To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.
* The expenses used to figure cost of goods sold,
* Capital expenses, and
* Personal expenses.
Cost of Goods Sold
If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.
* The following are types of expenses that go into figuring cost of goods sold.
* The cost of products or raw materials, including freight.
* Direct labor (including contributions to pension or annuity plans) for workers who produce the products.
* Factory overhead.
Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.
This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.
You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called “capital expenses.” Capital expenses are considered assets in your business. In general, you capitalize three types of costs.
* Business start-up costs
* Business assets.
Business Start-Up Costs
Start-up costs are amounts paid or incurred for: (a) creating an active trade or business; or (b) investigating the creation or acquisition of an active trade or business. Start-up costs include amounts paid or incurred in connection with an existing activity engaged in for profit; and for the production of income in anticipation of the activity becoming an active trade or business.
Qualifying costs. A start-up cost is amortizable if it meets both of the following tests.
* It is a cost you could deduct if you paid or incurred it to operate an existing active trade or business (in the same field as the one you entered into).
* It is a cost you pay or incur before the day your active trade or business begins.
Start-up costs include amounts paid for the following:
* An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.
* Advertisements for the opening of the business.
* Salaries and wages for employees who are being trained and their instructors.
* Travel and other necessary costs for securing prospective distributors, suppliers, or customers.
* Salaries and fees for executives and consultants, or for similar professional services.