Nondeductible Expenses

Business Expenses That Are Not Deductible for Tax Purposes

Profit (or loss) is simply defined as income minus expenses. However, there are certain business expenses that reduce a business’s profits, but are not deductible on a federal income tax return. So it is possible for a business to operate at a loss and still have taxable income.

The following is a discussion of some of the more common business expenses that may not be deductible. This list is by no means comprehensive. The final authority is the Internal Revenue Code and the publications prepared by the Internal Revenue Service.

Government Penalties and Fines

IRS Publication 535, Business Expenses, states that “penalties or fines paid to any government agency or instrumentality because of a violation of any law are not deductible.”

The most common penalties that are nondeductible are tax penalties. For instance, the IRS may impose penalties for non-filing of tax returns, late filing of tax returns, late payment of taxes, and underwithholding of taxes. At the same time, the IRS will also impose interest on the penalties and any taxes due until they are paid. Although the penalties cannot be deducted, the interest on the penalties is still tax deductible.

Other types of penalties or fines that may be nondeductible could include state and local tax penalties, fines for conviction of a crime or violation of certain legal regulations, and fines for traffic law violations incurred by employees.

Lobbying Expenses or Political Contributions

Lobbying expenses include any amounts paid or incurred to influence legislation; influence the general public regarding elections, legislative matters, or referendums; communicating directly with any government agency in an attempt to influence any official actions; or any research, preparation, planning, or coordination of activities to carry out any of the preceding activities.

Any political contributions or gifts paid to political parties or candidates are not deductible expenses. In addition, any expenses incurred while participating in a political campaign are also nondeductible.

Many trade and business associations may be involved in lobbying activities, and a portion of the dues collected from members may be used for lobbying activities. Such organizations are required by law to reveal to members how much of their dues are used for lobbying activities, either as a dollar amount or a percentage of their dues. Businesses are required to separate the cost of lobbying from the rest of the dues because the lobbying portion is not tax deductible.

Meals and Entertainment

Although certain meal and entertainment costs are qualified business expenses, there is a limit on how much can be deducted on a tax return. Generally, the deduction is limited to 50% of the cost of the expense. IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, outlines the rules for determining what entertainment costs are deductible.

Generally, the cost of entertainment for the spouse of an employee or the spouse of a customer is not deductible. IRS Publication 463 does state on page 13 that “you can deduct these costs if you can show that you had a clear business purpose, rather than a personal or social purpose, for providing the entertainment.”

On the other hand, if a spouse of an employee is invited to a social event that is being provided primarily for the benefit of employees for the purpose of promoting goodwill among employees, such as a Christmas party, then the entire cost of the event can be treated as a deductible business expense.

Business Gifts

According to IRS Publication 463, gifts that are given to customers, or members of a customer’s family, can be deducted as a business expense. However, there is a limit of $25 per tax year for each individual that either directly or indirectly receives the gift. Any excess cost must be treated as a nondeductible expense.

There are some exceptions to the $25 limit. For instance, incidental costs, such as engraving, packaging, insuring, and mailing, are not included in determining the cost of the gift. In addition, if a company has items that it distributes widely, such as pens, desk sets, bags, cases, etc., and the cost of an individual item is less than $4, then the $25 limit on gifts to an individual does not apply.

In some cases it may be necessary to distinguish whether an expense is an entertainment expense or a gift in order to determine which limit applies. For instance, if a business owner gives a customer tickets to a sporting event or theater performance, and the owner attends with the customer, then it would be an entertainment expense, subject to the 50% limit. However, if the owner does not attend the event with the customer, then it would be treated as a gift, subject to the $25 limit.

Club Dues and Membership Fees

The Omnibus Budget Reconciliation Act (OBRA) of 1993 amended Section 274(a) of the Internal Revenue Code to deny a business deduction for any “amounts paid or incurred for membership in any club organized for business, pleasure, recreation, or other social purpose.” Page 44 of IRS Publication 535 identifies what organizations are clubs and those that are not.

Although the dues or membership fees of a club may not be a deductible expense, any services provided at the club to a customer or other business associate may be treated as a meal or entertainment business expense if it has a business purpose.

There is an exception to the above restriction. If the cost of the club dues is treated as a working condition fringe benefit for an employee, then it may be treated as a taxable fringe benefit to the employee. It would be subject to income tax withholding, and the expense would be treated as wages and salaries on the company’s books.

Not All Business Expenses Are Tax Deductible

So some business expenses are nondeductible expenses. Besides those listed above, there are other expenses that cannot be deducted, such as federal income taxes, professional examination fees, certain life insurance premiums, etc. Consult an accountant and the appropriate IRS publications for additional details.