Every year, entrepreneurs are responsible for calculating the federal tax liability of their business.
Determining your exact tax burden is a real challenge because it requires calculating your businesses's taxable income, which is often different from your operating net income. In most cases it will be greater than your operating net income.
The reason for the discrepancy between taxable net income and operating net income is that different operational expenses must be accounted according to particular Internal Revenue Service regulations. To ensure that your tax filings follow IRS regulations, business leaders should employ the help of experienced accountants to accurately calculate their tax liability and properly execute their tax filings.
Entrepreneurs can, however, develop an idea of their estimated taxable income by subtracting a number of deductible business expenses from their total revenue.
Here, we examine a number of business expenses business leaders can expect to deduct from their business income.
First lets start with entrepreneurs who work from their home.
The Home Office
Business leaders who work from their home are eligible to deduct a portion of their personal home expenses form their company’s revenue.
To do this entrepreneurs must be able prove that they are entitled to make the deductions to any IRS authority by satisfying two conditions;
A. A defined space is dedicated as the principle place of your business.
This includes using space in your home to meet and deal with clients or customers, or for other acceptable purposes, for instance storing inventory.
B. The space is used regularly and exclusively for the operations of your business.
Deducible Items include; direct costs, for instance painting your office space. And, indirect costs, such as a percentage of your utilities, rent or mortgage interest and real estate taxes that accurately reflect the portion your business uses of your residence.
To calculate how much of your home-related expenses are tax deductible, consider measuring your work area and dividing it by the square footage of your home. The resulting percentage is the estimated fraction of expenses you are eligible to claim.
Now, lets focus on deductions traditional businesses can make.
Cost Of Goods Sold
All of the costs associated with creating the products or services your company markets & sells are fully tax deductible.
Business that purchase products for resale can also deduct the expenses as cost of goods sold.
Typically the inventory of a business is not immediately deductible against revenue.
But, businesses can employ two methods to deduct their inventory:
A. The first, and common strategy, is to use the accrual method of accounting and include the inventory in the cost of goods sold, which reduces the income recognized from sales.
B. The second method applies specifically for small businesses, whereby a company can employ the cash method of accounting to treat inventory as materials and supplies which are fully deductible.
A small business is defined by the IRS as a business with annual average gross receipts not exceeding $10 million for three years prior to the current filing, or for the years in operations if less than three.
Entrepreneurs should be aware that the cash method can only be employed in certain industries that generally focus on service-based businesses that keep certain inventory items, for instance beauty salons that provide haircutting services, but also carry retail merchandise.
For business leaders who want to switch from the accrual to cash methods of accounting to treat inventory as part of your C.O.G.S, filling a change of accounting method on IRS Form 3115 is required. Automatic IRS consent procedures exist to simplify the process.
To learn mode about inventory deduction procedures here; Rev. Proc. 2002-28.
Fright & Delivery
All of the expenses your business incurs to ship and deliver your product or service is fully deductible from your company's revenue.
Commissions paid to sales representatives, outside consultants, or other professionals related to the operations of your business are fully deductible.
Entrepreneurs are eligible to deduct royalty payments that represent compensation for the privilege to use intellectual property including; patents, copyrights, technologies, brands, or for the use of a natural resource property such as minerals, oil and natural gas.
Businesses that pay royalties based on a percentage of sales or profits realized from the use of licensed intellectual property or resources are able to fully deduct the payments as business expenses.
Promotion & Advertising
Advertising and Marketing
All promotion and marketing expenses, as long as they are directly related to your business, are fully deductible. Deductible promotional expenses span a variety of marketing items including business cards, trade shows, yellow page ads, internet ads, TV ads, radio ads, magazine ads, and even sponsorships.
Research & Development
Generally speaking, research and development (R&D) costs are considered capital expenses, and as such are not tax deductible against your business revenue.
Research & Development expenditures represent reasonable costs for activities intended to provide information that limits uncertainty about the development or improvement of a product and/or service.
Expenditures commonly accepted as R&D costs include:
And, any related fees to all of the above items.
Expenditures that are not commonly accepted as R&D costs include:
Quality control testing
Advertising & promotion
Research in connection with literary, historical or similar projects
The Acquisition of another’s patent, model, production or process
Entrepreneurs, however, are eligible to deduct research & development expenditures on your business tax return in the first year your business incurs such expenditures.
If R&D expenditures are not deducted in the first taxable year in which they are incurred, you cannot do so in subsequent taxable years without specific IRS authorization.
Business leaders can take advantage of two methods to account for deductible R&D expenditures:
A. Deduct your R&D expenditures in the first tax year that you incurred or paid for the expense.
B. Or, amortize the R&D expenditure of a period of 60 months or more.
All research & development expenditures that are not deducted in the current period, or deferred and/or amortized over time must be charged to a capital account.
For certain qualified R&D expenditures, entrepreneurs are eligible to claim specific R&D expenses as a credits against their tax liability, and combine the credits with their general business credit. In this case the R&D credit represents a nonrefundable tax credit.
For more information on deducting research & development expenses view Current-Year Deduction of Research & Development Expenditures, and Amortization of R&D Expenditures on IRS.gov.
Entrepreneurs are eligible to fully deduct their rent expense for their office space, storefront, factory, or other type of facility as long as the rent accounts for the property used to conduct your business activities.
However, be aware that if you individually own or your business owns or receives full or partial equity in the property you are using for your business, you cannot deduct the rent expense. The reason for this is that the “rent” you are claiming is considered either personal or business income by the IRS.
All of the utilities associated with operating your business including; electricity, water, trash and telephone bills are fully deductible as regular business expenses.
All janitorial expenses can be fully deducted form your business income.
If you or your employees use personal cell phones to conduct business, highlight the specific business calls and deduct that portion from your cell phone bills. Dong this correctly requires keeping a close record of your call history, which can be a inconvenient challenge.
Therefore, as soon as it is economically feasible, offer employees phones dedicated to business operations. Not only can it improve productivity, but it will simplify your end of year tax calculations.
Costs associated with the faxing of documents & information, as well as the technology that supports the activity are fully tax deductible.
If you work from your home, and claim a home office deduction, the cost of your first landline to your home is not deductible, however if you have a second line, you can deduct the second line utility cost as a business expense.
All of the expenses associated with mailing and postage services for your business are fully tax deductible.
The cost to connect your office & business to the world wide web is fully tax deductible.
Books, Publications & Subscriptions
All books, trade journals, newspapers, and subscribed subscriptions that are related to your business can by fully deducted.
The everyday stationery that supports your business operations is fully deductible. Pens, paper, staples, thumb tacks, cleaning supplies, etc.. are all eligible. So keep your receipts!
The furniture of your business is fully tax deducible. Business leaders can either deduct the entire cost of the office furniture in the year it was purchased, or depreciate the expense it over several years.
The technology and equipment used to support your business operations is fully deductible. These items include; fax machine, copier, printer, computers, postage machines, etc…
Entrepreneurs can elect to either fully deduct the technology and equipment expenses in the year it was purchased, or partially deduct the expense by depreciating it over several years.
Rent on Machinery and Equipment
Any fee paid to lease or rent machinery and office equipment used to support your operations, such as an all in one printer, copier, scanner, and fax machine, is fully tax deductible.
All printing and/or copying services required for your business and the associated expenses can be fully tax deducted.
Repairs and Maintenance
The costs your business incurs to repair or maintain any equipment and property in active operating condition are fully tax deductible.
While ordinary repairs and maintenance are deductible, any cost that adds value to your property must be capitalized and therefore cannot be tax deducted.
Exceptions to this rule exist, however do not bet on it. For more specific information on repairs and maintenance tax regulations review chapters 7 and 8 in IRS publication 535.
Any software purchased, downloaded form the web or subscribed to online that supports your business operations is fully tax deductible.
Auto Maintenance and Mileage
Businesses who employ the use of motor vehicles are eligible to deduct the costs associated with the vehicles from their business's revenue in two ways; standard mileage or actual expense.
A. Standard Mileage
Standard mileage lets business deduct a portion of the costs associated with operating their vehicles. In 2016 the rates for cars, vans, pickups and panel trucks were the following:
54 cents per mile driven for business miles driven.
19 cents per mile driven for medical or moving purposes.
14 cents per mile driven in service of charitable organizations.
For more information on Standard Milage deductions visit the 2106 standard milage rates webpage at irs.gov.
B. Actual Expense
The actual expenses method allows entrepreneurs to calculate all of the actual costs associated with operating and maintaining their motor vehicles and deduct the full amount from their business revenue.
But, to use the method, entrepreneurs must have accurate records to prove any the usage of their vehicles and their associated expenses. Therefore keep your receipts!
Business leaders considering which method to adopt, and who have all the appropriate records on hand, should use the method that results in the larger deductible amount.
More detailed information on vehicle deductions can be found in the following IRS Publication.
Startup Expenses (Capital Expenses)
Entrepreneurs starting a new business are eligible to deduct up to $5,000 of the startup costs. The deduction can include research costs incurred for creating your business.
Business leaders may be eligible to deduct startup costs incurred before officially launching the business, however the must be officially operational at the time of the tax filing, and the deduction can only be made in the first year of your operations.
The reason why the limit is $5,000 is because the IRS views such expenditures as capital expenses, which are generally not tax deductible.
Startup costs that exceed $5,000 can be amortized proportionally over a period of 15 years. However, certain restrictions apply if your startup costs exceed $50,000.
For more more information about startup expense deductions view IRS Publication 535.
All expenses related to moving the operations of your business between locations can be fully tax deducted.
In addition, entrepreneurs or employees who are forced to move because of their employment situation can expense the moving cost from their personal income.
Salaries and Wages
Entrepreneurs are eligible to fully deduct the salaries and wages paid to employees as a business expense, as long as the renumeration is paid in cash, property or services.
Business leaders should be aware that any payments to sole proprietors, partners and LLC members do not represent salaries in the eyes of the IRS and are not deductible from the business’s income.
For more information on salaries and wages examine IRS Publication 535.
Bonus & Variable Compensation
Business leaders are also eligible to fully deduct variable compensation and bonuses as a business expense, as long as the renumeration represents additional pay for services performed, and do not represent gifts.
For more information on bonus compensation deductions view IRS Publication 535.
Employee Benefit Programs and Qualified Retirement Plans
Business leaders are eligible to fully deduct all corporate health care plans, life insurance, and adoption assistance. The costs of employee benefit programs, such as education assistance and dependent care assistance are also fully deductible, as well as contributions to employee’s qualified retirement plans.
For self employed entrepreneurs, contributions to their personal qualified retirement plans are deductible following the guidelines set on IRS Form 1040.
In addition to the employee benefit plans, all of the costs associated with payments towards social security, state unemployment insurance, federal unemployment insurance and workers compensation are fully tax deductible.
Profit-Sharing or Pension Plans
Entrepreneurs are eligible to fully deduct contributions made to your employee's simplified employee pension plan or "SEP", and savings incentive match plan for employees or "SIMPLE", as well as other qualified plans.
The "SIMPLE" plan is particularly useful for new & small businesses who want to start a retirement savings plan for their employees.
More information on retirement plans and their tax implications can be found here on irs.gov.
Health Insurance premiums
Health insurance premiums are not views by the IRS as a regular business expense, and therefore cannot be tax deducted.
But, small business may qualify for a tax credit for up to 50% of the premiums paid, which is better economic benefit than a deduction.
Entrepreneurs who pay for their own health insurance premiums and for, their spouse, dependents and any child under age 27 are eligible to fully deduct the costs as personal expenses on IRS Form 1040.
Self employed business leaders or individuals who own more than 2 percent of an S Corporation can also deduct health, life and disability insurance premiums from their individual income tax return.
All educational items aimed to improve employee knowledge and professional competencies related to your business or industry are fully tax deductible. These items include; magazines, books, seminars, CDs, DVDs, courses, and trade shows.
Entrepreneurs are eligible to fully deduct expenses related to improving the working environment of their employees such as communal furniture, stereo equipment and televisions, kitchen equipment, vending machines, etc…
All expenses related to the recruitment of employees and related staff for your business are fully deductible.
Deductible recruitment expenses include; employee agency fees, professional recruiters, career counseling, contract negotiating fees, advertising, transportation costs for interviews, long distance cell phone charges, publications with classifieds, and resume or portfolio preparation fees.
For more information on tax deductions for recruitment view IRS Publication 535.
Business leaders who employ the help of independent contractors or freelancers are eligible to deduct the full cost of the labor.
Entrepreneurs who employ contract labor should issue any contractor a Form 1099-MISC.
Typically, if the payment to the contractor is made via a credit card, PayPal or similar service, it is the responsibility of the processor to issue the contractor a Form 1099-K, however it is wise to send the contractor your own Form 1099-MISC to protect your business from any potential irregularities.
For more information on contract labor tax deductions view Independent Contractor Defined on irs.gov.
Entrepreneurs can deduct nearly all travel expenses related to their business operations. Travel expense items include; airfares, hotels, car rentals, cab fares, and other travel expenses like Wi-Fi access and dry cleaning.
It is important to clearly understand and meet the substantiation requirements set by the IRS and explained in Publication 463 to claim any travel deduction.
Unfortunately, local commuting costs are typically not deductible.
Meals and Entertaining
Business leaders should be aware that eating out with colleagues on a day-to-day basis does not represents a tax deductible expense.
However, if you are taking a client or prospective client out for a meal, the 50% of the meal cost is tax deductible. Similarly, taking a client out for drinks and/or to a special event is 50% tax dedcutible.
Entrepreneurs should make sure that the time out with the client is either within a business setting or taking place before or after a business meeting. In addition, any claimed deduction must be substantiated, meaning proven with receipts or with organized/registered meeting confirmations.
For more information on the deductions for meals and entertainment view IRS Publication 463.
Uniform & Gear
Business leaders can deduct the full cost of any employee uniforms or gear required to preform their every-day operative duties.
Deductible expenses include; protective clothing, uniforms, dry cleaning costs, specialized clothing designed specifically for your business operations, and any safety equipment.
Employee or Client Gifts
Entrepreneurs are eligible to fully deduct any gift to a client or employee that equals to or is less than $25 in value per year, per person.
Entrepreneurs who are self-employed are eligible to deduct 50% of the social security and medicare taxes paid your personal income using IRS Form 1040.
Any salaries and expenses related to employees below the age of 18, for instance interns or summer workers, can be fully tax deducted.
Penalties & Fines
Business leaders are eligible to fully deduct any penalties or fines related to the late performance or non performance of an employee and outside contractor.
Outside Professional Services
Any outside professional service employed to facilitate your business operations is fully tax deductible. These services include; accountants, lawyers, financial advisors and other professional consulting services.
Fees associated with payroll processing, inventory management, customer relationship management, and email among other professional technology services are also fully tax deductible expenses.
For more information on professional services deductions view IRS Publication 334.
Bank & Financial Services
Entrepreneurs are eligible to fully deduct any banking fees and expenses associated with their business's checking accounts, ATM withdrawals and other banking services.
Moreover, any credit card fees and credit card processing fees are also fully tax deductible.
Any fees associated with licenses and/or permits required for your business to operate are fully tax deductible expenses. This includes any and all local, state and federal authorizations.
For more information on license and permit deductions view IRS Publication 535.
Entrepreneurs are eligible to either fully or partially deduct any business insurance policy and insurance premium designed to protect their business from potential legal action.
Insurances that can be fully deducted include;
General liability insurance.
Malpractice insurance that covers personal liability for professional negligence resulting in injury or damage to patients or clients.
Business continuation insurance.
Insurance that covers fire, storm, theft, accident, or similar losses.
Credit insurance that covers losses from business bad debts.
Contributions to a state unemployment insurance fund.
Overhead insurance that pays for overhead expenses during long periods of disability caused by injury or sickness.
Vehicle insurance that covers vehicles used in your business for liability, damages, and other losses.
Business interruption insurance that pays for lost profits if your business is shut down due to a fire or other cause.
Insurances that are partially deductible include:
1. Group hospitalization and medical insurance for employees, including long-term care insurance can be treated in two ways:
A. If a LLC Partnership pays accident and health insurance premiums for its partners, the business can generally deduct the costs as guaranteed payments to partners.
B. If an S Corporation pays accident and health insurance premiums for employees who own more than 2% of the company shares, it generally can deduct them, but the deduction must also be included in the shareholder's wages subject to federal income tax withholding. For more information view IRS Publication 15-B.
2. Workers’ compensation insurance as defined by State law covering any claims for bodily injuries or job-related diseases suffered by employees, regardless of fault can be treated in two ways.
A. If an LLC Partnership pays workers' compensation premiums for its partners, it generally can deduct them as guaranteed payments to partners.
B. If an S Corporation pays workers' compensation premiums for employees who own more than 2% of the company shares, the business can generally deduct them, but is also required to include them in the shareholder's wages.
For more information on insurance deductions examine Topic 6 of IRS Publication 535.
Business leaders can fully deduct any interest payments on purchases for equipment, technology, supplies, machinery etc.. as business expenses. All finance charges, for instance credit-card interest, interest on payment plans, and interest paid on other business related loans are also fully deductible.
For more information on interest payments view Topic 4 of Publication 535.
Any business that owns property or realty can fully deduct the mortgage interest payments from their business revenue. Unlike interest on a personal residence, business have no cap on the size of the loans on which they must pay interest.
Interest on Business Indebtedness
While the interest on a loan that a business takes is typically fully tax deductible as a business expense, the same rule do not apply for the interest of a business's indebtedness.
The IRS does not allow any tax deduction for interest paid or incurred by a business for any loan taken for the purposes of acquiring another business to the extant that the interest exceeds $5,000,000 minus the interest paid by the business on the loan used to make the acquisition.
Moreover, the IRS does not allow any tax deduction for the interest on a loan a business takes to purchase assets of another company.
Entrepreneurs who purchase property to use for ordinary business operations generally cannot deduct the entire cost of the property in the taxable year of its purchase.
Business leaders can however, spread the cost over more than one taxable year and deduct part of the purchase amount each year. In other words depreciate the cost over an extended period of time.
The small businesses tax deduction represents an allowance for the cost of buying property for the operations of your business, and includes a deduction on equipment purchases of up to $500,000. For equipment purchases beyond the $500,000 threshold, small business are eligible to deduct 50% of the “bonus” depreciated purchases, however this regulation only applies to new equipment.
Business leaders are eligible to deduct the bad debt owed to your business only if the amount was previously included in your gross income.
For instance, if your business lent money to an employee, a vendor, or a client and has not yet been repaid within the tax year, the business is eligible to deduct the loss.
Therefore, the treatment of the loan depends wether or not the debt is recognized as a bad business debt, as in the example above, or a nonbusiness related bad debt.
To deduct a nonbusiness bad debt, the debt must be considered totally worthless. Worthless means your business has no reasonable expectation to receive payment, after clearly demonstrating that steps were taken to try and collect the debt.
For more information on bad debt deductions view IRS Topic 453.
Entrepreneurs who did not take advantage of certain tax deductions in prior years, or if your net capital losses were more than the deductible limit in a taxable year, may be entitled to do so in the present tax year.
Be sure to check which deductible items and their corresponding dollar amounts are eligible to be carried forward from previous years at irs.gov Capital Gains and Losses Helpful Facts, and Publican 536.
It may seem strange, but entrepreneurs are eligible to fully deduct all local, state, and foreign taxes incurred from operating your business when calculating your federal tax obligations.
Business leaders are also allowed to fully deduct employer taxes including; the employer share of FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and state unemployment taxes, as well as real estate and property taxes.
Self-employed business owners should be aware that deducting the employer equivalent to the self-employment tax does not represent a business tax deduction, but rather an adjustment to gross income on your personal income tax return.
Other Deductible Items
Entrepreneurs are eligible to fully deduct charitable contributions of $250 of more, but must have letters from the charitable organization verifying the donation.
More detailed information on monetary and non-monetary donations to charity can be found on IRS Publication 561.
Theft and Loss
Generally speaking, if a theft or loss was not avoidable by the business, entrepreneurs are eligible to deduct the cost of the loss as a business expense.
But, accidents that occur within the normal operations of your business and the regular wear and tear of machinery, equipment, furniture and technology over time are not tax deductible expenses.
Petty Cash and Tips
Entrepreneurs are eligible to deduct small business expenses, for instance tips for any particular service. Business leaders can also allowed to make deductions for expenses with our receipts, however, you should have some form of documentation to protect your claims against any audit.
Last, but not least, business leaders can fully deduct the expenses related to having a guard dog to protects your company property and inventory as a regular business expense.
Generally speaking, all of the costs associated with operating your business can be fully deducted from your company's revenue. This analysis provides insight into the expenses you are likely able to deduct when calculating your estimated taxable income to the federal tax authorities.
Where things get particularly difficult is when accounting for specific items or expenses that do not easily fall within clearly defined IRS definitions.
Already, the documentation provided by the IRS on all corporate tax deductions is complex, full of legal jargon, and confusing to the untrained eye, which is why the hiring of experienced tax professionals has become commonplace.
It is imperative that entrepreneurs hire professional tax accountants to oversee all of their company's tax filings and accounting preparation.
Not only will they provide accurate estimates of your business's yearly tax liability and properly execute the required filings, but they represent the surest way to prevent any IRS audit or unexpected local, state and federal tax liability on your business.
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