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Are Your Business-Related Expenses Tax-Deductible? Not Always

July 14, 2022, 8:45 AM

Earlier this month, Elon Musk announced he would terminate his agreement with Twitter. As a result, Musk could be on the hook for a $1 billion termination fee—some are calling it a breakup fee—as well as additional costs.

Predictably, opinions about the breakup—and the fee—started flying on social media shortly after the announcement. Among other things, some dismissed the enormous fee as the cost of doing business, shrugging it off as tax-deductible.

From single-member limited liability companies to multinational enterprises, taxpayers often believe that the act of paying a business-related expense makes it deductible for federal income tax purposes. But despite a number of videos making the round on TikTok, that’s not the case. Here’s a look at some expenses that might be considered a cost of doing business, but are not tax-deductible:

Personal Expenses

You can’t deduct personal expenses on your tax return even if the company agrees to pay for them. Titling a residence or automobile in the name of a company isn’t enough to make the costs a business expense—and, depending on the kind of expense, it could be taxable to you as compensation.

The deductibility of business expenses hinges on two questions:

  1. Is this for business use?
  2. Is it an ordinary (common and accepted in your industry) and necessary (helpful and appropriate for your trade or business) expense?

The answer to both of those questions should be yes to claim an expense as a business-related tax deduction under Section 162 of the tax code—assuming no exceptions apply. You can find a discussion of common business expenses in IRS Publication 535.

That’s true even if costs are paid out of an LLC or a corporation, since creating an entity doesn’t change the character of the expenses—or make them deductible.

If expenses are mixed, meaning that you use them for personal and business expenses, you can only deduct the portion attributable to business. Always keep excellent records.

Fines Paid to the Government

Meeting the ordinary and necessary criteria isn’t always enough to make an expense deductible. Section 162 is quite lengthy and includes several exceptions. One of those exceptions—found in Section 162(f)—makes clear that taxpayers may not deduct fines paid to a government or government entity for the violation of any law. That’s true even if the fine would otherwise be deductible as an ordinary and necessary business expense.

That’s something that Musk found out in 2018. According to the SEC, Musk tweeted that he could take Tesla private, when he knew the transaction was uncertain. The tweet resulted in “significant market disruption.” The SEC filed a complaint and ultimately reached a settlement with Musk and Tesla agreeing to each pay a $20 million penalty to be distributed to potentially harmed investors.

There’s an exception to the exception that offers an out: If the fine is used to provide restitution, including remediation of property, for damage or harm caused by the act, the restriction on deductibility doesn’t apply to that portion.

In Musk’s case, the SEC anticipated that exception, and the terms of the settlement make clear that the penalty “shall be treated as a penalty paid to the government for all purposes, including all tax purposes.” In other words, no deduction will be allowed for Musk and Tesla even if the funds are ultimately used for restitution.

Illegal Bribes and Kickbacks

What about bribes and kickbacks? Those are generally paid to help grease a palm or pave the way to make doing business easier. Depending on your industry, you could argue that those, too, could be ordinary and necessary. However, as with fines, those are specifically disallowed as a deduction under Section 162(c).

Certain Legal Damages

My husband, a corporate attorney, jokes that in his line of business, the US view is that everything can be resolved with money. That’s why parties to a contract may agree in advance to pay damages if there’s a breach—as with Musk and Twitter—or may agree to a settlement after the fact.

In most cases, the damages need to be tagged to a reasonable figure—generally, enough to restore the harmed or aggrieved party to where they were before the breach or make up for any lost profit or other costs. These damages are commonly referred to as liquidated damages—although the term is rather broad.

Typically, these amounts are considered deductible for federal tax purposes if the underlying acts that led to the break or litigation were ordinary and necessary.

In Rev. Rul. 80-211—which may not be directly used or cited as precedent—the IRS made clear that damages should be examined on a facts and circumstances basis to determine whether the damages meet the criteria in Section 162. That means taxpayers should keep excellent records and legal advisers should ensure any settlements or related agreements clearly establish the nature of the damages.

For example, if an amount payable as a result of a settlement is considered a disguised fine or penalty, then it would not be deductible. Similarly, some kinds of damages might be denied by statute—Section 162(g), for example, limits deductions related to antitrust suits.

Large or complicated settlements may address many underlying factors—making figuring deductibility a challenge. Typically, the more precise the language, the better for the taxpayer.

Political Contributions

In the current climate, there’s a lot of pressure to fund political causes and candidates. That’s true for businesses, too—especially if those contributions could lead to increased support for your geographic area or industry. Even if cases like Citizens United make it legal for corporations to write some kinds of checks, Section 162(e) generally denies a deduction for political contributions. That’s an important takeway: Even if a transaction is allowable, it doesn’t make it deductible.

Expensive Gifts

I’ve often relayed the story about a law firm that used to overnight bottles of expensive champagne to clients—it definitely made an impression, although it wasn’t always a good one.

But you want to be thoughtful before sending an expensive gift, and not just because of how it might be viewed by clients, but how it might be viewed by the IRS. A gift may be a legitimate business expense as far as the company is concerned, but you are typically limited to a deduction worth $25 per person per year.

Fun note: The law firm likely got a pass on overnighting the gift. Incidental costs like packing or shipping aren’t included in the $25 limit if they don’t add substantial value.

Unreimbursed Business Expenses

There is no Schedule A deduction for unreimbursed business expenses for employees through 2025. However, the rules for self-employed persons and independent contractors did not change. If you are self-employed—including as a freelancer or gig worker—you can continue to deduct business-related expenses.

Conclusion

The rules for tax deductions are generally the same for all businesses—whether you’re a solo entrepreneur or the richest man in the world. And whether you’re a business owner, an employee, or a legal adviser, understanding a few key concepts—like “ordinary” and “necessary,” as well as when to seek help—can help you make sound business and tax decisions.

This is a regular column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.

To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com