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Taxmap/pubs/p535-001.htm#TXMP77df35ed Chapter 1 Deducting Business Expenses

Business Expenses, Deductible

Introduction

This chapter covers the general rules for deducting business expenses. Business expenses are the costs of carrying on a trade or business and they are usually deductible if the business is operated to make a profit.

Useful items

You may want to see:

See chapter 14 for information about getting publications and forms.

Taxmap/pubs/p535-001.htm#TXMP4b4e23b8 What Can I Deduct?

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

It is important to distinguish business expenses from:

• The expenses used to figure cost of goods sold.
• Capital expenses.
• Personal expenses.

Taxmap/pubs/p535-001.htm#TXMP7e0012d9 Cost of Goods Sold

Cost of Goods Sold

If your business manufactures products or purchases them for resale, you must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.

The following are types of expenses that go into figuring cost of goods sold.

• The cost of products or raw materials, including freight.
• Storage.
• Direct labor (including contributions to pension or annuity plans) for workers who produce the products.
• Factory overhead.

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.

For more information, see the following sources.

• Cost of goods sold—chapter 6 of Publication 334.
• Inventories—Publication 538.
• Uniform capitalization rules—Publication 538 and section 263A of the Internal Revenue Code and the related regulations.

Taxmap/pubs/p535-001.htm#TXMP6656e0dc Capital Expenses

Capital Expense

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called "capital expenses." Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.

1. Business start-up costs (See Tip below).
2. Business assets.
3. Improvements.

You can elect to deduct up to $5,000 of start-up costs that are paid or incurred after October 22, 2004. The remaining costs can be amortized over 180 months. See chapters 8 and 9 for more details.

Taxmap/pubs/p535-001.htm#TXMP167ed256 Cost Recovery.

Although you generally cannot take a current deduction for a capital expense, you may be able to recover the amount you spend through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are able to recover your capital expense. See Amortization (chapter 9) and Depletion (chapter 10) in this publication. For information on depreciation, see Publication 946.

Taxmap/pubs/p535-001.htm#TXMP49ea5353 Business Assets

Business Assets

There are many different kinds of business assets; for example, land, buildings, machinery, furniture, trucks, patents, and franchise rights. You must fully capitalize the cost of these assets, including freight and installation charges.

Certain property you produce for use in your trade or business must be capitalized under the uniform capitalization rules. See section 1.263A-2 of the regulations for information on these rules.

Taxmap/pubs/p535-001.htm#TXMP5259bf73 Improvements

Improvements

The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. Improvements are generally major expenditures. Some examples are: new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements.

However, you can currently deduct repairs that keep your property in a normal efficient operating condition as a business expense. Treat as repairs amounts paid to replace parts of a machine that only keep it in a normal operating condition.

Taxmap/pubs/p535-001.htm#TXMP0307c0c9 Restoration plan.

Capitalize the cost of reconditioning, improving, or altering your property as part of a general restoration plan to make it suitable for your business. This applies even if some of the work would by itself be classified as repairs.

Taxmap/pubs/p535-001.htm#TXMP105d89e0 Capital versus Deductible Expenses

Capital versus Deductible Expenses

To help you distinguish between capital and deductible expenses, different examples are given below.

Taxmap/pubs/p535-001.htm#TXMP46701af4 Motor vehicles.

You usually capitalize the cost of a motor vehicle you use in your business. You can recover its cost through annual deductions for depreciation.

There are dollar limits on the depreciation you can claim each year on passenger automobiles used in your business. See Publication 463.

Generally, repairs you make to your business vehicle are currently deductible. However, amounts you pay to recondition and overhaul a business vehicle are capital expenses and are recovered through depreciation.

Taxmap/pubs/p535-001.htm#TXMP55bc8fad Roads and Driveways.

The costs of building a private road on your business property and the cost of replacing a gravel driveway with a concrete one are capital expenses you may be able to depreciate. The cost of maintaining a private road on your business property is a deductible expense.

Taxmap/pubs/p535-001.htm#TXMP3e23ce34 Tools.

Unless the uniform capitalization rules apply, amounts spent for tools used in your business are deductible expenses if the tools have a life expectancy of less than 1 year or their cost is minor.

Taxmap/pubs/p535-001.htm#TXMP0175adb5 Machinery parts.

Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition, but not add to its life, is a deductible expense.

Taxmap/pubs/p535-001.htm#TXMP3cc12dae Heating equipment.

The cost of changing from one heating system to another is a capital expense.

Taxmap/pubs/p535-001.htm#TXMP29d35259 Personal versus Business Expenses

Personal versus Business Expenses

Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.

For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and is not deductible. See chapter 5 for information on deducting interest and the allocation rules.

Taxmap/pubs/p535-001.htm#TXMP1c937357 Business use of your home.

If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation.

To qualify to claim expenses for the business use of your home, you must meet both of the following tests.

1. The business part of your home must be used exclusively and regularly for your trade or business.
2. The business part of your home must be:
   1. Your principal place of business, or
   2. A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or
   3. A separate structure (not attached to your home) used in connection with your trade or business.

You generally do not have to meet the exclusive use test for the part of your home that you regularly use either for the storage of inventory or product samples, or as a daycare facility.

Your home office qualifies as your principal place of business if you meet the following requirements.

• You use the office exclusively and regularly for administrative or management activities of your trade or business.
• You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

If you have more than one business location, determine your principal place of business based on the following factors.

• The relative importance of the activities performed at each location.
• If the relative importance factor does not determine your principal place of business, consider the time spent at each location.

For more information, see Publication 587.

Taxmap/pubs/p535-001.htm#TXMP0ed908f3 Business use of your car.

If you use your car exclusively in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage.

You can deduct actual car expenses, which include depreciation (or lease payments), gas and oil, tires, repairs, tune-ups, insurance, and registration fees. Or, instead of figuring the business part of these actual expenses, you may be able to use the standard mileage rate to figure your deduction. For 2004, the standard mileage rate is 37.5 cents a mile for all business miles driven.

If you are self-employed, you can also deduct the business part of interest on your car loan, state and local personal property tax on the car, parking fees, and tolls, whether or not you claim the standard mileage rate.

For more information on car expenses and the rules for using the standard mileage rate, see Publication 463.

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