Deductions are expenses that reduce the amount of income that is subject to taxation. The government has determined that certain expenditures should not be taxed, so it allows taxpayers to remove those expenses from their taxable income calculations.
For example, a taxpayer can deduct the cost of a meal from their overall income calculation if that meal were purchased for business entertainment purposes. If the taxpayer purchased the same meal for himself and a friend, however, the meal would not be deductible. This is because the government has decided to encourage business expenditures, but not ordinary social encounters.
When a person begins doing their taxes, they first calculate their gross income. This is the total amount of income that the taxpayer received during the year, minus a few tax-exempt items. From there, the taxpayer can remove a few more expenses from their gross income figure to arrive at their adjusted gross income.
Taxpayers can then elect to claim either the standard deduction or list individual deductions. Most of the time, this decision rests on whether the standard deduction is larger than the individual deductions. (See FindLaw's article Who Should Itemize? for more information.) These individual deductions are known as “itemized deductions” because each item is listed separately.
There are many, many things that taxpayers can include in the list of itemized deductions, including medical expenses, charitable contributions, business travel and entertainment expenses, and educational expenses. (For a more comprehensive list, see IRS Tax Topic 500.) If a taxpayer’s adjusted gross income is above a certain amount, however, the total amount of deductions must be reduced. To learn more about the formula used to calculate the reduction, see 26 U.S.C. 68.
It is important to note the difference between an itemized deduction and a tax credit. A deduction reduces the amount of income subject to tax – the taxpayer’s “taxable income.” A tax credit, on the other hand, reduces the amount of tax that the taxpayer owes – even after deductions have been factored in.