The part of any business that gets taxed is the net business profit and the net business profit is determined by subtracting the cost of doing business from the total gross income of the business.
Business expenses refer to the cost of carrying on a trade or business and these expenses are typically deductible if the business operates to make profits.
In order for a business expense to be deductible, it has to be both ordinary and necessary. Ordinary expenses refer to expenses which are common and accepted in your trade or business while necessary expenses refer to expenses which are helpful and appropriate for your trade or business.
It is important to note that an expense does not have to indispensable for it to be considered necessary. Some examples of business expenses which are deductible are:
- Wages and Salaries: You can typically deduct the pay that you give to your employees for the services that they perform for your business.
- Rent Expenses: Rent refers to any amount you pay to use property which you do not own and generally you can deduct rent as an expense if the rent is for property that you use in your trade or business. However, rent is not deductible if you have or will receive equity in or title to the property.
- Interest Expenses: Business interest expenses refer to the amount that is charged for using money that you borrowed for business activities.
- Insurance Expenses: You can typically deduct the ordinary and necessary cost of insurance if it is for your trade, business or profession.
- Taxes: Federal, state, local and foreign taxes which are directly attributable to your trade or business can be deducted as business expenses.
- Retirement Plans: These are savings plans that offer you tax advantages so that you can set aside money for your own retirement as well as for your employees’ retirement.
- Advertising and Promotion: The cost of advertising your business such as through websites, business cards, yellow page ads and other methods are deductible as current expenses. Also, promotional costs which create business goodwill are deductible as long as there is a clear connection between the sponsorship and your business.
- Books and Professional Fees: Business books are fully deductible and fees that you pay to lawyers, tax professionals or consultants can generally be deducted in the year incurred.
If a part of your home is used for business purposes, you may be able to deduct expenses related to the business use of your home. These expenses can include:
- Mortgage interest;
- Depreciation; and
Also, if you use your car for business, you can deduct the car expenses. However, if you use your car for both business and personal purposes, you have to divide your expenses based on the actual mileage.
It is important to distinguish business expenses from personal expenses, cost of goods sold and capital expenses.
- Personal Expenses: You generally cannot deduct personal, living and family expenses. But if you use something partly for business and partly for personal use, you can divide the total cost between the business and personal parts and deduct the business part.
- Cost of Goods Sold: You generally have to value inventory at the beginning and end of each tax year to determine your cost of goods sold if your business manufactures products or purchases them for resale. Some of your expenses may be included in calculating the cost of goods sold and if you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.
- Capital Expenses: You have to capitalize rather than deduct some costs and these costs, called capital expenses, are a part of your investment in your business. The three types of costs that you capitalize are business start-up costs, business assets and improvements.
Tax laws can be complex and difficult to understand. If you are not sure how to do your business taxes or if you want to be sure that you are getting every benefit under current tax laws, then it would be beneficial to talk to an accountant.
But, if you feel that you may have (or know you have) violated the tax law regarding small business deductions, then it is in your best interest to contact a local business attorney. While it might be tempting to ignore it and hope that the IRS doesn’t catch your error, there are serious consequences for those who are committing tax evasion. Especially for small business owners, who can be penalized severely under federal and state tax laws.