Claiming deductions can save your company thousands of dollars in income taxes. However, if you’re claiming ineligible business expenses, you risk facing an audit. If the thought of filing your taxes is enough to make you sweat, you’re not alone.
The IRS announced a plan to increase audits for small businesses by 50% for the 2020 tax year. Companies need to consider strategies to help them eliminate tax mistakes that can result in fines, interest, and other penalties. Hiring a tax professional can protect your company from costly errors and ensure you are aware of all your possible deductions.
In order to qualify for a deduction, a business expense must be ordinary and necessary for the production or collection of income. If you are wondering whether legal fees are tax-deductible or need help with miscellaneous itemized deductions, this guide will give you some clarity.
Understanding Deductible Business Expenses
Deductions work by reducing your total gross income. After subtracting deductions, you’ll only need to pay taxes for your net revenue. The current business tax rate is 21% at the federal level, plus state corporate taxes that range anywhere from 0-11.5%. Each state has different tax laws, and it’s a good idea for businesses to get advice for tax preparation.
Owners of “pass-through businesses” may choose to file with a standard deduction. These are businesses where the owners pay taxes on their individual tax returns, and they are increasingly becoming the new standard. They may be sole proprietors, partnerships, LLCs, LLPs, or S corporations.
Under the Tax Cuts and Job Act, pass-through businesses with qualifying incomes can deduct 20% of their income. The law also made changes to many categories of deductions. You should seek tax advice to determine whether or not to itemize in these situations.
The tax treatment of each deduction varies, and you’ll have to understand what makes certain business expenses ineligible for deduction. Let’s take a closer look at some of the complications involved in business deductions and how they will affect your income taxes.
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Cost of Goods Sold vs. Cost of Service
Retailers and Services account for operating costs much differently. For services companies, the formula is more straightforward. The cost of services is simply the sum of all direct costs, the majority of which are salaries and production costs that contribute to the revenue.
On the other hand, retailers will need to take stock of their inventory as well as the cost of labor. To determine the cost of goods, you’ll need to do a little more math. You’ll start with the total cost of your opening inventory, then add the cost of additional purchases and production costs throughout the year. Once you have the total, you’ll subtract the value of your closing inventory.
It’s not uncommon for the price you pay for inventory to shift throughout the year. To account for this, most businesses use an average weighted value for each product. You’ll also need to account for the costs of shipping, transportation, and storage fees.
What’s Happening With Business Meals?
Starting in 2018, the tax act made big changes to how business meals and client entertainment were handled. Entertainment costs that were a 50% write-off are no longer considered deductible. The rules for meals with clients are murky, but mostly off the table. Local employee meals lowered from 100% to 50%.
However, the government changed rules for the 2021 and 2022 tax years to encourage businesses to spend money at restaurants. For these two tax years, you can deduct 100% of the cost of business meals, so long as you have the right documentation.
Are Legal Fees Tax Deductible in 2020?
A common question for business owners is how fees for legal advice work. You can deduct legal expenses from your taxes, but there are some restrictions.
Legal services are tax-deductible so long as they are reasonable and necessary for your business. For example, you can deduct legal expenses related to tax issues, discrimination cases, or drafting and reviewing contracts.
Attorney fees related to issues not related to the business are exempt. For example, legal fees related to personal physical injuries, divorce, or custody cases won’t qualify. In some cases, determining whether or not a legal fee is personal or business-related is difficult.
For example, bankruptcy legal fees are tax-deductible if the bankruptcy is directly related to the failure of the business. But what if the bankruptcy occurred in a year prior to the tax filing. If you’re not sure whether your legal fees are tax-deductible from a 2019 bankruptcy for your 2020 taxes, you should seek expert advice.
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Are Legal Settlements Tax Deductible?
In the event that someone files a suit against your company, you may be wondering what you can deduct. Most legal expenses are tax deductible regardless of the outcome of the case. Additionally, any settlement you agree to pay out is fair game, as well as remedial or compensatory damages.
However, any fines or punitive damages are not considered deductible. On the other hand, if your company receives damage awards as the result of a lawsuit or settlement, you won’t have these gains to your gross income.
In some cases, expenses from compensatory damages and settlement agreements aren’t immediately deductible. If the dispute is regarding an asset, such as real estate, you’ll need to capitalize before you can make a deduction. Once you sell the asset, you can add your legal fees to the cost of purchase when you calculate your capital gains.
Understanding the implications of lawsuits requires expertise and experience to ensure you’re making the right deductions for your business.
Changes on the Horizon
There are currently many proposals in Congress that may pass that can affect income tax rates and tax treatments of various deductions. Many of them may affect the 2021 tax year. The best way to maximize your tax savings and prevent an IRS audit is to connect with a reliable expert.
Luckily, you don’t need a full-time accounting team to realize the best savings on your income taxes.
At inDinero, we closely monitor all the latest developments that can affect your business deductions. We combine our expertise with proprietary software to help you keep your taxable income to a minimum. That means If there is a way to save on taxes at the national, state, local, or individual level – we know it, and you’ll get it.
Our outsourced accounting, CFO, and tax services can help your business stay organized year-round so you can keep your finger on the pulse of your business and simplify your tax filing process. Reach out today to connect with our experts and learn more about how we can help.