Revisiting the rules for business deductionsby
By Gil Charney, CPA, CFP®, MBA
In a recent article, we met John Keats, a full-time corporate employee who also has outside income from writing and publishing articles about his bicycle tour experiences. We discussed the importance of properly identifying a client’s activity as a business or hobby, and the effect of such a classification on how and where activity income and deductions are reported.
In this second article we discuss common expenses related to client business (or hobby) activities and the propriety of such expenses to support the income from that activity.
Despite John’s being employed full-time in a large corporation, he spent considerably more time at his freelancing activity this past year. The activity involves touring on his bicycle, writing articles, and taking pictures about his tours, the local attractions, and the people he met along the way. He sold these articles to various publishers and increased his income significantly in 2010 over 2009. At first only a few publishers of bicycling magazines were interested, but soon word spread and travel magazine publishers liked his “on-the-road” perspective of local attractions and the people he encountered.
John, encouraged by the positive response from these publishers (and their checks!), made seven bicycle tours during 2010 and documented each with copious notes, photographs, and even recorded interviews with locals about their area. Taking more bicycle tours and publishing more articles generated not only more freelance income for John but also a variety and level of expenses that he had not incurred in 2009.
Based on your analysis of Reg. Sec. 1.1832(b) and evaluation of the facts and circumstances surrounding John’s situation, you have taken a position that John’s freelance activity in 2010 qualified for business treatment.
RECORDKEEPING AND DOCUMENTATION
Sophisticated-looking printouts and reports created from accounting or financial software may be impressive, but these by themselves are not adequate to support deductions.3 Although due diligence does not require you to review the source documents to ensure the accuracy of the report, it does require you to ask whether the client has the source documentation (in either paper or electronic form) to support the items, and that you understand the nature of the expenditures and their suitability as business deductions.
You noted that although John did not keep a separate checking account for several months in 2010, his checkbook register and computer printouts reflected recordkeeping separating his personal and business expenses with adequate detail. Although a separate checking account for a business is an indicator of the “manner in which the taxpayer carries on the activity,”1 it is not a hard-and-fast requirement to differentiate business activity, especially in the early stages of a business.
Income entries in his checkbook and related records show the source (publisher) of the income, the publication where the article appeared, the publisher’s check number, check amount, and date of deposit. The expenses show a similar level of detail.
John’s expense ledger shows the following cash purchases and expenses for 2010:
- 1 Custom-made bicycle for $6,800;
- 1 New notebook computer for $800;
- 1 Digital SLR camera for $700;
- 1 New smartphone for $200;
- 1 iPod for $299, plus over $75 in downloaded music tracks;
- Various items of bicycle clothing for $1,500;
- Subscriptions to various publications, including those dealing with bicycling, photography, a general news magazine, and a marketing journal;
- Fees to masseurs for rub-downs after long rides for $200;
- Payment of $750 to a website developer to create a website documenting his bicycle adventures and promoting his articles; and
- Expenses related to seven trips around the U.S., all of which required air travel and transportation for his touring bicycle and equipment.
You understand that as a tax preparer you are not obligated to audit individual expenses,2 but due diligence does require you to ask John about how he records his expenses and whether he has retained the source documentation. John confirms that for his expenses he has the original receipt, invoice, or statement. He mentioned that whenever he returns from a tour he hands all his travel receipts to his wife who enters the information into a spreadsheet. He retains all receipts and records on the spreadsheet for anything he buys that might be even remotely related to his freelancing business. He commented that he wasn’t sure exactly what was deductible, so his list may contain expenses that are not deductible.
You conclude that John’s recordkeeping is sufficient to allow you to create a profit and loss statement and prepare Schedule C for his freelancing activity for 2010.
As you leaf through his documents, you ask John to describe the nature of the expenses so you can evaluate their business purpose. You inform John that only business expenses that are “ordinary and necessary” may be deducted.
The famous “Cohan Rule” is not a substitute for adequate recordkeeping. Reg. Sec.1.274-5T(a) states: “…This limitation [the requirement for substantive documentation] supersedes the doctrine founded in Cohan v. Commissioner F.2d 540 (2d Cir. 1930). The decision held that, where the evidence indicated a taxpayer incurred deductible travel or entertainment expenses but the exact amount could not be determined, the court should make a close approximation and not disallow the deduction entirely. Section 274(d) contemplates that no deduction or credit shall be allowed a taxpayer on the basis of such approximations or unsupported testimony of the taxpayer.”
ORDINARY AND NECESSARY
The general rule for whether an expense is deductible is that it must be “ordinary and necessary” to conduct business.4 Generally, an ordinary expense is one that is common and accepted in the trade or business. A necessary expense is one that is helpful and appropriate for the trade or business. Furthermore, an expense does not have to be indispensable to be considered necessary.
Using the “ordinary and necessary” principle is not a mechanical decision tool, but it is the beacon that can lead tax preparers to a correct decision – or at least a reasonable one, based on the facts and circumstances.
For instance, using a magazine subscription as an example, a bicycling magazine would likely be an ordinary and necessary business expense for a professional cyclist, bicycle repair shop, or health and fitness club. In Stemkowski v. Commissioner, 5 a professional hockey player was allowed to deduct a subscription to a hockey magazine because it was considered an ordinary and necessary expense for professional players.6 Similarly, a subscription to a tax magazine is a deductible expense for a tax preparer or an accountant, and a subscription to a medical journal is a deductible expense for a physician.
However, while a subscription to a bicycling magazine may be an ordinary and necessary expense for a professional cyclist, it is not ordinary and necessary for a recreational bicyclist or even an avid hobbyist.
What about John? He is not a professional cyclist but he is more than a hobbyist. Because you have already established that his freelancing activity qualifies as a business, any expenses that are “ordinary and necessary” for that business may be deducted. Taxpayers who develop a recreational hobby into a moneymaking business – or simply enjoy the business they are in – may still deduct expenses that are ordinary and necessary for that business.
As for John, he enjoys reading the bicycling magazine (irrelevant), but each monthly issue lists a calendar of upcoming tours and bicycling events that he uses to plan his trips and articles (ordinary and necessary). Therefore, you conclude that the subscription is deductible in John’s freelancing business.
TRAVEL AND ENTERTAINMENT
Taxpayers – and even tax professionals – sometimes become confused as to whether certain travel expenses are deductible or not. Central to the deductibility of a travel expense is the concept of the taxpayer’s “tax home.”
Determining the location of one’s tax home has been the subject of many court cases and rulings,7 the details of which are beyond the scope of this article. However, determining a client’s tax home, and whether travel occurred within or outside of the tax home, is critical in establishing whether certain travel expenses are deductible.
Travel expenses incurred by a taxpayer outside of his or her tax home, and for business purposes, may be deducted. Generally, if John travels outside his tax home8 for a business purpose, he may deduct travel expenses.
You note several trips listed on John’s ledger and you take this opportunity to explain to him that in order for his travel expenses to be deductible they must take him “away from home,”9 or outside John’s “tax home” – the location of John’s regular place of business. As a corporate employee who works in his employer’s office, the metropolitan area where John works is his tax home. Any trip outside that area for business purposes may be deducted. This includes transportation (airfare, automobile mileage, etc.), meals (limited to fifty percent), lodging, local transportation (e.g., taxi from the airport to the hotel), and incidentals. All such expenses must be documented as to dates, locations, expense amounts, and purpose of the trips. Generally, all such expenses must be documented with receipts or other form of source documentation (except for business miles driven in a personal automobile, which must be documented in the taxpayer’s log of business miles driven).
Note: The Treasury regulations do not require that the taxpayer obtain a receipt for an individual expense less than $75 “if such documentary evidence… is not readily available.”10 However, even when a receipt for an expenditure less than $75 cannot be obtained, the taxpayer is not relieved of the responsibility of documenting the expenditure in a log, journal, account book, or similar record.11
John’s ledger lists several pages of expenses, including trips to California, North Carolina, Vancouver, New England, and several other locations. All the trips were of a duration from 2–5 days.
John’s recordkeeping for travel expenses appears to be adequate in light of the Treasury regulation’s12 substantiation requirements. His ledger shows the necessary detail prescribed in the regulation, including dates, locations traveled, nature and amount of the expense, etc. He confirmed that he has receipts for most of the expenses shown in the ledger, including those expenditures less than $75. He did not have receipts for cash tips and some incidentals, but he did have a record of the expenses.
ON THE ROAD
John mentions an upcoming tour in New Mexico in April. He plans to drive there because he also has friends in the area and wants to have use of his car. He asks how he should document the trip since no airline ticket will be issued.
First, you inform him that only business miles are deductible, so any trips to visit friends or other non-business related side trips cannot be deducted. However, the fact that he enjoys the bicycle tours or visiting with friends does not impair the deductibility of his business-related travel expenses if the primary purpose of the trip is business-related (which in John’s case, means writing about the tour and trying to sell the article). John may establish that the trip was primarily for business if he can demonstrate that he wrote and submitted articles for publication, regardless whether the publishers decide to publish the article.
You then mention to John that he will need to document all business miles driven by recording the information in his log. The log will need to show the dates traveled, miles driven, and business purpose of the trip.13
You also mention that using an atlas or an Internet mapping service to document mileage is not sufficient documentation because it is not maintained by the taxpayer. In Olsen et ux. (TC Memo 2002-42), the taxpayers recorded mileage from an atlas rather than actual odometer readings. The court disallowed the deduction because the mileage was based on a computer database and was not recorded at the time of the trip. Note: a mileage log does not need to be recorded “contemporaneously” – at the moment the trip is taken. However, doing so adds significant credibility to the documentation.14
You then describe the two methods available to John for deducting business miles – the actual expense method and the standard mileage method.
If John were to use the actual expense method, he will need to keep track of all vehicle expenses, including gasoline, maintenance and repairs, licenses and fees, insurance, etc. He will also need to keep track of all miles driven, whether personal or business, because the ratio of business miles to total miles is used to allocate actual expenses between deductible business and nondeductible personal vehicle expenses. The business mileage log will need to show miles driven, locations traveled to, dates and times of such travel, and the business purpose of the trip (including the name of each bicycle tour, sponsoring organization, and other details).
He would not need to document personal trips taken (e.g., “January 15 – drove round trip from home to grocery store to buy milk, 2.4 miles”). However, he would need to show total miles driven for the year, which may be obtained by subtracting the car’s odometer reading on January 1 (too late now!) from the odometer reading on December 31. The percentage of business miles driven may then be determined by dividing total business miles (as shown in the log) by total miles driven. The ratio is then applied to vehicle expenses to allocate and deduct vehicle expenses.15
If John were to use the standard mileage method (which he could not do if he incorporates his business), he would need to keep track only of business miles driven (using a log as described above). His business miles would then form the basis for a deduction when applied by the standard mileage rate (0.51 cents/mile in 2011). Using a single rate simplifies the record-keeping requirements of the actual expense method and replaces the cost of maintenance and repairs, gas and oil, insurance, depreciation or lease payments, etc. The deduction is entered on Form 1040 Schedule C, Part II, Line 9 (car and truck expenses). A taxpayer may not use the standard mileage rate for a vehicle after using any depreciation method under the Modified Accelerated Cost Recovery System (MACRS) or after claiming a Sec. 179 deduction for that vehicle.
“Listed property” is personal property that could have both business and personal usage – such as John’s car. Code Sec. 280F(d)(4) does not define listed property as such, but “lists” specific items that fall under the documentation requirements of this section.
Examples of listed property include passenger automobiles, computers and electronics, photographic and entertainment equipment, etc. The expenses for purchasing or operating such equipment may be deductible by a business if the business usage exceeds fifty percent – hence the need for careful documentation to support the business use percentage.
You describe to John the usage and reporting requirements to deduct such items as cameras, computers, personal music players, and other such equipment. John agrees that although he has used his camera to take pictures to accompany his articles and for posting on his Web site, his use of the camera is largely personal. He also commented that he did not feel it was worth the hassle to keep track of business and personal use for this equipment. With a slight shrug, he reached over the ledger to scratch off the list the entries for the computer, the smartphone, and the iPod.
Certain other expenses listed on John’s ledger may or may not be proper business expenses, so you ask him many questions about them. Of course the bicycle for $6,800 stands out, so you discuss this with John. He explains that he needed a new bike, and now that he was making money from the tours, he thought he could “write off the bike.” However, you learn from John that although he uses this bike (one of four he owns) exclusively when he takes bicycle tours, he also uses it significantly for recreation on evening and weekend rides with his friends in the bicycling club. Because of this, you inform John that the cost of the bicycle is not deductible. You also mention to John that he is not a professional cyclist who earns income from racing, but rather a freelance writer who earns his income from writing. You also note that in John’s case, purchasing a new bicycle is not an “ordinary and necessary” business expense for a writer, although it could be if John were a professional racer or if the bicycle was required under another set of circumstances.
For the same reason, you conclude that John’s bicycling clothing is not deductible because he uses it also for personal reasons. Clothing of any nature is not “ordinary and necessary” for his writing business, even though the clothing is of a type that is not suitable for ordinary wear. John states that although bicycle tour organizers do not require any special kind of clothing, they do require that riders wear helmets for safety reasons. Therefore, a case for John’s deducting his bicycle helmet might be made except that he purchased his helmet prior to his freelancing, and he uses the helmet on personal rides.
There is no specific statutory guidance on clothing. However, to be deductible as a business expense under IRC Sec. 162, clothing that is used only for a business purpose or is required for safety or appearance in the profession (e.g., steel-toed boots for construction workers, nurses uniforms, etc.), and is not suitable for general wear may be deducted. Although bicycle clothing may fit the description of “work clothing” for a professional cyclist, John is not required to wear such clothing as his business is from writing, not riding. Moreover, John’s wearing the clothing on recreational rides is determinative for not deducting the expense.
Finally, you address the other expenses on John’s list. Even though the massages helped John recover from long rides which he later wrote about, the expense is purely personal in nature and therefore cannot be deducted.
However, you do have good news for John about his Web site. Because the Web site is used strictly for promoting John’s freelancing activity, you believe it may be deducted as an advertising expense (although capitalizing its development cost has also crossed your mind.) You will have to research that issue before John returns to your office to sign the completed tax return.
On his Web site, John posts his articles (after receiving permission from the publishing companies who own the rights to the article), pictures of his tours, and other bicycling-related content. He is enthusiastic about using the Web site as a source of revenue, so he is exploring the possibility of selling advertising on his Web site to bicycle equipment and accessories manufacturers. You wish John good luck, and as you escort him from your office with a handshake you begin to think about how you will need to set up a meeting after tax season with him to do some tax planning.
The deductibility of a business expense depends largely on the facts and circumstances of the deduction – the nature of the expense and the circumstances under which it was incurred, among other factors. The broadness of the language of IRC Sec. 162 allowing a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year” imposes a responsibility on the tax preparer to use judgment in reporting such expenses which are not always clearly deductible or clearly nondeductible. Failure to conduct due diligence by asking questions of the taxpayer about certain expenses could subject the tax preparer to accuracy-related penalties under IRC Sec. 6662 if the resulting tax liability is substantially understated. EA
About the author: Gil Charney, CPA, CFP®, MBA, is a principal tax analyst at The Tax Institute at H&R Block, where he conducts research into complex tax problems and analyzes tax legislation. He also leads a team of EAs, CPAs, and tax attorneys in maintaining The Tax Institute’s Tax Research Center. He has extensive experience in consulting, research, and corporate financial management. He also has taught graduate-level courses in accounting and finance and directed H&R Block’s tax training department.
1 Reg. Sec.1.183-2(b)(1)
2 Reg. Sec. 1.6694-1(e)(1)
3 Moore v. Comm. (TC Summary Opinion 2010-102)
4 IRC Sec. 162(a)
5 50 AFTR 2d 82-5739 (690 F.2d 40)
6 Reg Sec. 1.162-6
7 Wilbert, 103 AFTR 2d 2009-485; Henderson (81 AFTR 2d 98-1748); Rev. Rul. 99-7
8 One example where local travel is deductible is if travel is to a temporary work location (Rev. Rul. 99-7) 9 IRC Sec. 162(a)(2)
10 Reg. Sec. 1.274-5(c)(2)(iii)(A)(2)
11 Reg. Sec. 1.274-5T(c)(2)(ii)
12 Reg. Sec. 1.274-5T
13 Reg. Sec. 1.274-5T(c)(2)(ii)(C)
14 Reg. Sec. 1.274-5A(c)(1))
15 Reg. Sec. 1.280F-6(d), and reflected in Form 1040 Schedule C, Part IV, Information on Your Vehicle