In our many years of practice and consulting entrepreneurs, one of the most common questions we get is: What expenses can be legitimately deducted for business purposes? This is a great question because it's scary dealing with the IRS. Nobody wants to face an audit, especially when the IRS has the power to scrutinize your tax return for up to three years or even six years in some cases.
Picture this: the IRS picks up your return for an audit, and you can't prove those business deductions. The result? The IRS denies them. That means your taxable income goes up, and you'll have to pay not only more taxes but also penalties and interest. And that interest starts piling up from the day your tax return is due.
And remember, the IRS can audit you for up to 3 years. So, if they come knocking in year 3, you're looking at interest and penalties accruing from 3 years ago. That can seriously add up. So, you don't want to be in a situation where the IRS disallows your deductions. But what exactly qualifies as a legitimate business deduction?
Expense vs. Deduction: Know the Difference
Let's begin by clarifying a common source of confusion: the distinction between an expense and a deduction.
Not every expense you incur automatically qualifies as a deduction on your tax return, whether in full or in part. Many entrepreneurs mistakenly believe that simply using their business account or business credit card for a purchase automatically labels it as a business deduction - you'd be wrong if you thought that way.
And you can still claim tax deductions for purchases made from your personal accounts. Some people use their personal accounts to make business-related purchases, and if these expenses meet specific criteria, they can be deductible for business purposes. However, we strongly discourage the practice of mingling personal funds with business expenses, or vice versa. This separation is key for maintaining financial clarity and ensuring compliance with tax regulations.
So, what determines whether an expense qualifies as a deduction for business purposes? It's your industry or line of business. Different industries or lines of business may have different expenses that are eligible for tax deductions.
Tailoring Deductions to Your Business: Ordinary and Necessary Expenses
So when it comes to business deductions, there is no one-size-fits-all. Your industry plays a significant role, and what qualifies as a deduction for you may differ drastically from what your friend in a different industry can claim.
The key is to understand that the expense must be ordinary and necessary for your industry or line of business. So for example, a hair salon can legitimately consider shampoo as a deduction, but for a law firm, shampoo on a tax return would raise eyebrows.
Ordinary means just that – not extraordinary, extravagant, or a superfluous luxury item.
So, what about the big corporations that have private jets and whatnot?
Well, here's the deal: They can argue that for their CEOs and top executives to effectively conduct business, they must travel swiftly from point A to point B. They claim that this expedited travel is critical for their business's continued success. However, unless you're on the same playing field as a Fortune 500 company, a private jet won't find a place on your tax return.
Now let’s talk about makeup. Whether you work in marketing, a law firm, or even own a hair salon, your makeup generally isn't considered a deductible business expense. So kudos for looking great, but you won't be able to claim your daily makeup routine as a business deduction.
Now, there are a few exceptions to this rule. For example, in certain cases, if you're involved in marketing activities that require a professional image, having your makeup done professionally for a photo shoot directly related to your business may be deductible.
Maximizing Deductions: Pre-Startup Expenses and Your Business
Let's dive into an essential aspect of tax deductions: expenses incurred before your company officially kicks off. You know the drill – market research, legal consultations, drafting agreements, and registering your company with the state. These expenses pile up before your business is official. But what's the deal with these costs?
The good news is that these pre-startup expenses are deductible. In general terms, you can deduct up to $5,000 within the first year of registering your company. Any remaining expenses can be deducted gradually over 15 years. Of course, there might be some exceptions and nuances, but for most small businesses, this rule applies.
These deductions are specifically for expenses incurred before your business officially launches. Once your business is up and running, all expenses within that fiscal year become deductible in the year they are incurred.
Home Business Use Deductions: Tips and Traps to Avoid
Let's answer a question that often arises: Can you deduct expenses related to your home when you work from home as a business owner? This is one of the trickiest deductions out there, and many people have faced audits and have had this expense disallowed. We don't mean to scare you, but it's important to be very careful in this area, as it's often abused.
First, make sure you are eligible for home business use deductions. They are exclusively available to entrepreneurs and businesses, not W-2 employees working from home for their employer's convenience. In the past, this deduction was part of itemized deductions on Schedule A, but it's no longer available for employees since 2017. Now, it's strictly for business owners and entrepreneurs who are actively conducting a legitimate business, not a hobby.
To qualify for the home business use deduction, you must prove that you're using a specific space in your home for business purposes. You can't deduct expenses for your entire home, but only certain expenses on a prorated basis, depending on your home's size and the space dedicated solely to business activities.
Be mindful that working from home and having a tripod in your living room to record content for social media doesn't mean that your entire home is deductible. Ownership status, insurance, property taxes, utilities, and other factors also play a role in this deduction.
Entrepreneurs often ask us about deducting groceries, pet-related expenses, or expenses related to their children. To determine whether you can deduct such expenses, think like an employer. Imagine you're running a business, and your employees or contractors work from home for your convenience. Would you reimburse them for these types of home-related expenses? The likelihood is low, so if you wouldn't reimburse an employee for a particular home expense, it's a sign that you should not deduct it from your business taxes.
Remember, meticulous record-keeping is crucial. You must track expenses and accurately measure the square footage of your entire home and the designated business area. Having a dedicated workspace for meetings and business activities is essential, as this is an area that the IRS tends to audit.
Top Tips for Maximizing Your Tax Deductions
Now that you have a better understanding of what expenses are deductible, here are some key takeaways:
Keep Your Receipts and Records
Good records and receipts should include the date of purchase, a clear description of what was purchased, and how it was paid for. These records are important in case of an audit, as they provide solid evidence for your deductions. In today's digital age, it's easy to keep track of receipts by taking photos and organizing them in a dedicated folder for tax purposes.
Use Credit Card or Bank Statements as Backup
If you ever lose a receipt, credit card or bank statements can serve as backup records. It's crucial to ensure these statements provide enough detail to differentiate between personal and business expenses. Look for statements that at least show where you made the purchase, the date of the transaction, and where you purchased it from.
The reason why this is the next best thing is because, for instance, you might have a record that simply says "Amazon." Amazon sells a wide range of items, both personal and business-related. So, if all you have is a record stating that you purchased something from Amazon, it may not be clear whether it was a personal or business expense. To overcome this, you may download your invoices or order confirmations from Amazon. These documents provide a detailed description of the items purchased, helping clarify the nature of the expenses. This level of detail is important to maintain accurate records for your tax deductions.
Avoid Commingling Personal and Business Funds
Use your business account exclusively for business expenses and your personal account for personal expenses. This clear separation makes it easier to track and justify your deductions.
Work With Professionals
It's wise to hire a tax preparer or other professional. Do not try to go at this alone. While gaining knowledge on your own is valuable, an expert can ensure that you correctly identify eligible deductions and avoid claiming ineligible ones. This not only prevents potential legal issues but also maximizes your deductions and minimizes your taxable income and liability.
You can write off 100% of the purchase price of most business equipment from your taxable income. This includes machinery, vehicles, computers, and more. This year (2023), the deduction limit is $1,160,000, with a total spend cap of $2,890,000.
Collaborate with your tax professional to plan. Discuss strategies to maximize deductions and minimize tax liability for the upcoming year. This proactive approach can help you make informed financial decisions and optimize your tax situation.
Empowering Your Entrepreneurial Journey
While deductible expenses are a common topic entrepreneurs have questions about, we understand that you may have more questions on your journey. That's why we've created two essential courses: Turn Your Passion Into Profit: Starting Your Business and Turn Your Passion Into Profit: Growing Your Business. These courses address the most frequently asked questions entrepreneurs like you face, providing practical insights and guidance.
If you've found this information useful, don't miss out on the opportunity to unlock your full potential. Invest in your success today by signing up for these courses. Don't let anything hold you back from achieving your dreams.