Deductions and Losses: Trade or Business, Production of Income, and Personal
Three deduction categories
IRC §162 allows ordinary and necessary expenses paid or incurred in carrying on a trade or business. §212 allows expenses for the production or collection of income, or for management of property held for income. Personal, living, and family expenses are nondeductible under §262. A deduction also must be substantiated, not capital, and not disallowed by a specific provision.
Trade or business vs production of income
- Business expenses include wages, rent, supplies, repairs, insurance, business interest, taxes, bad debts, and reasonable compensation.
- §212 expenses are often investment-related: advisory fees, safe deposit boxes, and investment interest subject to §163(d).
- A business requires continuity, regularity, and a profit motive. Hobby activities are limited by §183: deductions only to the extent of hobby income, and otherwise itemized deductions are reduced.
- Capital expenditures are capitalized under §263 and recovered through depreciation, amortization, or basis. Repairs that restore property or add value must be capitalized.
- Start-up costs are deductible under §195 up to $5,000, reduced dollar for dollar above $50,000, with the remainder amortized over 15 years. Organizational costs follow §248.
Limits and substantiation
Meals are generally 50% deductible under §274(n); entertainment is disallowed by §274(a). Travel must be away from home, ordinary and necessary, and not lavish. Home office expenses are limited by §280A and require exclusive and regular business use. §274(d) requires substantiation by adequate records for travel, meals, gifts, and listed property; the Cohan rule does not apply.
Worked example
A sole proprietor pays $1,000 for client meals, $2,000 for country club dues, and $500 for a seminar on new regulations in her industry. The meals are 50% deductible, or $500. Club dues are nondeductible under §274(a)(3). The seminar maintains or improves skills in her existing business and is deductible under §162. Total deduction: $1,000.
Traps
- Deducting commuting costs or personal clothing.
- Treating a hobby as a business to avoid §183.
- Deducting 100% of meals or any entertainment.
- Capitalizing repairs that merely keep property in working order, or deducting improvements.
- Ignoring §274(d) substantiation and relying on estimates.