Making the right IRS tax deductions is an important way to reduce your tax burden. But sometimes people take it too far, resulting in all sorts of wacky deductions that could even be illegal. Knowing what you can and can't deduct is half the battle.
Itemized deductions are the key for individuals and businesses that wish to claim some of the many opportunities available. To ensure that everything is accounted for with the right amounts, you must have solid organization and recordkeeping strategies for properly documenting deductions and tracking them throughout the year.
Below are some general guidelines for the types of deductions available and how both individuals and businesses can use them to their best advantage – as well as some off-the-wall deductions people have tried to take that you definitely cannot. [Need more help with your taxes? Check out our best tax software reviews and best picks.]
Crazy (and illegal) tax deductions
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 actually 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, 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
The birth of IRS Tax Code Section 280E
Perhaps one of the most out-there tax deductions stories comes to us from the 1970s in the case of Jeffrey Edmondson v. Commissioner. Edmondson was convicted for 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 even 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, so it's no surprise that in 1982, Congress adopted Tax Code 280E, which banned businesses trafficking in Schedule I or Schedule II substances from deducting business expenses. Ironically, 280E is negatively impacting legal cannabis businesses 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.
These crazy deductions aside, there are plenty of tax deductions your business actually can (and should) take to reduce your overall tax burden this year.
Expenses you can deduct on your taxes
Small businesses and the self-employed can take advantage of a number of deductions to reduce their obligations. Deductions can be itemized on federal taxes, and listing them out enables you to reduce the amount of your taxable income.
For individuals, itemized deductions can offer significant value over the federal standard deduction. In general, the standard deduction is worth it if it’s a higher figure than what your itemizations add up to. Properly listing your applicable deductions on your taxes can take some time, though. Tax preparation software or a tax advisor can make sure you take advantage of the right ones.
Many items fall under the allowable individual deductions as well. One place to start is the changes brought forth by the Tax Cuts and Jobs Act. While this law passed in 2017, according to the IRS, a few key categories should still be top of mind for tax filers.
- Education: The student loan interest deduction is popular, as it allows the taxpayer to deduct the lesser of $2,500 or the amount of interest paid during the year. Educators can take advantage of the educator expense deduction.
- Medical and dental expenses: Medical and dental care for yourself, a spouse, or dependents may be deducted if it equals more than 7.5% of your adjusted gross income.
- State and local taxes: These deductions are limited to $10,000, or $5,000 for married taxpayers filing separate returns. This tax must have been imposed directly on the taxpayer and paid within the same tax year.
- Home equity loan interest: The IRS notes there has been confusion around this deduction from the 2017 tax law. According to the IRS, taxpayers can deduct interest on a home equity loan or line of credit, so long as the funding is used to "buy, build or substantially improve the taxpayer's home that secures the loan." See more IRS guidance on this deduction.
- Property taxes: State and local real estate taxes may be eligible for a deduction based on the value of the property and if they're collected for the "general public welfare." However, you cannot deduct transfer taxes on sale of property, homeowners association fees, estate or inheritance taxes, and a number of other items outlined in the deductible taxes section of the IRS website.
- Charitable contributions: In general, charitable deductions can count as deductions on your taxes, offering another way to lower your taxable income.
As indicated earlier, the Tax Cuts and Jobs Act may still create a number of questions as to the types of deductions that can be claimed or if they have changed in any way. The IRS offers a document, "Tax Reform Basics for Individuals and Families," for anyone who wants to check out the changes for themselves. Of course, some situations may warrant tax advice from an outside professional.
Individual filers must also be aware of the limitations, with some deductions unavailable or requiring several parameters to be met. For example, miscellaneous deductions in general can't be claimed unless the individual taxpayer falls into a specific employment category, claiming a deduction that relates to unreimbursed employee expenses.
What about tax credits?
There are also several tax credits you may be able to access. Credits such as the earned income tax credit and write-offs for child and dependent care expenses are popular and can be major savings for some taxpayers.
Income and savings credits are also available. The earned income tax credit can be used by low- and moderate-income earners who meet a series of requirements. The IRS offers an online assistant that walks you through the process of determining if you quality.
For families with three or more children, the child tax credit is another one to consider. To find out if recent education may be eligible for a credit, check out the online tools for the American opportunity credit and lifetime learning credit. There are many different credits to consider, so examine your situation thoroughly so as not to leave any money on the table.
With these credits and deductions available, there is a lot of value in itemizations as opposed to the standard deduction. However, everyone's situation is different, so choose what works best for you.
What can be included in itemized deductions for business?
In general, business expenses are allowed for a number of operational aspects. 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.
Organization and the use of an ongoing tracking system are key for businesses, according to Marc Scott, CPA with California-based M. Scott & Company. A company can undertake various strategies to ensure their books are ready for when it's time to file and 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 said. "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 said businesses should also be aware of the changes stemming from the Tax Cuts and Jobs Act. One expense that may impact businesses is the elimination of expenses related to entertainment, amusement or recreation.
"Entertainment expenses have been eliminated completely, so you can't take somebody to a ballgame or out to the opera," Scott said. "These type of use cases for expenses are officially gone."
Businesses can still deduct 50% of the cost of business meals, as long as you or someone from the business are present and the meals aren't "lavish or extravagant." As with other aspects of filing business taxes, consulting the latest documentation and working with a tax professional will keep your business on the right path.
Businesses may also wish to explore the qualified business income reduction, which can provide up to 20% reduction for sole proprietorships, partnerships, S corporations, and some trusts and estates. However, there are numerous income requirements and limitations to claiming this deduction. See the FAQs from the IRS and check with your accountant to see if you qualify.
As the tax year rolls on, this may only be the beginning of the tax advice you'll need. Checking in with a certified tax professional or investigating the options for tax preparation software can help you pull together the right documentation as Tax Day approaches. If it's getting to be crunch time and you need more time to get your documentation in order, also consider filing a tax extension.
Chad Brooks contributed to this article.