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What are Business Deductions, and How Can They Help You Save Money on Your Taxes?

Did you know that you can deduct from your income taxes any ordinary and necessary cost that you have incurred while running your business? This can greatly reduce the overall amount of taxes that you owe. 

It's an age-old saying: "You have to spend money to make money." What you might not realize is that spending that money can bring you a double benefit. The money you spend as a business owner can often be deducted from your business income when determining your taxable income.

Business expenses generally deductible provided these two conditions are met: 

  1. The expenses were "ordinary and necessary"
  2. You kept the records that the IRS requires to support your claims 

For almost every small business, the quest for tax savings should start with maximizing your deductions.  These are the threshold considerations that apply to all business decisions:

  • Business expense versus capital asset. It is important to understand the distinction between these two concepts. A business expense refers to the amounts paid for an item that is not expected to last more than one year. For example, purchasing copy paper is a business expense; but, purchasing a photocopying machine is not a business expense; instead, it is a capital asset. 
  • Appropriateness of the expense. Was the expenditure ordinary and necessary for your business? 
  • Relation to a business activity. The IRS is keenly aware that taxpayers may be tempted to write off things as business expenses that are really nondeductible personal expenses. Stay clear of this tactic, as it can get you in trouble. If the expense was only partly for business, you'll need to allocate the total cost between the business and personal portion.
  • Documentation. Gather adequate records to substantiate the deduction, because if your business ends up being audited, the IRS agent will ask you to show proof of the expense. This is where your recordkeeping routines come into play. If you have kept good records, proving your deductions won't be a problem. Remember, on most tax matters, the IRS can require you to prove that your deduction (or other item on your personal or business return) is correct. If you can't do this, the IRS will compute your tax liability based on its view of the question under dispute.

How to Know if a Business Expense is Tax Deductable

Only expenses that are related to carrying on a trade or business are deductible: Personal expenses are not deductible. In addition, these expenses must be ordinary and necessary for your type of business. Finally, the amount paid must be reasonable under the circumstances.

Business Expenses Must Be Related To Your Business

In order to claim a business expense as part of your tax deductions, the expense must relate to your business, not your personal life. That's an easy principle to state, but in real life, the distinction between business and personal can be unclear, especially if you work from home or work at your family business. However, the IRS has come down hard on those who don't keep their personal and business expenses separate, and who attempt to deduct personal living expenses against business income.

Special rules apply to items seen as "high-abuse"

The tax laws contain many very specific rules regulating areas where business expenses can be most difficult to disentangle from personal expenses. For example:

  • commuting expenses are nondeductible
  • business meals and entertainment deductions are limited
  • certain property ("listed property") that is commonly used for both business and for recreation or amusement is subject to special depreciation rules and more stringent reporting

As a rough rule of thumb, if you're in doubt about whether a particular expense qualifies as a business or personal expense, ask yourself whether you would still have to pay the expense if you had the same income level but didn't work. If you would still have to pay the expense, there's a good chance that what you have is a personal expense, not a business expense.  

Allocation Required Between Business and Personal Use

If an expense was incurred partly for business and partly for personal purposes, you need to allocate the expense and deduct only the portion that pertains to business use. The method of allocation depends on the nature of the expense. It can be done on the basis of time, space, usage, or any other reasonable method.

As an example: Bob hires a cleaning lady who cleans both his office and his home. He can deduct that portion of wages and payroll taxes that compensate the employee for the time spent cleaning his office, but not his home. In addition, he drives his car for both business and personal purposes. He must allocate his car expenses on the basis of the mileage driven for business purposes, as opposed to that for personal or commuting purposes.

Only Ordinary and Necessary Business Expenses Are Deductible

Assuming that you have incurred an expense in connection with your business, you still must establish that the expense was "ordinary" and "necessary" to be justified in claiming a deduction. But, what do "ordinary" and "necessary" mean? Ordinary means an expense is common and accepted in a field of business. Ordinary usually refers to expenses that are frequent and ongoing, such as amounts spend on gasoline or business meals, but can also apply to something that you pay only once, such as an installation fee for a business telephone line. Necessary is defined as helpful and appropriate to your business. An expense does not have to be indispensable to be necessary. 

Business Expenses Must Be Reasonable

In addition to being "ordinary and necessary," a business expense must also be "reasonable." Whether an expense is reasonable depends upon the facts and circumstances in the particular situation. For example, one case held that providing a chauffeured luxury car to an employee was not unreasonable given the nature of the employment and the congested area in which the car was driven. Similarly, although entertainment and meal expenses are not deductible to the extent that they are lavish or extravagant, an expensive dinner at an exclusive restaurant might be acceptable under certain circumstances.

Review Your Expenses to Make Sure They Pass IRS Muster

In applying the "ordinary and necessary" deduction test, the IRS isn't looking to second-guess your business decisions. You can expect that almost any expense that's fairly common for your type of business will pass muster without serious question. IRS agents use this test to make sure that: the money was actually spent, and the expense pertains to the business (instead of personal or family needs); is not also being deducted elsewhere on the return (such as in the cost of goods sold computation), and is a current, rather than capital, expense.

Adequate Records Are Essential

If you claim business expense deductions, you will need to have the books and records to substantiate those expenses. The nature of the documentation depends upon the type of expenses, but you need to be able to prove the amount and purpose of each expense. All taxpayers are required to keep accurate, permanent books and records so as to be able to determine the various types of income, gains, losses, costs, expenses, and other amounts that affect their income tax liability. These records must be retained for as long as they may be relevant for any tax purpose. This applies to business expenses, as well as all other deductions and income items. 

You Must Be Able to Prove the Expense

In order to claim any deduction, a business owner must be able to substantiate the expense. That is, you must be able to prove two facts: the purpose of the expense, and that the expense was, in fact, paid or incurred. A receipt or invoice showing the description and cost of the item, plus a canceled check or credit card charge slip, are two types of documents that prove the amount and purpose of an expense.

In some cases, if you don't have records of a particular business expense, but it's obvious that you must have incurred it, the IRS will estimate the amount of your expenses and allow you to deduct only that amount when your return it audited. An example would be a retailer who has incomplete records of inventory purchases: The IRS will come up with a reasonable estimate of what the purchases should have been. However, there are some expenses that must be supported by hard evidence to be allowed as deductions. Expenses that are particularly susceptible to cheating are subject to special documentation rules and must be proven by adequate records or other evidence.

If you have no records, the deduction will be completely disallowed—the IRS and the courts will not estimate an allowable amount. The following are expenses that require careful documentation: expenses for travel away from home (including meals and lodging while traveling) meals and entertainment expenses business gifts cars and other means of transportation computers, and other property of a kind that is generally used for entertainment or recreation The recordkeeping (substantiation) rules for these expenses are discussed in the articles related to the particular expense.

How to Claim Business Expense Deductions

How you have organized your business (e.g., as a sole proprietorship, S corporation or regular corporation) determines the IRS form you'll use to claim your business deductions.

  • If you operate your business as a sole proprietorship, you will report business deductions on Schedule C of Form 1040. (You can use the simpler Schedule C-EZ if your business expenses are under $5,000, you do not have inventory or employees, you use the cash method of accounting, and certain other requirements are met.) A single-member LLC is treated like a sole proprietorship, unless you have made an election to have the LLC taxed as a corporation.
  • If you do business as a partnership, you'll file Form 1065 that will report the expenses for the partnership. Certain expenses will be passed through to you on a Schedule K-1. A multi-member LLC typically is treated like a partnership, unless you have made an election to have the LLC taxed as a corporation.
  • If you operate as a corporation or as an LLC that elects to be taxed as a corporation, you'll file Form 1120 or Form 1120-S for S corporations. If you file Form 1120-S, many expenses will flow-through to you and be reported to you on a Schedule K-1. A regular corporation reports the expenses on its own tax return; no expenses flow-through directly to shareholders.

Here are additional tips to consider:

  • Spending the time and energy to unearth every legitimate deduction that you can claim is usually your best bet for reducing your taxable income (and therefore your tax bill) as much as possible in the short run. In the long run, there may be other ways to save even more tax dollars - such as by shifting income to other tax years and by taking advantage of tax credits - that can take a certain amount of advance planning. 
  • Getting a tax deduction may be nice, but make sure that the deductible expense is justified from a business operations perspective. Particularly if you are in the startup phase of your business, the money you have to spend is limited. You don't want to fall into the trap of justifying the purchase of a gold-plated filing cabinet by saying: "So what if I really don't need it, it's deductible!"
  • Certain types of expenses are declared "not deductible" by tax laws for public policy reasons. These include items such as lobbying expenses and political contributions, fines and penalties such as parking tickets, and illegal payments such as kickbacks. For instance, a traveling salesman who receives a speeding ticket must pay it, or risk losing his driver's license and his ability to earn a living. It could potentially be argued that the cost of the ticket is an ordinary and necessary business expense. Nevertheless, the law specifically states that legal fines and penalties are never deductible, so the ticket must be paid out of the salesman's own pocket.
  • There are some personal expenses that can be deducted without regard to whether you are operating a trade or business. Many of these are relevant to those who work out of their homes. For example, if you itemize, you can deduct your mortgage interest and real estate taxes, even if you don't claim a home office deduction. Other expenses might be deductible even if they are personal expenses, but the amount of the deduction will be far more limited. Non-business casualty losses are deductible, but not to the extent business casualty losses are deductible.

You will need to keep all records that support items on your tax return for at least four years after you file your tax return because the IRS may challenge your return for up to three years after its due date. For some transactions, such as the purchase of property or equipment for your business, you will need to hold onto the records for at least as long as you hold on to the asset, plus four years. 

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