Deductibility: Taxes and Your Small Business

This time of year, when snow gives way to rain and ice to slush, you know that that most hallowed of governmentally-oriented days is right around the corner. The ads on TV and radio, the new storefront operations and the myriad of billboards peppering buses and looming large over expressways take all uncertainty away: Tax Season is upon us yet again and we are rushing headlong into another April 15th

One of the biggest questions posed during this time of year, especially by new small business owners, is this: “What business expenses can I deduct?” Legitimate deductions can save you lots of money. On the other hand, improper deductions can land you across the desk from a tax auditor and no one wants that.

Business expenses are the cost of doing business and as long as you are trying to make a profit, these costs are deductible. According to the IRS, “a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. 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.” That means if you are a contractor working on a house, the cost of  equipment—such as a nail gun or steel-toe work boots—would be considered an ordinary and necessary expense. Other things you could consider deducting include:

  • Payroll
  • Retirement Plans
  • Rent
  • Interest on Loans
  • Taxes
  • Insurance

The key is to keep your business expenses separate from you personal expenses, capital expenses and the cost of goods sold.

Personal expenses are pretty straightforward. If the expense is used for your yourself or your family, you cannot deduct it. Things get sticky when you have something for both personal and business reasons. If that is the case, you have to divide the usage between personal and business. You may then deduct the portion used for business. You can deduct for the use of your car. This is based on mileage and if you use your car for both personal and professional purposes, you will have to divide the mileage accordingly. That same kind of division comes into play when you use a portion of your home for business. How much of your home is used for business? Do you have a dedicated business phone? These questions and others will affect how much you can deduct from your mortgage interest, insurance, utilities, repairs, and depreciation. 

Capital expenses are considered to be part of your investment in your company and so are considered assets for tax purposes. They include start-up costs (some of these may be amortized or deducted), assets and improvements.

The most complex item is determining the cost of good sold. This applies if you are a manufacturer or if you are a reseller. Either way, you have to value your inventory at the beginning and at the end of each tax year. This determines your cost of goods sold, which is then deducted from your gross receipts to determine your gross profit for the year. The expenses that are used to figure the cost of goods sold include:

  • Cost of raw materials and/or products (including freight)
  • Storage
  • Factory overhead
  • Direct labor costs for the production workers (including pensions and annuity contributions)

Under certain circumstances, you may be required to capitalize both the direct costs and part of the indirect costs of goods such as rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. This, however, will not come into play if you acquire personal property for resale as long as your annual gross receipts for the preceding three tax years are no more than $10 million.

You will notice that some of the indirect costs are the same as some of the things that are, clearly, business expenses. The rule for this is that if you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.

For those of you determined to do it yourself—and we salute you—we have a couple of specials you might be interested in. For members of America’s Best Companies, H&R Block is offering a 25% discount on your Taxcut Online Federal Return, Intuit has taken 36% off their Quicken and 20% off their QuickBooks products and TurboTax is offering a 15% discount off of their online Federal products. You will also want some guidance from the IRS at www.irs.gov. Look for Publications 334 (Tax Guide for Small Businesses), 463 (Travel, Entertainment, Gift, and Car Expenses), 535 (Business Expenses), 538 (Accounting Periods and Methods) and 587 (Business Use of Your Home, and Standard Mileage Rates).