SMALL BUSINESS TAXES
What is and is not -- a
tax-deductible business expense?
Just about any "ordinary, necessary, and
reasonable" expense that helps you earn business income is deductible. What
is ordinary and necessary? The IRS has defined this as anything that's
"helpful and appropriate" for your business. For example, buying a
computer, or even a sound system, for your office or store can be an
"ordinary and necessary" business expense. Buying the same items for
your family room cannot be a business expense, however.
A few things are specifically prohibited by law from being
deducted even if the expenses are for the purpose of
conducting business -- for instance, a bribe paid to a public official. Other
deduction no-no’s are traffic tickets, your home
telephone line, and clothing you wear on the job, unless it is a required
uniform.
If I use my car for business, how
much of that expense can I write off?
You can calculate your vehicle deduction using the standard
mileage method or the actual expense method. The standard mileage method is more commonly used because the record-keeping
requirements are much simpler. Under this method, the IRS determines the amount
you can deduct per mile. (For the tax year 2005, the rate is 40.5 cents per
mile. In 2004, the rate was 37.5 cents per mile).
Under the actual expense method, you deduct the actual costs
you incur each year to operate your car, plus depreciation you pay for gas and
repairs (according to a tax code schedule). Your deductible costs include gas
and oil, repairs and maintenance, license fees, insurance, tolls, and even car
washing. If you use the car partly for personal use, you must multiply your
actual expenses by your percentage of business use.
Most people use the standard mileage rate because they do
not want to bother with a lot of record keeping. However, this ease comes at a
price -- you usually get a lower deduction using the standard mileage rate than
you would with the actual expense method. You must use the standard mileage
rate, however, if you claimed certain related deductions (such as under Section
179 of the IRC) in previous years. (For more information on Section 179
depreciation, see Understanding Small Business Tax Deductions.)
To use
either of these methods, you must keep track of how much you use your car for
business. (In addition, you will need to produce your records if you are audited.) Keep logs showing the miles for each business
use, always noting the purpose of trip.
You can also depreciate (write off) the cost of the vehicle
over a number of years. For more information, see Deduct It!:
Lower Your Small Business Taxes, by Stephen Fishman (Nolo).
Can I claim a deduction for
business-related entertainment?
You may deduct only 50% of expenses for entertaining clients
or customers for business purposes, no matter how many martinis or Perriers you swigged. (Yes, this is a change. In the old days,
you could write off 100% of every entertainment expense, and, until a few years
ago, 80 %.) Qualified business entertainment includes taking a client to a ball
game, a concert, or dinner at a fancy restaurant, or just inviting a few of
your customers over for a Sunday barbecue at your home.
Keep in mind that if you are audited,
you must be able to show some proof that the entertainment expense was either
directly related to, or associated with, business. So, keep a guest list and
note the business (or potential) relationship of each person entertained.
Parties, picnics, and other social events that you put on
for your employees and their families are an exception to the 50% rule -- such
events are 100% deductible, and you need not prove it was
directly related to a business goal.
What is the difference between
current and capital expenses?
Current expenses can be deducted
from your business's total income in the year you incur them. They include the
everyday costs of keeping your business going, such as office supplies, rent,
and electricity.
Expenditures for things that will help generate revenue in
future years -- a desk, a copier, or a car, for example -- are
called capital expenses and must be written off over their useful life.
Usually that period is three, five, or seven years, according to IRS rules.
There is one important exception to
this rule, called the Section 179 deduction, which may let you fully deduct
capital expenses in the year you incur them.
If I buy a new computer system this
year, do I have to deduct the cost over a five-year period?
Probably not. Under Section 179, you can deduct
in one year the cost of tangible personal property that you buy for your
business (such as computers, office furniture, and equipment). This is a major
exception to the general rule that the cost of "capital equipment" --
equipment that has a useful life of more than one year, such as a computer
system -- must be deducted over a number of years.
There is a limit to the total amount
of business property expenses that you can deduct each year under Section 179. For 2004
the limit was $102,000; for 2005 the limit is $105,000. Many small businesses
can fit all of their capital expenditures each year into this allotted amount. However,
watch out -- the Section 179 limit is scheduled to go
back down to $25,000 in 2008 (although Congress could decide to make the higher
limits permanent).
Section 179 does not apply to land, buildings, inventory,
intangible assets, and air conditioning and heating units. It does apply to
vehicles, but special rules limit the portion of the cost of a car that you can
depreciate each year. For more information, see Deduct It!:
Lower Your Small Business Taxes, by Stephen Fishman (Nolo).
I am planning a trip to a trade
show. Can I take my family along for a vacation and still deduct the expenses?
If you take others with you on a business trip, you can
deduct business expenses for the trip, but no more than
if you were traveling alone. If, for example, your family rides in the back
seat of the car and stays in one standard motel room, then you can fully deduct
your automobile and hotel expenses. But you can't
claim a deduction for your family's meals or jaunts to
If you extend your stay and partake in some of the fun after
the business is over, the expenses attributed to, the non-business days are not
deductible, unless you extended your stay to get discounted airfare (the
"Saturday overnight" requirement). In this case, your hotel room and
meals would be fully deductible.
In addition, you can fully deduct the cost of your airline
ticket even if it features a two-for-one or "companion" discount.
I work in my home part time. Can I
take the home-office tax deduction?
If you run a business out of your home, you can often claim
a deduction of rental or mortgage costs, as well as some depreciation for the
portion of the home used for business. In addition, you can deduct some related
costs -- such as utilities, insurance, and remodeling. However, there are
strict requirements you must meet. For instance, you will not qualify if you
work part time at home, because your primary office is elsewhere, or if you use
your den partly for work and partly for personal use.
The disadvantage of taking these deductions is that they can
lead to extra taxes down the road when you sell your house -- if you do not
live in your house in two of the last five years before you sell the house. For
more information, check with a tax professional.
I want to start my own small
business. What do I have to do to keep out of trouble with the IRS?
Start by learning a new set of "3 Rs":
record keeping, record keeping, and (you guessed it) record keeping. IRS
studies show that poor records -- not dishonesty - - cause most small business
people to fail to comply with their tax reporting obligations and to lose at
audits, with resulting fines and penalties.
Even if you
hire someone to keep your records, you need to know how to supervise him or her
-- because if your bookkeeper goofs up, you are the one held responsible.
Consider using a computer to keep your records if you aren't
already in the electronic age.
Keep all
receipts and canceled checks for business expenses, and keep them organized and
in a safe place. Separate the documents by category, such as:
Auto expenses
Rent
Utilities
Advertising
Travel
Entertainment, and
Professional fees.
Put your documents into individual folders or envelopes. If
you are ever audited (and small businesses are about three times more likely to
be audited often than individuals are), the IRS is most likely to zero in on
business deductions for car expenses and travel and entertainment expenses.
Furthermore, the burden will be on you -- not the IRS -- to substantiate your
deductions. If you're unsure how to get started or
what documents you need to keep, consult a tax professional who is familiar
with small business record keeping.
Does incorporating a small business
start-up offer tax breaks?
Keep in mind that most corporate tax benefits flow to
profitable, established corporations, not to start-ups in their first few
years. For example, corporations can offer more tax-flexible pension plans than
sole proprietors or partnerships, but few start-ups have the cash flow needed
to take advantage of these tax breaks.
Similarly, the ability to split income between a corporation
and its owners -- thereby keeping some income in lower corporate tax brackets
-- is effective only if the business is solidly profitable.
In addition, incorporating adds state fees, as well as legal
and accounting charges. Therefore, unless you are sure that substantial profits
will begin to roll in immediately, you may want to hold off incorporating your
business.
Is it safe and sensible for me to
keep my own books and file my own tax returns?
To keep your own books, consider using a check-register type
computer program such as Quicken Home
& Business or QuickBooks (by Intuit) to track your expenses. If you are
doing your own tax return, use the companion program, TurboTax.
To make sure you are on the right track, it is a good idea
to run your bookkeeping system by a well-informed, small business tax pro. With
just a few hours of work, he or she should help you avoid most common mistakes
and show you how to dovetail your bookkeeping system with tax filing
requirements.
When your business is firmly in the black, consider hiring a
bookkeeper, to take care of your day-to-day payables and receivables, and an
outside tax pro, to handle your heavier-duty tax work. Not only are a tax pro's
fees a tax-deductible business expense, but chances are your business will
benefit if you put more of your time into running it and less into completing
routine paperwork.
I need to hire people quickly for a
big job coming up. Should I hire independent contractors or new employees?
If you will be telling your workers
where, when, and how to do their jobs, you should treat them as employees,
because that is how the IRS will classify them. Generally, you can treat workers as
independent contractors only if they have their own businesses and offer their
services to several clients -- for example, a specialty sign painter with his
own shop or a freelancer who works for many clients. If in doubt, err on the
side of treating workers as employees.
While classifying your workers as contractors would save you
money in the short run (you wouldn't have to pay the
employer's share of payroll taxes or have an accountant keep records and file
payroll tax forms), it may get you into big trouble if the IRS later audits
you. The IRS may reclassify your "independent contractors" as
employees and assess hefty back taxes, penalties, and interest against you.