Why should you care?
I've made it a point to start most of my blog posts with the heading "Why Should I Care." Primarily, it serves as a reminder to me to cut out the technical jargon and focus on the concepts that will either teach you something valuable or help you put together a list of questions when you visit with your tax advisor.
However, I think that most taxpayers don't need convincing when it comes to today's topic; nearly everyone, regardless of political affiliation, wants to make sure they aren't overpaying on their taxes.
Under the current tax law, most individuals don't have many opportunities to decrease their tax liability with deductions, since the standard deduction was nearly doubled with the passage of the Tax Cuts and Jobs Act (TCJA) in 2018. However, business-type activities still afford a number of tax planning opportunities that you might not have heard of.
My goal today is not to make you an expert on the various tax deductions, rather, I'd like to provide a basic overview of the types of deductions you should be taking advantage of, and some of the basic rules that guide whether or not an expense is deductible.
The Myth of Tax Planning
As a professional, I feel obligated to warn you that there are a lot of bad actors on the internet these spreading tax advice that simply isn't true. If your business is profitable and growing, you will eventually pay tax. If you make more money, you will pay more tax. There are no "secrets" that will make you pay no tax if your business is profitable.
However, I offer tax planning services. So what's the deal? What am I charging people for? Sometimes there are opportunities to change the tax consequences of a particular transaction and sometimes business owners want help in building out their compliance infrastructure and plan. Some of the most effective tax planning tools available are long-term plays, not quick fixes that can be implemented on April 14th.
More Resources:
Reader-Friendly:
From the IRS:
Other Technical Material:
Deductions Overview
Business Deductions, Generally:
The general code section that governs business expenses is section 162 of the Internal Revenue Code (IRC). Within §162(a), the IRC states that "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."
However, the deductibility of certain business expenses is litigated frequently and the current tax law is a patchwork of laws and regulations, so the rules as to what is and is not a deductible business expense are rarely so simple.
In tax court cases, these questions are typically investigated:
Is the activity a "trade or business" or a hobby?
Are the expenses "ordinary"
Are the expenses "necessary"
This is not an exhaustive discussion of tax court rulings on the deductibility of business expenses, but I wanted to point out some of the basic techniques that auditors will use to attempt to disallow deductions.
If the IRS is successful in characterizing your business as a hobby, you report all the income and the expenses are miscellaneous itemized deductions (disallowed under current tax law). As a result, hobby losses are disallowed, but all the income is reportable. Needless to say, this can prove disastrous to the Taxpayer. Recurring losses are one indicator that a business might be a hobby.
If the IRS can demonstrate that your business expenses are not ordinary OR that they are not necessary (they only have to get one to disallow the entire deduction) they are considered personal and your income is adjusted up for the year. Again, this is frequently disastrous to the Taxpayer.
So what? Should you just not take advantage of these expenses you have? Of course, you should be taking all the expenses you have. In fact, you are required to file complete and accurate tax returns, which means reporting all the expenses you have. However, you should also be keeping detailed records of the expense, and each expense should have a clearly demonstrable business purpose.
The biggest thing you can do as a business owner to avoid adverse audit adjustments (supposedly the selection of returns for audit itself is somewhat random) is to keep good records and not claim expenses that are clearly personal.
Classifying Business Expenses:
If you look at the tax return you filed last year (Form 1040, Sch C; Form 1065; Form 1120-S; Form 1120), you'll see a list of expenses and a box for "other expenses." When you report these deductions, you group the individual transactions into "functional categories." This means that they should be grouped based on their business purpose.
For example, assume you are a landscaping business and you buy business cards to distribute to potential customers. This would be best classified as advertising or marketing expense. So would ads in the local newspaper, or social media ads.
However, if you were a promotional printing business and you sold those business cards to a customer they would be more appropriately classified as cost of goods sold. Meaning, expenses can be reported on different lines based on the nature of your business. This is one reason that it makes sense to use an accountant who understands your industry, as the IRS compares returns from similar industries.
If you have an expense that does not neatly fit into the categories shown on the return, you can attach a list of the other expenses and claim them there. You just want to make sure that all of those are properly aggregated and that they are truly "ordinary and necessary" to your line of business.
Common Business Deductions:
Home Office Expenses:
This is one of the more complicated deductions but can be invaluable to small business owners. The key here is that the home office itself must be exclusively and regularly used for business.
There are two methods to calculate the deduction given that the business use criteria are met. One method involves a standard, per-square-foot rate, while the other involves allocating all the expenses of operating the home and taking partial depreciation on the home. For S-Corporations, these expenses must be reimbursed through an accountable plan.
You should ask your tax professional for a worksheet each year, and have them figure the deduction under each method, selecting the one that is most advantageous to you.
Auto Expenses:
Automotive expenses are another very complicated topic. To take automotive expenses, you need to keep track of the vehicle's total mileage and break that total down between business and personal/commuting miles.
Your tax professional will use this information to calculate a business use percentage that will be used to determine actual expenses or calculate the standard mileage deduction. As with the home office deduction, there are two methods here. So just send in the purchase invoice for new vehicles and the mileage information so your tax professional can determine which is most advantageous to you.
There is a bit of long-term thinking going on here since you can use the standard mileage rate forever, whereas depreciation ends when the vehicle is depreciated to a net book value of $0. Furthermore, you can switch from standard mileage to actual expenses, but not vice-versa. There are also limitations on the first-year depreciation if the vehicle is considered "listed property."
The key here is to coordinate and communicate with your tax professional to make sure your expectations are reasonable since there are a ton of bad actors spreading inaccurate information about vehicle "write-offs" on social media.
Equipment & Fixed Assets:
Under the current tax law, many types of equipment and business assets can be depreciated 100% in the first year, as opposed to being deducted over the course of the asset's useful life (as determined by the IRS).
However certain assets are not eligible for this treatment, so I say again, that it might be worth a visit with your tax professional before you make a massive purchase.
Employee Benefits:
There are a number of ways to pay your employees other than their salary, and some are nontaxable to the employee. Almost all employee benefits are deductible when you take the time to jump through the hoops of setting them up.
Advertising & Promotion:
Advertising can look different depending on what business you're in, but generally, the cost of advertising and promotional materials are fully deductible.
Professional Services:
Fees paid to accountants, attorneys, and return preparers are fully deductible.
Business Interest Expense:
Interest expenses incurred on debt related to running a business is deductible. This means that credit card interest, auto loan interest, formal notes, and lines of credit are all potentially deductible.
Dues & Subscriptions:
Professional dues, continuing education, and subscriptions to professional publications are all fully deductible.
Insurance Expenses:
Generally, the cost of business insurance is fully deductible. Life insurance premiums on owners and other key employees are not deductible.
Cost of Goods Sold & Materials:
Generally, the costs of producing products that are sold are deductible in the year of sale. Most taxpayers should implement an inventory management system, although some small taxpayers may be exempt from accounting for inventories for tax purposes.
Business Travel Expenses:
There are lots of rules regarding business travel, in particular when the purpose of the trip is partially personal and partially business. However, assuming the trip is 100% business related and the costs are not extravagant, the travel costs are fully deductible.
As with the home office deduction and business auto expenses, there is the option to use a second method: the per diem rates. S-Corporations can reimburse employees under an accountable plan. Consult with your tax advisor to determine which is most advantageous.
Software Expenses:
Amounts paid for "off-the-shelf" software are fully deductible. In-house "developed" software must be capitalized.
Utilities:
Business utilities (including cell phone and internet charges) are fully deductible. In the event that you have a home office that meets the business use rules outlined above, you can allocate a portion of those "personal" utilities to your business.
Conclusion
Generally, I find that after a discussion like today that most people find they can deduct more than they thought. If you think you've missed deductions in the past, it might be time to get serious about your business finances. Adopting some more formal processes can help you maximize your business's value and minimize your tax burden.
Feel free to reach set an appointment here if you need help with your accounting or taxes.
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