The Business Deduction Primer

As a small business owner, keeping your tax bill low should be one of your most important business strategies. Making sure that you deduct every legitimate business expense is vital to making sure Uncle Sam doesn't take any more of your hard-earned money than he is entitled to.

Your best tax-saving strategy is through the efficient tracking and use of all of your valid business deductions. The expenses you incur throughout the year towards the running of your business can be claimed on your tax return as deductions from your income. This reduces your business income, and consequently, your tax liability. The more expenses you can deduct from your income, the more money you will save.

A large majority of small business owners are not aware of all of the possible expenses allowed, and are forced to rely on complicated IRS publications to try to figure out what can be deducted and how to track and report them. You need to be aware that as a small business owner, you may have an increased chance of being audited by the IRS, so it is crucial that you familiarize yourself with what the IRS considers valid business deductions, and how you should report and document them.

Below you will become familiar with what expenses you can and cannot deduct, special tax treatment for certain expenses, and the proper documentation that is required to back up your deductions. With this knowledge, and proper receipts for documentation, you can keep more of your hard-earned dollars, and make the process of filing your taxes much easier and less painful.

What are "Business Expenses"?

The IRS defines business expenses as "the costs associated with carrying on a business or trade". According to that definition, in order for an expense to be deductible, it must meet the following criteria:

It must be an ordinary expense - this does not mean it has to be habitual or recurring, however it must be one that is common and accepted in your trade or business. An expense that is common and accepted in one type of business, may not be in another. For example: The cost of a chainsaw would be deductible if you are in the construction business, but not if you are an insurance salesman.
It must be a necessary expense - this doesn't mean absolutely crucial or required, but helpful and appropriate in your business or trade. For example: If a dentist purchases a television set to put in his waiting room, the cost of the TV would be a legitimate expense. While the TV may not be absolutely required to run his business, it is considered helpful in maintaining good customer relations, and would therefore be allowed.
It must be directly connected to your business - You cannot deduct personal, non-business expenses. For example: Referring to the dentist and the TV above, if the dentist had purchased the TV and put it in his family room at home, he would not be able to deduct the cost on his tax return.
The amount must be reasonable - Since the IRS realizes that most people don't intentionally overpay for something, they are looking to see that the expenses claimed are reasonable based on the particular circumstances. For example, while it may be perfectly reasonable for a large business with operations in several states to lease a private jet to accommodate meetings between regional managers, it would not be reasonable for a self-employed plumber to lease a jet to meet with his pipe-wrench supplier in Toledo.

Understanding the Different Types of Expenditures

Once you understand what the IRS considers a legitimate business cost, you need to recognize that not all business expenses are created equal. Some business expenditures are not fully deductible in the year they are paid. In order to properly account for your expenditures, and how you should treat them on your tax return, you need to understand the three different categories that these expenditures may fall into.

Start-Up Expenses:

Most businesses will have certain costs that they incur before they officially are up and running. These costs could include advertising, travel, consulting fees, market research, deposits on office space or utilities, equipment and office furniture, business cards and stationary, etc. All of these are legitimate business expenses, but since there isn't actually an existing business yet, the IRS requires special treatment of these costs.

Some start-up expenses will be the acquisition of business assets. These costs will not be a one-time deduction. Instead, they will be "deducted" over the useful life of the asset through depreciation (see below under "Capital Expenditures).

Other start-up costs would be considered normal operating expenses had they been incurred by an existing business. Most new business owners will choose to amortize these costs. Amortize means to spread the deduction out equally over a period of time. Start-up costs must be amortized over at least 60 months, but it can be longer if you choose to do so. If you don't choose to amortize these expenses, you won't be able to recover these costs until you close down or sell your business.

**Remember that if you are going to amortize start-up costs, you need to start taking the deduction in your first year of business.**

Capital Expenditures:

The costs associated with purchasing or acquiring assets that will have a useful life of more than one year also require special tax treatment.

The most common types of capital expenditures are buildings, equipment, and furniture and fixtures. Certain major repairs or enhancements to assets are know as capital improvements (such as a new roof or major rewiring of a building), and must be treated as capital expenditures as well.

The reason for this special treatment is based on the basic accounting principle that expenses should be "matched" with the income it produces. Therefore, if you buy a piece of equipment that you will be using in your business over several years, such as a server in a web hosting business, the cost of that item needs to be spread out to match the income produced over that same time period.

This is accomplished through “depreciation”, commonly known as "writing off" a portion of the cost each year over the life of the asset (building, piece of equipment, etc.). This is similar to amortization, except the yearly depreciation expense will be determined by the use of depreciation tables, so the expense is not necessarily the same amount each year.

You should also be aware of a special provision in the tax code know as a "Section 179 Deduction" that allows a taxpayer to write off certain capital expenditures up to a particular dollar amount (in 2004 it was $100,000) in the year of purchase. However, there are many rules governing the depreciating of assets involving class life and methods of depreciation, so most small business owners will probably want to consult with an accountant or tax specialist to deal with these issues when it comes time to file their taxes.

Current Business Expenses:

Most other business expenses will be considered normal operating expenses. These expenses will be deducted in the year they are incurred. The following is a list of common business expenses you may encounter:

Advertising
Bank charges
Bookkeeping
Car and Truck expenses (either actual expenses or using the standard mileage rate; covered later)
Internet Access, domain name registration, web-hosting fees, etc.
Commissions and fees
Computer supplies
Continuing education/seminars (must be related to current trade or business)
Dues for trade organizations
Employee benefits
Faxing costs
Insurance premiums (casualty and liability)
Interest on business loans and business credit cards
Legal and professional fees
Licenses and permits
Meals and Entertainment (only 50% deductible; covered later)
Office supplies
Postage
Rent
Repairs and Maintenance
Shipping and delivery costs
Subscriptions to trade magazines, newsletters, etc.
Travel
Utilities
Wages

Non-deductible Expenses

In most cases, a deduction is not allowed for the items below, either because they are non-deductible personal expenditures, or because Congress specifically made them non-deductible. (However, where noted, some of these qualify for special tax treatment):

Bar or professional examination fees
Capital expenditures (not fully deductible in year placed in service, but depreciated over it's useful life)
Charitable contributions or gifts by a business that is not a C corporation (sole-proprietors may be able to deduct them on their personal tax return on Schedule A)
Clothing, except for uniforms or protective equipment
Country club, social club, or athletic club dues
Commuting expenses (covered below under "vehicle expenses")
Federal income taxes
Fines and penalties for violation of laws, such as traffic tickets and federal income tax penalties
Gifts to employees that are valued at more than $25
Any portion of a gift to a business contact in excess of $25
Political contributions
Partnership organizational expenses, unless amortization election is made

The above lists are not all-inclusive. If you are unsure about a particular expense, it would be a good idea to talk to a tax professional for further clarification.

It is possible to have some expenses that are both a personal and business expense (such as vehicles or computer equipment). You can still deduct (or depreciate) the part that is used for your business.

Vehicle Expenses

Business use of your car or truck is another area that has special tax rules. You have two choices as to how you treat these costs:

Actual Cost Method - you may choose to deduct all of your business-related vehicle expenses such as gas, oil, insurance, license fees, interest on your vehicle loan, car washes, parking fees, toll fees, repairs and maintenance, tires and supplies, and depreciation. You will need to keep receipts when possible, and make sure you jot down things like car washes and parking fees where you won't have a receipt.

If you also use your vehicle for personal use, you will need to compute the percentage of business use. This is done by dividing your business miles by the total miles you used your vehicle that year. You would then multiply your total vehicle expense by this percentage.

For example: if you drove a total of 10,000 miles for the year, and 6,000 of those miles were for business, your business use percentage is 60% (6,000 divided by 10,000 = .60). If your total vehicle expenses were $2,500, then you can deduct $1,500 (2,500 x .6).

You should keep a mileage log to keep track of your business miles, keeping in mind to record the odometer reading at the beginning of the year and the end of the year. Mileage logs can be purchased at any office supply store for just a few dollars. Your log should show the date, the miles driven, and the purpose of your trip (Meeting with Hank Smith, post office, office supply store, etc.).

Standard Mileage Method - the other option you have is to use the standard mileage rate. This is a much simpler method, and you don't have to keep track of your car receipts. Using this method, you would simply multiply your total business miles by the standard mileage rate that is set each year by the IRS. For 2003, that rate is 36 cents per mile. You will need to keep a mileage log to keep track of your miles. Make sure your record the odometer reading at the beginning of the year, and the end of the year.

Keep in mind that commuting miles (miles between your home and place of business) are not deductible. On your tax return, you will need to know total miles driven, business miles, commuting miles and personal miles. If you use the standard mileage method, you cannot deduct any other actual vehicle expenses, with the exception of parking and toll fees, and vehicle loan interest (see below).

Interest paid on a vehicle loan - whether you use actual expenses or the standard deduction, you can deduct the interest on your vehicle loan, however you must pro-rate the interest if you also use the vehicle for personal use. Also, if you are an EMPLOYEE (not self-employed) claiming vehicle expenses (on your Schedule A under job expenses), you CANNOT deduct the interest.

Meals and Entertainment Expenses:

In addition to meeting the general rules for business deductions listed at the beginning of this article, in order for meals or entertainment expenses to be deductible, they must be either directly related to the active conduct of business, or must precede or follow a substantial and bona-fide business discussion and be associated with the active conduct of business. What this means is that you can take a customer, potential customer, or business associate to dinner and as long as you discuss business, it is deductible. You can also take a customer, potential customer, or business associate to a football game, concert, movie, etc. if you had a business discussion earlier in the day (or discuss business after the game). You can throw a party or backyard barbeque for customers, potential customers, or business associates and that would also be deductible.

Keep in mind that these expenses are only 50% deductible. However, parties and picnics, etc. that you throw for your employees are 100% deductible.

The IRS tends to look closely at these types of expenses, so you should be especially careful to follow the rules and document them clearly. In fact, it would be a good idea to keep a log to track and record these expenses (be sure to keep the receipts as well, of course.)

Health Insurance Premiums

Self-employed individuals can now deduct 100% of the cost of health insurance premiums for themselves, their spouses, and their children. This deduction is not included on the Schedule C, but is entered on Line 28 of Form 1040.

The Importance of Proper Documentation:

If you are going to claim an expense as a business deduction on your tax return, it is important to have accurate, clear documentation for the expense. While the IRS may not require you to have a receipt for some of the small, incidental expenses you incur, the more documentation you have, the better off you will be, should you ever be audited. Remember, you will have the burden of proof should the IRS have questions about any of the expenses you claim. However, by maintaining well-organized and well-documented records, you should have no problem if you are ever questioned. Besides that, you will be much less likely to overlook a legitimate business deduction if you get in the habit of saving all of your receipts.

Certain types of expenses have proven to be particularly susceptible to cheating by business owners in the past, so the IRS has special documentation requirements for these expenses. The following is a list of expenses that will be disallowed without adequate documentation:

Expenses for travel (including lodging and meals)
Meals and entertainment expenses
Business gifts (limited to $25 per person per year)
Cellular phones, computers, and other items generally used for entertainment

For these items, you will need a receipt for anything over $75, and any lodging regardless of cost. The documentation must include the amount, time and place, and business purpose. You must also show the business relationship for anyone receiving a gift or entertainment.

Types of Documentation

The most common and accepted types of documentation are receipts, invoices, cancelled checks, and credit card receipts. The receipt should show the date, amount, and what it is you purchased. Be sure to ask for a receipt if they don't offer one. (Think about this next time you go to the post office and buy a book of stamps). If you order something off the Internet, be sure to print the receipt or confirmation page from your order.

Try to make sure the receipt goes into your wallet or purse and not into the bag with your purchase. Make sure that the receipt clearly shows the date, the name of the store, a description of the purchased item (what exactly was “PC PPR FL Min # 200”?), and how much it cost. When you get home, put it in a folder or large envelope with all other receipts so they are all together. It is also a good idea to record them in some sort of journal or ledger as soon as possible, so that you can keep track of what it is costing you to run your business, and specifically what aspects of your business you are spending your money on.

Successful business owners realize how important it is to make sure they are deducting every business expense they are entitled to. Keeping complete and accurate records of your expenses will keep you on the good side of the IRS, as well as providing you with the information you need to grow your business through informed management decisions.