Some people mistakenly think that forming a limited liability company automatically entitles the limited liability company owner to additional tax deductions. I’m not sure about this, but I believe that some of the financial advisers who run those popular weekend seminars promote this idea. And I’ve also half-heard some real estate investment gurus promote the idea that the LLC somehow, magically, gives investors additional tax deductions. Accordingly, let me clear up this point of confusion. Limited liability company status should not trigger additional tax deductions for a business or investor.
The general rule for a business tax deduction is this: Any ordinary and necessary expenditure of operating the business may be deducted. The word “ordinary” means exactly what you expect: typical, expected, and customary. The word “necessary” again means exactly what you expect: required, relevant, and appropriate.
The bottom-line? The “ordinary and necessary” rule means that a sole proprietor may deduct any ordinary and necessary business expenditure. Similarly, a limited liability company may deduct any ordinary and necessary business expenditure. Anything that’s extraordinary or unnecessary is not deductible. And that lack of deductibility depends not one bit on whether the business or investment is operated as a limited liability company. No difference in tax accounting treatment exists.
Caution: In some cases—typically because many taxpayers have been behaving badly–tax laws may restrict deducting business expenses that are otherwise “ordinary and necessary.” For example, special rules apply to deductions for investment expenses, company vehicles, meals and entertainment expenses, travel, personal computers, cell phones and so forth. However, the general rule still holds. What’s more, the general rule as well as the restrictions apply with equal force to LLCs and non-LLCs.
I often tell new small business owners that they can further understand the “ordinary and necessary” requirement by applying two common sense tests: the “giggle” test and the “employee expense reimbursement” test.
Let me explain the “giggle” test first. Any deduction you want to claim should not be so silly that you will be embarrassed to tell an Internal Revenue Service examiner or your accountant that you have taken the deduction. Similarly, no deduction should trigger snickering or out-loud laughter if shared with business friends or family. Summing up, probably no expenditure qualifies as “ordinary and necessary” if people giggle when they hear about it.
The other useful test that I like to suggest flows from the practice of reimbursing employees for business expenditures. Many of us have worked for large organizations where, if we incur some expenditure on the behalf of the employer, the employer reimburses us for the expenditure.
So here’s the test that falls out of this common practice: Any expenditure that you want to deduct on a business tax return should be the sort of expenditure that an employee might reasonably put down on his or her employee expense reimbursement form. In other words, any expense that you would feel comfortable requesting reimbursement for is probably an ordinary and necessary expense. (By the way, you can think about the reimbursement angle from two points of view: what you would be willing to reimburse an employee for if you’re the employer, and what you might have asked a past employer for when you were an employee.)
When you apply these two rules to the subject of the business tax deductions of a small business, you can pretty clearly see which expenditures represent valid business tax deductions—and which don’t. You can also pretty clearly see that whether the business or investment is operated as an LLC makes no difference.
For example, even if an expense is incurred by a limited liability company, a family trip to Disneyland, the commuting expenses that any employee has, furniture for your vacation cabin, and such similar personal items, are never going to be ordinary and necessary business deductions.