Business Deductions - Module 4 of 5

Module 4: Business Deductions

            After looking at personal income tax deductions in Module 3, we’ll now turn to income tax deductions- also specified in the Code- that are mainly relevant to businesses and business income.

Costs of Doing Business

First and foremost, expenses for production or collection of income are deductible.[1]  These must be ordinary and necessary expenses paid or incurred during the tax year by businesses or individual taxpayers who own businesses.  Deductible expenses include payments made for payroll, billing, utilities, advertising, consulting, supplies and equipment rental, as well as payments made for management, conservation or maintenance of property held for the production of income. Virtually all reasonable expenses of a business are deductible on the theory that what is spent on a business should be deducted before the business’ true income can be ascertained.

Net operating loss[2] is deductible for taxpayers who engage in a for-profit trade or business and incur expenses that exceed income. This net operating loss is deductible against any other income of the taxpayer for that tax year.[3]  If the taxpayer’s business expenses exceed all other income, the taxpayer has a net operating loss that may be applied to other tax years as a net operating loss carryover.[4]  This deduction is the lesser of the net operating loss carryover from a previous year or 80% of the taxpayer’s taxable income for the year the carryover applies.[5] 

For example, if Taxpayer A has a net operating loss carryover of $100,000 to tax year 2022, and his 2022 taxable income is $80,000, then he may claim a net operating loss deduction of 80% of that $80,000 taxable income, which is $64,000. This reduces his 2022 taxable income to $16,000. The remaining $36,000 net operating loss deduction will carry over to the 2023 tax year.

For net operating losses sustained by a farming business,[6] these losses may be carried back 2 years[7] and then carried forward for up to five successive tax years.

For tax years covered by the Tax Cuts and Jobs Act (as of now, through 2025), the cap for net operating losses is $250,000 for individual taxpayers and $500,000 for married taxpayers filing joint returns.[8]  Net operating losses that exceed these caps are carried forward to the next tax year.            

Bad debt deductions[9] are allowed when a debt owed to the taxpayer becomes worthless during a taxable year (such as when the debtor gets a bankruptcy discharge or makes it apparent that she does not have the ability to pay it).[10] The amount of the deduction is the value of the enforceable debt obligation that became worthless.[11] The debt must qualify as a bona fide debt arising from a debtor-creditor relationship based on a valid enforceable debt obligation. The amount of the bad debt is deductible as an ordinary income loss.

Debts that did not arise from a taxpayer’s trade or business and that become worthless during a tax year are referred to “nonbusiness dad debts.”  These debts are considered short-term capital losses and are deductible as such.[12]

Depreciations and Amortization

Depreciation deductions[13] are allowed when businesses (or individuals) purchase (or create) real estate structures (like houses and fixtures within those houses) or tangible personal property – like vehicles, equipment, books, computers and software and furniture – that will be used for more than one year for business purposes or for the production of income.[14]  The deduction is the price paid for the asset over the number of years the property will be used.  The assets are depreciated based on the exhaustion, wear, tear, and obsolescence the asset will sustain over the number of years the asset will be used, defined as its “useful life.”  The depreciation is subtracted annually, over the useful life of the asset, from the cost of the asset when put into service.

Rather than applying depreciation to each asset and requiring the taxpayer to figure out the rate at which any given asset will depreciate, the IRS sets forth detailed rules about the rates at which various assets can (and must) be depreciated.[15] The asset’s useful life is determined by the nature of the asset and IRS publications set forth various methods to determine the depreciation allowances for various assets. For example, houses are typically assigned useful lives of 27.5 years, commercial buildings 39.5 years, automobiles five years, etc.

The amount that can be depreciated is the value for which the property was purchased minus the “salvage value,” which is its projected value once its useful life has been depleted.[16] The speed at which assets can be depleted depends on which of various methods of depreciation are applied. These range from “straight line” depreciation, which spaces the depreciation equally over the useful life, to various forms of accelerated depreciations. These methods are covered in more detail in our Accounting course.

The date an asset is placed in service and the date depreciation begins are based on the “applicable convention,” which is the half-year convention.[17]  This means the asset is considered to have been placed in service in the middle of the taxable year and that depreciation begins in the middle of that tax year.[18]  However, residential real property is considered to have been placed in service in the middle of the month of service placement,[19]  and assets placed in service during the last quarter of the tax year are considered to be placed in service in the middle of that quarter.[20]

            Depreciation may be taken as a business deduction and the amount of allowable depreciation decreases the cost basis of the property by that amount, regardless of whether the depreciated is actually claimed. For example, if equipment is purchased for $75,000 and has allowable depreciation of $20,000 over the course of the next several years, its new cost basis is $55,000. If the equipment is sold for $70,000, the owner has realized a taxable capital gain of $15,000.

Businesses or business owners may use deductions of the amount spent rather than depreciation for some types of assets.  They may deduct up to $1,000,000 of the purchase price of some specific types of property.[21] These include computer software, roofs of buildings, heating and air conditioning systems and alarm systems.  

Amortization is a similar concept to depreciation. It allows the taxpayer to deduct the estimated decrease in value of something with a limited lifespan as it ages. Instead of applying to physical property like depreciation, amortization is applied to intangible assets such as intellectual property interests, non-compete agreements, licenses, permits, trade names and leases. The Code also provides that, in amortizing the value of a purchased lease (such as an up-front payment to take over someone else’s below-market lease on office space), the value can be amortized over the remaining lease period and all renewal options, assuming the values of all renewal options are less than 75% of the total purchase price of the lease.[22]

Qualified Business Income Deduction

The qualified business income deduction[23]  was created by the Tax Cuts and Jobs Act. It allows a taxpayer, other than a C Corporation, to deduct up to 20% of certain qualified trade business income and certain qualified real estate trust or partnership income.[24]  

A “qualified trade or business” can be a sole proprietorship, partnership, S Corporation, trust or estate. The deduction is above-the-line (before AGI is computed) and so is available whether the taxpayer itemizes deductions or takes the standard deduction.[25]

While the maximum deducible amount is 20% of qualifying income, the maximum deduction is limited for high income taxpayers.[26] High income for this purpose means about $160,000 (single) or $320,000 (married filing jointly), as of 2019. Certain business owners who are not “service” providers can make an extra $50,000 (single) or $100,000 (joint) before being considered high income. Service providers, in this context, means people who primarily sell their personal services, such as attorneys, doctors, athletes and actors. 

Taxpayers who earn more than the threshold are limited in the deduction they can take to the greater of:

-       50% of the W-2 income that the business paid employees over the course of the year; or

-       25% of the W-2 income that the business paid employees over the course of the year plus 2.5% of what the taxpayer’s business spent on depreciable property.

In other words, taxpayers who earn high incomes from businesses are encouraged by the tax code to pay employees and/or acquire investment property. High income taxpayers who do not employ people or purchase property will miss out on this deduction. For these taxpayers, the deduction phases out after the taxpayer exceeds the income threshold. Note that the qualified business income can be in addition to other W-2 (wage) income, but the deduction applies only to the business income.

 For example, assume John is married and earned $125,000 in W-2 wages and $150,000 in qualified business income. He can take a qualified business income deduction of $30,000, or 20% of the business income.

Assume Joan is single and is a sole-practitioner attorney who earns a net income of $300,000. Since the cap is (approximately) $160,000 for a service provider, she would not be eligible for the deduction. However, assume that her firm pays $100,000 in salaries to paralegals and secretaries over the year. Now, she can take a $50,000 deduction, since that is 50% of the W-2 income paid that year. She cannot take the full 20% of her income ($60,000), though.

The IRS has established various anti-abuse rules to prevent manipulation of these rules by disguising wages as business income or buying property solely to increase the value of the allowed 2.5% deduction.

Qualified business income does not include capital gains, dividend income, dividend income equivalents or payment in lieu of a dividend. It also does not include any interest income other than that generated by property allocable to a trade or business, net gains from foreign ­currency transactions and commodities transactions or amounts received from an annuity that is not received in connection with the trade or business.[27]

Corporate Deductions

Corporations that receive corporate dividends from other corporations in which they are shareholders can deduct either 50% or 100% of those dividends. The reason is that these dividends are going to be taxed eventually, when they are distributed to the shareholders. While corporations are subject to double taxation when they earn income and then distribute dividends, to apply the double taxation when both steps are dividend distributions would be even more inappropriate.

100% of the dividend is deductible (that is, the dividend is not taxable) if:

-       The dividend is received by a small business investment company under the definition of such set forth by the Small Business Investment Act of 1958;[28]  or

-       The dividend is “qualifying,” which means that it is paid by a corporation to an affiliate corporation and it is distributed from earnings and profits for a specific tax year.[29]   An affiliate corporation is one connected through stock ownership with a parent corporation that owns 80% of all the affiliate’s stock.[30]  Affiliate corporations cannot be tax exempt organizations, insurance companies, regulated investment companies or S Corporations.[31]   

For all other dividends, the deductible percentage is 50 percent,[32] except for dividends received from a corporation by a recipient corporation that owns at least 20% of the corporate stock, in which case the amount that can be deducted is 65%.[33]

Corporate organizational expenditures are also deductible.[34] These are any expenses related to the creation of the corporation that are chargeable to a capital account and that, if expended to create a corporation that has a limited life, would be amortizable over such life.   The corporation may claim this deduction in the tax year the expenditures occurred or in the subsequent two tax years.[35]  

The deduction is limited to the lesser of the corporation’s organizational expenditures or $5,000. If the organizational expenses exceed $5,000, the excess is deducted ratably over a 15-year period. 

Other Business Deductions

            The code allows many other deductions for expenses related to business operations. We will cover some of them here.

Circulation expenses for newspapers, magazines, or periodicals are deductible, unless those expenditures are “for the purchase of land or depreciable property or for the acquisition of circulation through the purchase” of another newspaper, magazine or periodical publisher.  The expenses must be used to “establish, maintain or increase” circulation of a newspaper, magazine, or other periodical.[36]

Research and experimental expenditures are deductible by taxpayers if these expenditures are paid or incurred during the taxable year in connection with a trade or business.[37]  There are various ways in which the deduction can be taken, including a straight deduction the year of the expenditure or amortization of the expense over a number of years. For example, a company may spend a lot in research and development in a year in which the company has no profits and so would not derive much benefit from a deduction. It might, then, choose, instead, to amortize those costs over the course of many years, thus extending the deduction into the years that the company is profitable and can better use the deduction.

This election can be made in the first year the expenditure is made without requiring IRS approval.[38]  After the first year, the taxpayer must get IRS approval to select a new deduction method.[39]

Soil and water conservation expenses and endangered species recovery expenditures[40] are deductible by taxpayers engaged in the business of farming for costs related to soil or water conservation or erosion prevention, or for costs related to habitat recovery for endangered species. Deductions cannot exceed 25% of the gross income derived from farming for the tax year.  Expenses in excess of this 25% limit can be carried over for an unlimited number of successive tax years, provided the total amount deducted does not exceed 25% of the farming gross income for that year.[41]

Fertilizer expenditures by farmers[42] are deductible for taxpayers engaged in the business of farming for the purchase or application of fertilizer, lime, ground limestone, marl or other materials to enrich, neutralize or condition land used for farming. 

Finally, it should be noted that, prior to 2018, taxpayers who were either employees or self-employed were allowed to deduct moving expenses when the move was to a new job or position located at least 50 miles from the taxpayer’s home.[43] This deduction has been repealed for years affected by the Tax Cuts and Jobs Act (as of now, through 2025).

In our last module, we’ll turn to tax credits. While there are fewer of them than deductions, tax credits allow dollar-for-dollar tax reductions (sometimes resulting in negative income tax), thereby being far more valuable than deductions on a dollar-for-dollar basis.