What is a Qualified Business Expense (Deduction)?

Early stage or established small business owners and startup founders need to be able to depend on the bookkeeping, accounting, and tax products (services) they invest in.

However, too many owners or managers attempt to go it alone or hire out friends and family.

This usually involves hiring a discounted, remote bookkeeping company or self-preparing their business tax returns on HR-Block.com or TaxAct.

Unfortunately, businesses either misunderstand, misinterpret, or get terrible advice from those who should be trusted.

Common Issues with Uniforms, Meals, Entertainment, & Travel Expenses

For example, the newest commercial from TaxAct that advertises that a business owner who is a professional dog walker can deduct his new Chucks as a deduction. 

FALSE!

Clothing attire is an allowable deduction if it is both necessary and cannot be used outside of the workforce.

Medical scrubs for a self-employed doctor and steel-toed boots paid for the employees of a construction company are examples of clothing that is necessary and cannot be reasonably worn personally.

Chuck Taylors do not fit this description.

It’s terrible, but businesses report items like this every year and upon audit (random or selected), they suffer the consequences.

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UPDATE: The COVID-19 Relief Bill, signed by the President on December 27, 2020, made changes to deductions for business meals in tax years 2021 and 2022. Businesses will be permitted to fully deduct business meals that would normally be 50% deductible. Although this change will not affect your 2020 tax return, the savings will offer a 100% deduction in 2021 and 2022 for food and beverages provided by a restaurant. The objective of the temporary deduction is to stimulate the restaurant industry. In the list of examples below, we’ve indicated those deductions which will change between 2020 and 2021.

Avoid the Pitfalls

Sometimes it is helpful to be reminded of this and avoid potential pitfalls.

When deciding whether each transaction or purchase can be deducted, keep the following in mind.

The IRS states that a business expense should be both:

1. Ordinary – “one that is common and accepted in your trade or business”

-AND-

1. Necessary – “one that is helpful and appropriate for your trade or business”

One major pitfall that owners and cardholders fall into is regarding Meals & Entertainment (M&E) and Travel Expenses.

Both of these areas provide legitimate expenses but should also be understood and applied correctly to avoid negative backlash from a potential audit.

You can learn more about these deductions and rules in IRS Publication 535 “Business Expenses” and  IRS Publication 463 “Travel, Entertainment, Gift, and Car Expenses”.

Take note of recent changes in 2018

Beginning in 2018, the 2017 Tax Cuts & Jobs Act made “entertainment” non-qualified business expenses.

Although the entertainment expense is no longer allowed, I included the descriptions here as they provide clear boundaries for other types of grey area deductions.

For more information on the changes, view our recent article: 2017 Tax Cuts & Jobs Act Top 6 Changes to Individuals & Business

Meals and Entertainment

Meals and Entertainment are first reduced by 50% and in order to be considered a legitimate business expense, the activity must meet ONE of the following tests:

1. Directly related test –

• The main purpose of the combined business and entertainment was the active conduct of business,

• You did engage in business with the person during the entertainment period, and

• You had more than a general expectation of getting income or some other specific business benefit at some future time.

-OR-

1. Associated test –

• Associated with the active conduct of your trade or business, and

• Directly before or after a substantial business discussion with another person

Note: If you eat or entertain alone, there is no deduction. Stopping by Starbucks on the way to work is not a deduction, as you did not engage with an individual in order to benefit the business. Travel meals are allowable if the travel meets certain requirements.

Is it legitimate?

For Entertainment to be legitimate, the activity must not be a substantial distraction from business activities.

The IRS also gives guidance on what is considered a “substantial distraction” from conducting business, examples include:

• A meeting or discussion at a nightclub, theater, or sporting event.

• A meeting or discussion during what is essentially a social gathering, such as a cocktail party.

• A meeting with a group that includes persons who aren’t business associates at places such as cocktail lounges, country clubs, golf clubs, athletic clubs, or vacation resorts.

(Retrieved from IRS Regulations – Travel Entertainment – FAQ)

Is it used for Business?

Lastly, if a transaction or activity is not 100% used for businesses, such as a home office or personal vehicle used for both personal and business, the expenses must be split reasonably between business and personal use, and accurate records must be kept.

Please note that your bookkeeping, accounting, and/or tax firm should review your records for accuracy as well as to ensure you are following proper laws.

This is in order to protect your business, accounting records, and tax returns.