Business Tax Deductions
Within the day-to-day life of your small business, you will incur
ordinary and
necessary
expenses that you can deduct when filing your taxes. So what does that mean?
"Ordinary" means they are common and accepted in the general industry in which the business owner
is working. "Necessary" means they are appropriate and required in operating your small business.
Here's a brief description of ordinary and necessary expenses that could turn into tax deductions:
Advertising
These expenses are incurred to promote a business, such as newspaper ads, flyers (including the
cost of distributing them), television and radio promotions and business cards.
Commissions and Fees
Referral fees or occasional amounts paid to individuals who are not employees or independent
contractors may be deductible. This does not include commissions paid to employees.
Contract Labor
Payments that are paid to independent contractors (non-employees) for services rendered are
deductible.
Employee Benefit Programs
Contributions to employee benefit programs include those to education, recreation, health and
welfare programs.
Insurance
Premiums paid to protect the business against losses are deductible as an operating expense.
Current or prior-year premiums may be deducted in the year paid for a cash-basis business owner.
Whether the cash or accrual method of accounting is used, advance payments may be deducted only in
the year to which they apply. Types of insurance for which premiums are deductible include fire,
theft, flood, merchandise and inventory, credit, public liability, workers' compensation,
business interruption, errors and omissions, disability (for employees), malpractice, display
window and product liability.
Mortgage Interest
The interest portion of mortgage payments on property used in the business is deductible.
Note: If the small business is located in the proprietor's home, the business portion of mortgage
interest is not included here but is part of the business-use-of-home deduction. There are strict
requirements on home offices; make sure you understand the restrictions.
Other Interest
Other interest includes all interest on business indebtedness for which the business owner did
not receive a Form 1098. This includes finance charges on credit card purchases made for business
purposes, interest paid on installment sale purchases and other types of loans for the business.
Legal and Professional Services
Costs for legal and professional services such as attorney, accounting, and tax preparation fees
that are ordinary and necessary to the operation of the business are deductible.
Office Expense
Office expenses are the costs of consumable office supplies such as pads, pens, pencils, order
books, receipt books, supplies for equipment (for example, cash registers, computers, and copiers),
postage and record books and related supplies.
Pension and Profit-Sharing Plans
Amounts paid by the business as employer contributions to a pension, profit-sharing, or annuity
plan for employees are deductible.
Rent or Lease
Rent or lease payments of business property are deductible in the tax year for which the rent is
due.
Repairs and Maintenance
Repairs and maintenance includes amounts necessary to maintain property in an ordinary, efficient
operating condition, such as labor, supplies, the yearly portion of the cost of service contracts,
and other items incidental to the repair.
It is important to distinguish between repair expenses and improvement expenses because an
improvement (a capital expenditure) must be depreciated. A capital expenditure increases the value
of the asset, increases the productivity of the asset, prolongs the asset's useful life, or adapts
it to a different use.
Supplies
Any supply items necessary to the proprietor's business are tax deductible, including gift wrapping
materials, cleaning or maintenance supplies, and maintenance of a watchdog on business property
or electronic security system.
Taxes and Licenses
Licenses, such as occupation, liquor, chauffeur, building, and regulatory fees paid annually to
state or local governments in connection with the business are deductible.
Taxes that are directly attributable to the trade or business are deductible, including:
- Real estate tax imposed on business property. (Real estate taxes paid on a personal
residence with a qualified home office are deducted as business-use-of-home expenses.)
- Any state or local tax on gross income (as distinguished from net income) directly
attributable to a trade or business.
- Personal property taxes imposed on property used in a trade or business other than those
for vehicles.
- Sales taxes imposed on sales of property or services at retail and measured by gross
sales price or gross receipts. If this tax is collected from the buyer, the amount must be
included in gross receipts. Note: Sales taxes paid on supplies or depreciable
property are added to the cost basis of the property.
- Compensating use taxes that are generally imposed on the use, storage, or consumption of
an item brought in from another taxing jurisdiction.
- Federal highway use tax.
- Payroll taxes.
Payroll Taxes
Employment taxes that a business must pay on behalf of its employees are deductible, including:
- Social security tax of 6.2 percent on each employee's wages up to $90,000.
- Medicare tax of 1.45 percent on each employee's wages.
- Federal unemployment tax (FUTA) ranging from 0.8 percent up to 6.2 percent on each
employee's wages up to $7,000.
- State unemployment tax, which varies by state.
Travel
Expenses incurred while you or your employees are away from home on business may be deductible.
An individual is away from home if he or she is required to be away from his or her tax home
substantially longer than for an ordinary day's work and he or she needs to get sleep or rest to
meet the demands of the work while away from home. The tax home is the entire city or general
area in which an individual regularly works, no matter where he or she lives. Deductible travel
expenses include:
- The cost of airplane, train, bus travel or car and truck expenses for traveling between
the tax home and the destination.
- The cost of local transportation, including bus, taxi, or limousine fares, while working
at the destination location.
- The cost of renting a car at the destination location.
- The cost of sending baggage or shipping samples or display materials to the temporary
work location.
- The cost of lodging and related tips, cleaning, laundry, telephone, and fax expenses.
Meals and Entertainment
Ordinary and necessary entertainment includes any activity generally considered to provide
amusement, entertainment, or recreation, including meals provided to a customer or client.
For entertainment expenses to be deductible, there must be a clear business purpose for them, and
substantial business discussions must be held before, during, or after the entertainment. The
expenses can't be lavish or extravagant, and the tax deduction is generally limited to 50% of the
expenses incurred.
The cost of business gifts to current or prospective customers is deductible up to a maximum of
$25 per customer per year. Tickets to shows or sporting events given to clients to promote
business are deductible. If the business owner accompanies the customer to the event, the cost of
the tickets is deductible as an entertainment expense. If the business owner doesn't accompany the
client, the cost may be deducted as either an entertainment expense (subject to the 50 percent
limitation) or as a gift (subject to the $25 maximum), whichever is more advantageous.
Utilities
The utilities deduction includes charges for electricity, gas, telephone, water, and sewer on
business property. If the small business owner has qualified business-use-of-home expenses, the amounts
paid for home utilities are deducted on Form 8829. The cost of basic local telephone service
(including taxes) for the first telephone line in the home is not deductible. The cost of an
additional line added for business purposes is deductible as are any long distance charges
incurred for the small business.
Wages
To be deductible, compensation must be an ordinary and necessary expense of carrying on the
business, reasonable in amount, for personal services actually rendered, and actually paid or
incurred during the tax year. Gross salaries, wages, or other compensation paid to relatives
(including the business owner's spouse and children) are deductible provided all these
requirements are met.
The actual cost of meals and lodging furnished to employees is deductible as compensation paid
regardless of whether the value is taxable to the employee. The value of meals and lodging
furnished for the employer's convenience is not included in the employee's gross wages. If
furnished as additional employment incentives, the value is included in wages.
Other Expenses
Examples of tax deductions that might be listed as other expenses are:
- Bank service charges (including the service charge for accepting credit cards).
- Dues to trade or professional organizations.
- Subscriptions to publications.
- Trash removal fees.
- Laundry and cleaning expenses for uniforms.
- The cost of food consumed by day-care recipients (other than the provider's dependents)
in a day care. However, if the provider is reimbursed under a USDA program, only the food
cost that exceeds the amount of the reimbursement is deductible. If the reimbursement
amount exceeds the cost of the food, the excess is included in income.
Bad Debts from Sales or Services
Customer accounts receivable and notes receivable that are definitely known to be worthless are
business bad debts and are deductible if the income was included in gross income. Generally, only
accrual method business owners have a bad debt deduction. A cash method business owner is not
entitled to claim a deduction for business bad debts because the sale was never included in
income.
Start-up Expenses
When someone begins a start-up business, he or she often incurs expenses just to get the business up and running.
As part of the American Jobs Creation Act, taxpayers can deduct up to $5,000 of start-up costs and
$5,000 of organizational expenses incurred in the first year of their small business.
Start-up expenses are the costs the business owner has for setting up an active trade or business.
If these costs meet the following tests, they may be recovered through a process known as
amortization:
- The costs would be deductible if they were paid or incurred for an existing trade or
business.
- The costs must be paid or incurred before the small business begins operations.
Examples of costs that may qualify as start-up expenses include the following:
- A survey of potential markets.
- Analysis of available facilities, labor, supplies, etc.
- Advertisements for the opening of the business.
- Salaries and wages for trainee-employees and their instructors.
- Travel and other necessary costs for securing prospective distributors, suppliers, or
customers.
- Salaries and fees for executives and consultants and for other professional services.
Start-up expenses do not include deductible interest, taxes, or research and experimental costs.
Expenses not deductible within the first year can be amortized over 15 years.
Car and Truck Expenses
A business owner who uses his or her automobile or reimburses an employee for using an automobile
has two methods available for claiming car and truck expenses. The two methods are actual
expenses or the optional method.
- Actual Expenses - A business owner who uses the actual expense method will claim the business portion of the actual
expenses paid to run the vehicle. Actual expenses include the cost of gas, oil, insurance, tires,
licenses, repairs, garage rent, and cleaning. If the car is rented, the lease or rent amount can also be a tax deduction (within limitations).
If the business owner owns the car, he or she may claim a depreciation tax deduction.
- Optional Method (Standard Mileage Rate) - The second method is known as the optional, or standard mileage rate, method. Business owners who
own or lease their cars and who don't operate a fleet of vehicles for their businesses are
eligible for this method.
The standard mileage rate for 2006 is 44.5 cents a mile. Business owners should take this into
account when calculating their income and expenses or paying the expenses of employees.
Note: The optional method may be used only if the business owner: 1) owns the car and used
the optional method in the year the car was placed in service (for vehicles placed in service
after 1980), or 2) leases the vehicle and uses the optional method for the entire lease period.
(For leases beginning before January 1, 1998, the entire lease period means the part of the lease
period after December 31, 1997.)
- Additional Expenses - The standard mileage rate is considered to cover most of the ordinary expenses listed under the
actual method. However, certain expenses may be claimed using either method. These expenses
include:
- Parking fees and tolls.
- The business-use percentage of finance charges paid on the purchase of the vehicle.
- The business-use percentage of personal property taxes on the vehicle.
Actual Expenses Depreciation
Depreciation is the annual tax deduction allowed to recover the cost or other basis of business
property with a useful life of more than one year. Generally, assets placed in service after 1986
are depreciated using the Modified Accelerated Cost Recovery System, MACRS. The term "MACRS"
essentially refers to two different depreciation systems, the General Depreciation System and the
Alternative Depreciation System.
The General Depreciation System is the most common and applies the depreciation rate against the
asset. The Alternative Depreciation System is different in that the depreciation is deducted over
longer periods of time. This system is generally used for listed property where the business use
drops to below 50 percent and for situations where the General Depreciation System cannot be applied.
But it doesn't apply if the standard tax deduction is claimed.
