by: Anthony Parent 2019-05-17
The owners of businesses must pay various taxes on the profits that their business generates. If your business is a sole-proprietorship, partnership, LLC, or S Corporation, those profits “flow through” to your personal tax return, which is where you will pay any taxes that are owned. C corporations are taxed slightly differently, and pay corporation tax on any profits.
The key point here is that you pay taxes on profits — which is your revenue less your expenses. The more you can claim in legitimate expenses, the less profit you will need to pay tax on, and the lower your tax bill will be. The question is — what is a legitimate expense? What does the IRS allow you to claim against the revenue of your business?
Well, the IRS has a lot to say on this matter! So much so, that “Publication 535, Business Expenses” runs to nearly 80,000 words, and it’s not exactly light reading!
We’ll cover the main areas of expenses, provide some guidance on what you can claim, and let you know how you can reduce your tax bill. We’ll give you a helpful overview of your write offs, deductions, and business expenses.
Note that because every business situation is unique, you should always consult your accountant or another tax professional to understand exactly what your tax liabilities are.
In this guide, we cover expenses on areas including:
Cost of goods sold.
Business use of your home.
Business use of your vehicle.
Payments made to employees.
Rented and leased property.
Deduction of taxes.
Utilities and services fees.
Other common expenses.
If you want to deduct a business expense, the IRS says it has to be both ordinary and necessary.
Ordinary expense are ones that are common and accepted in your industry. For example, a tree surgeon could deduct the cost of a chainsaw they use in their arborist business or the costs of renting a tree stump grinder or storage yard, since those are normal parts of running this type of business.
A necessary expense is one that is helpful and appropriate for your trade or business. It should directly contribute to the running of your business. For example, if you pay for online advertising that helps you to attract new clients.
Note that if you are audited, the IRS will require proof that you have spent what you have said you did in any tax returns. This means you should retain any receipts of your expenses that clearly states where you spent money, the data, and what the money was spent on.
The IRS insists that certain types of deductions are capitalized and the expenses are claimed over time. This is a complex area and you should speak to your accountant about how to report and file these expenses. Generally speaking, capitalization can include:
The cost of starting a business including expenses for advertising, travel, or wages for training employees.
Business assets including land, buildings, machinery, furniture, trucks, patents, and franchise rights.
Motor vehicles which you usually capitalize and depreciate over time.
In some cases, you may have an expense for something that is used partly for your business and partly for personal purposes. In those cases, you can deduct the percentage of the total value that is used exclusively for business purposes. For example, if you have a personal mobile phone, but you use it to make and receive business calls and email half the time, you can deduct half the cost of the phone and your ongoing phone rental as a business expense.
Let’s get into some detail of the many types of business expenses you can claim.
If your business sells products at a profit, you can deduct the cost of sourcing, obtaining, and otherwise dealing with those items. Typical expenses may include:
The cost of purchasing the product or raw materials in the first place.
Prototyping and development costs.
Direct labor costs for paying workers.
The overhead of factories and other facilities.
Distribution, storage, and other logistics costs.
The cost of sending products to customers.
According to the IRS, larger businesses must, “capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.” This does not apply to small businesses with average annual gross receipts of $25 million or less over the last three years.
You can deduct reasonable expenses for business use of your home, provided that:
The business part of your home must be used exclusively and regularly for your trade or business.
The business part of your home must be your principal place of business, a place where you meet or deal with customers in the normal course of your trade or business, or a separate structure (not attached to your home) used in connection with your trade or business.
If you use a vehicle only for your business and not for personal use, you can capitalize the cost of the vehicle and depreciate it over time. If you use a vehicle for both business and personal use, you must calculate how much mileage is used for each, and deduct only the percentage for exclusive business use. You can also deduct car expenses, including depreciation / lease payments, gas and oil, tires, repairs, tune-ups, insurance, and registration fees. This area can be an audit red flag to the IRS, so we have some helpful tips.
If you have employees that work for your business, you can typically deduct the costs of wages, salaries, bonuses, commissions, certain employee benefits, or other non-cash compensation. Note that as an employer, you will have other tax liabilities like payroll and other taxes which will be due on amounts you pay to employees.
The IRS says, “Your deduction for wages paid is not reduced by the social security and Medicare taxes, Additional Medicare Tax, and income taxes you withhold from your employees. You can deduct the employment taxes you must pay from your own funds as taxes.”
You can deduct rental or lease payments on property that you use as part of your business. If you lease business property, you can typically deduct any taxes you have to pay to or for the lessor. In many cases, you can also deduct the costs associated with setting up or exiting from a lease.
In some cases, the IRS allows you to deduct taxes you have paid elsewhere as a business expense. You can typically only deduct these taxes in the year that you pay them.
Real estate and property taxes — you can typically deduct these taxes if they are related to property you use in your business.
Federal income taxes — you cannot deduct federal income taxes.
State and local income taxes — a corporation or partnership can deduct state and local income taxes imposed on the corporation or partnership as business expenses. An individual can deduct state and local income taxes only as an itemized deduction on Schedule A (Form 1040), subject to limitations. The deduction is limited to $10,000.
Foreign income taxes — typically, you can take a deduction or credit for income taxes imposed by a foreign country.
Unemployment fund taxes — you may need to make payments to a state unemployment or state disability fund. These can be deducted as an expense.
Excise taxes — typically, you can deduct excise taxes incurred during business operations.
Franchise taxes — typically, you can deduct corporate franchise taxes.
Fuel taxes — taxes on fuel are normally included as part of the cost of the fuel and should not be deducted separately.
Sales taxes — sales tax you pay on products or services for your business can be deducted as part of the cost of the product or service.
Typically, you can deduct the cost of insurance if it is for your trade, business, or profession. Types of insurance this may apply to includes:
Insurance that covers fire, storm, theft, accident, or similar losses.
Insurance for business property.
Insurance for business vehicles or equipment.
Credit insurance that covers losses from bad debts.
Medical and healthcare insurance for employees, including long-term care insurance.
Liability and malpractice insurance.
Workers' compensation insurance.
Business interruption insurance that pays for lost profits if your business is shut down due to a fire or other cause.
Typically, you cannot deduct the following insurance costs:
Self-insurance reserve funds.
Loss of earnings insurance.
Some life insurance and annuities
Insurance to secure a loan.
You can typically deduct utility and service fees for your business premises. Be aware that you should not deduct these twice — for example, if you are claiming for business use of your home, that may already take into account certain utility provisions and should only be deducted once. Types of utilities you may be able to deduct include:
Electricity and gas.
Water and sewage.
Garbage and waste disposal.
Broadband and phone service.
Building maintenance and repairs.
There are hundreds of expenses your business could claim, and we can’t cover them all in this guide, but here are some further examples:
Costs for developing, hosting, and updating your website.
Software development costs for building apps and other services.
Ongoing subscription and membership costs for software, organizations, or other fees you incur on a regular basis in the running of your business.
Marketing, advertising, and other promotional costs.
Costs of making business filings like annual reports and returns.
Accountancy and legal fees directly related to your business.
Computer and other hardware and peripherals.
Office equipment, stationery, and sundries.
Licenses and permits.
Bank and finance processing charges.
Services you purchase from other independent contractors.
We hope this has given you a useful overview of the main expenses and deductions you can claim for your business. Remember, you should always speak to your accountant or another tax professional about your unique tax situation, and get advice tailored to your specific needs.