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Taking the right tax deductions may help reduce your tax liability significantly.
Income tax deductions are an essential and legitimate way to reduce your tax burden. Every business or individual has a right to minimize its tax bill. However, sometimes people go too far, taking all sorts of wacky deductions that could even be illegal. Knowing what deductions you should take and where to draw the line is crucial.
We’ll explain general guidelines for available deductions and how individuals and businesses can use them to their best advantage. We’ll also share some off-the-wall deductions people have tried to take that you definitely cannot.
We asked some of our readers to tell us about the most off-the-wall tax deductions they’ve encountered. Many of these are illegal but, believe it or not, some worked. Here’s what they had to say:
“I had a client who wanted to know if he could deduct the motorcycle he recently purchased because he said that riding it relieved his stress, which helped him perform better in his business.” ― Logan Allec, certified public accountant and owner of Money Done Right
“My favorite: fees paid to a psychic fortune teller to whom one of my clients went to for ‘business advice.'” ― Logan Allec
“One client tried to deduct the cost of a shotgun. Another wanted to deduct practice range time to increase his firing accuracy.” ― Steven J. Weil, president and tax manager of RMS Accounting
“A client wanted to deduct the cost of his dog, claiming he was the company mascot and the company provides medical coverage for employees.” ― Steven J. Weil
“The swimming pool one [business] owner was having installed in his home. I asked what made it a business expense and he didn’t even have some fantastically wild rationalization, like it was to help relieve the stress of his very crazy job. He just said he wanted to reduce his taxable income.” ― Katie L. Thomas, owner of Diamond J Accounting
“I had a real estate agent try to tell me that every meal she purchased was a business expense because she wore her name tag to the restaurant, which meant everyone saw she was a real estate agent and could ask her questions.” ― Katie L. Thomas
Perhaps one of the most out-there tax deduction stories comes to us from the 1970s in the case of Jeffrey Edmondson v. Commissioner. Edmondson was convicted of selling large quantities of methamphetamine, cocaine and cannabis. Following his conviction, the IRS attempted to claim $17,000 in back taxes from Edmondson. In return, Edmondson filed a tax return claiming normal business deductions for phone service, business trips, cost of goods sold and a portion of his rent as a “home office,” all of which related to his illegal drug-dealing activities. The IRS balked at this attempt to claim deductions and the matter ended up in court.
To the surprise of the IRS, Edmondson won the lawsuit. The court decided he was entitled to “both ordinary and necessary” business expenses related to his drug-dealing activities. The decision was handed down in 1981.
As a result, in 1982, Congress adopted Tax Code 280E, which banned businesses trafficking in Schedule I or Schedule II substances from deducting business expenses. Ironically, 280E impacts legal cannabis businesses negatively today because, although they operate in compliance with state law, they rely on a product that remains a Schedule I substance under the federal Controlled Substances Act.
Crazy deductions aside, there are plenty of tax deductions your business can (and should) take to reduce your overall tax burden this year. Consider the following personal and business deductions that may reduce your tax liability.
Since the Tax Cuts and Jobs Act of 2017, the standard deduction has been significantly higher for individuals. As a result, many taxpayers now take the standard deduction instead of itemizing deductions. However, it’s still worth the extra time to track itemized deductions if you think your total deductions may exceed the standard deduction. You may also use a standard vs. itemized deduction calculator to help you decide. For every dollar your itemized deductions are greater than the standard deduction, you lower your total tax bill.
Check out these common itemized deductions:
Other deductions are now unavailable or have additional restrictions. For example, most taxpayers can no longer take a deduction for expenses they incur as an employee.
Some deductions are taken “above the line,” which means you can use them to reduce your income even if you don’t itemize deductions. These are called “Adjustments to Income” and are reported on Schedule 1, Part II of your individual tax return. Because these deductions reduce your adjusted gross income, which is used to determine your eligibility for certain tax benefits, they may also benefit you in other ways.
Here are some of the most common Adjustments to Income:
Unlike tax deductions, which lower the amount of income used to calculate your taxes, tax credits directly reduce the amount of tax you owe. Credits can bring significant savings for some taxpayers. Here are a few examples:
Business deductions are allowed for several operational expenses. A key phrase for the IRS is that expenses must be “ordinary and necessary.” In other words, the expense is commonly accepted in the profession and is helpful and appropriate for the trade or business.
Consider the following tax tips for business owners.
You must keep records of deductions and be able to find them at tax time. According to Marc Scott, a CPA with California-based M. Scott & Company, a tracking system is vital for businesses. A company can undertake various strategies to ensure its books are ready for tax season and to help it get the most out of any potential deductions.
“Having an ongoing system where you track potential expenses throughout the year is a way to keep the filing time less chaotic,” Scott advised. “At a minimum, you want the categories that are listed on the Schedule C, Form 1120 or [Form] 1065. For your internal tracking, you may have more categories than what the forms provide, but you’ll have a breakout of what deductions you’ll be taking when filing.”
Scott says businesses should also be aware of any changes, including those stemming from the Cuts and Jobs Act. Here are a few tax law changes you should become familiar with.
By learning about tax deductions and keeping good records throughout the year, you’re already on the right track. For more help, consult with a tax professional or investigate the options for tax preparation software. You should never hesitate to take tax deductions and credits to which you and your business are entitled.
Derek Walter contributed to this article. Source interviews were conducted for a previous version of this article.