Deductions Your Small Business Shouldn't Miss
It's very simple: the more tax deductions your business can legitimately take, the lower its taxable profit will be. And in addition to putting more money into your pocket at the end of the year, the tax code provisions that govern deductions may also yield a personal benefit: a nice car to drive at a small cost, or a combination business trip and vacation. It all depends on paying careful attention to IRS rules on just what is, and isn't, deductible.
When you're toting up your business's expenses at the end of the year, don't overlook these 14 common business deductions.
1. Auto Expenses
Operating a car is expensive. The good news is that if you use your car for business, or your business owns its own vehicle, you can deduct some of the costs of keeping it on the road. Mastering the rules of car expense deductions can be tricky, but well worth your while.
There are two methods of claiming expenses: You can either keep track of and deduct all your actual business-related expenses, or simply deduct a certain amount (36.5 cents in 2002 and 36 cents in 2003) for each business mile driven. As a rule, if you use a newer car primarily for business, the actual expense method provides a larger deduction at tax time.
If you use the actual expense method, you can also deduct depreciation on the vehicle. For the tax year 2002, the tax code allows a maximum depreciation deduction of $3,060 for the first year a vehicle is used in a business.
If your auto is used for both business and pleasure, only the business portion produces a tax deduction. That means you must keep track of just how the vehicle is used, and add it all up at the end of the year. Certainly, if you own just one car or truck, no IRS auditor will let you get away with claiming that 100% of its use is business related.
2. Expenses of Going Into Business
Once you're running a business, expenses such as advertising, utilities, office supplies and repairs can be deducted as business expenses. But not so before you open your doors for business. The costs of getting a business started are capital expenses, which must be deducted over the first five years you are in business.
Tip: If you expect your business to make a profit immediately, you may be able to work around this rule by delaying paying some bills until after you're in business, or by doing a small amount of business just to get officially started. But if, like many businesses, you will suffer losses during the first few years of operation, you might be better off taking the deduction over five years, so you'll have some profits to offset.
3. Education Expenses
You can deduct education expenses if they are related to your current business, trade or occupation, but you must follow strict rules. The expense must be to maintain or improve skills required in your present employment, or be required by your employer or as a legal requirement of your job. The cost of education that qualifies you for a new job isn't deductible.
4. Legal and Professional Fees
Fees you pay lawyers, tax professionals or consultants generally can be deducted in the year incurred. But if the work clearly relates to future years, they must be deducted over the life of the benefit.
5. Bad Debts
If someone stiffs your business, the bad debt may or may not be deductible -- it depends on the kind of product your business sells.
If your business sells goods, you can deduct the cost of goods that you sell but aren't paid for.
If, however, your business provides services, no deduction is allowed for time you devoted to a client or customer who doesn't pay. The rationale behind this rule is that it would be too easy for businesses to inflate bills and claim large deductions for bad debts.
6. Business Entertaining
If you pick up the tab for entertaining present or prospective customers, you may deduct 50% of the cost if it is either:
- "directly related" to the business, and business is discussed
-- for example, a catered meeting at your office; or
- "associated with" the business, and the entertainment takes place immediately before or after a business discussion.
Tip: On the receipt or bill, always make a note of the specific business purpose -- for example, "Lunch with Joyce Slater of Ace Manufacturing Co. to discuss widget contract."
When you travel for business, you can deduct many expenses, including the cost of plane fare, costs of operating your car, taxis, lodging, meals, shipping business materials, clothes cleaning, telephone calls, faxes and tips.
What about combining business and pleasure? It's okay, as long as business is the primary purpose of the trip. But if you take your family along, you can deduct only your own expenses, just as if you had traveled alone.
8. New Equipment
Some small businesses (those that spend less than $219,000 per year on depreciable items) can write off the full cost of some assets in the year they buy them, rather than "capitalizing" them -- deducting their cost over a number of years (see Current vs. Capitalized Expenses for information on expenses that need to be capitalized). Section 179 of the Internal Revenue Code allows you to deduct up to $24,000 of newly purchased equipment in 2002 and $25,000 in 2003. Some assets don't qualify for this § 179 deduction, including real estate, inventory bought for resale and property bought from a close relative.
If, like many folks, you use credit to finance business purchases, the interest and carrying charges are fully tax-deductible. The same is true if you take out a personal loan and use the proceeds for your business. But be sure to keep good records showing that the money was really put into your business. Otherwise, if you're audited later, the interest expense deduction could be disallowed because it's considered a personal expense.
10. Moving Expenses
If you move because of your business or job, you may be able to deduct certain moving costs that would otherwise be non-deductible personal living expenses. To qualify, you must have moved in connection with your business (or job, if you're an employee of your own corporation or someone else's business). The new workplace must be at least 50 miles farther from your old home than your old workplace was. (Technically, moving expenses aren't business expenses; there's a special place to list them on your Form 1040 tax return.)
As a general rule, software bought for business use must be depreciated over a 36-month period. But there are three important exceptions:
- Software with a useful life of less than a year -- and given the rapid change in technology, this could apply to a lot of programs -- can be deducted as a business expense in the year you buy it.
- When software comes with a computer, and its cost is not separately stated, it's treated as part of the hardware and is depreciated over five years.
- You can write off a whole computer system, including bundled software, in the first year (under a special provision, IRC § 179) if the total cost is less than a certain amount ($24,000 in 2002; $25,000 in 2003).
12. Charitable Contributions
If your business is a partnership, limited liability company or S corporation (a corporation that has chosen to be taxed like a partnership), your business can make a charitable contribution and pass the deduction through to you, to claim on your individual tax return. If you own a regular (C) corporation, the corporation can deduct the charitable contributions.
Tip: If you've got some old computers or office furniture, giving it to a school or nonprofit organization can yield goodwill plus a tax benefit. But if the equipment has been fully depreciated (written off), you can't claim a deduction.
Taxes incurred in operating your business are generally deductible. How and when they are deducted depends on the type of tax.
- Sales tax on items you buy for your business's day-to-day operations is deductible as part of the cost of the items; it's not deducted separately. But tax on a big business asset, such as a car, must be added to the car's cost basis; it isn't all deductible in the year the car was bought.
- Excise and fuel taxes are separately deductible expenses.
If your business pays employment taxes, the employer's share is deductible as a business expense. Self-employment tax is paid by individuals, not their businesses, and so isn't a business expense.
- Federal income tax paid on business income is never deductible. State income tax can be deducted on your personal return as an itemized deduction, not as a business expense.
- Real estate tax on property used for business is deductible, along with any special local assessments for repairs or maintenance. If the assessment is for an improvement -- for example, to build a sidewalk -- it isn't immediately deductible; instead, it is deducted over a period of years.
14. Advertising and Promotion
The cost of ordinary advertising of your goods or services -- business cards, yellow page ads and so on -- is deductible as a current expense. Promotional costs that create business goodwill -- for example, sponsoring a peewee football team -- are also deductible as long as there is a clear connection between the sponsorship and your business. For example, naming the team the "Southwest Auto Parts Blues" or listing the business name in the program is evidence of the promotion effort.