Tax deductible expenses are almost any "ordinary, necessary, and reasonable" expenses that help to earn business income. Deductible expenses are those that can be subtracted from a company's income before it is subject to taxation. When it comes to what exactly is meant by ordinary, necessary, and reasonable expenses, the Internal Revenue Service (IRS) has defined these as any expenses that are "helpful and appropriate" for a business. The standard business deductions—which include general and administrative expenses, business-related travel and entertainment, automobile expenses, and employee benefits—are outlined in Section 162 of the Internal Revenue Code. Some expenses are considered "current" and are deducted in the year that they are paid, while others are considered "capitalized" and must be spread out or depreciated over time. There are a few business expenses that are specifically prohibited by law from being deductible, even though they may be used by the business to earn income. These include such things as a bribe paid to a public official, traffic tickets, the clothing one wears for work unless they are a required uniform, and expenditures deemed to be unreasonably large (like a corporate jet for a small retail business to use in visiting a few suppliers).
Good management of a business must include efficient management of the company's tax liabilities, maximizing the deductions and minimizing the obligations within the boundaries of the law. Taking advantage of allowable tax deductions can benefit to small business owners in many ways. "Knowing how to maximize your deductible business expenses lowers your taxable profit," noted Frederick W. Dailey in his book, Tax Savvy for Small Business. "To boot, you may enjoy a personal benefit from a business expenditure—a nice car to drive, a combination business trip/vacation and a retirement savings plan—if you follow the myriad of tax rules." Solid record-keeping is vital for small businesses that hope to claim their allowable tax credits and deductions. After all, deductions can be disallowed for even legitimate business expenditures if those expenditures are not adequately supported by business records. Some of the major categories of tax deductible business expenses are described below:
GENERAL AND ADMINISTRATIVE EXPENSES
All of the basic expenses necessary to run a business are generally tax-deductible, including office rent, salaries, equipment and supplies, telephone and utility costs, legal and accounting services, professional dues, and subscriptions to business publications. Education expenses are deductible if they are necessary to improve or maintain the skills involved in one's present employment or are required by an employer. However, education costs cannot be deducted when they are incurred in order to qualify for a different job. Some other miscellaneous expenses that may be deductible in this category include computer software, charitable contributions, repairs and improvements to business property, bank service charges, consultant fees, postage, and online services.
In most cases, general and administrative business expenses are deductible in the year in which they are incurred. An exception applies to the costs of starting a business, costs that may be incurred prior to beginning operations. These expenses must be capitalized over five years, which may seem strange since they are deductible immediately once the business is open. Depreciating the costs of starting a business might be preferable if the business is expected to show a loss for the first year or two. Otherwise, it may be possible to avoid the need to capitalize these expenses by delaying payment on invoices until the business opens or by doing a trivial amount of business during the startup period.
Home Office Deduction
The use of part of a home as a business office may enable an individual to qualify for significant tax deductions. The "home office deduction" allows individuals who meet certain criteria to deduct a portion of mortgage interest or rent, depreciation of the space used as an office, utility bills, home insurance costs, and cleaning, repairs, and security costs from their federal income taxes. Although IRS has established strict regulations about who qualifies for the deduction, about 1.6 million people claim the deduction each year. The savings that this deduction enables can be considerable, as much as $3,000 annually for a sole proprietor living in a home valued at $150,000.
Home office operators may claim a deduction for those offices on IRS Form 8829 (Expenses for Business Use of Your Home), which is filed along with Schedule C (Profit or Loss From Your Business). There are restrictions, however, which are covered in IRS Publication 587 (Business Use of Your Home). The restrictions were eased somewhat with the passage of the Taxpayer Relief Act of 1997, which will take effect beginning with returns filed in 2000.
In general, a home office deduction is allowed if the home office meets at least one of three criteria: 1) the home office is the principal place of business; 2) the home office is the place where the business owner meets with clients and customers as part of the normal business day; or 3) the place of business is a separate structure on the property, but is not attached to the house or residence. The 1997 changes expanded the definition of "principal place of business" to include a place that is used by the taxpayer for administrative or management activities of the business, provided there is no other fixed location where these activities take place.
The deduction is figured on the size of the home office as a percentage of the total house or residence. For example, if the total house size is 2,400 square feet and the home office is 240 square feet, 10 percent of the total house is considered used for business. That would allow the business owner to deduct 10 percent of the household's costs for electricity, real estate taxes, mortgage interest, insurance, repairs, etc. as business expenses. The total amount of the deduction is limited to the gross income derived from the business activity, less other business expenses. In other words, the home office deduction cannot be used to make an otherwise profitable business show a loss.
Most people have occasion to drive a car while conducting business. Business-related automobile mileage is tax deductible, with the exception of commuting to and from work. Any other mileage from the place of business to another location can be considered a business expense as long as the travel was made for business purposes. The IRS allows the mileage deduction to be calculated using two different approaches. The straight-mileage approach multiplies the cents-per-mile allowed by the IRS (40.5 cents in 2006) by the number of miles attributable to business use of the automobile. For example, a small business owner who drove 1,000 miles at .405 per mile would gain a deduction of $405.
In contrast, the actual-expense approach adds up all the costs of operating the car for a year—such as gasoline, insurance, maintenance, and depreciation—and multiplies that total by the percentage of the annual mileage that was attributable to business purposes. For example, a small business owner who paid a total of $3,000 in operating costs and drove a total of 15,000 miles, only 1,500 of which were business-related, would gain a deduction of $3,000 × .10 or $300. Businesses are required to use the actual-expense approach under certain circumstances—if the vehicle is leased, if more than one vehicle is used for the business, or if the approach was used for that vehicle during its first year of service—but otherwise can choose the approach that yields the larger deduction. In either case, it is necessary to maintain an accurate log of business mileage and associated automobile expenses.
ENTERTAINMENT AND TRAVEL
Reasonable travel and entertainment costs are tax deductible if they are: 1) directly related to business, meaning that business took place or was discussed during the entertainment; or 2) associated with business, meaning that business took place or was discussed immediately before or after the entertainment (i.e., a small business owner took a client out to dinner or to a sporting event following a meeting). Because they include a personal element, only 50 percent of meals and entertainment expenses are deductible as business expenses. Business-related travel, however, is fully deductible.
Careful records are necessary to substantiate the deductions. For business-related meals and entertainment, these records should include the amount, place, date, reason for entertainment, nature of business discussion, and name and occupation of the person being entertained. It is not necessary to retain receipts for expenditures less than $75. Entertainment that is done within the home is also deductible in some cases. Company parties that involve all employees are 100 percent deductible, although they must be infrequent and not overly extravagant. In addition, gifts to clients and customers are deductible to amaximum of $25 per year, or $400 if the business name is imprinted on them.
The costs of reasonable and necessary business travel—including meetings with clients and suppliers as well as conferences and seminars intended to expand a business person's expertise—are fully deductible as business expenses. The costs that can be deducted include airfare, bus or train fare, car rental, and taxi fare, hotels and meals, and incidentals such as tips and dry cleaning expenses. Restrictions apply to travel in foreign countries or on cruise ships. In addition, travel to investment-related seminars are not deductible, though the cost of the seminars may be. A variety of rules apply to deducting business travel expenses, so it is necessary to review them in detail or enlist the help of a tax professional.
According to Section 179 of the Internal Revenue Code, small business owners can write off the first $18,000 of equipment purchased for business use each year during the year in which it was purchased. In many cases, it makes sense to take advantage of this tax break immediately, particularly if purchases will be fairly regular from year to year. If the item is a one-time purchase or if the total amount spent is greater than the limit, however, the business owner may wish to depreciate the cost over future time periods. Depreciation is a tax-deductible business expense.
Depreciation for tax purposes is determined by an IRS formula and has nothing to do with the actual value of equipment at year end. Instead, the amount claimed as depreciation is designed to spread the cost of the equipment over time and maximize the annual tax deductions associated with it. Most companies use a straight-line depreciation method for their financial statements, because the even amounts approximate the rate at which the equipment is used up and will need to be replaced. However, they tend to use accelerated depreciation methods for tax purposes in order to deduct a larger portion of the equipment's cost sooner. The IRS applies different "life spans" to different types of equipment for the purposes of depreciation. For example, it applies a five-year life to telecommunications equipment and automobiles, and a seven-year life to computers and office equipment like desks, chairs, and fixtures.
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 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.
Carter, Gary W. Small Business Tax Secrets: Ultimate Tax Savings for the Self-Employed!. John Wiley & Sons, March 2003.
Cash, L. Stephen, and Thomas L. Dickens. "New Home Office Rule Applies for 2000 Filing Season." Strategic Finance. February 2000.
Dailey, Frederick W. Tax Savvy for Small Business. Ninth Edition. Nolo Press, 2005.
Ennico, Cliff. "Preparing Your IRS Forms 1099 and W-2." Entrepreneur.com. 27 January 2003.
Fink, Philip R. "Individuals and Small Business Tax Planning Guide." The Tax Adviser. September 2005.
U.S. Department of Treasury. Internal Revenue Service. "Business Expenses." Publication 535. 2005.
U.S. Department of Treasury. Internal Revenue Service. "Forms and Instruction." Available from http://www.irs.gov/formspubs/lists/0,id=97817,00.html. Retrieved on 17 May 2006.