Deductible business expenses: Save your receipts and be realistic

Its all about reasonableness, proof and legal compliance.

As is well known and widely used, the Internal Revenue Code allows the deduction of ordinary and necessary expenses used to carry out your trade or business. But the IRS understands some have used this provision to deduct potentially questionable expenses, so when considering a business expense for this purpose, there are two questions to ask:

  • Can you substantiate the expenditure with a receipt or other tangible business record?
  • Is the expenditure the type of expense the section is meant to cover and that the IRS would likely approve in an audit?

Burden of proof

According to Bloomberg Tax, inadequate substantiation is a main reason for appeals to the U.S. Tax Court after the IRS rejected the deductions. The taxpayer must have adequate documentation to prove that an expenditure claimed as a business expense was actually paid. This should usually be a receipt or invoice from the recipient.

The link between the expenditure and the trade or business must also be clear.

In some cases, the IRS or a reviewing court may allow a business expense deduction even without proper receipts by applying the so-called Cohan rule. A 1930 federal case established this exception in a 1930 federal case involving composer and entertainer George M. Cohan's failure to keep adequate records. Under this rule, a taxpayer might be allowed to deduct a reasonable approximation of expenses if he or she can provide background information that substantiates the claimed expenditures, but Cohan allowances tend to be less than the full amount claimed.

Cohan may not be applicable to certain kinds of expenses like travel, gifts, entertainment and some others specifically outlined in the Internal Revenue Code.

Authentic business expenditure

The Code allows a taxpayer to deduct "ordinary and necessary" expenses from "carrying on any trade or business." Federal tax law does not define "trade or business," but courts have considered whether the activity's primary purpose is to make money or profits and whether it occurs on a regular or ongoing basis.

The expense must also be:

  • Ordinary in the sense that it is commonly incurred in the particular business
  • Necessary meaning that it supports business expansion and success
  • Reasonable in amount and not excessive

According to the Bloomberg Tax article, the types of business expenses that the IRS most commonly challenges are:

  • Meals or food
  • Home office expenses
  • Entertainment
  • Travel

The more exotic, luxurious or excessive the nature of the expense, the more likely the IRS will raise questions about its authenticity. Bloomberg Tax describes some examples of questionable expenses:

  • Yacht repairs
  • Caribbean vacations
  • Expensive dining
  • Living expenses

Notably, new federal tax laws have made changes in the deductibility as business expenses of entertainment and meals beginning with tax year 2018. For example, most entertainment expenses like sporting events are no longer deductible and many meal or dining situations are only 50 percent deductible, with some types becoming nondeductible in 2026.

Anyone with questions or concerns related to business expense deductions, whether taken on past returns, in contemplation of future returns or to consider as an aspect of business planning, should speak with an experienced tax attorney.

The lawyers at Brown, PC, in Fort Worth, Texas, provide comprehensive advice and representation related to business expense issues to taxpayers situated in the Metroplex, across the state of Texas and nationally.

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