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Overstated deductions

Don't underrate their contribution to the tax gap.

In the August issue, we delved into underreporting and its role in California's tax gap. This month we will examine the flipside of underreporting: overstating deductions, an equally critical focus of our efforts to bridge the tax gap.

Businesses are allowed to deduct all ordinary and necessary expenses paid during the taxable year in carrying on any trade or business. An ordinary expense is one that is common and accepted for your business, like purchasing office supplies. A necessary expense is one that is helpful and appropriate for your business: pilot fees, for example. Expenses generally fall into the categories of cost of goods sold, and general business expenses.

Cost of goods sold is the expense a business incurs to manufacture, create, or sell a product. It includes the purchase price of the raw materials as well as the expenses of turning it into a product. Common mistakes in calculating cost of goods sold include:

  • Making a charitable contribution of an item included in beginning inventory, without reducing cost of goods sold by the cost of the item. This does not apply to inventory purchased and donated in the same year.
  • Adding trade discounts, or cash discounts in purchase costs. A trade discount is the difference between the stated price, and the actual price paid. A cash discount is the amount deducted from the purchase invoice for prompt payment.
  • Adding returns and allowance amounts in purchase costs.
  • Failing to deduct the value of any merchandise withdrawn for personal use from the cost of goods sold calculation.

General business expenses are the costs associated with running a business. They do not include costs that must be capitalized. Examples of business expenses are advertising expense, interest expense, travel expense, wages expense, car and truck expense, etc.

Common mistakes to avoid when deducting general business expenses:

  • Personal, living, or family expenses are not deductible. However, if the expense is for something that is used partly for business, and partly for personal purposes, divide the total cost between the business and personal portions. You can deduct only the business portion as a business expense.
  • Personal commuting expenses are not deductible. These include the costs to drive between the home and the regular workplace, and parking fees incurred at the regular workplace.
  • You can use either the standard mileage rate, or your vehicle's actual expenses, but not both. (If you choose to use the standard mileage rate for a car you lease, you must use it for the entire lease period.)
  • Acquired property that is expected to last more than one year cannot be deducted in full. It must be capitalized and depreciated over the useful life.
  • No deduction is allowed for the sole proprietor's salary, or personal withdrawals.
  • Certain insurance premiums are not deductible, including those for self-insurance reserve funds, loss of earnings policy, life insurance in which you are a benenficiary, or insurance to protect a business loan.
  • Interest paid on a personal loan is not deductible.
  • Legal fees paid to acquire business assets, or for personal services are not deductible.
  • Unreasonable rent paid to a related person is not deductible.
  • Entertainment expenses cannot be deducted unless they meet the directly related test, or the associated test.
  • A deduction for expenses related to the business use of the home is not allowed unless the business part of the home is used exclusively and regularly for the business. The business part of the home must be either the principal place of business, a place where you deal with customers in the normal course of the business, or a separate structure used in connection with the business.

Certain other expenses that are usually not deductible business expenses, include:

  • Bribes and kickbacks.
  • Charitable contributions.
  • Demolition expenses or losses.
  • Dues to business, social, athletic, luncheon, sporting, airline, and hotel clubs.
  • Lobbying expenses.
  • Penalties and fines paid to a governmental agency because a law was broken.
  • Political contributions.
  • Repairs that add value to the property, or increase its life.
  • Personal expenses.

California does not wholly conform to federal tax law, resulting in several non-conformity issues for businesses:

Law Description
Federal Law
California Law
Election to expense the cost of certain business property in lieu of depreciation.

Property cost phase-out.
Up to $105,000.

Starts at $420,000
(Federal Section 179).
Up to $25,000.

Starts at $200,000.
First year depreciation deduction, and AMT depreciation adjustment. Federal law allows an additional 30 percent for property placed in service after 9/10/01.

The first year depreciation deduction is increased 50 percent for property placed in service on or after 5/5/03 and before 1/1/05.
California did not conform to these provisions.
Depreciation of qualified leasehold improvements and qualified restaurant property. 15-year recovery period. 39-year recovery period.

Overstated expenses and understated income reported on the Schedule C are areas of particular interest to FTB, as we continue to reduce the tax gap through education, self-compliance measures, and audits. Your clients' business transactions should be supported by good documentation, including canceled checks, cash register tapes, credit card sales slips, invoices, and account statements.

For additional information see the following resources: Internal Revenue Code Section 162, Internal Revenue Service (IRS) Publication 334, Tax Guide for Small Business; IRS Publication 583, Starting a Business and Keeping Records; and Franchise Tax Board Publication 1001, Supplemental Guidelines to California Adjustments.