A tax deduction (also called a tax write-off) is an amount of money you are entitled to subtract from your gross income (all the money you make) to determine your taxable income (the amount on which you must pay tax). The more deductions you have, the lower your taxable income will be and the less tax you will have to pay. Through this post I discuss the four types of business tax deductions. But before that, I outline three major tax deduction types, how to make tax deduction work for you and how tax deduction works as general overview. Enjoy!
Types of Tax Deductions
There are three basic types of tax deductions: personal deductions, investment deductions, and business deductions. This post covers only business deductions—the large array of write-offs available to business owners.
. Personal Deductions
For the most part, your personal, living, and family expenses are not tax deductible. For example, you can’t deduct the food that you buy for yourself and your family. There are, however, special categories of personal expenses that may be deducted, subject to strict limitations. These include items such as home mortgage interest, state and local taxes, charitable contributions, medical expenses above a threshold amount, interest on education loans, and alimony. Tis book does not cover these personal deductions.
. Investment Deductions
Many people try to make money by investing money. For example, they might invest in real estate or play the stock market. These people incur all kinds of expenses, such as fees paid to money managers or financial planners, legal and accounting fees, and interest on money borrowed to buy investment property. These and other investment expenses (also called expenses for the production of income) are tax deductible, subject to certain limitations. Investment deductions are not covered in this post.
. Business Deductions
People in business usually must spend money on their business—for office space, supplies, and equipment. Most business expenses are deductible, sooner or later, one way or another. and that’s what this post is about: the many deductions available only to people who are in business (sole proprietors, independent contractors, and small business owners).
You Only Pay Taxes on Your Business Profits
The federal income tax law recognizes that you must spend money to make money. Virtually every business, however small, incurs some expenses. Even someone with a low overhead business (such as a free lance writer) must buy paper, computer equipment, and office supplies. Some businesses incur substantial expenses, even exceeding their income.
You are not legally required to pay tax on every dollar your business takes in (your gross business income). Instead, you owe tax only on the amount left over after your business’s deductible expenses are subtracted from your gross income (this remaining amount is called your net profit).
Although some tax deduction calculations can get a bit complicated, the basic math is simple: The more deductions you take, the lower your net profit will be, and the less tax you will have to pay.
Example: Katlyn, a sole proprietor, earned $50,000 this year from her consulting business. Fortunately, she doesn’t have to pay income tax on the entire $50,000—her gross income. Instead, she can deduct from her gross income various business expenses, including a $5,000 home office deduction and a $5,000 deduction for equipment expenses. She deducts these expenses from her $50,000 gross income to arrive at her net profit: $40,000. She pays income tax only on this net profit amount.
What make One Eligible for Tax Deduction?
Must have a legal basis for your deductions. All tax deductions are a matter of legislative grace, which means that you can take a deduction only if it is specifically allowed by one or more provisions of the tax law. You usually do not have to indicate on your tax return which tax law provision gives you the right to take a particular deduction. If you are audited by the IRS, however, you’ll have to provide a legal basis for every deduction you take. If the IRS concludes that your deduction wasn’t justified, it will deny the deduction and charge you back taxes and, in some cases, penalties.
You must be in business to claim business deductions. Only businesses can claim business tax deductions. This probably seems like a simple concept, but it can get tricky. Even though you might believe you are running a business, the IRS may beg to differ. If your small-scale business doesn’t turn a profit for several years in a row, the IRS might decide that you are engaged in a hobby rather than a business. Tis may not sound like a big deal, but it could have disastrous tax consequences: people engaged in hobbies are entitled to very limited tax deductions, while businesses can deduct all kinds of expenses. Fortunately, this unhappy outcome can be avoided by careful taxpayers.
Types Of Business Tax Deductions
Business owners can deduct four broad categories of business expenses:
- Start-up expenses;
- Operating expenses;
- Capital expenses; and
- Inventory costs.
Below exhibit may help you to quickly overview this topic. But I would suggest you to read all details after the exhibit. Though some examples will give you even better understanding.
Caution: You must keep track of your expenses. You can deduct only those expenses that you actually incur. You need to keep records of these expenses to (1) know for sure how much you actually spent, and (2) prove to the IRS that you really spent the money you deducted on your tax return, in case you are audited.
Next, let’s talk in detail for each of them. Read on…
The first money you will have to shell out will be for your business’s start-up expenses. These include most of the costs of getting your business up and running, like license fees, advertising costs, attorney and accounting fees, travel expenses, market research, and office supplies expenses. You may deduct up to $5,000 in start-up costs the first year a new business is in operation. You may deduct amounts over $5,000 over the next 15 years.
Example: Henry, a star hairdresser at a popular salon, decides to open his own hairdressing business. Before Henry’s new salon opens for business, he has to rent space, hire and train employees, and pay for an expensive pre-opening advertising campaign. These start-up expenses cost Henry $20,000. Henry may deduct $5,000 of his $20,000 in operating expenses the first year he’s in business. He may deduct the remaining $15,000 in equal amounts over the next 15 years.
Operating expenses are the ongoing day-to-day costs a business incurs to stay in business. Tey include such things as rent, utilities, salaries, supplies, travel expenses, car expenses, and repairs and maintenance.These expenses (unlike start-up expenses) are currently deductible—that is, you can deduct them all in the same year when you pay them.
Example: After Henry’s salon opens, he begins paying $5,000 a month for rent and utilities. This is an operating expense that is currently deductible. When Henry does his taxes, he can deduct from his income the entire $60,000 that he paid for rent and utilities for the year.
Capital assets are things you buy for your business that have a useful life of more than one year, such as land, buildings, equipment, vehicles, books, furniture, machinery, and patents you buy from others. These costs, called capital expenses, are considered to be part of your investment in your business, not day-to-day operating expenses.
Large businesses—those that buy at least several hundred thousand dollars of capital assets in a year—must deduct these costs by using depreciation. to depreciate an item, you deduct a portion of the cost in each year of the item’s useful life. Depending on the asset, this could be anywhere from three to 39 years (the IRS decides the asset’s useful life).
Small businesses can also use depreciation, but they have another option available for deducting many capital expenses: under section 179 of the tax code, small businesses can deduct up to $250,000 in capital expenses for tangible personal property in 2008. This is scheduled to go down to $128,000 in 2009 (plus an inflation adjustment).
Example: Henry spent $5,000 on fancy barber chairs for his salon. Because the chairs have a useful life of more than one year, they are capital assets that he will either have to depreciate over several years or deduct in one year under section 179.
Certain capital assets, such as land and corporate stock, never wear out. Capital expenses related to these costs are not deductible; the owner must wait until the asset is sold to recover the cost.
Inventory includes almost anything you make or buy to resell to customers. it doesn’t matter whether you manufacture the goods yourself or buy finished goods from someone else and resell the items to customers. Inventory doesn’t include tools, equipment, or other items that you use in your business; it refers only to items that you buy or make to sell.
You must deduct inventory costs separately from all other business expenses—you deduct inventory costs as you sell the inventory. Inventory that remains unsold at the end of the year is a business asset, not a deductible expense.
Example: in addition to providing hair styling services, Henry sells various hair care products in his salon that he buys from cosmetics companies. In 2009, Henry spent $15,000 on his inventory of hair care product but sold only $10,000 worth of the product. he can only deduct $10,000 of the inventory costs in 2009.