Most people dread tax season when April 15th comes rolling around, but I actually get excited and almost giddy.
The reason is not because I enjoy filling out paperwork and paying the government large sums of money, but because it’s only during tax time that I fully realize how large of a tax deduction I can take on my business expenses every single year.
Most people get caught up on the sidelines doing research and debating whether their business idea even has a chance, but they are missing the point.
They don’t realize how much money can be saved by having a small business even if it initially doesn’t make any money at all.
Enjoy this guide which will teach you what business expenses you can deduct and what you can not.
Small Business Startup Guide
When you don’t have a small business, the government is truly ripping you off. All of your earnings get taxed as ordinary income (up to 39%) before you are even allowed to spend it.
With a small business however, you get to spend your money first and only get taxed on what is left over.
The best part is that even if your business is losing money on paper, you can pass these paper losses from your business directly to lower your own taxable income! Either way, your net worth benefits whether you are profitable or not.
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What Expenses Are Deductible?
The IRS states that any “ordinary and necessary” business expenses can be subtracted from your business income prior to being to taxed. For our online wedding linens business, this includes computers, office equipment, machinery, office supplies, utilities and much more.
In addition, by planning our vacations around our business trips, we save a lot by deducting travel and entertainment expenses as well. The general rule is that as long as the expense is made for business and not personal purposes, you can deduct it from your business income.
Small Business Deduction Guidelines
Naturally, the government imposes many rules and regulations over how and what can be deducted on your tax return. Otherwise, small businesses would abuse these deductions all over the place.
I’ve put together a mini small business tax deduction guide below along with an outline of the most commonly taken small business writeoffs.
Disclaimer: I’m not an accountant or a tax lawyer. Any information provided in this article should be used as a guideline only and not taken as fact. Tax rules change all of the time and you should check with the IRS before taking any deductions with your business.
The Tax Code
The tax code is a little bit vague which is why many people get themselves into trouble. A deductible business expense is defined as any expense that is ordinary and necessary for the business and not extravagant.
The expense must also be primarily used for business and not for personal reasons. While it is up to you to interpret the above statement, its best to always err on being conservative.
For example, if I owned a delivery business, I probably wouldn’t want to try and write off a Ferrari as the company car.
For all of your expenses, use common sense and always be able to justify your deductions. Keep good documentation of all of your purchases.
Common Writeoffs for Small Businesses
While there are many items that you can deduct off of your taxes, here are some of the big ticket items that will save you the most on your taxes. Depending on your business, some of these may not apply.
Disclaimer: Once again, keep in mind that I am not a tax professional and that you should consult your own accountant for the specific rules that may apply to you or the area that you live in.
How To Deduct Your Vehicle On Your Taxes
Deducting your vehicle as a business expense is a bit tricky but well worth it, especially if you’re putting a lot of miles on your car. The number one rule of thumb when expensing your vehicle is to keep detailed records.
Make sure you use a trip or mileage log and write down each and every mile that you are using the car for business. This sounds like a major pain, but it’s not too bad if you keep a log book and pen in your car at all times. There are also many smartphone apps that do this for you
Whenever you drive somewhere, just write down your starting and ending odometer value for all business related travel. (Note: This only applies to the mileage method)
There are 2 main ways to deduct your car, the mileage method or the actual expense method.
The Mileage Method
This is the simplest way to deduct the use of your car. Simply take the number of miles that you’ve driven for business at the end of the year and multiply this number by the per mile deduction amount specified by the government.
Add in additional expenses such as parking and tolls and you’re done! Using this method is advisable when you’re using an older vehicle that isn’t worth very much money or if you drive a super fuel efficient car such as a hybrid.
Actual Expense Method
With newer vehicles, you can almost always deduct more with the actual expense method. Below is how you calculate your deduction using the actual expense method.
- Add up all of your vehicle related expenses including gas, repairs, insurance and registration etc…
- Add a depreciation deduction. There are different ways of depreciating your vehicle which will be covered in a later post. If you are leasing your vehicle, you don’t have to worry about this at all. Go ahead and deduct the value of your lease payments.
- Calculate the percentage of time you are using your vehicle for business. You can do this by simply dividing the number of business miles driven by the total number of miles driven for a given year.
- Multiply this percentage by the sum of expenses and use this as your deduction!
Before deducting any portion of your vehicle, make sure you check the IRS for the latest rules. There are changes every single year so make sure that the rules that you apply still work based on the present year and locale.
You can always switch from the mileage method to the actual expense method at any time, but not the other way around. In the beginning, you should do the calculations for both and choose which one gives you the greater deduction.
As with all taxes, bookkeeping is key. As long as you log all of your miles and destinations, you should have no problem justifying your deductions.
How To Deduct Your Home Office
In order to deduct your home office, your business must follow the following rules.
- Your home must be your principal place of business. This means is that you conduct all of your business related activities in your home and you have no other set locations where you do business
- You must have a special area sectioned off for your business. This might be a separate room or the garage. Anywhere that you store inventory or products counts as well.
- You must actually conduct business at home and use the dedicated space solely for business. This one sounds like a no brainer, but this is to prevent people from setting up a fake office and taking it as a deduction. What this also means is that you should remove the bed and dressers from the room as well.
If you meet the above rules, the way you handle the deduction depends on whether you own or rent your home.
Deducting a Rental
Deducting a home office for renters is the simplest case to deal with. Simply calculate the percentage of space that your business occupies and multiply this by the amount of rent that you pay each year.
Also, don’t forget to include your utilities and insurance policies as well.
Deducting a Home That You Own
When you actually own your own home, things start to get a bit more complicated and the tax rules aren’t nearly as advantageous as when you rent. Below are steps you must follow to claim your home office deduction.
- Calculate the percentage of space that your business occupies.
- Calculate the cost of your house itself. You’ll need to separate out the cost of the house versus the cost of the land. Unfortunately, in many cases, the value of your land greatly trumps the value of your house
- Calculate all of the expenses relating to utilities, repairs, taxes and insurance.
- Add up items 2 and 3 above and multiply this by the percentage calculated in item 1.
- Add the depreciation amount applicable to your house. Check the IRS and figure out what the depreciation rules are for your house. This isn’t that complicated, but you should check with your accountant just to make sure how to do it properly since it changes from year to year.
- Add in any expenses that we done directly to your home office and not to the rest of the house. This includes decorations and furnishings.
The main disadvantage of running your business out of a home that you own is that you’ll have to pay taxes on the amount you’ve depreciated on your house when it comes time to sell your home.
For example, if your house is worth 100k and you depreciated it 10k. When you sell your house, you’ll need to pay taxes on the gain from what you sold it for minus 90k.
How To Deduct Equipment And Supplies
The biggest advantage for small businesses is a little Internal Revenue Code known as Section 179. Section 179 allows small businesses to deduct up to 1 million dollars(Note: This number changes every year) of assets completely every year.
What this means is that you can deduct up to this amount in business equipment, computers, furniture etc… without having to worry about depreciation or other tax calculations. Of course, section 179 comes with a few requirements that must be met.
Purchases must be used mostly for business
The official rule is that the asset that you are deducting must be used for at 50% or more for business. Let’s say for example that you are trying to write off a computer in its entirety for a given tax year.
You should make sure that you are using this computer more for business more than pleasure and be able to demonstrate this if you ever get audited. For the most part, as long as you don’t abuse this rule, you should be fine.
Certain Purchases are excluded
Some common things that you can’t use section 179 are listed below. I might be missing some items so you should definitely check for yourself but these are some of the more common exclusions.
- Inventory – Basically you can’t write off stuff that you are planning on selling
- Gifts – Anything that you’ve obtained or inherited as a gift can’t be deducted
- Real Estate
- Items that you already own or did not purchase for the tax year
Most small businesses will choose to take the Section 179 deduction for most of their assets. There are some cases where you wouldn’t want to however.
For example, if you business profits are low and you’re at the lowest tax bracket already, you might want to defer some of those write offs for when your business is more profitable to keep yourself at a lower tax bracket later.
In any case, you should always do the math both ways to see what makes sense for you.
In general, your chances of getting audited when taking the home business deduction are much higher if your business doesn’t show a profit for an extended period of time.
If you do take the deduction, make sure that you can prove that your business is actually legit and not just a hobby of yours that you are taking advantage of. Also keep in mind that your chances of an audit go up for every year that you don’t show a profit.
How To Deduct Entertainment And Meals
Deducting entertainment and meals is often a gray area that people take advantage of. My general rule of thumb is that as long as you don’t abuse the tax code, you should be fine.
I use what I call the “BS” code. If I can tell my wife with a straight face that a particular expense was used for business purposes, and my wife doesn’t think its BS, its usually good enough for me.
Officially though, anything you expense must obey the following rules.
- The entertainment expense must be reasonable and accepted in your field of business – For example, if I’m selling vegetarian food over the internet, it most likely wouldn’t fly if I took the employees out for a steak dinner. In any case, you get the point.
- The purpose of the entertainment expense must be to bring in revenue – For example, if you are hosting an event to promote your company, this is perfectly acceptable. Even if you and your business partner go out to eat to discuss the business, your meal can be deducted as well.
- The expense can’t be extravagant – Basically, this means don’t abuse this deduction!
Anyways, entertainment is defined as any activity or recreation that is directly for customers, clients or employees. Only 50% of entertainment and meals is deductible but these expenses can add up over the course of the year.
For our store, my wife and I go out at least once every few weeks to discuss new ways to expand the business.
How To Deduct Travel Expenses
Ever heard your spouse complain that you never go on enough vacations? Using your business as a tax shelter is a great way to fund your next vacation without breaking the bank. With proper planning, you can get your business to pay for and write off most of your trip!
For starters, the trip’s primary purpose must be for business. As long as your destination is not completely random, chances are you can find a way to do business there.
Below are some general guidelines on what and how you can deduct during your travels. Keep in mind that you can only deduct expenses on those days in which you are actually conducting business.
- Lodging is can be deducted in its entirety
- Food can be deducted 50%
- Transportation can be deducted 100%
- Laundry and Mobile Office related fees can be deducted 100%
There are 2 ways of deducting your business travel, the per diem method or the actual expense method.
Per Diem Method
The IRS allows for a set deduction per day when you travel. Every year, the IRS publishes a table which specifies a per diem value depending on your destination. You should check what the per diem rate is before you do your calculations.
In any case, even if you spend less than your per diem rate, you can still take the entire per diem deduction. One thing my wife and I do(when we’re not trying to make a vacation out of it), is to travel on the ultra cheap.
That way, we end up deducting more than we actually spend on our trip. Keep in mind though that sole proprietorships are not allowed to use the per diem method for their lodging deductions. All other expense are fair game as far as per diems go.
Actual Expense Method
This is pretty straightforward. Simply keep all of your receipts and add up the total amount of deductions based on what you have spent. The important thing is to make sure you keep the receipts for everything you spend your money on.
We always carry along a small box where we throw all of our receipts in at the end of the day.
As with all tax deductions, don’t go overboard. Make sure you document exactly which business partners or customers that you are visiting on a given day.
After your meetings, you are free to spend the rest of your day as leisure. My wife and I typically plan on hitting one vendor per day early in the mornings leaving the rest of the day for pleasure.
We also usually try and plan ahead to decide whether we’re going to use the per diem or actual expense method. On business vacations, we usually go all out and use the expense method. If the trip is purely for business, usually we’ll skimp and take the per diem.
What To Be Careful Of
Before you proclaim yourself a small business and start taking deductions all over the place, there are a few things to watch out for as far as the government is concerned. For one thing, you have to be able to prove to the IRS that your business is in fact a real business.
The definition of “business” is fairly broad. In general, you only need to prove to the IRS that you are actively trying to make money even though you may not necessarily be succeeding. Here are the criteria that the IRS uses to determine if your business is “real”.
- If your business makes a taxable profit for 3 out of 5 consecutive years, you’re generally safe from your business being considered just a hobby.
- If your business continues to declare a loss year after year, you will need to gather and keep evidence that you are making an active effort to turn a profit. This includes having a business website, business cards, a distinct and separate set of financial books, business licenses, permits and advertising expenses etc…
- You have to stay up to date with all of the necessary business filings. For example, if you sell physical goods, you still have to declare your sales taxes even if you made no sales at all
Don’t Be Afraid Of The IRS!
Most people don’t take deductions that they are entitled to because they don’t want to get audited or even take the risk. But the tax rules for businesses are in place for a reason so you should take advantage of them!
Naturally, your chances of getting audited can go up depending on what you choose to deduct but if you are truly trying to a run a legit business, you have nothing to worry about.
For our wedding linens business, we make sure not to be too over aggressive when it comes to taking business expenses yet we still manage to save thousands of dollars in taxes every year.
Just make sure that you consult a tax accountant before taking any crazy deductions. In addition, if you have any specific questions regarding what we deduct with our wedding linens business, feel free to drop me a line.
Once you sit and down and think about it, the tax benefits alone make starting your own venture a safer bet.
Need Additional Help?
Recently, I’ve started using CorpNet.com for all of this type of work because they are super accessible.
For example, you can get a free 20 minute consult right off the bat where you can ask questions to a real lawyer WITHOUT GETTING CHARGED. As a result, I use them to file trademarks and answer both my legal and tax questions.
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