Running a business comes with various costs, many of which can be deducted to reduce your taxable income. To qualify for a deduction, business expenses must be deemed both “ordinary and necessary.” Here’s a breakdown of what that means and how to navigate the complexities of business expense deductions.
What Are “Ordinary and Necessary” Expenses?
- Ordinary Expense: This is an expense that is common and accepted in your trade or industry. For example, a marketing firm purchasing ad space is considered ordinary.
- Necessary Expense: While not indispensable, necessary expenses are those that are helpful and appropriate for running your business, such as purchasing software for bookkeeping.
These expenses must be directly tied to the pursuit of profit for your business to be deductible.
Separating Business and Personal Expenses
It’s crucial to keep business expenses distinct from personal expenses. Generally, personal expenses cannot be deducted. However, if an expense is used for both personal and business purposes, you can deduct the portion related to business use.
Example:
If you take out a loan and use 75% of it for business and 25% for personal purposes, you can deduct 75% of the interest as a business expense.
Costs vs. Capital Expenses
Some costs, especially those related to your investment in your business, must be capitalized rather than deducted as expenses.
- Capital Expenses:
These are considered long-term investments and include:- Start-Up Costs: Costs incurred in creating or acquiring a business, including franchise fees.
- Business Assets: Purchases such as equipment, vehicles, and land.
- Improvements: Enhancements that add value or extend the life of your property or equipment.
- Cost of Goods Sold (COGS):
If your business involves manufacturing or reselling goods, you must calculate and deduct the COGS separately. This includes:- Raw materials and their transportation/storage.
- Direct labor costs for producing goods.
- Factory overhead.
Since COGS is deducted from gross receipts to determine gross profit, it cannot be claimed again as a separate business expense.
Common Business Expense Deductions
Here are some of the most typical deductible expenses:
- Business Use of Your Car & Home: Deductions are allowed for the percentage of use tied to business operations.
- Employee Pay: Wages, salaries, bonuses, and other compensation.
- Retirement Plans: Contributions to employee or self-employed retirement plans.
- Rent Expense: Cost of leasing office or equipment space.
- Interest, Taxes, and Insurance: Business-related interest on loans, property taxes, and insurance premiums.
Specialized Deductions
In addition to common deductions, businesses may qualify for more specific ones:
- Bad Debts: Debts from sales or services that are deemed uncollectible but were previously reported as income can be deducted. If the debt is recovered later, it must be reported as income in the year of recovery.
- Research and Experimentation: Costs related to developing or improving products or processes.
- Amortization: For certain intangible assets like goodwill or pollution-control facilities.
- Gulf Opportunity Zone Clean-Up Costs: Expenses tied to cleaning up or restoring specific disaster-affected areas.
Understanding Uniform Capitalization Rules
Certain production or resale activities require that direct and some indirect costs be capitalized instead of being deducted. However, small businesses with average gross receipts of less than $10 million over the past three years are exempt when it comes to personal property acquired for resale.
Stay Informed
For a comprehensive guide on business expense deductions, refer to the IRS’s Publication 535: Business Expenses.
Navigating the complexities of business expenses and deductions can be daunting. Consulting a tax professional is often a smart move to ensure compliance and maximize your eligible deductions.