Tax Deductible Business Expenses

EMPLOYEE BENEFITS

The cost of providing employees with a wide variety of fringe benefits is considered a tax deductible business expense for employers. Most of these benefits are not considered income for employees, so they receive a tax break as well. Certain types of benefits—particularly retirement and pension plans—are also deductible for self-employed persons and small business owners. However, it is important to keep up with the rapidly changing tax laws regarding these matters. Some of the types of employee benefits that may be considered tax deductible business expenses include: retirement plans, health insurance, disability and life insurance, company cars, membership in clubs and athletic facilities, dependent care assistance, education assistance, employee discounts, and business meals, travel, and lodging.

Retirement and Pension Plans

Small business owners have a wide variety of retirement plans from which to choose in order to gain tax advantages. In most cases, employer contributions are tax-deductible business expenses, and the money is allowed to grow tax-deferred until employees reach retirement age, at which point, it is assumed, they will be in a lower tax bracket than during their working years. The most important thing to remember is that a small business owner who wants to establish a qualified plan for him or herself must also include all other company employees who meet minimum participation standards. As an employer, the small business owner can establish retirement plans like any other business. As an employee, the small business owner can then make contributions to the plan he or she has established in order to set aside tax-deferred funds for retirement, like any other employee. The difference is that a small business owner must include all nonowner employees in any company-sponsored qualified retirement plans and make equivalent contributions to their accounts.

For self-employed individuals, contributions to a retirement plan are based upon the net earnings of their business. The net earnings consist of the company's gross income less deductions for business expenses, salaries paid to nonowner employees, the employer's 50 percent of the Social Security tax, and—significantly—the employer's contribution to retirement plans on behalf of employees. Therefore, rather than receiving pre-tax contributions to the retirement account as a percentage of gross salary, like nonowner employees, the small business owner receives contributions as a smaller percentage of net earnings. Employing other people thus detracts from the owner's ability to build up a sizeable before-tax retirement account of his or her own. For this reason, some experts recommend that the owners of proprietorships and partnerships who sponsor plans for their employees supplement their own retirement funds through a personal after-tax savings plan.

Nevertheless, many small businesses sponsor retirement plans in order to gain tax advantages and increase the loyalty of employees. A number of different types of plans are available. In nearly every case, withdrawals made before the age of 59 1/2 are subject to an IRS penalty in addition to ordinary income tax. The plans differ in terms of administrative costs, eligibility requirements, employee participation, degree of discretion in making contributions, and amount of allowable contributions.

Health Insurance

Health insurance benefits provided to employees are also tax deductible. However, self-employed persons are only able to deduct a portion of their own payments for health insurance (40 percent in 1997, gradually increasing to 80 percent in 2006). An exception to this rule is included under Section 105 of the Internal Revenue Code. This loophole allows a small business owner whose spouse works in the business to fully deduct his or her health insurance and unreimbursed medical expenses by creating a medical reimbursement plan for employees. The spouse is then covered under the plan, the small business owner is covered under his or her spouse's insurance, and the entire bill is a tax-deductible business expense. Many tax professionals and insurance providers offer this sort of plan to their clients. It is important to note, however, that the same plan must be available to all of the business's employees.

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