanding what expenses are deductible and what are not deductible may be a difficult exercise come tax time.
The general rationale for the deductibility rules is that only expenses incurred for the purposes of earning or producing income should be deductible from a taxpayer’s income because only these expenses increase a taxpayer’s ability to pay. Expenses incurred for personal enjoyment, living, or savings, on the other hand, do not increase a taxpayer’s ability to pay and should therefore not be deductible.
Tax disputes often arise over where to draw the line between expenses incurred for the purposes of earning income and expenses incurred for the purposes of personal enjoyment, living, or savings. There are often two important factors to consider in resolving tax disputes of this kind. The first is whether the expense is deductible according to the deductibility rules. The second is whether the amount deducted was deducted at the appropriate time.
The Deductibility of Expenses
As mentioned above, the deductibility of an expense usually depends on whether the expense was incurred for the purpose of earning or producing income. The income for which the expense was incurred must be generated from a business or a property.
Expenses incurred in earning or producing income from a business or property might include, for example, employee wages, interest on money borrowed to finance operations, inventory or supplies costs, or rent and utilities costs for a business premises or rental property. Expenses incurred for personal enjoyment might include, for example, those incurred for the purchase of food, shelter, clothing, or personal entertainment.
Determining the purpose of an expense is fundamental for determining its deductibility. Determining the result of an expense, on the other hand, is irrelevant to determining its deductibility. Although the distinction between “purpose” and “result” may seem vague, it has at least one important consequence: expenses incurred for the purpose of earning or producing income from a business or property are deductible even if the result of incurring those expenses turns out to be a loss. This means, for example, that the expenses incurred in a given tax year for the purpose of starting a business may be deductible even if the business does not earn or produce income in that tax year.
The Timing of the Deduction
Expenses are generally categorized as current expenses or capital expenses (i.e., “capital expenditures”). Current expenses are fully deductible in the year in which they are incurred. Capital expenditures are deductible over a period of time during which the expense provides value to the business (click here for more information on the deduction of capital expenditures).
The general timing rule is that a taxpayer may deduct expenses in the year they are incurred (i.e., current expenses) only if the value of the expense is totally consumed in the year for the purpose of earning or producing income. The reason for this general rule is that, if the value of an expense is totally consumed in earning or producing income, then it cannot have been consumed for personal enjoyment, living, or savings.
On the other hand, if the value of a capital expenditure (e.g., the cost of purchasing a table saw used in a business) is not totally consumed in the year for the purpose of earning or producing income, the portion of the capital expenditure that is not yet consumed still has value. The remaining value is like the value of cash sitting in a bank account and waiting to be used for the purpose of earning or producing income. Just like cash sitting in a bank account, the remaining value of a capital expenditure could still be used for personal enjoyment, living, or savings rather than for the purpose of earning or producing income. This means that the “purpose” of the expenditure is still unknown, and so the portion of the value of the capital expenditure not yet consumed should not be deducted in the year.
It can be difficult to know where and when to draw the line between expenses incurred for the purposes of earning income and expenses incurred for the purposes of personal enjoyment, living, or savings. If you have questions regarding the deductibility of your expenses or when to deduct your expenses, call us today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.