Tax Deductions for Small Businesses

by Deborah Lee Moulton, A Step Up Bookkeeping Services

Ordinary and Necessary Expenses

Small businesses owners who file a Schedule C may deduct business expenses directly from business income to arrive at the net profit of the business.  This amount is what is used to calculate self employment taxes, so it is important to keep good records so that the maximum deductions can be claimed.  In order to be deductible, expenses must be “ordinary” and “necessary” to your type of business.

Allowable business tax deductions include: professional services (such as accounting, attorney and consulting services), logistical support (alarm systems, cleaning, long-distance phone service, office supplies, postage, shipping, printing, repairs and maintenance), the cost of financial services (such as bank service charges and credit card merchant fees), office equipment, furniture and fixtures, travel, entertainment, wages and salaries, marketing, insurance, payroll taxes and other non-income taxes.

If there are more expenses than income, a loss may offset other ordinary (personal) income on the tax return. Or, the “net operating loss” (or NOL) can be carried back, to reduce the previous year’s business income, and forward, to reduce the future year’s taxable business income.

Capital vs. Deductible Expenses

Generally equipment purchases and major improvements that are expected to last longer than one year are capital expenses and should be depreciated over the useful life of the asset.  There are many choices on how to depreciate assets, including straight-line and accelerated methods.  Your tax preparer or accountant can advise you on the best method to use for your tax goals.  In the first year of service, up to 100% of the asset may also be deducted as a Section 179 expense. This may or may not be appropriate for your situation.  It is important to remember to treat equipment as a capital asset however, and either depreciate it or claim the Section 179 deduction.  Although the resulting deduction from the Sec. 179 100% deduction and just expensing the entire 100% may yield the same number, they are very different to the IRS.  If you are audited, the IRS may disallow a capital expense that was not depreciated, and then you will not be allowed to either depreciate or claim the Section 179 deduction for that item at all.

Car Usage

Small business owners who drive their personal car for business can opt to deduct their actual expenses or rely on a standard mileage rate. For 2008, the IRS changed the mileage rate mid-year. For the first half of the year, you may deduct 50.5 cents per mile. For July 1 through December 31, 2008, deduct 58.5 cents per mile. For 2007, the rate was 48.5 cents per mile. This optional rate can be used for vehicles that are owned or leased. Commuting miles, the travel from your home to your primary place of business, are specifically NOT deductible.  However, if you have a qualified home office, the commute from your home to your office is zero, so all business travel miles are deductible.  Be sure to keep accurate, written records of all business miles.

Travel, Meals and Entertainment

Business travel expenses, such as airfare and lodging, are 100% deductible. But if you take your family, only your costs can be deducted. So only the cost of the room for a single, and only the cost of your meal can be taken as a business deduction. Their costs are separate, and are not deductible.

Business meals and business entertainment can be taken as a deduction at 50% of the cost. Make sure your keep records of the cost, the guests and their relationship to your business. If you put on a party for your employees, you can deduct 100% of the costs.

Business Owner Deductions

If you pay health insurance premiums, you can deduct 100% of your premium. You do not qualify if you are eligible under a spouse’s health plan. Other deductions include payments to a SEP or IRA. Social security payments, of which you pay all, can be deducted at ½ of your total contribution.  These deductions are taken on the first page of Form 1040, NOT on Schedule C.

Home Office Deduction

Businesses that operate out of the home may be entitled to deduct some of the expenses related to the home, including: depreciation on the house, home mortgage interest and real estate taxes (or rent), home insurance, utilities, wages for domestic help and local phone service (excluding your basic service).  Unlike the business expenses deducted directly on Schedule C, the home office deduction cannot reduce the business income below zero.  Thus, it can only be taken if the business still has a positive net income after expenses (including depreciation) have been subtracted.

Regular and Exclusive qualification

In order to qualify for the home office deduction, you must have a separate area of the home that is dedicated exclusively to the business and used on a regular basis.  The area need not be an entire room, but it does need to be a separate area. If you perform services at varied locations or client offices, the home office should be the location where you perform substantial administrative and management tasks, such as invoicing and bookkeeping, or the place where you normally meet or deal with clients, customers or patients.

For example, if you have a 1000 square foot home and you are using a spare bedroom that is 100 square feet, and only using it for your home office, you have a business percentage of 10% (100 feet is 10% of 1000). But if you also use the area as a guest room, the whole 100 feet cannot be considered business space.

Use Form 8829, Expenses for Business Use of Your Home, to calculate your deduction.  There are two columns on this form – one for direct expenses and one for indirect expenses.  Direct expenses are those costs that apply only to the home office space, such as painting or repairs directly in the home office area.  Indirect expenses are the general home expenses, such as mortgage, real estate taxes, property insurance, utilities and home improvements relating to the entire property, such as roof repair or landscaping.  Direct expenses are deducted 100%. Indirect expenses are deducted only to the extent of the business percentage (i.e. 10% of the home is the business area, so 10% of the indirect costs are deducted.)  Note that when you deduct home office expenses, a portion of the home must be depreciated as business property.  When the home is sold, the total depreciated amount must be subtracted from your basis to calculate the gain or loss on the property.

The most important thing you can do is to keep accurate records of your expenses that qualify as home-based business deductions. It is important to know what is a legitimate deduction and what is not, since small or home-based business owners are three times more likely to be audited than non-small or home-based business owners. Then be sure to file your taxes with a knowledgeable tax preparer or CPA.

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We hope you have enjoyed this article, written by Debbie Moulton, owner of A Step Up Bookkeeping Services.  A Certified QuickBooks ProAdvisor, Debbie has helped many small business owners improve their cash flow by streamlining their bookkeeping processes.  To improve your own accounting system, call Debbie at 603-679-2022 for a no obligation, no cost initial consultation.