How to identify whether an expense is tax deductible or not.
Let’s explore what makes an expense deductible and how to account for it, this way you can maximize your business expenses.
First and foremost, do note that under the current tax code only self-employed individuals and business owners can write off a business expense. Now that that’s out of the way, a lot of expenses can be considered a business write off but not everything can be written off.
Whether you have had your business for a month, a year, or even 5 years, at one point or another you may have probably asked “wait, can I write this off?”. I’m sure that your answer was sometimes delayed due to uncertainty (this is very common).
The deductibility of a business expense is determined by the facts and circumstances of the situation. Which means that given the right circumstance you can deduct almost all the expenses that your business incurred. However, under no circumstances should you fabricate the expenses or its facts, it can cost you a lot more than you are trying to save further down the line (trust me, IRS audits are not fun, and they can be (uncomfortably) thorough). Therefore, it is better to proactively plan for taxes rather than to react so that it works in your favor. Hence, the reason tax planning is such a critical tool when you are a business owner. It may seem pricey at first, but it will be worth it when you not only save tax dollars but do so according to the tax code.
In the United States of America, the tax system is written in favor of self-employed individuals, business owners, and investors, not employees. Therefore, if you identify as any of those favorable status you are afforded flexibility in what you can write off as a business expense.
The first thing we must identify is what makes an expense a tax write off.
For an expense to be considered a business deduction it must be an ordinary and necessary cost that the business has incurred to operate. So pretty much, if you needed it to operate your business whether it was to keep it going or to enable further growth, guess what? You can write it off. BUT the facts and circumstances must fit within the Internal Revenue Code based on your business and the industry you operate in.
Before I lose you, let’s define what ordinary and necessary mean in this context.
1. Ordinary refers to what is common and customary within your business and its industry. In other words, are similar businesses incurring the same type of expenses and can you prove that it is business related? If you can answer yes to these questions, then we are much closer to being able to take a tax write off.
- An example of this could be the comparison between meals purchased if you were a truck driver versus if you were a movie star, the cost based on the norm and statistics would show a major difference. Yes, this may be subjective, however, if you incur an expense outside of the ordinary scope, ensure that you have documentation to substantiate the expense.
2. Necessary, ask the question, how will an expense help your business to grow and perform better. Under these circumstances, it’s not enough to go to lunch, but what was discussed for the betterment of the business. (This is why you need to DOCUMENT EVERYTHING).
Don’t forget, altogether the expense must have a business purpose.
Examples of ordinary and necessary business expenses include but are not limited to:
- Advertising & Marketing (paying to promote your business)
- Legal & Professional Fees (acquiring professional expertise to assist within the different areas of your business)
- Office Expenses
- Job Supplies & Materials
- Salary & Wages
- Contractor Labor
- And the list goes on
Now that we have identified what a business expense is, let’s look at how you can actually write it off.
Once you have identified that an expense is tax deductible, you need to document it and then report it on your business tax return or Schedule C of your Form 1040 when filing your year-end income tax return.
Not sure if you heard, but documentation is key. In fact, I like to say that “Documentation is your weapon in a legal battle”, yes, this does include providing proof to the IRS. Therefore, you need a system in place to help you keep record of every expense that you incur for your business activities. As well as ensuring that you keep a digital copy of all receipts and invoices paid.
So, if you are not already tracking your business expenses, “yesterday” was a great day to get started. In other words, begin to establish a bookkeeping system that can help you to organize all your business’s financial records. I will dedicate a future blog post just for this, however, in the meantime, you can acquire more insight through watching Lesson #2 of my Dear Business Owner series on YouTube.
- Depending on the facts and circumstances of an expense, you may be able to write it off as a business deduction, however it must be ordinary, necessary, and have a business purpose.
- In addition to this, you must document the expense and report it on the appropriate tax return or schedule.
For further information or guidance, you can contact our accounting firm at email@example.com