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Earlier this month, Elon Musk announced that he was ending his deal with Twitter. As a result, Musk will pay a $1 billion severance fee — some call it a severance fee — as well as additional expenses.
Predictably, comments about the breakup and the payout started flying on social media shortly after the announcement. Among other things, some have dismissed this high fee as a business expense and called it tax deductible.
From limited liability companies to sole proprietorships to multinational enterprises, taxpayers often believe that business-related expenses are deductible for federal income tax purposes. But despite the many videos doing the rounds on Tik Tok, that is not the case. Here are some expenses that may be considered business expenses but not tax deductible:
Personal expenses
You can’t deduct personal expenses on your tax return, even if the company agrees to pay for them. Giving away a residence or a car in the name of a company is not enough to make the expenses a business expense – and you will be taxed as an offset depending on the type of expense.
Deductibility of business expenses is based on two questions.
- Is this for business?
- Is it ordinary (normal and acceptable in your industry) and necessary (important and appropriate for your trade or business) expense?
The answer to both questions must be yes in order to claim a business-related tax deduction Section 162 of the Tax Code – Assuming no exceptions apply. You can find a discussion of common business expenses in IRS Publication 535.
That is true whether the expenses are paid from an LLC or a corporation, as creating a legal entity does not change the nature of the expenses or make them deductible.
If the expenses are mixed, meaning you use them for both personal and business expenses, you can only deduct the business portion. Always keep good records.
Fines to be paid to the government
It is not always enough to meet the standard and necessary requirements for deduction. Section 162 is very long and includes many exceptions. One of those exceptions—found in Section 162(f)—makes it clear that taxpayers cannot reduce the penalties they pay to the government or government entity for violating any law. That is true even if the penalty is deductible as an ordinary and necessary business expense.
That’s what Musk found out in 2018. According to the SEC report, Mook tweeted that he might take Tesla private when he realized the deal was uncertain. The tweet caused “significant market disruption.” The SEC filed a complaint and eventually agreed with Musk and Tesla to pay a $20 million fine each to distribute to potentially harmed investors.
There is an exculpatory exception: If the penalty is used to compensate for the injury or damage caused by the action, including the improvement of the property, the prohibition on mitigation does not apply under this section.
In Musk’s case, the SEC assumed that exception, and the terms of the settlement provided that the penalty “will be considered a penalty payable to the government for all purposes, including all tax purposes.” In other words, Musk and Tesla will not be allowed any deductions if the money is ultimately used to return it.
Illegal bribes and loans
What about bribes and kickbacks? Those are generally paid to help palm oil or facilitate trade. Depending on your industry, you could argue that those are both trivial and important. However, like penalties, those are specifically disallowed as deductions under section 162(c).
Certain legal damages
My husband, a corporate lawyer, jokes that the American attitude in his work is that everything can be solved with money. That’s why parties to a contract can agree to a settlement if there is a breach — like Musk and Twitter — or after the fact.
In most cases, damages need to be assessed at a reasonable figure—generally sufficient to restore the injured or injured party to their position prior to the breach or to compensate for lost profits or other expenses. These damages are commonly referred to as liquid damages – although the term is much broader.
Typically, these amounts are considered deductible for federal tax purposes if the underlying actions that led to the termination or lawsuit were ordinary and necessary.
By Rev. Rul. 80-211—not used directly or as a condition precedent—the IRS makes clear that damages must be based on facts and circumstances to determine whether a loss meets the criteria in Section 162. This means taxpayers must keep good records. Legal counsel should ensure that any settlements or related agreements clearly address the nature of the damages.
For example, an amount paid as a result of an agreement is not deductible if it is treated as a hidden fine or penalty. Similarly, certain types of damages may be prohibited by statute—section 162(g), for example, limits deductions related to antitrust claims.
Large or complex settlements can address many underlying issues—making deductions challenging. Typically, the more precise the language, the better for the taxpayer.
Political contributions
In the current climate, there is tremendous pressure to fund political causes and candidates. This is true for businesses as well—especially if those contributions can further support your geographic area or industry. Although they seem to be issues. Citizens United Legalizing corporations to write certain types of checks, Section 162(e) generally disallows the deduction for political contributions. That’s an important way: a transaction is allowable but not deductible.
Expensive gifts
I relayed the story of a law firm that often served expensive bottles of champagne to clients—which, while not always good, certainly made a good impression.
But you want to think before you send an expensive gift, and not just how it will be viewed by customers, but how it will be viewed by the IRS. A gift may be a legitimate business expense for the company, but you are limited to a deduction of $25 per person per year.
An interesting note: the law firm will likely go through the gift overnight. Incidental costs such as packaging or shipping are not included in the $25 limit unless they add significant value.
Unpaid business expenses
In the year There is no timetable until 2025 to cut off unpaid business expenses for employees. However, the rules for self-employed and independent contractors have not changed. If you’re self-employed—including as a freelancer or gig worker—you can deduct business-related expenses.
Conclusion
The tax deduction rules are generally the same for all businesses – whether you’re a sole proprietor or the richest person in the world. And whether you’re a business owner, employee, or legal advisor, understanding a few key concepts like “ordinary” and “relevant,” as well as when to ask for help, can help you make sound business and tax decisions.
This is a regular column from Taxgirl Kelly Phillips Erb. Erb provides the latest commentary on tax news, tax law and tax policy. Look for Erb’s weekly column from Bloomberg Tax and follow her on Twitter. @tax girl.
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