Your employees must adequately account to you for their expenses. They must give you documentary evidence of their travel, mileage, and other employee business expenses. This evidence should include items such as receipts, along with either a statement of expenses, an account book, a diary, or a similar record in which the employee entered each expense at or near the time the expense was incurred.

An excess reimbursement or allowance is any amount you pay to an employee that is more than the business-related expenses for which the employee adequately accounted. The employee must return any excess reimbursement or other expense allowance to you within a reasonable period of time.

A reasonable period of time depends on the facts and circumstances. Generally, actions that take place within the times specified in the following list will be treated as taking place within a reasonable period of time.

You can take a deduction for travel, meals, and entertainment expenses if you reimburse your employees for these expenses under an accountable plan. The amount you deduct for meals and entertainment, however, may be subject to a 50% limit, discussed later. If you are a sole proprietor, deduct the reimbursement on line 24 of Schedule C (Form 1040). If you file a corporation income tax return, include the reimbursement in the amount claimed on the Other decutions line of Form 1120, U.S. Corporation Income Tax Return, or Form 1120–A, U.S. Corporation Short-Form Income Tax Return. If you file any other income tax return, such as a partnership or S corporation return, deduct the reimbursement on the appropriate line of the return as provided in the instructions for that return.

The federal rate can be figured using any one of the following methods.

Your employee is considered to have accounted to you for car expenses that do not exceed the standard mileage rate. For 2003, the standard mileage rate is 36 cents per mile for each business mile.

You can choose to reimburse your employees using a fixed and variable rate (FAVR) allowance. This is an allowance that includes a combination of payments covering fixed and variable costs, such as a cents-per-mile rate to cover your employees' variable operating costs (such as gas, oil, etc.) plus a flat amount to cover your employees' fixed costs (such as depreciation, insurance, etc.). For information on using a FAVR allowance, see Revenue Procedure 2002-61 in Internal Revenue Bulletin 2002-39. You can read Revenue Procedure 2002-61 at many public libraries or online at www.irs.gov.

If your employee actually substantiates to you the other elements (discussed earlier) of the expenses reimbursed using the per diem allowance, how you report and deduct the allowance depends on whether the allowance is for lodging and meal expenses or for meal expenses only and whether the allowance is more than the federal rate.

The regular federal per diem rate is the highest amount the federal government will pay to its employees for lodging, meal, and incidental expenses (or meal and incidental expenses only) while they are traveling away from home in a particular area. The rates are different for different locations. Publication 1542 lists the rates in the continental United States.

Per diem rates are available on the Internet. If you have a computer and a modem, you can access per diem rates at www.policyworks.gov/perdiem.

The federal rate for meal and incidental expense (M & IE) is the standard meal allowance. You may pay an allowance for meal and incidental expenses only if, for example, you reimburse actual lodging expenses or do not reimburse lodging expenses because there are none.

This is a simplified method of computing the federal per diem rate for lodging and meal expenses for traveling within the continental United States. It eliminates the need to keep a current list of the per diem rate in effect for each city in the continental United States.

Under the high-low method, the per diem amount for travel during 2003 is $204 ($45 for M & IE) for certain high-cost locations. All other areas have a per diem amount of $125 ($35 for M & IE). The high-cost locations eligible for the $204 per diem amount under the high-low method are listed in Publication 1542.

The following paragraphs explain how to report per diem and car allowances. The manner in which you report them depends on how the allowance compares to the federal rate.

If your allowance for the employee is less than or equal to the appropriate federal rate, that allowance is not included as part of the employee's pay in box 1 of the employee's Form W–2. Deduct the allowance as travel expenses (including meals that may be subject to the 50% limit, discussed later). See How to deduct under Accountable Plans, earlier.

If your employee's allowance is more than the appropriate federal rate, you must report the allowance as two separate items.

You include the allowance amount up to the federal rate in box 12 (code L) of the employee's Form W–2. Deduct it as travel expenses (as explained above). This part of the allowance is treated as reimbursed under an accountable plan.

You include the amount that is more than the federal rate in box 1 (and in boxes 3 and 5 if they apply) of the employee's Form W–2. Deduct it as wages subject to income tax withholding, social security, Medicare, and federal unemployment taxes. This part of the allowance is treated as reimbursed under a nonaccountable plan as explained later under Nonaccountable Plans.

The 50% deduction limit applies to reimbursements you make to your employees for expenses they incur for meals while traveling away from home on business and for entertaining business customers at your place of business, a restaurant, or another location. It applies to expenses incurred at a business convention or reception, business meeting, or business luncheon at a club. The deduction limit may also apply to meals you furnish on your premises to your employees (discussed in chapter 2).

Taxes and tips relating to a meal or entertainment activity you reimburse to your employee under an accountable plan are included in the amount subject to the 50% limit. Reimbursements you make for expenses, such as cover charges for admission to a nightclub, rent paid for a room to hold a dinner or cocktail party, or the amount you pay for parking at a sports arena, are all subject to the 50% limit. However, the cost of transportation to and from an otherwise allowable business meal or a business-related entertainment activity is not subject to the 50% limit.

If you provide your employees with a per diem allowance (discussed earlier) only for meal and incidental expenses, the amount treated as an expense for food and beverages is the lesser of the following.

If you provide your employees with a per diem allowance that covers lodging, meals, and incidental expenses, you must treat an amount equal to the federal M & IE rate for the area of travel as an expense for food and beverages. If the per diem allowance you provide is less than the federal per diem rate for the area of travel, you can treat 40% of the per diem allowance as the amount for food and beverages.

The 50% limit does not apply to the food or beverages an employer provides on an oil or gas platform or drilling rig located offshore or in Alaska. This exception also applies to food and beverages provided by an employer at a support camp that is near and integral to an oil or gas platform or drilling rig located in Alaska.

You can deduct 65% of the reimbursed meals your employees consume while away from their tax home on business during or incident to any period subject to the Department of Transportation's hours of service limits.

Individuals subject to the Department of Transportation's hours of service limits include the following.

The 50% limit does not apply to an expense for food or beverage that is excluded from the gross income of an employee because it is a de minimis fringe benefit. See Publication 15–B for additional information on de minimis fringe benefits.

You can deduct the cost of food and beverages you provide primarily to your employees on your business premises. This includes the cost of maintaining the facilities for providing the food and beverages. These expenses are subject to the 50% limit unless they qualify as de minimis fringe benefits, discussed in Publication 15–B, or unless they are compensation to your employees and you treat them as provided under a nonaccountable plan, as discussed later.

You can deduct the expense of providing recreational, social, or similar activities (including the use of a facility) for your employees. The benefit must be primarily for your employees who are not highly compensated employees.

For this purpose, a highly compensated employee is an employee who meets either of the following requirements.

These expenses are not subject to the 50% limit. For example, the expenses for food, beverages, and entertainment for a company-wide picnic are not subject to the 50% limit.

If you provide a person who is not your employee with meals, goods, services, or the use of a facility, and the item you provide is considered entertainment, you can deduct the expense only to the extent it is included in the gross income of the recipient as compensation for services or as a prize or award. If you are required to include these expenses on an information return (Form 1099–MISC), you cannot claim a deduction for them unless you file the necessary information return. For more information about when to file Form 1099–MISC, see the General Instructions for Forms 1099, 1098, 5498, and W–2G. These expenses are not subject to the 50% limit.

You can deduct entertainment expenses directly related to business meetings of your employees, partners, stockholders, agents, or directors. You can provide some minor social activities, but the main purpose of the meeting must be your company's business. These expenses are subject to the 50% limit.

You can deduct expenses directly related to and necessary for attending business meetings or conventions of certain exempt organizations. These organizations include business leagues, chambers of commerce, real estate boards, and trade and professional associations. Meal and entertainment expenses are subject to the 50% limit.

You can deduct the cost of providing meals, entertainment, goods and services, or use of facilities you sell to the public. For example, if you run a nightclub, your expense for the entertainment you furnish to your customers, such as a floor show, is a business expense. These expenses are not subject to the 50% limit.

You can deduct the cost of providing meals, entertainment, or recreational facilities to the general public as a means of advertising or promoting goodwill in the community. For example, the expense of sponsoring a television or radio show is deductible. You can also deduct the expense of distributing free food and beverages to the general public. These expenses are not subject to the 50% limit.

The 50% limit does not apply to the expenses covered by a package deal that includes a ticket to a charitable sports event if the event meets certain conditions. See Entertainment tickets in chapter 2 of Publication 463 for a list of the conditions a charitable sports event must meet.

You generally can deduct reasonable advertising expenses if they relate to your business activities. Generally, you cannot deduct the cost of advertising to influence legislation. See Lobbying expenses, later.

You can usually deduct as a business expense the cost of institutional or goodwill advertising to keep your name before the public if it relates to business you reasonably expect to gain in the future. For example, the cost of advertising that encourages people to contribute to the Red Cross, to buy U.S. Savings Bonds, or to participate in similar causes is usually deductible.

You cannot deduct the costs of advertising on foreign radio and television (including cable) where the advertising is primarily for a market in the United States. However, this rule only applies to advertising expenses in countries that deny a deduction for advertising on a United States broadcast primarily for that country's market.

Anticipated liabilities or reserves for anticipated liabilities are not deductible. For example, assume you sold 1-year TV service contracts this year totaling $50,000. From experience, you know you will have expenses of about $15,000 in the coming year for these contracts. You cannot deduct any of the $15,000 this year by charging expenses to a reserve or liability account. You can deduct your expenses only when you actually pay or accrue them, depending on your accounting method.

If you, as a coal mine operator, make a contribution to a qualified black lung benefit trust, you may be able to deduct your contribution. To deduct it, you must make your contribution during the tax year or pay it to the trust by the due date for filing your federal income tax return (including extensions). You must make the contribution in cash or in property the trust is permitted to hold.

Figure your allowable deduction for contributions to a black lung benefit trust on Schedule A of Form 6069.

You cannot deduct bribes, kickbacks, or similar payments if they are either of the following.

A state law is considered generally enforced unless it is never enforced or enforced only for infamous persons or persons whose violations are extraordinarily flagrant. For example, a state law is generally enforced unless proper reporting of a violation of the law results in enforcement only under unusual circumstances.

A kickback includes a payment for referring a client, patient, or customer. The common kickback situation occurs when money or property is given to someone as payment for influencing a third party to purchase from, use the services of, or otherwise deal with the person who pays the kickback. In many cases, the person whose business is being sought or enjoyed by the person who pays the kickback does not know of the payment.

Kickbacks, bribes, and rebates paid in Medicare or Medicaid programs are not deductible.

If you pay kickbacks during your tax year, whether or not they are deductible on your income tax return, you may have to report them on an information return, Form 1099–MISC. For more information about when to file Form 1099–MISC, see the General Instructions for Forms 1099, 1098, 5498, and W–2G.

You can deduct the costs of operating a car, truck, or other vehicle in your business. These costs include gas, oil, repairs, license tags, insurance, and depreciation. Only the expenses for business use are deductible. Traveling between your home and your place of business is usually not business use.

Under certain conditions, you can use the standard mileage rate instead of deducting the actual expenses for your vehicle. The standard mileage rate for the cost of operating your car, van, pickup, or panel truck in 2003 is 36 cents a mile for all business miles. For more information on how to figure your deduction, see Publication 463.

Cash payments to charitable, religious, educational, scientific, or similar organizations may be deductible as business expenses if the payments are not charitable contributions or gifts. If the payments are charitable contributions or gifts, you cannot deduct them as business expenses. However, corporations (other than S corporations) can deduct charitable contributions on their income tax returns. See Charitable Contributions in Publication 542 for more information. Sole proprietors, partners in a partnership, or shareholders in an S corporation may be able to deduct charitable contributions made by their business on Schedule A (Form 1040).

If you contribute inventory (property you sell in the course of your business), the amount you can claim as a contribution deduction is the smaller of its fair market value on the day you contributed it or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that you would otherwise include in your opening inventory for the year of the contribution. You must remove the amount of your contribution deduction from your opening inventory. It is not part of the cost of goods sold.

If the cost of donated property is not included in your opening inventory, the property's basis is zero and you cannot claim a charitable contribution deduction. Treat the property's cost as you would ordinarily treat it under your method of accounting. For example, include the purchase price of inventory bought and donated in the same year in the cost of goods sold for that year.

A corporation (other than an S corporation) can deduct its basis in the property plus one-half of the gain that would have been realized if the property had been sold at its fair market value on the date of contribution. But the deduction cannot be more than twice the property's basis. For more information on the charitable contribution of property by a corporation, see section 170(e)(3) of the Internal Revenue Code.

Generally, you cannot deduct amounts you pay or incur for membership in any club organized for business, pleasure, recreation, or any other social purpose. This includes country clubs, golf and athletic clubs, hotel clubs, sporting clubs, airline clubs, and clubs operated to provide meals under circumstances generally considered to be conducive to business discussions.

None of the following organizations will be treated as a club organized for business, pleasure, recreation, or other social purpose unless one of the main purposes is to conduct entertainment activities for members or their guests or to provide members or their guests with access to entertainment facilities.

Special rules apply to compensation you receive for damages sustained as a result of patent infringement, breach of contract or fiduciary duty, or antitrust violations. You must include this compensation in your income. However, you may be able to take a special deduction. The deduction applies only to amounts recovered for actual injury, not any additional amount. The deduction is the smaller of the following.

You cannot deduct any amount paid or incurred to demolish a structure or any loss for the undepreciated basis of a demolished structure. Add these amounts to the basis of the land where the demolished structure was located.

If property you buy to use in your business has a useful life that extends substantially beyond the year it is placed in service, you generally cannot deduct the entire cost as a business expense in the year you buy it. You must spread the cost over more than one tax year and deduct part of it each year. This method of deducting the cost of business property is called depreciation.

However, you may be able to elect to deduct a limited amount of the cost of certain depreciable property in the year you place it in service in your business. This deduction is known as the section 179 deduction.

For information on depreciation and the section 179 deduction, see Publication 946.

You can deduct donations to business organizations as business expenses if all the following conditions are met.

For example, a donation you make to a committee organized by the Chamber of Commerce to bring a national convention to your city may be deductible.

You can deduct the ordinary and necessary expenses you pay for the education and training of your employees. For more information, see Education Expenses in chapter 2.

You can also deduct your own education expenses (including certain related travel) related to your trade or business. You must be able to show the education maintains or improves skills required in your trade or business, or it is required by your employer, or by law or regulations, for keeping your pay, status, or job.

You cannot deduct education expenses you incur to meet the minimum requirements of your present trade or business, or those that qualify you for a new trade or business. This is true even if the education maintains or improves skills presently required in your business. For more information on education expenses, see Publication 970.

You can deduct certain costs to clean up land and to treat groundwater you contaminated with hazardous waste from your business operations. You can deduct the costs you incur to restore your land and groundwater to the same physical condition that existed prior to contamination. You cannot deduct costs for the construction of groundwater treatment facilities. You must capitalize those costs and you can recover them through depreciation. For more information, see Environmental cleanup costs, in chapter 8.

If you buy a franchise, trademark, or trade name, you can deduct the amount you pay or incur as a business expense only if your payments are part of a series of payments that are:

When determining the term of the transfer agreement, include all renewal options and any other period for which you and the transferrer reasonably expect the agreement to be renewed.

A franchise includes an agreement that gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities within a specified area.

Any amounts you pay or incur that are not described in (1) through (3) must be charged to a capital account. These are section 197 intangibles and are amortized over 15 years. See chapter 9 for more information on amortization.

You can elect to apply this treatment to any franchise, trademark, or trade name acquired after July 25, 1991. This election is binding and cannot be revoked without approval of the IRS.

For a transfer not treated as a sale or exchange of a capital asset, you can deduct a lump-sum payment of an agreed upon principal amount ratably over the shorter of the following.

For a transfer not treated as a sale or exchange of a capital asset, you can deduct, in the year made, a payment that is one of a series of approximately equal payments payable over either of the following.

The above business deductions do not apply to transfers after October 2, 1989, and before August 11, 1993, if the principal sum is over $100,000.

Charge any payment not deductible because of these rules to a capital account. However, you can deduct the payments charged to a capital account over the life of the asset if you can determine the useful life of the asset. Otherwise, you can choose to amortize the payment over a 25-year period beginning with the tax year the transfer occurs.

For contracts to buy a franchise, trademark, or trade name entered into before October 3, 1989, you can deduct payments contingent on productivity, use, or disposition. The rules discussed earlier for annual and substantially equal payments do not apply.

If you transfer, sell, or otherwise dispose of a franchise, trademark, or trade name, you must recapture as ordinary income (up to any gain realized) the payments you deducted as any of the following.

For more information about dispositions of franchises, trademarks, and trade names, see chapter 2 in Publication 544.

If you are disabled, you can deduct expenses necessary for you to be able to work (impairment-related expenses) as a business expense, rather than as a medical expense.

You are disabled if you have either of the following.

You can deduct the expense as a business expense if all the following apply.

Reimbursements you make to job candidates for transportation or other expenses related to interviews for possible employment are not wages. You can deduct the reimbursements as a business expense. However, expenses for food, beverages, and entertainment are subject to the 50% limit discussed earlier under Meals and Entertainment.

Legal and professional fees, such as fees charged by accountants, that are ordinary and necessary expenses directly related to operating your business are deductible as business expenses. However, you usually cannot deduct legal fees you pay to acquire business assets. Add them to the basis of the property.

If the fees include payments for work of a personal nature (such as making a will), you take a business deduction only for the part of the fee related to your business. The personal portion of legal fees for producing or collecting taxable income, doing or keeping your job, or for tax advice may be deductible on Schedule A (Form 1040) if you itemize deductions. See Publication 529.

You can deduct as a trade or business expense the cost of preparing that part of your tax return relating to your business as a sole proprietor. The remaining cost may be deductible on Schedule A (Form 1040) if you itemize deductions.

You can also take a business deduction for the amount you pay or incur in resolving asserted tax deficiencies for your business as a sole proprietor.

Licenses and regulatory fees for your trade or business paid each year to state or local governments generally are deductible. Some licenses and fees may have to be amortized. See chapter 9 for more information.

Generally, you cannot deduct lobbying expenses. Lobbying expenses include amounts paid or incurred for any of the following activities.

Your expenses for influencing legislation and communicating directly with a covered executive branch official include a portion of your labor costs and general and administrative costs of your business. For information on making this allocation, see section 1.162-28 of the regulations.

You cannot take a charitable or business expense deduction for amounts paid to an organization if both the following apply.

If a tax-exempt organization, other than a section 501(c)(3) organization, provides you with a notice on the part of dues that is allocable to nondeductible lobbying and political expenses, you cannot deduct that part of the dues.

For purposes of this discussion, a covered executive branch official is any of the following.

The general denial of the deduction does not apply to the following.

Generally, the cost of moving your machinery from one city to another is a deductible expense. So is the cost of moving machinery from one plant to another, or from one part of your plant to another. You can deduct the cost of installing the machinery in the new location. However, you must capitalize the costs of installing or moving newly purchased machinery.

You can deduct the costs of outplacement services you provide to your employees to help them find new employment, such as career counseling, resumé assistance, skills assessment, etc.

The costs of outplacement services may cover more than one deduction category. For example, deduct as a utilities expense the cost of telephone calls made under this service and deduct as rental expense the cost of renting machinery and equipment for this service.

For information on whether the value of outplacement services is includable in your employees' income, see Publication 15–B.

Penalties you pay for late performance or nonperformance of a contract are generally deductible. For instance, if you contracted to construct a building by a certain date and had to pay an amount for each day the building was not finished after that date, you can deduct the amounts paid or incurred.

On the other hand, you cannot deduct penalties or fines you pay to any government agency or instrumentality because of a violation of any law. These fines or penalties include the following amounts.

Examples of nondeductible penalties and fines include the following.

A fine or penalty does not include any of the following.

You can deduct a nonconformance penalty assessed by the Environmental Protection Agency for failing to meet certain emission standards.

You cannot deduct contributions or gifts to political parties or candidates as business expenses. In addition, you cannot deduct expenses you pay or incur to take part in any political campaign of a candidate for public office.

You cannot deduct indirect political contributions and costs of taking part in political activities as business expenses. Examples of nondeductible expenses include the following.

You can deduct the cost of retiring and removing a depreciable asset in connection with the installation or production of a replacement asset. However, you must capitalize the cost of removing a component of a depreciable asset if the replacement adds to the value or usefulness of the asset or significantly increases its useful life.

The cost of repairing or improving property used in your trade or business is either a deductible or capital expense. You can deduct repairs that keep your property in a normal efficient operating condition, but that do not add to its value or usefulness or appreciably lengthen its life. If the repairs add to the value or usefulness of your property or significantly increase its life, you must capitalize them. Although you cannot deduct capital expenses as current expenses, you can usually deduct them over a period of time as depreciation.

The cost of repairs includes the costs of labor, supplies, and certain other items. You cannot deduct the value of your own labor.

Examples of repairs include the following.

You cannot deduct the cost of repairs you added to the cost of goods sold as a separate business expense.

If you had to repay an amount you included in your income in an earlier year, you may be able to deduct the amount repaid for the year in which you repaid it. Or, if the amount you repaid is more than $3,000, you may be able to take a credit against your tax for the year in which you repaid it.

The type of deduction you are allowed in the year of repayment depends on the type of income you included in the earlier year. For instance, if you repay an amount you previously reported as a capital gain, deduct the repayment as a capital loss on Schedule D (Form 1040). If you reported it as self-employment income, deduct it as a business deduction on Schedule C or Schedule C–EZ (Form 1040) or Schedule F (Form 1040).

If you reported the amount as wages, unemployment compensation, or other nonbusiness ordinary income, enter it on line 22 of Schedule A (Form 1040). However, if the repayment is over $3,000 and Method 1 (discussed later) applies, deduct it on line 27 of Schedule A (Form 1040).

If the amount you repaid was $3,000 or less, deduct it from your income in the year you repaid it.

If the amount you repaid was more than $3,000, you can deduct the repayment, as described earlier. However, you can instead choose to take a tax credit for the year of repayment if you included the income under a claim of right. This means that at the time you included the income, it appeared that you had an unrestricted right to it. If you qualify for this choice, figure your tax under both methods and use the method that results in less tax.

Figure your tax for 2003 claiming a deduction for the repaid amount.

Figure your tax for 2003 claiming a credit for the prepaid amount. Follow these steps.

If Method 1 results in less tax, deduct the amount repaid as discussed earlier under Type of deduction.

If Method 2 results in less tax, claim the credit on line 67 of Form 1040, and write “I.R.C. 1341” next to line 67.

This discussion does not apply to the following.

If you use the cash method of accounting, you can take the deduction (or credit, if applicable) for the tax year in which you actually make the repayment. If you use any other accounting method, you can deduct the repayment or claim a credit for it only for the tax year in which it is a proper deduction under your accounting method. For example, if you use an accrual method, you are entitled to the deduction or credit in the tax year in which the obligation for the repayment accrues.

You can deduct as a business expense subscriptions to professional, technical, and trade journals that deal with your business field.

Unless you have deducted the cost in any earlier year, you generally can deduct the cost of materials and supplies actually consumed and used during the tax year.

If you keep incidental materials and supplies on hand, you can deduct the cost of the incidental materials and supplies you bought during the tax year if all the following requirements are met.

You can also deduct the cost of books, professional instruments, equipment, etc., if you normally use them up within a year. However, if the usefulness of these items extends substantially beyond the year they are placed in service, you generally must recover their costs through depreciation. See Depreciation, earlier.

Your business expenses for heat, lights, power, and telephone service are deductible. However, any part due to personal use is not deductible.

You cannot deduct the cost of basic local telephone service (including any taxes) for the first telephone line you have in your home, even though you have an office in your home. However, charges for business long-distance phone calls on that line, as well as the cost of a second line into your home used exclusively for business, are deductible business expenses.