Welcome to David in Taxland - a series of tax articles written for business owners. Spoilers: a deduction is a deductible expense – and – pancakes and pianos should be kept separate.
Do you find taxation confusing? I did. Then I became a tax accountant. I still find it confusing. Just not as much or as often. I write these articles to help you wrap your mind around key concepts and practices. I want taxation to make sense to you.
Hey, before we start, let’s get this out of the way: there are a gazillion articles out there on business deductions; many are worth reading. IRS Publication 535 Business Expenses is a very good guide. When you make tax-related business decisions, please rely on appropriate and legit sources, not blog articles—especially not mine. When in doubt: study, learn what you can then talk with a tax pro. Enough about that. Let’s get right to it.
Business Deductions - The Basic Idea
In Taxland, deductions are subtractions from income. The IRS and state tax agencies know businesses need to spend in order to earn, and they tax your business on the difference between the two. Here’s the basic formula:
INCOME – DEDUCTIONS = TAXABLE INCOME
TAXABLE INCOME X TAX RATES(S) = INCOME TAX
A Deduction is a Deductible Expense
An expense is the cost of a resource that’s been used—as it is recorded on your business’ books, however those books are kept. A deduction is an expense that’s deductible on a tax return. Your books are prepared one way (cash or accrual method, because these methods are useful) and your tax return another (IRS regs and rules, because it is required). There are legitimate differences between the two; I’ll take this on in a later article.
Ordinary and Necessary
How can we know what’s deductible and what’s not?
The IRS tells us that deductions should be ordinary and necessary expenses. An expense is ordinary if it’s usual, common or acceptable for a particular business. As for necessary, it turns out this word sounds stronger than it is. Necessary, in this context, means it’s helpful and appropriate for a business.
The IRS Tells Us
“To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
But That’s Not All
There is an additional layer of rules and guidelines that involve depreciation, non-deductible expenses and other weirdness. I offer brief introductions to some of this in the appendix to this article. Back to our new friends, Ordinary and Necessary.
Ordinary and Necessary - An Example
Let’s say I open an urban food cart. Equipped with my mother’s recipe, I cook and sell Norwegian pancakes (oh…please allow me a moment of homesickness…OK, I’m back).
What can I deduct from the income I earn from pancake sales?
The cost of the flour, eggs, butter, sugar, milk, raspberry jam, ricotta and so on—all the good stuff that goes into the pancakes. I can deduct the cost of the packaging it’s sold in, fuel to cook it, advertising, insurance, little Norwegian flag thingies that decorate the cart, rent for the lot and so on. Also, I can deduct the cost of my equipment and the food cart itself since I own these assets (these costs might be deducted over a number of years, which is the basic idea behind depreciation—more on this later).
How about if I try to deduct the cost of a piano? Ordinary for a food cart? No, that’s not right—there’s no space in or near my food cart for a piano. I’m selling food; nobody’s getting their Elton on anywhere near the pancakes! Necessary/appropriate? Not that either. It’s a bad deduction. It has no business being anywhere near a tax return.
On the other hand, if I open a bar and grill, buy a piano and use it in the business to help clients chill as they dine, the cost of the piano is a legitimate deduction because it’s ordinary and necessary. I’d probably deduct it over a few years, so there’s that depreciation thing again.
Paying Less Business Income Tax
The main way of paying less income taxes is almost too simple. A business can spend more on deductible goods and services. Since more deductions mean less taxable income, then the more deductions a business has, the less it pays in income taxes. Let’s say, for simplicity’s sake, you have a profitable business and it’s combined federal and state income taxes are 30%. If it spends an additional $100,000 on deductible expenses, the business saves $30,000 in taxes. It spends a net of $70,000 ($100,000 expense less $30,000 tax savings). In other words, you can spend a dollar to save thirty cents.
Another way of saving on income taxes is educate yourself on tax guidelines and rules that are relevant to your business and use that knowledge to help you make good business decisions that affect taxation. There are many different strategies and they differ between types of businesses (a start-up tech company typically has a different approach than a food cart), entity types (c-corps, s-corps, partnerships, sole-proprietorships and so on), and the plans, dreams, risk-tolerance and so on of the owners. Study, learn what you can, check out the appendix and talk with your tax pro.
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Appendix: Depreciation, Non-Deductible Expenses and Other Weirdness
- Depreciation. When we depreciate an asset, instead of deducting its cost during one tax year, we deduct the cost over multiple years. Usually we depreciate assets for 3, 5, 7…up to 40 years, depending on the type of the asset. Here’s the weird part: tax law allows for bonus and Section 179 depreciation which allows certain assets to be depreciated in one year. In other words, if an asset is eligible for bonus or Section 179, they can deduct the entire cost of the asset in one year. There’s a lot more to depreciation; study, learn what you can and ask your tax pro.
- Entertainment. A few years ago, the IRS stopped allowing deductions for entertainment, amusement and recreation. This also applies to club dues. There are some exceptions. If entertainment is a significant part of your business, study and ask your tax pro to be sure you understand the specific rules and exceptions.
- Federal Taxes. While state income taxes are usually deductible on a federal (IRS) tax return, federal taxes are not deductible on a federal return.
- Fines and Penalties. These are typically not deductible as the IRS does not wish to incentivize illegal behavior.
- Hobbies. The IRS assumes businesses are in business for profit. Some taxpayers have hobbies that bring in a little income. The income is taxable and, if there’s no for-profit motive, the IRS limits deductions. If you think your business might be considered a hobby, study, learn what you can and ask your tax pro.
- Illegal Activities. The income is reportable and taxable. Some of the deductions might be allowed. Here’s a link to an article about taxable income.
- Meals. Meals are typically only 50% deductible. The IRS knows we need to eat, even when we’re doing business, and has traditionally allowed only half of the cost of meals. If food and beverages are a significant cost in your business, study and ask your tax pro to be sure you understand the specific rules and exceptions.
- Net Operating Losses. Businesses often have losses in their early years. In the case of C-corporations (regular corporations), these losses often can be carried forward and deducted in future tax years. This can save some serious cash on income taxes during the first few profitable years. If you have a C-corp with a net operating loss (an NOL), check out this article.
- Payroll and Employee Benefits. These are often the largest deductions a business gets to take. There are plenty of strategies, some involve timing of compensation/bonuses. Consult an accountant and a payroll/benefit expert.
- Personal. If it’s personal, it’s not deductible. Keep personal and business expenses separate.