Tax deduction
Encyclopedia
Income tax systems generally allow a tax deduction, i.e., a reduction of the income subject to tax, for various items, especially expenses incurred to produce income. Often these deductions are subject to limitations or conditions. Tax deductions generally are allowed only for expenses incurred that produce current benefits, and capitalization of items producing future benefit is required, sometimes with exceptions. Most systems allow recovery in some manner over a period of time of capitalized business and investment items, such as through allowances for depreciation, obsolescence, or decline in value. Many systems reduce taxable income for personal allowances or provide a range of income subject to zero tax. In addition, some systems allow deductions from the tax base for items the tax levying government desires to encourage. Some systems distinguish among types of deductions (business versus non-business).
. This may be considered an expense, a reduction of gross income
, or merely a component utilized in computing net profits. The manner in which cost of goods sold is determined has several inherent complexities, including various accounting methods. These include:
(GAAP). 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...” subject to qualifications, enhancements, and limitations. 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:
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.
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.
. Examples include timing of recognition of cost recovery deductions (e.g., depreciation), current expensing of otherwise capitalizable costs of intangibles, and rules related to costs that should be treated as part of cost of goods not yet sold. 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.
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.
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 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. The annual depreciation deduction may be computed on a straight line, declining balance, or other basis, as permitted in each country's rules. 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.
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.” This may be determined by reference to the type of asset or business. Some systems allow specific charges for cost recovery for some assets upon certain identifiable events.
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. However, some systems provide for amortization of certain such costs, at the election of the taxpayer.
.” 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):
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. Such systems generally require, at a minimum, reporting of such amounts, and may require that withholding tax
be applied to the payment.
) for such groups. Group relief may be available for companies in EU member countries with respect to losses of group companies in other countries.
.
:
Canada:
United Kingdom: HM Revenue and Customs:
United States: Internal Revenue Service
:
Business expenses
Nearly all jurisdictions that tax business income allow tax deductions for expenses incurred in trading or carrying on the trade or business. Technical details of the allowance vary, and may be very general for all expenses, or very specific in respect of certain expenses. The amount of particular deductions may be limited based on character or amount, or deductions in aggregate may be limited or reduced. To be deducted, the expenses must be incurred in furthering a business. Generally, a business includes only those activities undertaken for profit.Cost of goods sold
Nearly all income tax systems allow a deduction for cost of goods soldCost of goods sold
Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
. This may be considered an expense, a reduction of gross income
Gross income
Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident."Except as otherwise provided" by...
, or merely a component utilized in computing net profits. 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.
- Methods for attributing common costs, such as factory burden, to particular goods.
- Methods for determining when costs are recognized in computing cost of goods sold or to be sold.
- Methods for recognizing costs of goods that will not be sold or have declined in value.
Trading or ordinary and necessary business expenses
Many systems, including the UK, levy tax on all chargeable “profits of a trade” computed under local generally accepted accounting principlesGenerally Accepted Accounting Principles
Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
(GAAP). 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...” subject to qualifications, enhancements, and limitations. 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.
- 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.
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
S Corporation
An S corporation, for United States federal income tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code....
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.
Accounting methods
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 GAAPGaap
In demonology, Gaap is a mighty Prince and Great President of Hell, commanding sixty-six legions of demons. He is, according to The Lesser Key of Solomon, the king and prince of the southern region of Hell and Earth, and according to the Pseudomonarchia Daemonum the king of the western region and...
. Examples include timing of recognition of cost recovery deductions (e.g., depreciation), current expensing of otherwise capitalizable costs of intangibles, and rules related to costs that should be treated as part of cost of goods not yet sold. 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
- Limits on deducting compensation of certain key employees
- Limits on lobbying or similar expenditures
- Nondeductibility of payments considered in violation of public policy, such as criminal fines
- Limits on deductions for business related entertainment.
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.
Capitalized items and cost recovery (depreciation)
Many systems require that the cost of items likely to produce future benefits be capitalized. Examples include plant and equipment, fees related to acquisition of property, and costs of 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
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
for costs of tangible assets and as amortization
Amortization
Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...
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. The annual depreciation deduction may be computed on a straight line, declining balance, or other basis, as permitted in each country's rules. 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.
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.” This may be determined by reference to the type of asset or business. Some systems allow specific charges for cost recovery for some assets upon certain identifiable events.
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. However, some systems provide for amortization of certain such costs, at the election of the taxpayer.
Non-business expenses
Some systems distinguish between an active trade or business and the holding of assets to produce income. 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
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. The UK grants a “personal allowancePersonal allowance
In the UK tax system, Personal Allowance is the level above which income tax is levied on an individual's annual income. A person who receives less than his/her personal allowance in taxable income in a given tax year does not pay income tax; otherwise, tax must be paid according to how much is...
.” 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)
- State and local income and property taxes
- Interest expense on certain home loans
- Gifts of money or property to qualifying charitable organizations, subject to certain maximum limitations,
- Losses on non-income-producing property due to casualty or theft,
- Contribution to certain retirement or health savings plans (U.S. and UK),
- Certain educational expenses.
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. Such systems generally require, at a minimum, reporting of such amounts, and may require that withholding tax
Withholding tax
Withholding tax, also called retention tax, is a government requirement for the payer of an item of income to withhold or deduct tax from the payment, and pay that tax to the government. In most jurisdictions, withholding tax applies to employment income. Many jurisdictions also require...
be applied to the payment.
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.” Generally, such deductions function in lieu of consolidated or combined computation of tax (tax consolidationTax consolidation
Tax consolidation is a regime adopted in the tax or revenue legislation of a number of countries which treats a group of wholly owned or majority-owned companies and other entities as a single entity for tax purposes...
) for such groups. Group relief may be available for companies in EU member countries with respect to losses of group companies in other countries.
International aspects
Many systems impose limitations on tax deductions paid to foreign parties, especially related parties. See International tax and Transfer pricingTransfer pricing
Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made between related parties for goods, services, or use of property . Transfer prices among components of an enterprise may be used to reflect allocation of resources among such components, or for other...
.
Further reading
- Crowningshield, Gerald, and Gorman, Kenneth: Cost Accounting, ISBN 9780395267974
- Horngren, Charles T., et al.: Cost Accounting, ISBN 9780136126638
- Hoffman, William, et al.: Individual Income Taxes (annual editions; 2011 edition ISBN 9780538468602 )
- Pratt, James, and Kulsrud, William: 2010 Federal Taxation, ISBN 9781424069866
- Whittenberg, Gerald, and Altus-Buller, Martha: Income Tax Fundamentals, ISBN 9780324663686
- Schneider, Leslie: Federal Income Taxation of Inventories
- Weltman, Barbara: J.K.Lasser's 1001 Deductions …, ISBN 978-0470445488
External links
Australia: Australian Taxation OfficeAustralian Taxation Office
The Australian Taxation Office is an Australian Government statutory agency and the principal revenue collection body for the Australian Government. The ATO has responsibility for administering the Australian federal taxation system and superannuation legislation...
:
- Main site
Canada:
- Laws
- Canada Revenue AgencyCanada Revenue AgencyThe Canada Revenue Agency is a federal agency that administers tax laws for the Government of Canada and for most provinces and territories, international trade legislation, and various social and economic benefit and incentive programs delivered through the tax system...
:
United Kingdom: HM Revenue and Customs:
United States: Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
:
- Main site
- Some relevant publications:
- 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)