The cost of doing business is unavoidable. However, with careful attention, you can use business expenses in your favor to decrease your tax liability. By knowing what business expenses to deduct, you can be sure you aren't paying more than you need to.
Use the tips below to maximize your profit when using legitimate business expenses to reduce your taxes.
What Are Business Expenses?
Costs associated with operating your business on a daily basis are called business expenses. Your business expenses are deducted from your revenue on your income statement. This leaves you with your net taxable income. If you are a business owner, you can deduct "ordinary and necessary" expenses that keep your business running.
A business's expenses are recorded on its income statement. Under the revenue section, include business expenses, and deduct them for a net profit or loss.
Inventory, payroll, and rent are examples. A fixed expense is one that doesn't change much - for example, rent or insurance. Variable expenses are ones that are expected but can fluctuate. Some examples include commissions, Shipping costs, and gas for business vehicles. Variable expenses are expected each month, but their amount will vary. Monitoring your business expenses helps you determine whether you'll make profits or losses.
Three Basic Types of Business Expenses
You will need to categorize business expenses according to these categories when reporting them for tax deductions:
The cost of a fixed business expense is the same, or almost the same, every time you pay it.
These are costs or expenses that do not fluctuate with changes in production level or sales volume.
Examples include rent, internet service, and subscription fees.
Unlike fixed expenses, variable expenses vary from month to month and are typically your biggest expense.
If you use freelancers or offer overtime pay, your payroll expenses may fluctuate. Equipment rental is also a variable expense.
Expenses that come up from time to time, such as replacing equipment or getting repairs, are periodic expenses.
Oftentimes, these are expenses that you don't think about, such as annual expenses like business vehicle registration. If you want to be prepared, look back at your reported periodic expenses from year to year so you can estimate what you spent and what to expect.
How Do Business Expenses Impact or Reduce Taxes?
The IRS allows deductions for ordinary and necessary expenses. To be written off, an expense must be incurred by a business intending to make a profit. There are some expenses that are fully deductible, whereas others are partially deductible or won't be fully deductible the year they are incurred.
Section 162 of the Internal Revenue Code (IRC) provides guidelines for business expenses. Tax liability can be reduced as long as expenses are deemed ordinary and necessary.
In the eyes of the IRS, ordinary expenses are those common to most business owners in their industry or trade. Expenses that are necessary help you run your business and are appropriate for your organization.
What types of business expenses are tax-deductible?
The IRS defines allowable deductions of those that are both "ordinary" and "necessary". A company may not be able to deduct all of its expenses.
The following are some common business expenses:
- Payroll expenses
- Employee benefits
- Home office expenses
- Insurance premiums
- Rent or mortgage payments
- Retirement plans
- Depreciation of equipment
- Interest expense
In order to maximize your deductions, you should keep a complete and accurate accounting of all your expenses. To reduce your overall tax bill, you can itemize these deductible expenses at tax time.
Helpful Resource: The Detailed List of Small Business Tax Deductions
What types of expenses are not tax-deductible?
Often, business expenses are assumed to be tax-deductible, but that's not always the case.
Here are some of the most common non-deductible expenses:
- Political contributions
- Government fines or penalties
- Demolition losses or expenses
- Certain education expenses
- Legal fees
- Capital expenses
General Rules for Claiming Allowable Business Expenses
When you are wondering if a business expense can be deducted, you can follow certain rules of thumb. The following are the general rules for claiming business expenses on your tax return.
- Business expenses must be incurred. Regardless of the date on which the money is actually paid, an expense is 'incurred' once the legal obligation to pay has arisen.
- You can only claim business-related expenses. It is important to show why you must incur expenses in order to earn income.
- Personal and private expenses are not allowable as they are unrelated to your business.
- Capital expenses (such as the purchase of fixed assets such as machinery and plant) are not allowable business expenses. Depreciation of fixed assets may be claimed as a capital allowance, however.
- Documentation about your expenses should be kept for at least five years to substantiate your claims.
Can Business Expenses Be Carried Forward?
The tax year in which the purchases were made is usually the one in which the expenses must be reported. The company may choose to file an amended tax return if the expenses missed were considerable and affected its taxes. The amended tax return must be filed within three years.
Helpful Resource: How to Amend Your Tax Return
In addition, expenses that are classified as capitalized costs will be carried forward, but depreciation amounts will change every year. For a new company with a lot of start-up costs, this is standard.
Personal vs. Business Expenses
Your company's taxable income can be reduced by deducting business expenses. Personal expenses cannot be deducted. What are some of the differences, and are there any gray areas?
Keeping your personal and business expenses separate is essential.
You can keep separate receipts this way, and if you have a business credit card or debit card, you can use that for business purchases.
Helpful Resource: Why You Should Open a Business Bank Account
Are you making a purchase to try and increase revenue at your business? In your industry, would this be considered a normal purchase? Most likely it's a business expense.
Record the purchase, keep the receipt, and note why the purchase was made. You can deduct the amount from your income and lower your tax bill.
A business purchase is a purchase you make as part of your normal operations. Personal expenses are items not related to your business. But, how do you handle home offices, for example? Your home office may be deductible if you use it exclusively for business purposes. However, you cannot deduct the full amount of your home mortgage.
Some expenses, such as utilities, real estate taxes, and phone bills, can be itemized. In case you are audited, it's especially important to keep meticulous records explaining why you are expensing these items.
How to Keep Track of Business Expenses
It can be challenging to keep track of your business expenses. However, it is also one of the easiest ways to reduce your overall tax liability. Listed below are some tips to make expense management a little easier.
Keep meticulous records
Keep it whenever in doubt. Receipts and other documentation of your business expenses will come in handy if you ever face an audit, and the IRS requires some records to be kept for up to seven years. Records such as receipts, tax returns, and employment records should be kept for 3-4 years. Bad debt documentation should be kept for seven years. To keep track of your expenses, you might want to consider using business accounting software.
Helpful Resource: Save It or Shred It: How Long To Keep Your Important Financial Documents
Separate personal and business expenses
You can deduct business expenses and reduce your taxable income. Separate your business expenses from your personal expenses as soon as possible. Set up a separate checking account for your business. Get a credit or debit card for the business. Be sure to inform your business partners which expenses are deductible and which are not.
Save receipts for business travel
Tax deductions are available for many business travel expenses. Record transportation, lodging, and some meals (usually 50% of the cost). You should keep your receipts for these expenses for at least three years, in case the IRS audits you.
Record expenses as soon as possible.
You should get in the habit of recording expenses right away, whether you store your records yourself or use an accounting software program. You should formalize the process for tracking and storing receipts and recording expenses.
Monitor and review expenses regularly
You can display expense information using charts and dashboards in business accounting software. Likewise, if you manually track your expenses, be sure to incorporate a regular review into your expense management policies and procedures. Consider double-entry bookkeeping to detect errors and prevent fraud.
Preparing Your Taxes With Business Expenses
Every time you are uncertain whether a cost is legitimate, ask yourself, “Is this an ordinary and necessary expense for my business?” If you are audited by the IRS, the IRS will ask you the same question. Don't take the deduction if the answer is no.
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