Tax season is just around the corner and tax professionals will be asked numerous variations on the question “is __________ tax deductible?”
Over the years, I have heard poker chips, underwear, breast implants, and animal waste. When calculating taxable self-employment income as a solo practitioner, you are allowed to deduct a wide range of expenses from gross revenue so long as they are business related. However, there are some basic rules and limitations.
Basic Deductibility Requirements
A business expense must meet certain not-so-clear-cut requirements to be deductible. First, the expense must be ordinary and necessary. For federal tax law purposes, an expense is ordinary if it is customary in the industry. An expense is necessary if it is appropriate and helpful in developing and maintaining a business.
A business expense must also be reasonable, meaning it cannot be lavish or excessive. Whether an expense is ordinary, necessary, and reasonable depends on the facts and circumstances. A stethoscope is an ordinary and necessary expense for a physician, but not for a personal injury attorney. Poker chips could be tax deductible for a professional gambler.
Some myths about deductibility:
- An expense can be made once. It does not have to be recurring in order to be ordinary or necessary.
- An expensive purchase can be reasonable, ordinary, and necessary.
Advertising is a good example, since these costs are usually large. And regardless whether you stop advertising after a short time, advertising costs are considered customary and helpful in developing and maintaining a law practice.
A comical example of a non-ordinary business expense can be found in the case of Henry v. Commissioner. The taxpayer was a CPA and tax lawyer who purchased a yacht and named it the 1040. On his federal income tax return, he deducted the yearly depreciation cost of the yacht along with insurance and maintenance costs. When he was audited, he argued that he bought the yacht to associate himself with fellow yacht owners who tend to be wealthy and are likely to need tax advice. He called it the 1040 to advertise himself as a tax specialist. The Tax Court disallowed the deduction, holding that a yacht is not a customary expense of a CPA/tax lawyer.
Exceptions to the Rule
Even if your business expense is ordinary, necessary, and reasonable, the tax code has a number of exceptions and modifications to the deductibility rule. Here are some of the common ones specific to solo lawyers.
Expense or Capitalize?
A business expense is fully deductible if you will enjoy the benefit of the purchase within the taxable year. But if the benefit of your asset lasts longer than one year (for example, purchasing a computer) or if it improves the value of the asset (upgrading a computer), then the expense must be capitalized and a portion of the cost must be deducted over a number of years. Typical purchases you must capitalize:
However, you can still fully deduct a capitalized asset by using the Section 179 deduction.
You may be tempted to expense a purchase that must normally be capitalized in order to get a lower tax bill for the current year. But if you are in a low tax bracket now and anticipate being in a higher tax bracket in a few years, then it may be a better idea to capitalize the asset and get bigger tax savings over the next few years.
Meals and Entertainment
As a solo, you have to network a lot. This means having lunch meetings with clients, potential clients, referral sources, industry leaders, and mentors to name just a few. Sometimes, you may discuss business at the golf course, a ball game, or at a soiree. However, with rare exceptions, you are only allowed to deduct 50% of the cost of meals and entertainment spent in connection with a business activity.
The question of what is a business-related meal or entertainment expense is highly dependent on your facts and circumstances. Some may innocently misinterpret the rule while others will abuse it. So if the IRS chooses to audit your meal and entertainment expenses, expect them to be very aggressive and intrusive. You will have to show who you met, the business purpose of the meeting, and what business objectives were accomplished at the meeting. Keep notes.
Many solo practitioners work from home, some or all of the time. If part of your home is used for your practice, then a percentage of your home expenses can be deducted as a business expense. This includes mortgage interest, rent, utilities, maintenance, and depreciation. Mortgage principal payments are not deductible.
You must meet two tests to qualify for the home office deduction:
- Part of your home must be used regularly and exclusively for the business. The easiest way to do this is to dedicate one room exclusively to your practice. This means no personal items — beds, video games, or children’s toys — in the room. To obtain the biggest tax benefit, consider converting the biggest room in your house into a home-office. While this might make your home look odd, it should not be a problem for those who live alone and rarely have guests over. If you live in a studio, you will have to dedicate a portion of the home exclusively for the business. So keep non-business items away from the designated business area.
- Your home office must be the principal place of business. This test is met if you use your home office exclusively and regularly for administrative or management activities. And you must have no other fixed location where you conduct substantial administrative or management activities.
Some people think that if the business has a separate office, then they automatically fail this test. Not always. When determining whether your home is the principal place of business, the IRS considers the relative importance of the activities performed at each place where you conduct business, and the amount of time spent at each place. You should be able to meet this requirement so long as you spend a majority of your time doing administrative and managerial work at home. This includes billing, legal research, brief writing, ordering supplies, setting up appointments, and keeping books and records. I know many attorneys who use a separate office address only to pick up mail and meet a client once in a while.
If you don’t think you meet the principal-place-of-business test, you can still claim the home office deduction if you meet clients at your home office or if you have a separate structure in your home used exclusively and regularly for your law practice.
There is speculation that those who claim a home-office deduction have a greater chance of getting audited. While this will likely remain a state secret, chances are the more aggressive you are with your home-office deductions, the more likely your chance of getting audited.
Most business-related purchases are obviously tax deductible. But there are many exceptions and limitations. Understanding them can help you minimize your tax bill and avoid an argument with a tax advisor, or worse, an IRS auditor.