Business Deductions Are Not Always Legal
Leonard G. Weld and Kaye F. McClung
on how to reduce taxes are simply overlooked deductions that
may be brought to mind by a newspaper or magazine article.
Other times, the ideas are promoted by tax scam artists. Many
erroneous beliefs have been used as justification to avoid
federal income taxation; for example, the tax system is voluntary.
radical idea is that a home-based business can save tax
dollars. If a legitimate business based in the taxpayer’s
home incurs an operating loss, then there is a tax savings.
Unfortunately, tax scam promoters promise deductions for
expenditures that are not legitimately deductible.
activity may be classified by the IRS as a hobby regardless
of what the taxpayer calls it. The distinction between a
business and a hobby is vitally important. A business may
incur an operating loss during a tax year. This loss can
offset income from other sources if the taxpayer or the
taxpayer’s spouse works in the business more than
500 hours during the year or works substantially all of
the hours required to operate the business. According to
the Individual Income Tax Returns Preliminary Data
in 2001, taxpayers filed approximately 17.6 million returns
that included business or professional activity, and 24%
of those returns reported a deductible operating loss.
from a hobby activity, on the other hand, is not deductible
and cannot offset other sources of income. The full amount
of hobby revenue is included in a taxpayer’s gross
income. If a taxpayer chooses to itemize deductions on Schedule
A, then hobby expenses may be deductible, but only up to
the amount of hobby revenue. Therefore, a taxpayer can never
have a hobby loss. Taxpayers must offset hobby revenue with
hobby expenses in this specific order: 1) mortgage interest
and property taxes attributable to the hobby, 2) normal
business expenses (e.g., salaries, office supplies, advertising),
and 3) depreciation.
hobby expenses are combined with other miscellaneous deductions,
such as unreimbursed employee business expenses, tax preparation
expenses, and investment expenses (other than investment
interest expense). The total of these miscellaneous deductions
is then reduced by 2% of the taxpayer’s adjusted gross
income (AGI). Any excess deductions over 2% of AGI are added
to other itemized deductions. If a taxpayer uses the standard
deduction rather than itemizing on Schedule A, then hobby
expenses are not deductible.
It a Business?
that the distinction between a business and a hobby is critical
to taxpayers, it is essential to understand the factors
the IRS uses to make a determination. Treasury Regulations
section 1.183-2 identifies nine relevant factors to distinguish
between a business and a hobby:
The manner in which the taxpayer carries on the activity,
e.g., maintaining accurate books and records;
The expertise of the taxpayer or the taxpayer’s
The time and effort expended by the taxpayer in operating
The expectation that assets used in the activity may appreciate
The history of success of the taxpayer in other activities;
The history of income and losses in this activity;
The amount of occasional profits, if any, that are earned;
The financial status of the taxpayer—that is, if
this activity is the taxpayer’s only source of income,
the IRS is more inclined to consider the activity a business—and
The elements of personal pleasure or recreation involved.
the regulations, none of these factors is given more weight
than another and there is no formula to ensure classification
as a business. Taxpayers and the IRS often disagree about
the proper classification of an activity. There are a plethora
of court cases on this issue. Relying on just one decision
would be ill advised. The facts of each case are distinct
and usually give the reader only an indication of how the
IRS might rule under very specific circumstances.
that a taxpayer’s activity is classified as a business
and that the business has an office in the taxpayer’s
home, additional criteria must be met before any deductions
are allowed for the office.
office must be used exclusively and on a regular basis as
the principal place of business by the taxpayer. If the
area is used eight hours a day for business but children
come in at night and play video games on the computer, the
office fails the exclusive use test.
are two exceptions to the exclusive use test. If the taxpayer
is in the business of selling products, the area of the
home that is used to store inventory does not have to meet
the exclusive use test. The storage space must, however,
be a specific, identifiable area.
other exception applies when the home is used regularly
to provide day-care services to children, handicapped persons,
or the elderly. A formula based on the number of hours of
business use and total use is applied to the allowable business
use means that a specific area is used on a continuous basis.
Occasional or incidental use does not meet the threshold,
even if the area is not used for any other purpose. Neither
the courts nor the IRS has specifically stated how many
hours per day (or per week) the office must be used for
business purposes. The time element depends on the facts
and circumstances of each individual case.
office in the home is used as a principal place of business
if it is a place used by patients, clients, or customers
to meet with the taxpayer in the normal course of the taxpayer’s
business. This use must be for the convenience of the employer,
not the employee, if the taxpayer is employed outside the
a taxpayer may not regularly meet with customers or clients
in the home, or perhaps the business consists mainly of
selling or providing services outside the home, Congress
recognized that almost every business needs a location where
a business owner can store records, complete paperwork,
and take care of other administrative tasks. Accordingly,
the Taxpayer Relief Act of 1997 expanded the definition
of the term “principal place of business” such
that a deduction can be taken if the home office is used
to conduct administrative or management activities, and
the taxpayer has no other fixed location in which to do
so. A deduction is allowed for business expenses associated
with the regular use of a separate structure that is not
attached to the taxpayer’s home, such as an artist’s
studio, a florist’s greenhouse, and a carpenter’s
Versus Personal Expenses
section 162 allows “a deduction for all the ordinary
and necessary expenses paid or incurred during the taxable
year in carrying on any trade or business.” It continues
by giving several examples:
A reasonable allowance for salaries or other compensation
for personal services actually rendered;
expenses (including amounts expended for meals and lodging
that are not lavish or extravagant under the circumstances)
while away from home in the pursuit of a trade or business;
Rental payments for equipment or real estate.
“ordinary” expense generally is one that is
normal, customary, or usual for a business under the facts
and circumstances of its situation. An expense can be ordinary
even if it only occurs once in the life of the business
(for example, legal expenses for defending against a patent
expense is one that is appropriate and helpful for the trade
or business. This requirement helps distinguish between
business and personal expenditures. A necessary expenditure
need not be vital, but it may be appropriate for that line
of business and helpful to the operation of the business.
For example, property insurance may not be necessary in
order to operate a business, but it is appropriate.
requirement is that the expense be “reasonable”
in amount. This is an issue that arises often in family-owned
businesses. Salaries paid to family members must be appropriate
for the amount and complexity of their work. Other expenses,
such as travel and entertainment, may be disallowed by the
IRS if the expenses are judged to be unreasonable for the
circumstances, or personal in nature.
and family living expenses are not deductible unless specifically
authorized by the IRC. Examples of deductible personal expenditures
include the following:
Prescription medicine and most medical expenses;
State and local taxes;
Home mortgage interest and property taxes;
Charitable contributions; and
Many investment expenses.
expenditures that might seem to be deductible business expenses
are actually nondeductible personal expenditures. For example,
the costs of commuting to and from work and the cost of
business attire are nondeductible personal expenditures.
to the IRS, home-based businesses and tax avoidance scams
have gained in popularity over the last few years. In a
consumer alert, the IRS warned that no matter how convincing
the claims in the marketing materials for these bogus business
schemes may appear, nondeductible personal living expenses
cannot be transformed into deductible business expenses.
to the IRS, the following are nondeductible personal expenses
that are commonly claimed as business expenses in home-based
Deducting the cost and operation of a personal residence;
n Paying children a salary for services, such as answering
telephones, washing cars, or other tasks, and then deducting
Deducting education expenses from the salary wrongfully
paid to children as employees;
Deducting excessive car and truck expenses when the vehicle
has been used for both business and personal use;
Deducting personal furniture, home entertainment equipment,
children’s toys, and other household items; and
Deducting personal travel, meals, and entertainment under
the guise that “everyone is a potential client.”
Commissioner Charles O. Rossotti has said, “Each year,
taxpayers reasonably search for deductions that will reduce
the amount they owe. But they should resist the temptation
of quick and easy schemes. Creating a bogus home business
or other schemes crosses the line and puts the taxpayer
on a path that will result in paying interest and penalties
on top of the taxes they owe.”
G. Weld, PhD, is a professor of accounting and head
of the accounting and finance department at Valdosta State
University, Valdosta, Ga.
Kaye F. McClung, DBA, CPA, is an associate
professor of accounting and head of the accounting and finance
department at the University of Tennessee at Chattanooga.