What kind of deductions can I take as a small business?
Sure, you pay tax on your business profits. But there’s good news, too. You can potentially reduce your taxable income significantly by taking all the deductions you’re entitled to as business expenses.
Knowing which expenses are deductible is important. If you are a shareholder or partner in the 25% tax bracket, for example, every dollar of deductions saves 25 cents of taxes. If you are located in a state that imposes an income tax, each write-off is worth even more because it will save you state taxes, as well.
To determine whether you can deduct an expense, ask yourself: Is this expense both ordinary and necessary to the business? The IRS requires both elements.
- An expense is ordinary if it is common and accepted in your industry.
- An expense is necessary if it is helpful and appropriate for your business.
As a small business owner, you can deduct automobile expenses for visits to clients, customers or travel to business meetings away from your regular workplace. If you have a home office, a drive from your home to a supplier and back home again is a 100 percent deductible business expense.
When figuring expenses, you may choose between taking the standard mileage rate (which generally changes every six months to a year), or deducting your actual expenses for items such as gas, oil changes, tires, repairs, preventive maintenance, insurance and registration. If you choose to deduct your actual expenses in the year you start using your car for business, you can’t switch to the standard mileage rate later. If you choose the standard mileage method first, you can switch to actual expenses in a later year.
In choosing the method that yields the higher deduction, the number of miles you drive each year is probably the most important factor. If you do a lot of driving, then the standard mileage rate method may work better for you. However, automobiles that consume more gas may let you claim a higher deduction using the actual expense method. If you decide to deduct your actual expenses, you must keep a log of your trips noting the date, the miles driven, and the purpose of each trip. Try to log your trips as they occur, when it’s easier to keep track of the details. Keep a record of your gas purchases, insurance and registration payments, and repairs and maintenance costs. If the IRS ever audits you, you will need to provide written documentation to substantiate your deduction.
If you’re self employed, you can also deduct the business part of interest on your car loan, state and local property taxes, parking fees and tolls, even if you claim the standard mileage rate.
How can something bad be good for you? Easy: If you loaned money to customers, suppliers or employees who never paid you back, you may be able to claim a bad-debt deduction to offset part of your loss. This type of debt must have the following characteristics:
Debtor-creditor relationship — There must be a legal obligation for a debtor to pay a creditor a specified sum of money. The best way to establish this relationship is with a written document stating the amount of the loan, interest rate, repayment schedule, etc. This is particularly important if you lend your corporation money. Without written documentation of the loan, the IRS may treat the advance as a contribution of capital to the business and it will not be deductible.
- Worthlessness — You must prove that the debt is uncollectible and that you attempted to collect it.
- Loss — You must have sustained a loss because of the debt.
It’s also possible to claim a bad-debt deduction if someone doesn’t pay you for work you performed or products you sold. To qualify for this tax-saving deduction, though, you must use the accrual method of accounting, which entails booking income when a product or service is sold, for example. If your business uses the cash-basis method, you can’t deduct a worthless receivable as a bad-debt expense because, with this accounting method, you don’t count income until it is received. So you don’t need a deduction to offset the amount not paid because you never include that amount in income.
With an ordinary business expense, you deduct the entire cost of the purchase in that tax year. But if you purchase an asset for your business that you will use beyond the current tax year, you must spread out the deduction over the asset’s expected life. This concept of spreading out a deduction over the life of an asset is called depreciation. The asset must meet three requirements in order to be depreciated. It must be:
Used in the business or held to produce income
Expected to last more than one year
Something that wears out, gets used up, or loses its value over time
The following assets can’t be depreciated:
- Property that you place in service and dispose of in the same year
Repair and maintenance expenditures that do not increase the value of your asset, make it more useful, or increase its life. (These outlays are generally deductible in full in the year you pay them.)
Of course, there are always exceptions. Small businesses may be able to deduct the entire cost of a depreciable asset in the year it is placed in service instead of spreading the cost out over the life of the asset. This is known as a Section 179 deduction, after the section of the tax code that authorizes it. It also goes by the alias “expensing,” because you get to deduct the full cost at once—just like you do for business expenses—rather than depreciating the capital asset over time.
For assets placed in service in 2014, you can take a maximum Section 179 deduction of $500,000. The amount you can expense in 2014 is reduced if you purchase more than $2,000,000 in eligible property during the year.
While the idea of taking a huge deduction right away may sound good to you, be careful, because there is a downside. If you sell an asset, you may have to recapture all or part of the depreciation deductions. (Recapture means reversing all or part of your earlier deductions by adding them back as income.)
Compensation you pay employees is deductible, including salaries, awards, bonuses and fringe benefits such as health insurance, sick pay and vacation pay. You get a deduction whether you pay wages to employees, to whom you provide a W-2, or use independent contractors, to whom you issue Form 1099.
You can also write off the cost of benefits such as group-term life insurance, adoption assistance, dependent-care assistance and educational assistance. Other deductible fringe benefits include:
- Discounts on goods or services
- Flights on airplanes
- Meals and lodging
- Memberships in country clubs
- Tickets to entertainment or sporting events
- Use of a car
You can work out of your home and save on taxes at the same time. Sound impossible? It’s not, but the home office deduction is a bit tricky, so you need to know all the ins-and-outs. To take the home office deduction, you must use your home office regularly and exclusively for your business. Generally, your home office must be your principal place of business, or you must use it to meet clients or customers on a regular basis.
Exclusive use means that you’ve got a specific area of your home that you use only for your trade or business. For example, if the den in your home is used only as your office, you can take the deduction. But if the kids also play there or you watch sports on TV in your den, you can’t. So do yourself a favor and move the toys and that big-screen TV to another room in your house.
Regular use means that you use the space as an office on an ongoing basis. Occasional or incidental use does not qualify for business use, even if the office is used exclusively for business purposes.
To claim that your home office is your principal place of business, you must:
Perform the most important part of your work there, or
Use the office for administrative or management activities, and not perform these activities at any other fixed location, such as another office off-site. Administrative and management activities include billing customers, keeping books and records, setting appointments, ordering supplies and writing reports. For example, if your business involves repairing clients’ computers in their homes, you can deduct your home office if you use it to set up appointments and bill customers, even though you don’t repair the computers in your office.
You can also claim the home office deduction if you store inventory or product samples there, or if you operate a day care facility.
The size of your deduction depends on the percentage of your home that is used for business. If your total business expenses exceed gross income from business use of your home, your deduction will be limited.
The two most common methods of calculating business percentage are:
Dividing your home office’s square footage by that of the entire house
Dividing the number of rooms used for business by the home’s total number of rooms, if all rooms are about the same size
Because the home office deduction is a complex area that has been the subject of much controversy and many court cases, you may want to look at more detailed discussions of this deduction in IRS Publication 587: Business Use of Your Home.