When it comes to deducting business expenses from taxable income, the general rule is that the expense is deductible if it is ordinary and necessary in the regular course of business. Because this definition is broad, most business expenses are deductible as a matter of common sense. However, there are some statutory exceptions that many people do not know about.
When preparing tax returns, most lawyers send their financial books to their tax preparer and let them handle the rest. Unfortunately, some simply add up the numbers and input them to the tax return without analyzing which expenses are deductible and which are not. Below are some of the more common nondeductible business expenses that lawyers should be aware of. If these expenses are incorrectly reported, it may create a big tax problem in the future.
Government fines and penalties for breaking the law. You might have paid a stiff parking fine because you didn’t know it was street cleaning day. Unfortunately, payments of any fines or penalties to the government are nondeductible from taxable income even if it was connected to a business purpose. This includes most sanctions and traffic violations. However, the fine or penalty has to be punitive in nature. Therefore, compensatory payments ordered by the government could be tax deductible. Also, if the fines are paid to a nongovernmental entity, the payment is tax deductible so long as it is an ordinary and necessary business expense.
Purchase and maintenance of clothing. To legally write off the purchase and maintenance costs of clothing, they must be required for the job and must not be suitable for general wear.
Lawyers are generally expected to dress like professionals. They are required to wear formal business attire in courtrooms or risk disciplinary action (this includes socks). But because business suits are considered suitable for ordinary wear, they are not tax deductible, even if they are worn only at work. This deduction was meant for the purchase and maintenance of uniforms. So lawyers are out of luck until we go back to wearing robes and wigs.
Country club and social club dues. Membership fees or dues to clubs organized for social purposes are nondeductible, even if your sole intent to join is to meet potential clients, colleagues, and referral sources. However, this is distinguishable from tax deductible dues to professional organizations such as the state bar and the local chamber of commerce, which may provide similar social events. Sometimes, the distinction between a social club and a professional organization can be narrow. There are some professional organizations whose annual dues are comparable to country club membership fees. They have regular mixers, educational meetings, and an annual golf tournament. But generally, if the principal purpose of the organization is to provide entertainment to its members, it is nondeductible.
Some donations to charity. There are several limitations to the charitable deduction for business purposes. Donations are not business expenses, even if there was a customary business purpose for the donation. Instead, they are deductible as a Schedule A itemized expense and only when the amount exceeds the standard deduction.
Also, if you received a benefit in exchange for the donation, the deduction is limited to the value that exceeds the benefit. For example, if you donated $100 for a charity dinner and the value of the dinner is $20, then you can only deduct $80.
The donation must be made to a qualifying 501(c)(3) entity or a private foundation and cannot be made to benefit an individual, even if they are clients. For example, you cannot deduct a donation to fund a client’s cancer treatment.
Finally, you cannot deduct the value of your services to charity. This is to ensure that attorneys will not be tempted to arbitrarily value their charitable services at a minimum of $5,000 per hour to get a very large tax deduction.
Forgiveness of outstanding debt. Suppose a client stiffs you on your bill and you decide not to take collection action. You cannot deduct the amount of the forgiveness as a bad debt business expense even if you did the work. This is because most people use the “cash basis” method of accounting on their tax returns. This means income is reported when money is received and expenses reported when money is spent. Under the cash basis method, there is no deductible loss because no money was spent.
Incorrectly reporting these sorts of expenses could increase the chances of an audit. Most of the nondeductible expenses above show up under the “Other Expenses” section of the Schedule C or on the corporate tax returns. In most cases, these expenses are relatively minimal. And considering the low audit rates, it is possible that these nondeductible expenses could go undetected. But if the tax return has other audit red flags, and an examiner was to see these nondeductible expenses, they are likely to go forward with an audit. To make things worse, they are likely to audit the entire tax return under the assumption that there may be other nondeductible expenses hiding in the return.
There are some business deductions that are nondeductible as a matter of law. A competent tax professional should know about these and advise the client not to report these expenses on the tax return.