Tax deduction

Tax deduction is a reduction of income that is able to be taxed, and is commonly a result of expenses, particularly those incurred to produce additional income. The difference between deductions, exemptions and credit is that deductions and exemptions both reduce taxable income, while credits reduce tax.

Tax deductions can be classified into those above the line, which are beneficial to the taxpayer regardless of income, and below the line, which are only valuable to the extent that they exceed the standard deduction amount of the taxpayer, which in 2014 in the U.S., for example, was $6,200 for a single taxpayer.

Often, deductions are subject to conditions, such as being allowed only for expenses incurred that produce current benefits. Capitalization of items producing future benefit can be required, though with some exceptions. A deduction is allowed, for example, on interest paid on student loans. Some systems allow taxpayer deductions for items the influential parties want to encourage as purchases.

Nearly all jurisdictions that tax business income allow deductions for business and trade expenses. Allowances vary, and may be general or restricted. To be deducted, the expenses must be incurred in furthering business, and usually only includes activities undertaken for profit.

Nearly all income tax systems allow a deduction for cost of goods sold. This may be considered an expense, a reduction of gross income, or merely a component utilized in computing net profits. The manner in which cost of goods sold is determined has several inherent complexities, including various accounting methods. These include:

Many systems, including the UK, levy tax on all chargeable “profits of a trade” computed under local generally accepted accounting principles (GAAP). Under this approach, determination of whether an item is deductible depends upon accounting rules and judgments. By contrast, the U.S. allows as a deduction “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business...” subject to qualifications, enhancements, and limitations. A similar approach is followed by Canada, but generally with fewer special rules. Such an approach poses significant definitional issues. Among the definitional issues often addressed are:

Note that under this concept, the same sorts of expenses are generally deductible by business entities and individuals carrying on a trade or business. To the extent such expenses relate to the employment of an individual and are not reimbursed by the employer, the amount may be deductible by the individual.

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