Whether on an individual level or as a business owner, every living, breathing citizen or resident of the United States of America has some familiarity with federal and state taxes. The mission of the Internal Revenue Service is to "provide America's taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all." This is why we must file taxes annually on our income each year.
If you think about it, taxes are a bit of a beautiful symbiotic relationship. One taxpayer’s expense is another’s income: Payroll, for example, is an expense to a business and income to an individual.
While individuals are limited to a narrow number of types of expenses they can deduct (general home ownerships, charitable contributions, and certain medical expenses), deductions for business expenses are actually even more liberal (but must be purely related to the business—no mixing business and personal!)
Which brings us to tax deductions
Tax-deductible business expenses offer a great way for businesses to reduce their tax liability, especially for early-stage companies that are in spending mode as a way to aggressively scale each year. This is why a tax strategy is so key to consider when choosing your business’s accounting method: accrual or cash. Cash basis taxpayers have leeway to determine the timing of their income and expense for each calendar year while accrual basis taxpayers may have the ability to accelerate expense and defer their income.
Sidenote: This is just part of what you should consider when selecting your business’s accounting method.
This guide provides answers to the basic questions entrepreneurs have about small business tax deductions.
What small business expenses are deductible?
To be deductible, tax law requires business expenses to be ordinary (common and accepted in your trade or business) and necessary (helpful and appropriate for your trade or business). They also emphasize how important it is to keep the expenses you deduct as a business separate from your personal expenses (as a business owner), capital expenses, and any expenses that go toward the goods you sell (your cost of goods sold).
In a previous article, we weeded through the IRS's website (as well as others) to put together a list of 92 tax deductions every small business should know about (and 11 things that you definitely shouldn't try to deduct). That is a great place to start and see what relates back to your business.
What you need in order to take deductions
If you’re ever faced with an IRS audit you will need to provide evidence that expenses are deductible. Here’s what will help:
1. A bookkeeping system
Really, every business should be doing this, but tracking your income and expenses also makes tax preparation and filing simple and complying with the IRS requirements quick and easy. To file taxes, your tax accountant or CPA will need an up-to-date balance sheet and an income statement as well as your capital-asset activities for the year (buying, selling, or disposing of capital assets that year).
Out of the many accounting solutions out there, the best ones (including inDinero’s) give you concrete data to make the best decisions on your taxes.
2. Receipts and records documenting expenses
Record keeping is key. Whether you store and categorize these digitally or are still using the old shoebox method, your CPA will thank you for maintaining detailed context for the deduction you claim.
Protip: Make this easy on yourself and spare yourself the clutter! Choose a bookkeeping software or solution that also allows you to upload and store your receipts.
3. Certain expenses require specific records
Take note, sometimes a receipt is not enough. Deducting the use of a personal car for business purposes is one example where you will need more information to back up your deduction. It’s best for you and your employees to track your mileage based on business vs. personal in a log.
Tax Deductions vs. Tax Credits
In addition to deductions, businesses performing set activities that the congress has chosen to incentivize can qualify for tax credits that provide a dollar-for-dollar reduction in tax liability. Tax deductions lower your tax liability by reducing your taxable income. To determine and file your tax credit, use the corresponding form from the IRS’s website.
Credits provide a greater benefit than deductions. Some activities, like research and development to create a new process or product may qualify for a credit but also have related tax deductions. These research and development costs are either deductible or creditable, but not both.
Claiming both credits and deductions involves detailed record keeping:
“It all starts with having your books organized. Taxes aren't that difficult if you have your accounting squared away.”
- Jessica Mah, Co-founder & CEO of inDinero
Whether you’re scrambling to make your 2016 tax deadline or are unsure which expenses you can deduct, well-organized bookkeeping will be your best friend. Not only will it make it easy for your to reference data if you file on your own, but having ready access to detailed records will also make it easy to solicit help from a tax professional or CPA who will need to understand your business and it’s year-long activities.
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