SUMMARY OF CHAPTER
Tax deductions are allowed to taxpayers only if specifically authorized by the Internal Revenue Code. Deductions allowable to individual taxpayers fall into three categories: trade or business deductions, production of income deductions, and personal deductions. This chapter is also concerned with business deductions as they appear on a sole proprietor's Schedule C, which is included as part of the taxpayer's individual income tax return.
Categories of Allowable Deductions
¶6001 Classification of Tax Deductions
The three categories of tax deductions allowable to individual taxpayers are (1) trade or business expenses (including the business-related expenses of employees); (2) production of income expenses (including expenses incurred for the production or collection of income; for the management, conservation, or maintenance of property held for the production of income, and in connection with the determination, collection, or refund of any tax); and (3) personal deductions. In addition, taxpayers are allowed deductions for certain losses.
¶6011 Trade or Business Deductions
In general, taxpayers are allowed a tax deduction for all the ordinary and necessary expenses paid or incurred during a tax year in carrying on a trade or business. In determining whether an expenditure is an allowable tax deduction for a trade or business, certain criteria must be met. These criteria are that the expense (1) must be ordinary and necessary, (2) must be reasonable in amount, (3) must be related to a trade or business, (4) must be for a business-related purpose rather than a personal expenditure, (5) cannot be a capital expenditure, (6) cannot be related to the generation of tax-exempt income, and (7) cannot frustrate public policy. Certain employment-related expenses of employees are also allowed by the Code as trade or business tax deductions. In order to be deductible by an employee, however, an employment-related expense must be directly related to the performance of the employee's duties or be required by an employment agreement.
¶6025 Production of Income Expenses Deduction
The term ‘‘production of income'' refers to expenses which do not qualify as trade or business expenses yet are still deductible expenses. Production of income expenses are investment expenses and tax planning and compliance expenses. To be deductible, production of income expenses must be ordinary and necessary, reasonable, cannot be capital expenditures, cannot relate to the generation of tax-exempt income, and cannot frustrate public policy.
¶6045 Personal Deductions
Section 262 of the Code, entitled ‘‘Personal, Living, and Family Expenses,'' explicitly states that personal, living, and family expenses are not deductible on a tax return unless expressly provided for by other sections of the Code.
¶6055 Losses Deductions
For individual taxpayers, deductible losses are limited to three categories: (1) losses incurred in a trade or business, (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business, and (3) losses of property not connected with a trade or business if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. The limitations placed on losses of individual taxpayers, in effect, restrict individual losses to business losses, investment losses, and casualty or theft losses. Personal losses are not deductible.
Factors Affecting Allowance of Deductions
¶6115 Tax Accounting Method
Taxable income, which consists of gross income less deductions, must be computed under the method of accounting regularly used by the taxpayer in keeping books. For tax purposes, the most common accounting methods are the cash method and the accrual method. Most individuals, small businesses, and professionals use the cash method of accounting for tax purposes. Corporations,...