What is the Allocation of Deductions?
The allocation of deductions involves the apportioning of deductible costs to different time periods, tax entities, or cost centers based on how much they have been used or how beneficial they are to earning income. Doing so helps to meet tax laws and accounting standards by ensuring that deductions are not claimed outside their corresponding period. Depending on the type of expense and tax laws, a business might have its own accounting practices that determine the method of allocation.
Purpose of Allocation of Deductions
It prevents informed businesses and individuals from running afoul of the law by claiming the tax benefits that they are not entitled to due to incorrect expense allocation. This can also prevent wasting money through overreporting or underreporting of deductions by ensuring there is no error in tax filing.
How is the Allocation of Deductions Calculated?
To allocate deductions, businesses determine the relevant expense (e.g., rent, utilities, or interest) and its relevance to various sources of income or tax periods. The allocation steps include:
- Identify incurred total expenses (rent, interest).
- Determine how much of the expense each department, project, or income source gets.
- Allocate depending on benefit or usage.
- Ensure accuracy in the allocation to reflect the actual benefit received.
Breakdown of Deduction Allocation in Various Situations
Allocation of Business Expenses: Rent and utilities expenses for a company running in many states could be allocated according to the income taxation in each state.
Allocation of Interest Expense: The loan interest that has been spent on a number of different projects would be allocable based on how much had been spent on the two projects, respectively. E.g. 60% for Project A, 40% for Project B.
Depreciation Allocation: Allocable depreciation is needed on a vehicle that is used exclusively for business and personal purposes.
Allocation of Shared Costs: Office rent can be apportioned to each department based on the proportion of space occupied (30% of the rent to the department that occupies 30% of the office space.)
Significance of the Allocation of Deductions
Through proper division and allocating business expenses, an individual or business is able to be more organized and efficient in every aspect of their finances.
- Fulfill impressions of tax authorities: This helps in meeting business compliance with taxation laws, which helps businesses and individuals avoid penalties for having mismatched or unqualified tax returns.
- Properly reflect costs: This enables both businesses and individuals to balance the expenses undertaken to earn an income accurately, leading to better quality financial statements as well as tax returns.
- Prevent tax issues: This helps prevent the chances of missing or being deducted from taxes by taking over generous estimations when calculating taxable income.