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Apparently actor Nicolas Cage can’t, at least according to the IRS. Cage is accused of wrongly deducting more than three million dollars in personal expenses—including meals, gifts, travel, and even his private jet!

Some of Cage’s disputed deductions were claimed on his personal tax return, others on the return for his business, Saturn Productions. The IRS also considered the disallowed Saturn Productions deductions to be salary and dividends to Cage, and therefore taxable on his personal return.

All told, the IRS claims that he owes nearly two million dollars in taxes and penalties. Cage’s business manager claims that the expenditures are deductible business expenses because they are customary in the entertainment industry.

Who’s right? If you’re not always sure of the difference between personal and business expenses, it seems you’re in good company. It can be difficult for many taxpayers, including Nicolas Cage and his advisors, to distinguish between personal and business.

The General Rule for Business Expenses
Business expenses are deductible for federal income tax purposes, whether you are an employee or you operate your own business. Personal expenses are not deductible—unless, of course, there is a specific provision in the tax code, such as the provisions for itemized deductions reported on an individual income tax return.

As a result, for federal income tax purposes, you are allowed to deduct the ordinary and necessary expenses (but not capital expenditures) that you incur during the year in carrying on your trade or business. This general rule applies to individuals, partnerships, corporations, trusts, and estates.

bullet graphic: green arrow  Ordinary and necessary—The IRS evaluates “ordinary and necessary” based on the specific facts and circumstances of each case. Ordinary expenses are those “common and accepted in your trade, business, or profession.” Necessary expenses are “appropriate and helpful to your business. An expense does not have to be required to be considered necessary.”

bullet graphic: green arrow  Expenses—Expenditures that do not significantly add to the value of an asset, extend its useful life, or adapt it to a new use are expenses. An expenditure that does add value, extend life, or adapt use, is a capital expenditure. Rather than deducting the expenditure in the year incurred, you deduct it over the asset’s life through depreciation, amortization, or depletion.

bullet graphic: green arrow  Trade or business—To establish the business relationship of the expenditures, they should be incurred with regard to an “activity carried on for a livelihood or for profit.” In other words, there must be some form of economic activity conducted and a profit motive.

At times, it may be necessary to allocate expenditures that relate to both personal and business use—for example, a car that is used for business travel during the workweek and for family trips on the weekends.

Eligible Deductions for Employees
As an employee, you can deduct reasonable work-related expenses as miscellaneous itemized deductions on your federal income tax return to the extent the expenses are not reimbursed by your employer. Not surprisingly, you must keep all receipts or other records necessary to support the business expenses that you deduct.

Typical expenses that you may be able to deduct include the following:

bullet graphic: green arrow  Travel expenses—including food and lodging, entertainment, and gifts—when your work requires you to be away from your tax home for more than a day

bullet graphic: green arrow  Local transportation that involves travel between workplaces (The cost of commuting from home to work is not deductible.)

bullet graphic: green arrow  Dues to professional or business organizations and subscriptions to professional and trade publications

bullet graphic: green arrow  Union dues and expenses

bullet graphic: green arrow  Uniforms or other work clothes that are required for work and are not suitable for other wear

bullet graphic: green arrow  Work-related educational expenses

bullet graphic: green arrow  Tools and any supplies necessary for your work

bullet graphic: green arrow  Job-related legal fees

bullet graphic: green arrow  Job search expenses, if the job search is related to your current occupation

bullet graphic: green arrow  Home office expenses if the space is used regularly and exclusively for work

If you are reimbursed by your employer or given an advance to cover your business expenses, you may have to report the payments from your employer as income and separately deduct the expenses on your tax return. However, if your employer’s reimbursement policy requires all of the following, you do not have to report the income and deductions on your tax return:

bullet graphic: green arrow  The expenses for which you request reimbursement must be deductible and have been incurred while you were performing services as an employee.

bullet graphic: green arrow  You must adequately account for such expenses within a reasonable period of time.

bullet graphic: green arrow  Any excess reimbursements or advances must be returned within a reasonable period of time.

Eligible Deductions for Businesses
Businesses—whether sole proprietorships, partnerships, or corporations—can deduct the ordinary and necessary expenses required to conduct their operations.

Nicolas Cage’s business, and many others, run into trouble with the IRS if they deduct expenses that are not considered to be ordinary and necessary for the industry in which they operate. They are also subject to IRS challenge if they appear to deduct expenditures that might be considered payments for the personal expenses of owners, partners, shareholders, or employees ― or their family members. For example, reasonable travel costs for attending an important business conference in Orlando are deductible as business expenses, but the related travel costs for a spouse and child who plan to visit Disney World during the conference are not.

Payments made by a business to cover personal expenses should generally be deducted as compensation by the business, and recognized as income by the person on whose behalf they were paid—in this case, Nicolas Cage.