Fair or fraud: which business expenses are deductible?

• Author: Spendlove, Gretta
• Position: EntrepreneurEdge

You've got a sharp pencil, a calculator and your tax forms--and a stack of receipts that you hope will reduce your tax burden. But take care: deducting the wrong things can land you in some seriously hot water.

"Some people think they can deduct all the utilities they use in their home because they have a home office. They think they can write off the entire family vacation because they stopped in to see one supplier during a seven-day trip," says Karen Summerhays, CPA with The Summerhays Group.

According to Summerhays, the IRS allows deduction of "ordinary and necessary" expenses for legitimate businesses, but excessive deductions can lead to audits--or even charges of fraud.

"The IRS uses 'dif scores' to compare income and expenses on a particular tax return to income and expenses on tax returns of similar sizes, locations and types of businesses," explains Summerhays. "If a return does not fall within the 'dif score' averages, an audit is more likely."

So writing off that vacation to Disneyland may trigger an audit. And if the audit reveals under-reporting of taxable income, the IRS can charge penalties and interest from the date the tax was due.

"Since the IRS is still auditing 2008 returns, the interest alone could be substantial," she says. "If the underreporting exceeds 25 percent, the IRS can prosecute for fraud."

Hot Button Issues

"Tax professionals keep track of the IRS's current hot button issues," says Summerhays. "For the past couple of years, the IRS has been particularly sensitive about owners of S corporations not taking enough wages."

Business owners using S corporations must pay themselves a reasonable salary and withhold employee taxes from that salary. They can then pay any remaining profit in the form of shareholder distributions, from which employee taxes need not be withheld.

The IRS may challenge shareholder salaries as "unreasonable" if they do not match prevailing rates of compensation for comparable positions, current economic conditions, and the nature, extent and scope of the employee's work. For instance, the president of a company that nets several million dollars in annual profit who pays himself $50,000 in wages but takes home $400,000 in distributions might well face an IRS challenge.

"Another sensitive area is deduction of insurance premiums," Summerhays explains. "Generally, small business owners cannot deduct premiums for life or disability insurance, and even deducting health insurance premiums can be...