THE GRAY AREA
When we are onboarding clients, we often hear that they “want to take advantage of the gray area of the tax law”. So, what is this mythical gray area?
While voluminous, the tax code does not speak to every single deduction one can have. Some deductible things are spelled out clearly like wages, retirement, and other items. Some items are prohibited like country club dues. The gray area exists where the code has not addressed a specific situation.
Does this mean a taxpayer can simply deduct anything and everything that falls into this gray area? It does not and the IRS accounts for this in Code Section 162. This section states that any deduction must be “ordinary and necessary” to the operations of a business.
This code section essentially puts the burden on the taxpayer to demonstrate that any deduction meets the “ordinary and necessary” standard.
While many tax newsletters make several claims of the deductibility of many expenses like children on the payroll, home office, automobile, and The Augusta Rule, they often leave out that ultimately these expenses must pass the Section 162 standard.
This is not to say that some of these deductions that are advocated by the newsletters can’t be justified. The key is to know what your justification is for these expenses and be reasonable in your usage of these deductions. For example, paying a newborn child $13,850 to be a model for your office sounds great, but is it ordinary and necessary? Do you typically hire models in your business or are you simply shifting income to a lower tax rate. Contrast this to paying an older child the same wage to do various things around the office. The newborn would almost certainly get disallowed in an audit and the older child would likely be allowed with no issue.
Look, we get that no one wants to pay any more in taxes, but as tax preparers we always want to give our clients a full understanding of any deduction that they want to take and look at the pros and also the potential pitfalls so they can make the best choice for them.