8052 / How are business expenses reported for income tax purposes?

Editor’s Note: The 2017 tax reform legislation suspended all miscellaneous itemized deductions subject to the 2 percent floor for tax years beginning after 2017 and before 2026.

The amount of the deduction for expenses incurred in carrying on a trade or business depends upon whether the individual is an independent contractor or an employee. Independent contractors may deduct all allowable business expenses from gross income (generally on Schedule C) to arrive at adjusted gross income.¹ The business expenses of an employee are deductible from adjusted gross income if itemized, but only to the extent that they exceed 2 percent of adjusted gross income when aggregated with other miscellaneous itemized deductions (described in Q 733).

A full-time life insurance salesperson will not be treated as an “employee” for purposes of IRC Sections 62 and 67 merely because the individual is a “statutory employee” for Social Security tax purposes.² The IRS has frequently challenged insurance agents’ claims of independent contractor status; however, its position has been struck down by at least two circuit courts of appeals, both of which held that the fact that an insurance agent received certain employee benefits did not preclude his being considered an independent contractor based on all the other facts and circumstances of the case.³ The IRS has instructed its attorneys to discontinue the practice of challenging certain independent contractor status claims of insurance agents who were treated as statutory employees by the companies for whom they worked.⁴ However, industrial agents (or “debit agents”) are treated as employees for tax purposes.⁵ Thus, as in the case of any employee, a debit agent can deduct transportation and away-from-home traveling expenses from adjusted gross income if he itemizes, only to the extent that the aggregate of these and other miscellaneous itemized deductions exceeds 2 percent of adjusted gross income.⁶

Self-employed taxpayers are permitted a deduction equal to one-half of their self-employment (i.e., Social Security) taxes for the taxable year. This deduction is treated as attributable to a trade or business that does not consist of the performance of services by the taxpayer as an employee; thus it is taken “above-the line.”⁷

In a legal memorandum concerning the deductibility of medical insurance costs, the Service ruled as follows:

(1) A sole proprietor who purchases health insurance in his individual name has established a plan providing medical care coverage with respect to his trade or business, and therefore may deduct the medical care insurance costs for himself, his spouse, and dependents under IRC Section 162(l), but only to the extent the cost of the insurance does not exceed the earned income derived by the sole proprietor from the specific trade or business with respect to which the insurance was purchased.

(2) A self-employed individual may deduct the medical care insurance costs for himself and his spouse and dependents under a health insurance plan established for his trade or business up to the net earnings of the specific trade or business with respect to which the plan is established, but a self-employed individual may not add the net profits from all his trades and businesses for purposes of determining the deduction limit under IRC Section 162(l)(2)(A). However, if a self-employed individual has more than one trade or business, he may deduct the medical care insurance costs of the self-employed individual and his spouse and dependents under each specific health insurance plan established under each specific business up to the net earnings of that specific trade or business.⁸

Later, with respect to the same taxpayer, the Service ruled that a self-employed individual cannot deduct the costs of health insurance on Schedule C; instead, the deduction under IRC section 162(l) must be claimed as an adjustment to gross income on the front of Form 1040.⁹

The Service has provided rules under which a 2 percent shareholder-employee in an S corporation is entitled to the deduction (under IRC Section 162(l)) for health insurance premiums that are paid or reimbursed by the S corporation and included in the 2 percent shareholder-employee’s gross income.¹⁰

The Tax Court has held that a taxpayer could deduct his expenses ($15,745) incurred in earning a master’s degree in business administration to the extent those expenses were substantiated and education-related. The court based its decision on the fact that the taxpayer’s MBA did not satisfy a minimum education requirement of his employer, nor did the MBA qualify the taxpayer to perform a new trade or business.¹¹

Editor’s Note: The deduction for business entertainment expenses was suspended for 2018025.

Expenses for business meals and entertainment must meet one of two tests, as defined in regulations, to be deductible. The meal must be: (1) directly related to the active conduct of the trade or business, or (2) associated with the trade or business. Generally, the deduction for business meal and entertainment expenses is limited to 50 percent of allowable expenses.¹² The 50 percent otherwise allowed as a deduction is then subject to the 2 percent floor which applies to miscellaneous itemized deductions.¹³ (The 50 percent limitation was increased to 100 percent for 2021 and 2022 if the expenses were incurred in a restaurant). The taxpayer or his employee generally must be present for meal expenses to be deductible, and expenses that are lavish or extravagant may be disallowed. Substantiation is required for lodging expenses and for most expenditures of $75 or more.¹⁴ An employee must generally provide an adequate accounting of reimbursed expenses to his employer.¹⁵