Are your business expenses tax deductible? Not always

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

Predictably, opinions about the split — and the fee — started flying on social media shortly after the announcement. Among other things, some dismissed the hefty fee as a cost of doing business, dismissing it as tax deductible.

From sole proprietorships to multinational corporations, 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 rounds on TikTok, this is not the case. Here’s an overview of some expenses that may be considered expenses 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 them. Title to a home or car in a company’s name is not enough to make the expense a business expense — and depending on the type of expense, it may be taxed as compensation.

Deducting business expenses depends on two things:

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

The answer to both questions must be yes to claim an expense as a business-related tax deduction Section 162 of the Internal Revenue Code – if no exceptions apply. You can find a discussion of ordinary business expenses in IRS Publication 535.

This is true even if the expenses are paid by an LLC or corporation, since the formation of an entity does not change the nature of the expenses or make them deductible.

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

Fines paid to the government

Meeting the ordinary and necessary criteria is not always sufficient to make an expense deductible. Section 162 is quite long and includes several exceptions. One of those exceptions—found in section 162(f)—clarifies that taxpayers cannot deduct fines paid to a government or governmental entity for a violation of any law. This is true even if the fine would otherwise be deductible as an ordinary and necessary business expense.

This is something Musk realized in 2018. According to the SEC, Musk tweeted that he might take Tesla private when he knew the deal was uncertain. The tweet caused “significant market disruption.” The SEC filed a complaint and eventually reached a settlement with Musk and Tesla, agreeing to each pay a $20 million penalty to be distributed to potentially harmed investors.

There is an exception to the exception that the out offers: If the fine is used to provide restitution, including recovery of property, for damage or injury caused by the act, the deduction limitation does not apply to that part.

In Musk’s case, the SEC provided this exception, and the terms of the settlement made 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? They are usually paid to help grease or pave the way for ease of doing business. Depending on your industry, you could argue that they can also be mundane and necessary. However, as with fines, they are expressly disallowed as a deduction under section 162(c).

Certain statutory damages

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

In most cases, damages should be marked up to a reasonable figure – usually enough to restore the injured or aggrieved party to where they were before the breach, or to compensate for any lost profits or other costs. These damages are commonly referred to as liquidated damages – although the term is quite broad.

Generally, these amounts are considered deductible for federal tax purposes if the underlying actions that led to the interruption or litigation were ordinary and necessary.

In Rev. Rul. 80-211—which cannot be directly used or cited as precedent—the IRS clarified that damages must be considered on the basis of the facts and circumstances to determine whether damages meet the criteria in section 162. This means that taxpayers must keep excellent records and legal counsel must ensure that any agreements or related agreements clearly establish the nature of damages.

For example, if an amount due as a result of a settlement is considered a disguised fine or penalty, then it is not deductible. Similarly, certain types of relief may be denied by statute—section 162(g), for example, limits deductions related to antitrust claims.

Large or complex agreements can address many underlying factors, making determining the deductible a challenge. Generally, the more precise the language, the better for the taxpayer.

Political contributions

In the current environment, there is a lot of pressure to fund political causes and candidates. This also applies to businesses – especially if those contributions can lead to increased support for your geographic area or industry. Even if cases like Citizens United made it legal for corporations to write certain types of checks, Section 162(m) generally denies a deduction for political contributions. This is an important takeaway: Even if a transaction is allowable, that doesn’t make it deductible.

Expensive gifts

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

But you should be careful before sending an expensive gift, and not just because of how it might be viewed by customers, but also how it might be viewed by the IRS. The gift may be a legitimate business expense as far as the company is concerned, but you are generally limited to deducting $25 per person per year.

Fun note: The law firm probably got a pass to overnight the gift. Incidental costs such as packaging or shipping are not included in the $25 limit if they do not add significant value.

Unreimbursed business expenses

There is no Schedule A deduction for unreimbursed business expenses for employees until 2025. However, the rules for the self-employed and independent contractors have not changed. If you’re self-employed — including as a freelancer or gig worker — you can still deduct business-related expenses.

Conclusion

The rules for tax relief are generally the same for all businesses – whether you’re a sole trader or the richest person in the world. And whether you’re a business owner, employee, or legal consultant, understanding a few key concepts—like “ordinary” and “necessary” and when to seek help—can help you make smart business and tax decisions.

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

Leave a Comment

Your email address will not be published.