All transactions made using company funds can be written off on the business’s tax return, right? In reality, this isn’t the whole truth.
It is accurate that qualified business expenses reduce a company’s taxable income, and thereby its tax liability. However, only certain costs can be deducted, like payroll expenses or purchases of raw materials.
In this guide, we walk through the difference between deductible and non-deductible expenses, helping to highlight the importance of accurate expense reporting and helpful tips for managing these costs accurately.
What are non-deductible business expenses?
Non-deductible business expenses are costs a company or its employees incur in the course of doing business that cannot reduce its taxable income.
Even if these certain costs are seemingly necessary to support operations, the IRS has strict guidance around what can and cannot be considered a business tax deduction.
Knowing which expenses are non-deductible is crucial for ensuring tax compliance and avoiding lengthy IRS audits that may result in fines and legal penalties.
While accounting teams need to have a clear understanding of non-deductible business expenses, it’s also something that employees making purchases and managers offering approvals should be aware of to help prevent misreporting.
Deductible vs non-deductible expenses
As the terms may reveal, a deductible expense is a cost that the business can write off on its tax return. In contrast, a non-deductible expense cannot be written off.
What this means is that a deductible expense can lower the company’s taxable income in a given period, thereby reducing its tax obligations.
On the other hand, non-deductible expenses result in a cash outflow but have no impact on the business’s tax bill.
How to determine if an expense is deductible
The IRS provides guidelines to help determine whether a business expense is deductible or not. Here is the criteria to use:
- Check if it’s “ordinary and necessary”: An expense is “ordinary” if it’s a common cost in the company’s industry and “necessary” if it’s useful for the business. It doesn’t have to be “indispensable”.
- Confirm it’s business-related, not personal: Only the portion of expenses that are used for business-related purposes can be deducted.
- Review IRS categories of deductions: The IRS Publication 334 lists different categories of deductible business expenses, including depreciation, employee wages, insurance premiums, and more.
- Watch for known non-deductibles: Get familiar with the everyday expenses that cannot be deducted, as we’ll discuss in further detail below.
Common types of non-deductible business expenses
Avoid misclassifying business expenses by being aware of the common costs that cannot be written off on a company’s taxes.
- Fines and penalties: If a business owes regulators or government agencies fines or penalties for non-compliance violations, this amount is not deductible from its taxes.
- Political contributions: Any amount a business or its leaders donate to political campaigns or candidates is not a deductible expense.
- Lobbying expenses: Businesses cannot deduct any costs they incur when lobbying legislators.
- Personal expenses: Only qualifying, business-related expenses can be deducted. Expenses incurred for personal use do not count.
- Commuting costs: What employees spend to get to their primary place of work cannot be deducted, including public transportation fees, gas, or tolls.
- Entertainment expenses: While traveling for business, employees cannot deduct costs for entertainment, including sporting events, tours, or concerts.
- Certain gifts: Companies can expense annual gift costs of up to $25 per recipient. Anything that’s spent over this amount cannot be deducted.
Tips for Managing Non-Deductible Expenses
Misclassifying expenses can have serious consequences, beyond inaccurate financial reporting.
Properly identifying and managing non-deductible expenses can help teams ensure tax compliance and avoid potential penalties and fines. Here are some helpful tips and best practices for teams to consider:
Know what’s not deductible
As mentioned throughout, being familiar with common non-deductible business expenses makes it easier for employees and accounting professionals to ensure accurate classification of costs and financial reporting.
This delineation may not always be black and white. However, understanding the main categories of expenses that can and cannot be deducted is a good place to start.
Track expenses with accounting software
Teams should meticulously track all spending using digital tools, such as accounting software. This includes both deductible and non-deductible expenses, providing teams with visibility into overall spending patterns.
Accounting software that integrates with a business’s bank account or expense tracking platform helps streamline record-keeping and reduce the risk of human error in manual data entry.
Create a “non-deductible” account
Even though non-deductible expenses cannot be written off on a business’s tax return, these costs should still be tracked for visibility and decision-making purposes.
This way, non-deductible expenses still have a classification in the business’s accounting system, helping to reduce the risk that they are accidentally grouped in with other deductible expenses. Plus, it provides a clear way to track spending on non-deductible expenses over time.
Train employees on expense policies
Employees who have been issued a P card should be well-informed about the company’s expense policies.
Ideally, these policies reflect what the IRS considers to be deductible business expenses. This helps prevent misuse of company funds while also ensuring that employees are spending money on transactions that can be written off on the business’s taxes.
Review expenses regularly
Simply keeping a record of all business expenses isn’t enough to effectively manage non-deductible costs.
Accountants should also make it a regular practice to review these records and ensure that expenses are being classified appropriately. This allows for earlier intervention if employees are not adhering to expense policies, helping to minimize spending on items that cannot be deducted.
Speak with a tax professional
Depending on the resources available in-house, it may be worth consulting a tax professional to seek guidance on how to track and minimize non-deductible business expenses.
The potential cost and penalty of misclassifying an expense is likely greater than the amount that could be wrongfully expensed in the first place.
Rather than guessing or assuming that a certain transaction can be expensed, it’s worth getting expert guidance from a tax professional who is well-versed on the topic and stays up-to-date with changing tax laws.
Streamline expense tracking with software
BILL’s free Spend and Expense platform helps businesses track employee spending and maintain budgets without manual data entry or expense reporting.
This all-in-one expense management solution provides real-time visibility into spending and offers flexible control over expense policies and budgets, encouraging spending on qualified expenses.
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Frequently asked questions
What are the most common non-deductible expenses I should watch out for?
Some of the common types of non-deductible expenses include commuting costs to and from work, personal meals, and entertainment expenses while traveling on business.
How do non-deductible expenses affect taxable income?
Non-deductible expenses have no effect on a business’s taxable income and will not impact its tax liability.
What criteria does the IRS use to define non-deductible business expenses?
The IRS defines non-deductible business expenses as those that cannot be considered “ordinary and necessary” for running operations.
How should non-deductible expenses be recorded in the books?
Teams should keep track of non-deductible expenses in a dedicated account for auditing and record-keeping purposes. However, this amount will not be used in determining a company’s net income amount.
What supporting documentation is needed to justify deductions vs. non-deductions?
To justify expenses that are deducted, teams should keep a record of the corresponding receipt or invoice, payment confirmation, and expense report (where applicable). This way, it will be easier for auditors to determine whether the expenses were, in fact, ordinary and necessary for business operations.
How do non-deductible expenses impact effective tax rates?
Since non-deductible expenses are not factored into a company’s taxable income, they don’t have a direct impact on its effective tax rate.
What role do non-deductible expenses play in financial planning and cash flow forecasting?
Despite having no impact on taxable income, non-deductible expenses do affect cash flows. These costs still affect the business’s cash balance and available funds, underscoring why it’s essential to maintain detailed records of them, even if there is no tax benefit they provide.
