Business tax deductions – three words that can cause stress and confusion for even the most seasoned entrepreneurs.
Most business owners spend their days managing operations, nurturing client relationships, and focusing on growth goals. It’s no wonder that tracking and claiming tax-deductible business expenses falls by the wayside.
But claiming as many tax deductions as possible is vital for your business’s financial health, so we’ve compiled this exhaustive guide to business expenses.
In this guide, we’ll teach you to save time by streamlining your expense tracking, cut your tax bill by optimizing your deductions, and ultimately help your business thrive by saving you revenue to invest back into your business.
This article covers the essential information about tax deductions, but here are some of our best resources if you want to get into specifics.
Dive in and find the solution to the exact problem you’re facing or keep reading to learn everything you need to know about tax-deductible business expenses.
- Small Business Tax Deductions
- Home Office Deductions
- Cash vs Accrual Accounting
- Nondeductible Expenses
- Form 941
- Commingling Funds
What Counts as a Business Expense for Tax Purposes?
In general, the IRS has this to say:
“To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. 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”IRS Publication 535
The ‘ordinary and necessary’ rule applies to all business expenses you wish to deduct. This can include advertising and marketing costs, bank fees, software, office supplies, and travel expenses. We’ll cover them all in detail below.
How to Keep Track of Business Expenses
Knowing how to track business expenses effectively enables you to make informed decisions, maximize tax deductions, and maintain a clear overview of your business’s financial performance. But how can business owners do this efficiently and accurately without sacrificing too much of their valuable time?
Follow these steps:
- Open a business bank account
Opening a business account is crucial for separating personal and business transactions. It’s a simple enough task, but commingling funds is a mistake that freshman entrepreneurs often make.
To minimize accidental accounting errors, consider opening an account at a bank different than the one you use for personal expenses. Be sure to secure a separate credit card as well.
- Choose the right accounting software & connect your bank
Software solutions are invaluable for categorizing business expenses for tax and cash flow management purposes. You can generate comprehensive reports that provide a clear breakdown of spending and revenue, empowering you to make future financial decisions and maximize business tax deductions.
The right software can save you a lot of time by automatically retrieving transactions from your bank, categorizing expenses, and ensuring no spending or revenue goes unaccounted for.
It’s crucial to make use of software as a young business, but as revenues grow, so does accounting complexity. Software is no replacement for professional help. When that time comes, consider indinero’s accounting services.
- Choose your accounting method: cash or accrual
The difference between these methods comes down to timing.
Cash accounting means registering transactions only when money lands in or leaves your account. Conversely, accrual accounting also encompasses future transactions, including invoices that have been sent but not paid.
Each method has advantages and disadvantages. See our article, Cash vs Accrual Accounting, for more information.
- Manage receipts properly
Not every transaction is digital. If you’re out and about spending money in person, the ‘shoebox’ method is not the way to go. Good accounting software includes apps that can take photos of receipts and will automatically record and categorize those expenses on the go.
Deductible Employee Pay
Salaries for employees or contractors are often a business’s largest expense. While there are certainly some non-deductible expenses, nearly all forms of pay are tax deductible.
Here are the types of employee compensation that businesses can typically deduct from their taxes:
Wages and salaries: Regular payments made to employees for their work hours, whether they are full-time, part-time, or seasonal.
Bonuses and Commissions: Additional payments made to employees as incentives or rewards for meeting performance targets and sales goals.
Overtime: Extra pay for employees who work beyond their regular working hours.
Sick Leave and Vacation: Remuneration for employees absent due to illness, injury, or vacation time.
Severance Pay: Lump-sum or periodic payments provided to employees upon termination.
Employee Benefits: Contributions to employee health insurance, retirement plans, life insurance, and other similar categories.
Reimbursements: Business-related expenses employees incur on behalf of the company, such as travel or meals.
Non-Cash Compensation: The fair market value of non-cash benefits, such as cars, housing allowances, or tuition assistance.
Payroll Taxes: The employer portion of social security and Medicare payroll taxes are deductible business expenses.
Test For Deductible Employee Pay
If pay for an employee or contractor doesn’t fit neatly into one of the above categories, use the following tests to determine whether or not it’s still a tax-deductible expense.
- Ordinary and necessary: As defined above
- Reasonable: The payment should reflect the fair market value for the services rendered and be consistent with what other businesses would typically pay for similar services
- Substantiated: You must have proper documentation and records to support the payment, such as contract, timesheets, or bank documents
Non-Tax Deductible Employee Pay
Volunteer Hours: You may not deduct the hourly time you or your employees spend on charitable causes.
Travel Expenses for Guests: While you may deduct some or all business-related travel expenses for employees, personal travel companions may not have their expenses deducted.
Non-Work Related Benefits: Benefits you provide employees related to entertainment, such as club memberships, social events, and recreational activities, do not qualify as deductible business expenses.
Employee pay as a tax-deductible business expense differs from employee tax deductions and withholding. As an employer, you’re responsible for withholding various taxes from employee paychecks. See our article on calculating gross vs net income for information on calculating employee withholding.
Is Business Rent Tax Deductible?
In a word, yes.
Rent paid for space used exclusively for your business is considered ordinary and necessary and is thus tax deductible. This applies to storefronts, office space, storage units, and other ordinary business rental agreements.
Additionally, if you’re responsible for property taxes as part of the rental agreement, pay to make improvements to the property, or incur administrative fees along the way, all of those expenses are also tax deductible.
However, there are some specific rules and regulations to keep in mind.
- You must have documentation of a valid lease agreement that clearly outlines the terms and conditions of the arrangement.
- If a portion of the space is used personally, such as your home, only the portion of rental expenses directly related to business activities may be deducted.
- “Unreasonably high” rent is not deductible. This might come up if the agreement is between related parties, such as family members or affiliated business entities, and the rent amount exceeds what would be considered reasonable for similar properties on the market. The deduction may be disallowed if the IRS determines that rent is inflated to shift income or gain other tax advantages.
- Should rent for a multi-year lease be paid upfront, only the portion of rent applied to the current tax year may be deducted.
- Businesses that own rather than rent their space are not eligible for a rental deduction. Only the interest portion of a mortgage payment is deductible for business tax purposes.
When deducting travel expenses, the most important things to remember are separating business and personal spending and properly documenting anything you plan to deduct.
According to the IRS, business travel refers to trips taken by an individual for “mostly business,” which involve staying away from their tax home for longer than an ordinary workday. This could mean traveling to a conference, meeting a client, or conducting market research.
To be considered “mostly business,” more than 50% of the days of the trip must be for business rather than personal purposes. Lastly, the IRS usually defines a “tax home” as where you live. If you live in one city but commute to another for work, your tax home is the city where you work.
The following are examples of what is considered ordinary and necessary business-related travel expenses:
Transportation: Airfare, train tickets, rental cars, ride shares, or other modes of transportation are eligible for deductions.
Accommodation: Expenses for lodging, such as a hotel or an Airbnb.
Meals: Up to 50% of the cost of meals while traveling may be deducted
Incidentals: Small expenses, such as tips, parking fares, wifi, or even dry cleaning, are tax-deductible
Special Rules for Traveling Abroad
If you travel overseas, your trip is considered “entirely for business” as long as less than 25% of the time is spent on personal activities. For example, say you take a twelve-day trip to London for a conference. You may allocate up to three of these twelve days for vacationing and meet the criteria.
Health Insurance Deductions
Premiums can be deducted as business expenses when they meet certain criteria. As with business rent, the premium paid by an employer on behalf of an employee must be ordinary, necessary, consistent with what other employers pay for similar coverage, and be properly documented.
Personal health insurance paid for by business owners or self-employed individuals is not a deductible business expense. Instead, these premiums may be eligible for deduction on an individual’s personal tax return.
Lastly, if an employer requires employees to contribute a portion of their health insurance premiums, the portion they pay is not a deductible business expense.
Bad Debts Written Off
Bad debts refer to unpaid amounts owed to a business by customers or clients. It arises when there is a genuine expectation of payment, but the debtor is unable or unwilling to fulfill their obligation.
A bad debt becomes worthless when there is clear evidence that it is unlikely to be recovered. Perhaps the debtor has filed for bankruptcy, is uncontactable, or demonstrates a prolonged inability or unwillingness to repay the debt. Be sure to document your efforts; should you be audited, the IRS will want to see good faith efforts to collect
First, to claim a bad business debt on your tax return, gather evidence of the transaction and your collection efforts. Next, remove any money you can recover from the debt through salvage value or insurance payouts. Finally, report the deduction.
Small Business Tax Deductions
Fortunately for business owners, the IRS is considerably more liberal with small business tax deductions than individual tax deductions. This recognition stems from the importance of small businesses to the economy—providing them with tax benefits fosters growth, innovation, and job creation.
In addition to what we’ve covered, the following are business expense categories that may be deducted.
Advertising and Marketing Costs
Promoting your business and attracting customers costs money. Expenses related to paid social media marketing, print ads, website development, and radio ads, as well as the costs of contractors or employees to fulfill these tasks, are fully deductible.
If you hire professionals, such as accountants, lawyers, or consultants, to assist with your small business, their fees are tax deductible.
Business Vehicle Expenses
If you use a vehicle for business purposes, you can deduct certain expenses related to its use. This includes fuel, maintenance, repairs, insurance, and lease payments.
You can calculate your deduction with the actual expense or the standard mileage rate method, whichever benefits you more. Should your vehicle serve both business and personal purposes, only the proportion of expenses incurred during business use is deductible.
Education and Training Expenses
Upskilling can be expensive. Thankfully, everything from seminars and workshops to conferences and online courses is tax-deductible.
Office Supplies and Equipment
Stationery, computers, software, furniture, and other necessary office materials are fully deductible.
Business Startup Tax Deductions
Businesses can deduct a wide range of initial startup costs as long as these expenses occur before the business begins offering services to the public.
In the first year, the business is operational, the startup deduction is capped at $5,000. Any costs over and above this amount are amortized monthly over the next fifteen years.
However, if your total startup costs exceed $50,000, the first-year deduction is reduced by the amount that exceeds $50,000. This is a bit complicated, but it may be easier to understand in this chart:
|Startup Cost||First Year Deduction||15-Year Amortized Deduction||Total Deduction|
The total deduction is always equal to the startup costs, but the amount you may deduct in the first year changes what is then amortized. For instance, if your startup costs amounted to $54,000, you may only deduct $1,000 in the first year since you exceeded the $50,000 by $4,000.
Remember that if you spend money in anticipation of starting a business but never launch, the IRS would consider these personal expenses, which would not be deductible on business or personal tax returns.
Home Office Deduction
The home office deduction allows independent contractors and small business owners to deduct expenses related to using their ‘homes’ for business use. For this deduction, in addition to the classic home office, a ‘home’ applies to various freestanding structures: studios, barns, garages, or even barns can count.
To qualify, your office must meet specific requirements:
- Exclusive and regular use
The area you work in should be dedicated solely to the business. For instance, you can’t count your kitchen even if you work there regularly.
- Principal place of business
If you use a variety of spaces to meet clients and work, the home must be your primary place of business.
Calculating the Home Office Deduction
The IRS provides two methods. You’re free to choose whichever provides the most significant benefit to you.
Simplified Method: Deduct $5 per square foot of space used for your business, up to 300 square feet.
Regular Method: Track and allocate actual expenses related to your home office. To use this method, determine the percentage of your home used for business purposes. Then, multiply that proportion against all expenses related to your home: rent, mortgage, interest, utilities, insurance, and repairs are all on the table.
You’ve invested incredible time and creative energy into building a business. That’s no small feat. By diligently recording and tracking business expenses, you can be sure to hold onto everything that’s rightfully yours.
The piece you’ve just read is our full breakdown of business expenses and tax deductions, but we’ve written extensively on the topic and gone deeper into the sections we covered here. If there’s a particular question or problem you want more information on, be sure to explore some of our other articles: