When you own a small business, you work hard to make a good life for yourself and your family. You look for every break you can to maximize your business’ tax position. Tax deductions are a big part of this equation, and so it is important to understand how to properly utilize business expenses for this purpose. When I say “properly”, that is because it is easy to fall into a trap of over-reporting expenses, which will cause the IRS to throw a flag at your tax return.
Expenses Must Be Ordinary and Necessary
The IRS requires Internal Revenue Code § 162, titled Trade or business expenses, states that:
“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and
(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.”
While the Code does not define what “ordinary” or “necessary” mean, some courts and practitioners have construed ordinary to mean normal and accepted within the business industry. Necessary generally means that the expense is appropriate and helpful for the business. When deciding whether to claim a business expense, be sure to run it through a filter of whether it is ordinary and necessary.
Some Significant Deductions
- Salaries and wages of employees or independent contractors. This includes benefits that are provided to employees like health insurance, pensions, and paid leave. These reported salaries and wages must match what you report in W-2 forms for employees and Form 1099 for contractors. Significantly, this does not include what you pay to yourself and to your partners, which is not considered deductible.
- Office space expense. If you rent office space, you can deduct the rental costs. If you are primarily working from a home office, you may deduct the percentage of your home that is exclusively used for business purposes. However, you should consult with an attorney before claiming this deduction, as there are specific criteria you must meet and because the IRS looks closely at this deduction.
- Insurance and Legal Costs. These costs can be especially high, especially when starting up.
- Vehicles for business use. You can claim a deduction based on mileage or actual expenses to claim this expense. However you cannot switch between the two methods of calculating this expense. Further, you need to maintain appropriate documentation or receipts to support either method and ensure that the vehicle use is for business purposes.
- Travel, food, and entertaining expenses. These are tempting expenses to claim, but be sure to keep receipts and that the expenses you are claiming pass the ordinary and necessary test. The IRS looks very carefully at these expenses for possible abuse.
If you own a small business, it is in your best interest to speak to a tax attorney before filing your tax return. I can provide you tax advice custom to your business, and will discuss the many tax advantages and audit traps that may lie ahead. I have been a tax attorney for over two decades and have a Master of Law Degree (LLM) in Taxation, and a license to practice in the United States Tax Court. Contact The Law Offices of Robert S. Thomas at 847-392-5893 or visit our website today.