Small business owners often wonder what they can deduct in their business. There is a perception that because you own a business, there are all sorts of tax write-offs (loopholes) that can be taken advantage of.
This is true, to an extent. The tax laws do favor businesses in what they can write off compared to individual taxpayers. What is important to remember, though, is that these write-offs can be subject to the size and scope of the business in question.
Your business might not be able to take advantage of the same deductions that a huge corporation like Apple or Microsoft can, simply because their resources allow them much more flexibility in planning for and implementing expenditures in the most favorable way.
Further, the type of business will determine what can be deducted. A manufacturing business has different types of opportunities available compared to a service business.
Also, there is a difference between a deduction and a tax credit, discussed below. Most businesses of any size will find things to deduct, but tax credits are much more specialized, have very complex rules and are very expensive to implement.
Finally, if a business loses money in one year there is the opportunity to carry that loss to another year to offset income incurred then.
It is these last two provisions, sometimes well-publicized, that make it appear that businesses are entitled to a multitude of write-offs.
Ordinary and Necessary Business Expenses
The Internal Revenue Service (IRS) provides insight into what a business can and cannot deduct. IRS regulations Section 1.162-1 states, in part, that
In general. Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business…
The key terms are “ordinary and necessary” and “trade or business.”
Ordinary and necessary depends on the nature of the business. The type of expense and its relevance to the business operations determines its deductibility. If it is a common or regular expenditure of that type of business the deduction will normally be allowed.
Trade or business. While not defined specifically by the IRS, there clearly has to be a profit motive or economic activity involved which normally assumes an ongoing business. Again, this is subject to the nature of the business and the facts surrounding its operation.
Given these two factors, most businesses engaged in business designed to earn money can deduct the expenses of running that business.
What Can A Business Deduct?
IRS tax forms give some indication of what can be deducted:
- Direct product, labor and other costs of generating sales (known as Cost of Goods Sold)
- Car and truck expenses (with some limitations)
- Commissions and fees
- Contract Labor
- Depreciation of buildings, equipment and fixtures
- Employee benefits
- Interest (on business loans)
- Legal and professional
- Meals (if for business purposes and limited to a 50% deduction)
- Office expenses
- Pension plans
- Repairs and Maintenance
- Taxes and licenses
- Travel (if for business purposes)
- Wages and salaries
- Any other ordinary and necessary business expenses (depending on the nature of the business)
Note that many of these expenses could be incurred by individual taxpayers but are not deductible unless they are for business purposes. Travel, meals and insurance are good examples.
Which expenditures are not immediately deductible?
Costs incurred to acquire machinery, buildings and office furniture and fixtures are generally capitalized, which means that they are considered assets that benefit a period longer than a year and must be written off over their useful life through depreciation.
For example, if you buy a machine for use in your business for $10,000 and it has a useful life to the business of 5 years, you can deduct $2,000 of the total cost each year. Depreciation is complex and subject to many rules and is beyond the scope of this discussion. The point is that these types of assets can be written off but over a period of time beyond the year of purchase.
Inventory is similar in its deductibility. In general, inventory, either purchased or manufactured for resale, is also capitalized as an asset and can only be deducted when the sale occurs. While this is normally a short-term event, some items can be held for sale or resale for longer than the year of purchase.
Other expenditures are limited in their deductibility or are not deductible at all. A prime example are business meals. A business meal is only 50% deductible for tax purposes. Business gifts are also limited. Entertainment and penalties are not deductible.
There are two deductions that business owners can take which have special rules.
The first is the business use of a car. This is a complicated deduction but one that all business owners ask about. In general, the business use of a vehicle is deductible but subject to many rules. A primary question is whether a car should be purchased by the business. The answer is maybe, depending on how the car will be used. For a much more detailed look at this topic, read more about how to deduct your vehicle for your business.
The second is the deduction for the business use of the home. It is only available to sole proprietors. This is a potential red flag item, so much so that the business owner has to weigh the tax effect of the deduction against the risk of audit it might create as well as the special rules that must be followed to ensure deductibility.
Technically, the office must be used solely for business and be a specifically designated portion of the house (the IRS refers to this as exclusive use). There can’t be another place of business in addition to the home office. An example would be a walled-off section of a garage used solely for the storage of inventory. Running a business on a kitchen table is more problematic.
The deduction is calculated by taking the percentage of the square footage of the office compared to the total square footage of the house and multiplying that against qualifying expenses such as utilities, rent or mortgage interest, taxes and insurance. Depreciation can also be factored in.
There is a simplified method that eliminates some of the record-keeping (but not the exclusive use) and allows a deduction of up to $1,500 per year. The rules for this deduction are complex and beyond the scope of this article. You should consult with a tax professional before considering this deduction.
How is a Deduction Taken?
Deductions reduce gross business revenue to determine taxable income.
|Expenses (any combination of those listed above)||($50,000)|
Depending on how the business is structured, the $75,000 would be subject to tax. So, any deductions that a business incurs reduces the income subject to tax.
What is a Tax Credit?
A tax credit reduces the amount of tax a business owes instead of being a deduction to determine taxable income.
|Expenses (any combination of those listed above)||($50,000)|
Tax credits are much more beneficial than tax deductions. They reduce taxes owed on a dollar for dollar basis rather than by a percentage of the amount spent. However, business tax credits can only reduce taxes owed to zero (referred to as a non-refundable tax credit) and so cannot produce a refund.
Some tax credits for individuals can produce a refund (refundable tax credits). If the business tax credit is larger than the taxes owed, the excess can be carried back one year or forward for 20 years to reduce taxes in those years if they exist.
While tax deductions are fairly straight forward, tax credits come filled with special rules, are expensive to implement and are normally targeted at specific activities, usually to fulfill some purpose that the government feels is important or for which there has been a strong lobbying effort. There are numerous credits available and they are taken on a business tax return as a General Business Credit on Form 3800.
Are Tax Credits Available to Small Businesses?
It is rare for a small business to qualify for a business tax credit. Again, most are very obscure and are designed for “large” small businesses. However, the following may fit certain businesses, but you should consult your tax professional to see if your business qualifies:
- Credit for employer-provided childcare facilities and services
- Credit for increasing research activities
- Credit for small employer health insurance premiums
- Credit for small employer pension plan start-up costs
- Disabled access credit
- Empowerment zone and renewal community employment credit
- Work opportunity credit
When business owners think of the fancy tax deductions they are supposedly entitled to, the tax credits are usually what they are thinking of. There is very often a lot of publicity about corporations getting huge tax write-offs and it is often these tax credits that are being referred to. This is perfectly legal, but as mentioned above, very few small businesses can qualify or have the resources for these credits.
Net Operating Losses
Another well-publicized write off is the net operating loss. Every business is entitled to this, but it is not necessarily a great deduction. It means that your business lost money which is not what most businesses want to or should do.
However, it does happen, and the loss means that no taxes are paid in the year it is incurred. In general, the loss then can be carried forward to future years indefinitely to offset income and reduce taxes until it is used up. This is why you may hear something like “XYZ company didn’t pay taxes for 10 years.”
While probably true, it’s most likely that the company had large losses for one or two years and is then carrying that loss forward for the eight profitable years it takes to use it up. While it sounds like the company may be doing something sneaky it is all very legal, just not very well explained.
Again, this is not a deduction you want to have if you are in business to make a profit. The definition of a net operating loss and the rules for taking it, as always, are very complex and you should consult a professional to determine how your business may be affected.
Final Thoughts on Small Business Deductions
A small business has many opportunities to legally reduce their taxes. Most revolve around what can be deducted and what tax credits are available. The size, structure, and complexity of the company very often determine what can be written off.
To make sure your company is taking full advantage of all possible tax deductions and credits, you should consult a business and tax professional such as a Certified Public Accountant or Enrolled Agent. Discover how to choose the right tax preparer.