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Tax deduction

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This article is about the deduction of expenses for the purpose of calculating taxable income. For tax deducted at source, see Withholding tax.

Tax deduction is a simplified phrase for meaning income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. The difference between deductions, exemptions, and credits is that deductions and exemptions both reduce taxable income, while credits reduce tax.[1]

Above and below the line

Above and below the line refers to items above or below adjusted gross income, which is item 37 on the tax year 2017 1040 tax form.[2] Tax deductions above the line lessen adjusted gross income, while deductions below the line can only lessen taxable income if the aggregate of those deductions exceeds the standard deduction, which in tax year 2018 in the U.S., for example, was $12,000 for a single taxpayer and $24,000 for married couple.[1][3]

Limitations

Often, deductions are subject to conditions, such as being allowed only for expenses incurred that produce current benefits. Capitalization of items producing future benefit can be required, though with some exceptions. A deduction is allowed, for example, on interest paid on student loans.[1] Some systems allow taxpayer deductions for items the influential parties want to encourage as purchases.

Business expenses

Nearly all jurisdictions that tax business income allow deductions for business and trade expenses. Allowances vary and may be general or restricted. To be deducted, the expenses must be incurred in furthering business, and usually only include activities undertaken for profit.

Cost of goods sold

Nearly all income tax systems allow a deduction for the cost of goods sold. This may be considered an expense, a reduction of gross income,[4] or merely a component utilized in computing net profits.[5] The manner in which cost of goods sold is determined has several inherent complexities, including various accounting methods. These include:

  • Conventions for assigning costs to particular goods sold where specific identification is infeasible.[6]
  • Methods for attributing common costs, such as factory burden, to particular goods.[7]
  • Methods for determining when costs are recognized in computing cost of goods sold or to be sold.[8]
  • Methods for recognizing costs of goods that will not be sold or have declined in value.[9]

Trading or ordinary and necessary business expenses

Many systems, including the United Kingdom, levy tax on all chargeable “profits of a trade” computed under local generally accepted accounting principles (GAAP).[10] Under this approach, determination of whether an item is deductible depends upon accounting rules and judgments. By contrast, the U.S. allows as a deduction "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business..."[11] subject to qualifications, enhancements, and limitations.[12] A similar approach is followed by Canada, but generally with fewer special rules. Such an approach poses significant definitional issues. Among the definitional issues often addressed are:

  • What constitutes a trade or business? Generally, the business must be regular, continuous, substantial, and entered into with an expectation of profit.[13][14]
  • What expenses are ordinary and necessary? The phrase deals with what expenses are appropriate to the nature of the business, whether the expenses are of the sort expected to help produce income and promote the business, and whether the expenses are not lavish and extravagant.

Note that under this concept, the same sorts of expenses are generally deductible by business entities and individuals carrying on a trade or business. To the extent such expenses relate to the employment of an individual and are not reimbursed by the employer, the amount may be deductible by the individual.[15]

Business deductions of flow-through entities may flow through as a component of the entity's net income in some jurisdictions. Deductions of flow-through entities may pass through to members of such entities separately from the net income of the entity in some jurisdictions or some cases. For example, charitable contributions by trusts, and all deductions of partnerships (and S corporations in the U.S.) are deductible by member beneficiaries or partners (or S corporation shareholders) in a manner appropriate to the deduction and the member, such as itemized deductions for charitable contributions or a component of net business profits for business expenses.[16]

Accounting methods

Main article: Tax accounting

One important aspect of determining tax deductions for business expenses is the timing of such deduction. The method used for this is commonly referred to as an accounting method. Accounting methods for tax purposes may differ from applicable GAAP. Examples include timing of recognition of cost recovery deductions (e.g., depreciation), current expensing of otherwise capitalizable costs of intangibles,[17] and rules related to costs that should be treated as part of cost of goods not yet sold.[18] Further, taxpayers often have choices among multiple accounting methods permissible under GAAP and/or tax rules. Examples include conventions for determining which goods have been sold (such as first-in-first-out, average cost, etc.), whether or not to defer minor expenses producing benefit in the immediately succeeding period, etc.

Accounting methods may be defined with some precision by tax law, as in the U.S. system, or may be based on GAAP, as in the UK system.

Limits on deductions

Many systems limit particular deductions, even where the expenses directly relate to the business. Such limitations may, by way of example, include:

  • Maximum deductions for use of automobiles[19]
  • Limits on deducting compensation of certain key employees[20]
  • Limits on lobbying or similar expenditures[21]
  • Nondeductibility of payments considered in violation of public policy, such as criminal fines[22]
  • Limits on deductions for business-related entertainment but no limit in 2021 taxes and beyond.[23]

In addition, deductions in excess of income in one endeavor may not be allowed to offset income from other endeavors. For example, the United States limits deductions related to passive activities to income from passive activities.[24]

In particular, expenses that are included in COGS cannot be deducted again as a business expense. COGS expenses include:

  • The cost of products or raw materials, including freight or shipping charges;
  • The cost of storing products the business sells;
  • Direct labor costs for workers who produce the products; and
  • Factory overhead expenses.

In 2005, the Australian government amended its taxation legislation to remove deductions for expenses incurred in conducting criminal business activities. This came after the Federal Court ruled in Commissioner of Taxation v La Rosa that a heroin dealer was entitled to a tax deduction for money stolen from him in a drug deal.[25]

Capitalized items and cost recovery (depreciation)

Many systems require that the cost of items likely to produce future benefits be capitalized.[26] Examples include plant and equipment, fees related to acquisition, and developing intangible assets (e.g., patentable inventions). Such systems often allow a tax deduction for cost recovery in a future period.

A common approach to such cost recovery is to allow a deduction for a portion of the cost ratably over some period of years. The U.S. system refers to such a cost recovery deduction as depreciation for costs of tangible assets[27] and as amortization for costs of intangible assets. Depreciation in these systems is allowed over an estimated useful life, which may be assigned by the government for numerous classes of assets, based on the nature and use of the asset and the nature of the business.[28] The annual depreciation deduction may be computed on a straight line, declining balance, or other basis, as permitted in each country's rules.[29] Many systems allow amortization of the cost of intangible assets only on a straight-line basis, generally computed monthly over the actual expected life or a government specified life.[30]

Alternative approaches are used by some systems. Some systems allow a fixed percentage or dollar amount of cost recovery in particular years, often called “capital allowances.”[31] This may be determined by reference to the type of asset or business.[32] Some systems allow specific charges for cost recovery for some assets upon certain identifiable events.[33]

Capitalization may be required for some items without the potential for cost recovery until disposition or abandonment of the asset to which the capitalized costs relate. This is often the case for costs related to the formation or reorganization of a corporation, or certain expenses in corporate acquisitions.[34] However, some systems provide for amortization of certain such costs, at the election of the taxpayer.[35]

Non-business expenses

Some systems distinguish between an active trade or business and the holding of assets to produce income.[36] In such systems, there may be additional limitations on the timing and nature of amounts that may be claimed as tax deductions. Many of the rules, including accounting methods and limits on deductions, that apply to business expenses also apply to income producing expenses.

Losses

See also: Loss on sale of residential property

Many systems allow a deduction for loss on sale, exchange, or abandonment of both business and non-business income producing assets. This deduction may be limited to gains from the same class of assets. In the U.S., a loss on non-business assets is considered a capital loss, and deduction of the loss is limited to capital gains. Also, in the U.S. a loss on the sale of the taxpayer's principal residence or other personal assets is not allowed as a deduction except to the extent due to casualty or theft.

Personal deductions

Many jurisdictions allow certain classes of taxpayers to reduce taxable income for certain inherently personal items. A common such deduction is a fixed allowance for the taxpayer and certain family members or other persons supported by the taxpayer. The U.S. allows such a deduction for “personal exemptions” for the taxpayer and certain members of the taxpayer's household.[37] The UK grants a “personal allowance.”[38] Both U.S. and UK allowances are phased out for individuals or married couples with income in excess of specified levels.

In addition, many jurisdictions allow reduction of taxable income for certain categories of expenses not incurred in connection with a business or investments. In the U.S. system, these (as well as certain business or investment expenses) are referred to as "itemized deductions" for individuals. The UK allows a few of these as personal reliefs. These include, for example, the following for U.S. residents (and UK residents as noted):

  • Medical expenses (in excess of 7.5% of adjusted gross income)[39]
  • State and local income and property taxes (the SALT deduction in the United States)[40]
  • Interest expense on certain home loans[41]
  • Gifts of money or property to qualifying charitable organizations, subject to certain maximum limitations,[42]
  • Losses on non-income-producing property due to casualty or theft,[43]
  • Contribution to certain retirement or health savings plans (U.S. and UK),[44]
  • Certain educational expenses.[45]

Many systems provide that an individual may claim a tax deduction for personal payments that, upon payment, become taxable to another person, such as alimony.[46] Such systems generally require, at a minimum, reporting of such amounts,[47] and may require that withholding tax be applied to the payment.[48]

Groups of taxpayers

Some systems allow a deduction to a company or other entity for expenses or losses of another company or entity if the two companies or entities are commonly controlled. Such deduction may be referred to as “group relief.”[49] Generally, such deductions function in lieu of consolidated or combined computation of tax (tax consolidation) for such groups. Group relief may be available for companies in EU member countries with respect to losses of group companies in other countries.[50]

International aspects

Many systems impose limitations on tax deductions paid to foreign parties, especially related parties. See International tax and Transfer pricing.

References

  1. ^ a b c Piper, Mike (Sep 12, 2014). Taxes Made Simple: Income Taxes Explained in 100 Pages or Less. Simple Subjects. ISBN 978-0981454214.
  2. ^ "Tax year 2017 tax form" (PDF). Retrieved June 30, 2022.
  3. ^ Internal Revenue Code, 26 U.S.C. § 1
  4. ^ PRATHAM MANGAT system computes taxable income qby subtracting deductions from gross income. Gross income, under 26 USC 61 is defined as gains from the sale of property plus other income. Gains, in turn, are defined in 26 USC 1001 as the amount realized less the adjusted basis of property sold.
  5. ^ The UK system computes income chargeable to tax as net business profits, plus other income, with adjustments. In such systems, the locally recognized generally accepted accounting principles apply. See, e.g., IAS 2, Inventories.
  6. ^ Examples of alternatives to specific identification include first-in-first-out (FIFO), average cost, and last-in-first-out (LIFO). Many EU countries do not permit LIFO.
  7. ^ Among the methods commonly used are: i) factory burden rate, in which overhead costs are assigned to goods produced based on labor hours or labor dollars; ii) standard costs, in which a cost including overheads is periodically determined for each type of goods and inventory and cost of goods sold are adjusted periodically for variances of actual costs from such standards; and iii) activity based costing, in which costs are assigned based on factors which drive the incurrence of such costs. Numerous variations on these are available in many systems.
  8. ^ Generally, determinations depend upon the overall method of accounting or overarching principles of local GAAP. These include the cash receipts and disbursements method, accrual methods, and deferred cost methods. Under these principles there may be a need to determine when amounts are properly treated as incurred.
  9. ^ GAAP often requires that the decline in value of unsold goods be charged to income when the decline occurs. This is often accomplished through a lower of cost or market value inventory accounting method, or inventory reserves. Some systems provide for differences in these determinations for financial reporting and tax purposes.
  10. ^ [ UK Income and Corporation Taxes Act of 1988 (ICTA) section [citation needed]]. The HMRC Business Income Manual at BIM 31001 states that "the starting point is accounts prepared in accordance with ordinary principles of commercial accountancy, and the commercial profits are then adjusted in accordance with the provisions of the Taxes Acts."
  11. ^ 26 USC 162(a).
  12. ^ Johnston, Kevin. "A List of Deductible Business Expenses for Schedule C." Small Business - Chron.com, http://smallbusiness.chron.com/list-deductible-business-expenses-schedule-c-21156.html. 29 June 2018.
  13. ^ In this regard, the United States Tax Court has issued well in excess of one thousand rulings. Among the factors considered are: a) whether the transactions are regular and continuous (discussed, e.g., prior to the income tax in Lewellyn v. Pittsburgh, B. & L. E. R. Co., 222 Fed. 177 (CA3, 1915), a case cited by the Tax Court), (b) whether the purported business is substantial (see, e.g., [citation needed]), (c) whether the transactions were profit motivated (see, e.g., Doggett v. Burnet, (1933), 65 F2d 191; also see hobby loss rules at 26 USC 183).
  14. ^ UK Business Income Manual 20200 describes various badges of trade.
  15. ^ See IRS Form 2106.
  16. ^ 26 USC 704(b) and 26 USC 170.
  17. ^ 26 USC 174.
  18. ^ 26 USC 263A.
  19. ^ UK: [ ICTA __], [ ]. U.S.: 26 USC 280F.
  20. ^ U.S.: 26 USC 162(m).
  21. ^ U.S.: 26 USC 162(e).
  22. ^ U.S.: 26 USC 162(f).
  23. ^ U.S.: 26 USC 274(n).
  24. ^ 26 USC 469. Income from passive activities includes not only operating income but also gains from disposition of the activity or assets used in the activity. See IRS Publication 925.
  25. ^ Gupta, Ranjana (2008). "Taxation of illegal activities in Australia and New Zealand" (PDF). Journal of the Australasian Tax Teachers Association. 3 (2): 106–128.
  26. ^ See, e.g., 26 USC 263; International Financial Reporting Standards ([IFRS]), particularly IAS 16, applicable in most EU jurisdictions for determining business profits as the starting point for taxable income.
  27. ^ U.S.: 26 USC 168, which prescribes depreciable lives by broad class;
  28. ^ For lives by class of assets, see: U.S. see Rev. Proc. 87-56, as updated, reproduced in IRS Publication 946; Canada Income Tax Regulations section 1100 et seq.
  29. ^ The U.S. permits declining balance switching to straight line in a particular year, by life of asset class. See Rev. Proc. 87-57, reproduced in IRS Publication 946 for percentages that may be used at the option of the taxpayer.
  30. ^ For international government specified lives by class of intangible asset, see the table in Tax amortization lives of intangible assets
  31. ^ UK: ICTA, ___; Canada: [ Income Tax Act section 20.(1(a))], which provides for deduction as provided in regulations; see [ Income Tax Regulations Part XI, sections 1100 et seq], Capital Allowances.
  32. ^ Canadian rules cited above specify more than 30 classes for which specific percentages are allowed.
  33. ^ For example, Germany allows a deduction for “depreciation” for assets that have come to be worth significantly less than their unrecovered cost due to identifiable events. English language [citation needed].
  34. ^ See INDOPCO v. Commissioner.
  35. ^ 26 USC 248 for corporations, 26 USC 709 for partnerships.
  36. ^ 26 USC 212; UK [ ICTA ].
  37. ^ 26 USC 151, 152. The amount is adjusted annually for inflation, and was $3,650 for 2009.
  38. ^ For 2009, the amount was £6,475, with additional allowances for married couples over age 75.
  39. ^ 26 USC 213.
  40. ^ 26 USC 164(a)(2). Individuals may elect for a tax year after 2003 to claim a deduction for state and local sales taxes in lieu of the deduction for state and local income taxes.
  41. ^ 26 USC 163 subsection (h) of which limits the deduction of personal interest.
  42. ^ 26 USC 170 Qualifying organizations generally include organizations that are tax exempt under 26 USC 503(c)(charitable organizations) or (d) (religious orders), as well as certain other organizations. Generally, the deduction is limited to 50% of gross income. This limitation is reduced in certain circumstances. Amounts in excess of the limitation may be deducted in future years, also subject to limitations.
  43. ^ 26 USC 165.
  44. ^ 26 USC 219, which provides deductions for contributions to “401(k)” and “IRA” plans, among others, and 26 USC 223, which provides deductions for contributions to “health savings accounts” that are used to pay for medical expenses.
  45. ^ 26 USC 221 and 222.
  46. ^ See, e.g., 26 USC 215.
  47. ^ See, e.g., Form IRS Form 1040, line 31b.
  48. ^ "Publication 504 (2017), Divorced or Separated Individuals - Internal Revenue Service". www.irs.gov.
  49. ^ UK [S380 ICTA et seq ]
  50. ^ See, e.g., UK draft guidance following the Marks & Spencer case.

Further reading

Australia: Australian Taxation Office:

Canada:

United Kingdom: HM Revenue and Customs:

United States: Internal Revenue Service:

  • Main site
  • Some relevant publications:
    • 334 Business expenses: Tax Guide for Small Business
    • 463 Travel and entertainment deductions
    • 501 Exemptions and standard deduction
    • 529 Miscellaneous deductions
    • 565 Business Expenses
    • 936 Home mortgage interest
    • 946 Depreciation
  • A few relevant forms (also see related instructions)
    • Form 1040 (individual tax return), Schedules C (business) and E (rental)
    • Form 1065 (partnership return of income), page 1, and Schedule K
    • Form 1120 (corporation tax return), page 1
    • Form 2106 (employee business expenses)
    • Form 4562 (depreciation and amortization)
    • Form 4797 (gain or loss on business assets)
    • Form 8825 (rental realty income)

India:

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