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Introduction to Tax Deductions Go to topics
A simple, basic knowledge of tax and accounting is critical to the success of your business. Businesses do not fail because of lack of customers or a poor idea - they fail because the owners didn't know what their costs or taxes were. In addition to seeking competent professionals, we urge you to take a community college class on business finance and record keeping.
 
Three basic rules    You cannot deduct an expense unless it meets federal and state rules. Generally, the expenses must be reasonable and necessary for your type of business.

If you buy something that will be used for more than one year, it must be capitalized ie. deducted as a business expense over several years. Capitalized expenses include equipment, buildings, cars, etc.

  • If you buy an existing business, you can capitalize the purchase price of the equipment or buildings. However, you may not capitalize (or deduct) the amount you paid for goodwill. Goodwill is the portion of the business' purchase price that exceeds the book value of the assets (equipment, cash and receivables).
  • If you start your own business, capitalized expenses include your start-up costs plus equipment and property that you purchase.

Note: The IRS and accountants call the spread-out deductions depreciation (on physical items like equipment) and amortization (on non-physical items, like patent rights).

Inventory can't be deducted as a cost until it is sold.

Because of capitalized expenses and inventory, you may think you broke even or lost money your first year, but the IRS may say you actually OWE taxes because those expenses can't fully be deducted the first year.

 
Start-up costs  Start-up costs are expenses you made to investigate and set up your business. Basically, they are any normally deductible expenses incurred prior to when you began business operations. If your total start-up costs are $60,000 or less, you can deduct $10,000 as a regular business expense (Section 195 expense) and amortize the remainder over 15 years. If your start-up costs exceed $60,000, the $10,000 deduction is reduced by the amount such start-up costs exceed $60,000, and the rest must be amortized over 15 years. If your costs exceed $70,000, all costs must be amortized over 15 years. To amortize the costs, use form form 4952 and include it with your annual business tax return. A separate election letter is no longer required.

Most businesses wait until they have begun business operations (i.e. opened their doors for business), before purchasing supplies so that these expenses can be deducted during their first year. Since the date you began business operations can be vague, we suggest that you talk with your tax advisor about which initial expenses are start-up costs.

 
Bottom line  For tax purposes, it is often better to delay major purchases until after you have begun business operations.
 
Are these expenses deductible?  Meals and entertainment

50% of reasonable business entertainment and meals with your customers are deductible. If you reimburse employees on a per diem basis, contact the IRS and request publication 1542 Per Diem Rates to determine the allowable per diem rates.

Cars and mileage

You must keep a mileage log of personal versus business use. You can either keep track of all your car expenses or use a standard mileage rate. The 2015 mileage rate is 57.5 cents a mile, regardless of the numbers of miles driven. In addition to the standard mileage rate, you can deduct business parking fees, toll charges and a portion of interest charges on your car. We suggest that you request Publication 917, Business Use of a Car, for further details. Call the IRS at (800) 829-4933 or visit http://www.irs.gov/Forms-&-Pubs.

Medical Insurance C-corporations may deduct medical insurance for their employees, as long as the same insurance is provided to all employees (it is not top-heavy).

S-corporation shareholders: Health insurance premiums for S-corporation shareholders (who own more than 2% of the corporation's stock) are deductible as a business expense, but must be reported as additional income for shareholders. Therefore the only time it makes sense is if there are multiple shareholders where some shareholders are not benefiting from health insurance. See http://www.irs.gov/pub/irs-pdf/p502.pdf for further information. This tax deduction is not available if health insurance is available through a spouse or another job or if the health plan is subsidized.

Club membership

Club membership is not deductible for federal tax purposes, but it is deductible for state taxes.

Existing furniture and computers now used for new business

If your business uses furniture or computers that you previously owned, you may deduct the value of these items at the time they were converted to business use. Computers must be depreciated (deducted) over a 3 year period; furniture over a 5 year period. You can either determine the fair market value at the time you began using the item for business, or use the depreciated value. Here is an example of calculating the depreciated value:

A $3500 computer was purchased 7 months prior to putting it into a business use. The normal write-off for equipment is 3 years = 36 months. In this case, $3500/36=97.22 per month. Subtract 97.22 x 7 months ($680.64) from the original $3500 purchase price. The remaining, $2,819 can be deducted as a business expense over 3 years.

Home Office Expenses

C-corporations generally cannot deduct home office expenses. Theoretically, the corporation can write a check to yourself for renting an office, but then you have to report the rental income on your 1040, using Schedule C. Then you could deduct actual costs from your rental income. Another option is to deduct the expense as an employee using Schedule A on IRS 1040. Either way, it gets very complicated.

S-corporation shareholders: You can deduct home office expenses if you use a part of your home exclusively and regularly for business either:

  • As a principal place of the corporation's business;
  • As a place to meet with your customers in the normal course of business, or
  • If you are using a separate structure (not attached to your house) for your business.
S-corporations who qualify for the home office deduction do not use a special IRS form. Instead, just include your home office expenses with your other business expenses on 1120S. Home office expenses can include:
  • All direct expenses (which were incurred for your business only);
  • A percentage of your indirect expenses (your normal household expenses which indirectly benefit the business);
  • The business percentage of your home mortgage (except equity loans which were not used for home improvement);
  • Depreciation on a portion of your house (.1% to 3.175% times the percentage of your home used for business).
 
Section 179 Equipment Deduction  Since equipment is a capital expense, normally it must be deducted over several years. However, in 2014 the IRS allows small businesses to fully deduct up to $500,000 per year for newly purchased equipment or off-the-shelf software. Thus, you can deduct the full cost of a computer, rather than spreading the cost over several years. This deduction also applies to vehicles, although you may not be able to deduct the entire cost. It does not apply to purchases of permanent structures. To get this deduction, check with the IRS or your tax advisor to make sure your equipment qualifies. Then when you complete your annual tax return, check the Section 179 box on IRS form 4562 (Depreciation). For more information, visit http://www.irs.gov/instructions/i4562/ch01.html
 
More information  Federal information: Call the IRS information hotline (800) 829-4933. For forms, call (800) 829-3676 or obtain them online at http://apps.irs.gov/app/picklist/list/formsPublications.html. You may wish to obtain:
  • 583 Taxpayers Starting a Business (shows the records you should keep);
  • 535 Business Expenses;
  • 917 Car Deductions;
  • 587 Business Use of Your Home; and
  • 334 Tax Guide for Small Business.