Essential Business Tax Rules: Deductions, Depreciation, and Accounting Methods

Gross Income and Business Deductions

Gross Income: Includes revenue from sales, services, rents, dividends, interest, etc. Exclusions include life insurance proceeds and municipal bond interest. Expenses associated with the production of tax-exempt income are not deductible.

Deductions Above the Line (for AGI)

Deductions for Adjusted Gross Income (AGI) include business expenses, rental expenses, self-employed health insurance, and IRA contributions.

• Ordinary & Necessary Test: An expense must be customary and appropriate for the business.
• Meals Deduction: Can deduct 50% of meals if the expense is ordinary, necessary, and reasonable, the employee is present, the person eating is a current or potential client, and the meal is purchased separately from entertainment.

Entertainment and Travel Expenses

• Entertainment: Mostly not deductible unless for the taxpayer’s employees or if part of employee compensation.
• Standard Mileage Rate (2024): 67 cents per mile.
• Travel Expenses: Include transportation, meals (at 50%), lodging, and incidental expenses.

Travel Expense Deduction Rules

• If travel is only business: All travel costs are deductible (meals at 50%).
• If primarily business: 100% deduction of transportation costs, but meals (at 50%), lodging, and incidental expenditures are limited to those incurred for the business portion of travel.
• If primarily personal: No deduction for transportation, but meals (at 50%), lodging, and incidental expenditures are limited to those incurred for the business portion of travel.

The primary purpose of the trip is subject to a facts and circumstances determination.

Record Keeping for Mixed-Motive Expenses

Taxpayers must maintain specific, written, contemporaneous records of time, amount, and business purpose for mixed-motive expenses like phones and computers.

Business Interest Expense Limitation (Section 163(j))

The business interest expense deduction is limited to business interest income plus 30% of Adjusted Taxable Income (ATI).

Adjusted Taxable Income (ATI): Taxable income calculated without business interest income/expense, Net Operating Loss (NOL) deduction, or Section 199A deduction (Qualified Business Income or QBI deduction).

Small Business Exception: No limit applies for “small businesses” with average annual gross receipts for the 3 prior taxable years less than or equal to $30 million, adjusted for inflation.

Any business interest expense not allowed as a deduction for any taxable year can be carried forward indefinitely.

Accounting Methods and Income Recognition

Accrual Method Income Deferral

Accrual-method taxpayers can elect to defer income recognition to the following year (but not beyond the following year). They cannot elect to defer income if:

1. The income is actually earned by the end of the year of receipt, OR
2. The prepayment was included in financial reporting income.

Economic Performance Test

Generally, expenses are deducted when economic performance occurs.

1. Receiving goods and/or services from another party: Generally, deduct the expense when the other party provides the good or service.
Exception: If the liability is paid before the good or service is provided, and the business reasonably expects the other party to provide the remaining goods or services within 3½ months after payment.

Adjustments for Accounting Method Changes

When businesses change accounting methods, they must make an adjustment to taxable income that reflects the cumulative difference—as of the beginning of the tax year—between:

• The amount of income/deductions recognized under the old method, AND
• The amount that would have been recognized for all prior years if the new method had been applied.

Rules for recognizing the adjustment:

• If the adjustment increases taxable income, the taxpayer recognizes it over 4 years beginning with the year of change.
• If the adjustment decreases taxable income, the taxpayer recognizes all of it in the year of change.

Cost Recovery: Depreciation and Amortization

Determining Asset Cost Basis

Cost recovery begins once the asset is placed in service (PIS).

Cost Basis includes all expenses to purchase, prepare for use, and begin using the asset (i.e., sales tax, shipping costs, installation). Generally, cost basis is the same for book and tax purposes.

Tax Basis: Cost minus Accumulated Depreciation.

Costs Incurred After Placed in Service

• Routine maintenance: Immediately deduct.
• Betterment, restoration, or new/different use for property: Capitalize.

Basis Rules for Converted or Acquired Assets

• Personal Asset Converted to Business Asset: Basis is the lesser of the cost basis or Fair Market Value (FMV) on the date of conversion.
• Acquired by Gift: Carryover basis (recipient's basis is the same as the transferor's basis).
• Acquired through Inheritance: Recipient’s basis is the FMV on the date of the transferor's death.

MACRS Depreciation Methods

Businesses elect a depreciation method for each asset class placed in service that year, which must be followed until disposal or full depreciation is reached.

• 200% Declining Balance (Double DB): This is the default method. It uses twice the straight-line rate until the straight-line method provides a greater depreciation expense.
• 150% Declining Balance (DB)
• Straight-Line (SL)

Note: Only a low Marginal Tax Rate (MTR) business that expects tax rates to increase in the future might elect to use the straight-line depreciation method (e.g., a startup incurring losses right now).

Depreciation Conventions for Personal Property

Depreciation convention determines the portion of a full year’s depreciation deductible in the year the asset is placed in service and sold. Must use either the Half-Year or Mid-Quarter convention with personal property (not real property).

Half-Year Convention (Default)

Allows deduction of half a full year of depreciation when placed in service, regardless of when in the year it was placed in service.

Mid-Quarter Convention (MQC)

The MQC applies when more than 40% of the total tangible personal property is placed in service during the fourth quarter (Q4).

• If MQC applies, it must be used for all tangible personal property placed in service during the tax year.
• The asset is treated as if placed in service in the middle of the quarter in which it was actually placed in service.
• Throughout the asset's life, the depreciation table for the quarter in which the asset was originally placed in service is used.

Disposal Under Mid-Quarter Convention

The asset is treated as if disposed of in the middle of the quarter in which it was actually disposed. Multiply full-year depreciation by the proportion of the year entitled to a depreciation deduction:

• Q1 Disposal Proportion: 12.5%
• Q2 Disposal Proportion: 37.5%
• Q3 Disposal Proportion: 62.5%
• Q4 Disposal Proportion: 87.5%

Real Property Depreciation

Real property includes land, residential rental property, and nonresidential property.

• Residential Rental Property: Includes houses, condos, and apartments. Has a 27.5-year recovery period.
• Nonresidential Property: All other buildings. If placed in service after May 13, 1993, it has a 39-year recovery period.

Substantial improvements to existing real property are treated as new, separate assets with the same original recovery period as the original building.

Method and Convention: Use the straight-line method for real property, and the convention is the Mid-Month convention. Deduct half a month of depreciation for the month when the property is placed in service (and disposed of).

Disposal Proportion: (Month in which asset was disposed of – 0.5) / 12

Immediate Expensing Provisions

Section 179 Immediate Expensing (2024)

Businesses can elect to immediately deduct up to $1.22 million of tangible personal property placed in service (PIS).

• The basis of the asset must be reduced by the elected Section 179 expense before computing regular MACRS on the remaining basis.
• Phase-Out: The maximum amount of Section 179 expense is subject to phase-out. Reduce the $1.22 million maximum dollar-for-dollar by the amount of tangible personal property over $3.05 million that was purchased and placed in service in 2024.
• Business Income Limitation: Deductible Section 179 expense is limited to the taxpayer’s business income before the Section 179 deduction but after all other deductions, including MACRS and bonus depreciation.
• Section 179 cannot create a Net Operating Loss (NOL), but MACRS can.
• Any Section 179 expense not currently deductible can be carried forward forever, subject to the total income limitation, but not subject to the phase-out on future returns.

Bonus Depreciation Rules

Bonus depreciation allows the immediate deduction of a percentage of the acquisition cost of qualifying assets. The Tax Cuts and Jobs Act (TCJA) implemented 100% immediate expensing for qualified property placed in service between September 28, 2017, and December 31, 2022. This benefit is phasing out:

• 2023: 80%
• 2024: 60%
• 2025: 40%
• 2026: 20%
• 2027 & after: 0%

Qualifying Property and Election

• Qualified property is: New to the taxpayer, has a regular recovery period of 20 years or less, or is software.
• Bonus depreciation is mandatory for all taxpayers that qualify.
• A taxpayer may elect out of bonus depreciation (which may make sense if the taxpayer has losses); this choice is made annually by property class.
• Bonus depreciation is calculated after the Section 179 deduction but before regular MACRS depreciation.

Amortization of Intangible Assets

Intangible assets have a recovery period of 180 months (15 years), regardless of actual life. The full-month convention applies to the amortization of intangibles, using the straight-line method.

Four kinds of amortizable intangibles:

1. Section 197 purchased intangibles;
2. Organizational expenditures/startup costs;
3. Research and Development (R&D) costs;
4. Patents/copyrights.

Note: Selling or marketing stock does not qualify as an organizational expenditure.

Organizational and Startup Costs

The first $5,000 of organizational costs and start-up costs can be immediately deductible. The $5,000 limit is phased out dollar-for-dollar by costs in excess of $50,000. Any remaining costs are amortized straight-line over 15 years.

Book-Tax Differences (BTDs) and Corporate Tax Issues

Understanding Book-Tax Differences

Book-Tax Differences (BTDs) arise when income or deductions are recognized differently for financial reporting (book) versus tax purposes.

Temporary BTDs

These differences reverse over time. Income or deduction/expense items are recognized at different times (i.e., in different periods) for book and tax purposes, but the total amount recognized for book and tax will be the same over time.

• Example: Accelerated MACRS depreciation causes taxable income to be lower than book income (favorable BTD) early in an asset’s life. Later in the asset’s life, accelerated depreciation will cause taxable income to be higher than book income (unfavorable BTD).

Permanent BTDs

These differences never reverse. They occur when an income or deduction item is recognized for one purpose but never for the other.

• Unfavorable Permanent BTDs: Cause taxable income to be higher than book income. (e.g., expenses associated with tax-exempt income).
• Favorable Permanent BTDs: Cause taxable income to be lower than book income.
• Example: Municipal bond interest income generates a favorable permanent BTD. This income is recognized for book purposes but never for tax purposes.

Corporate Dividends Received Deduction (DRD)

Congress allows a corporate deduction for dividends received from domestic corporations. This generates a favorable permanent difference in the year the dividend is received.

DRD Limitation

The DRD is limited to the product of the applicable DRD percentage and DRD modified taxable income (taxable income before DRD, NOL deduction, and capital loss carrybacks).

NOL Rule Exception: The DRD modified taxable income limitation does not apply if the DRD would create or enlarge a Net Operating Loss (NOL).

Net Operating Losses (NOLs)

NOLs are used in FIFO (First-In, First-Out) order.

• NOLs originating in tax years 2017 and earlier (pre-TCJA):
  • Carry back 2 years, forward 20 years.
  • Can offset up to 100% of taxable income before the NOL deduction in carryback and carryforward periods.
• NOLs originating in tax years 2018 and later:
  • No carryback, indefinite carryforward.
  • Can offset up to 80% of taxable income before the NOL deduction in the carryforward period.

For financial reporting, corporations expense losses in the year they incur them. Thus, in the NOL year, the corporation reports an unfavorable temporary BTD. In the year the NOL is deducted on the tax return, the corporation reports a favorable temporary BTD.

Corporate Charitable Contributions (CC)

Taxpayers may deduct charitable contributions if the recipient is a "qualified charitable organization." The deduction is taken in the year of payment.

Accrual Basis Exception

Accrual basis taxpayers may claim the deduction in the year preceding payment if:

• The contribution has been authorized by the Board of Directors (BoD) by the end of the year (EOY), AND
• Payment is made within 3.5 months of the tax year end.

Deduction Amount

• Long-Term Capital Gain Property: Usually the Fair Market Value (FMV) of the property.
• Ordinary Income Property: Usually the lesser of: 1) FMV or 2) Adjusted tax basis of the property.

Limitation

The CC deduction is the lesser of:

• The charitable contribution amount, OR
• 10% of Modified Taxable Income (MTI).

Excess contributions are carried forward 5 years. If the 10% of MTI limit applies, the corporation reports an unfavorable BTD in the year of the charitable contribution.