There are numerous reasons why it’s important to have good bookkeeping practices when conducting business, not the least of which is to make tax preparation easier and more accurate. Businesses pay a variety of taxes, one of which is a tax on their profits, more commonly known as the income tax.
Your profit is the revenue remaining after deducting expenses. Accordingly, the higher a business’s expenses are, the less tax it pays on its profits. This is a big reason why keeping track of business expenses is so important.
If the expense appears on your company’s income statement, it’s a general indication that the expense might be tax-deductible. There are lots of rules and exceptions, however, so be sure to get professional advice before you attempt the deduction. One of the best guides to deductible expenses is IRS Publication 535 (“Business Expenses”). In general, however, the IRS says a business expense must be “ordinary and necessary” to be deductible.
Below are some of the most important tax deductions for your business.
1. Cost of Goods Sold
This is the largest expense for many businesses. It might include the cost of your raw materials, the cost of storing those materials, the freight costs for those items and even the direct labor costs associated with making the materials. For more information, see IRS Publication 538.
Businesses that operate in brick-and-mortar locations know that rent can be costly. Thankfully, it’s usually tax-deductible. Just be sure to remember that rent is the amount you pay to use property that isn’t yours, which means equipment rental can be tax-deductible as well.
4. Professional Fees
This includes what you pay a third party to do your payroll, your taxes, your legal work or any other professional service. Consultants are also included in this category. In general, you deduct the work in the year in which it occurs; however, if the work is for future years, you may have to deduct that work over the useful life of the work.
If you’re making payments on a bank loan that’s related to starting or running your business, that interest is probably tax-deductible. This can be tricky, though, especially if interest is accruing on the loan but you’re not making payments yet (this may be due to the terms of the loan or something you’ve negotiated with the lender). Be sure to consult an accountant to understand exactly what you can and cannot deduct.
It’s very important to have insurance, and it’s even better when that insurance is tax-deductible. This includes liability insurance, director and officer insurance, commercial property insurance, product liability insurance and others. Be aware, though, that some life insurance and annuities are not deductible; neither is insurance that you buy in order to secure a loan. The IRS offers more insight here.
7. Your Home and Your Car
You can indeed deduct some of your mortgage, rent, utilities, homeowners insurance, house repairs and car expenses if you use these things for business. For example, if you’re a freelance writer who works from home and uses the car occasionally to meet sources for interviews, you may be able to deduct a portion of your home and car expenses (the deduction is related to the proportion of your home and car that you use for business).
Use the actual-expense method to deduct car expenses if you’ve kept track of every business-related auto expense; otherwise, use the standard-mileage-rate method and deduct a flat amount per business-related mile driven. You also have the option of taking a flat home-office deduction (rather than itemizing those expenses), but again, this is only if you use your home for business. Expenses associated with personal use aren’t deductible. For more, see IRS Publication 587 and IRS Publication 463.
8. Bad Debts
Most businesses have the unfortunate experience of selling to customers who end up being unable to pay. Some customers are slow payers or work out repayment terms that are longer than normal, but sometimes the check just never comes, and the business takes the loss. Consult IRS Tax Topic 453 for more information about deducting bad debt.
9. Travel and Entertainment
Businesses frequently incur these costs by sending employees to conferences or conventions, or when meeting with and entertaining clients. The catch here is that meals and entertainment expenses are generally only 50% deductible. Consult IRS Publication 463 for more information.
For example, let’s say that you pay $1,000 in personal property tax to your state on assets you use in your business. This may be tax-deductible, as would be employment taxes and many others. The catch is that you generally can only deduct taxes in the year that you pay them.
Billboards, commercials, online ads, print ads, business cards and sponsorships are all usually deductible as long as there’s a clear connection between the purchase and your business. For example, if you sponsor a local school event or festival, the acknowledgments should reference the business rather than an individual.
As you can see, lots of things are tax-deductible in business. Some people have even used businesses to lower their taxable income, although unless you have substantial wealth, this “strategy” will probably not apply to you. The bottom line is, as a business owner, you must educate yourself on the items and expenses you can and should deduct. Not doing so could have two negative consequences. First, you could be paying higher taxes than necessary, and two, you could be exposing yourself to a tax audit, which is an even bigger problem.