We know that the beginning of the year is when we start thinking about taxes. After all, this is something that comes around once a year. Taxes are not only something you will have to deal with as an individual, but also if you run a business then taxes are something you’ll have to deal with. So let’s see how to break down business expenses for taxes…
One of the most important expenses on your tax return is the expense report. This is where you write-off all of your business expenses and many people underestimate how important this section is. Personally, I spent months studying how best to structure this report because it can mean a difference of thousands of dollars in your pocket.
In order to properly break down business expenses for taxes, you need to consider how you will be reporting your income. If you file your taxes as an individual, then you can use Schedule C to report business income and expenses. However, if you are filing as a corporation or partnership, then you will have to use Form 1065 and Form 1120S respectively.
Once you have determined which form(s) to use, it’s time to begin breaking down your expenses. The IRS allows businesses to deduct certain types of expenses from their gross income when calculating their taxable income. These include:
-Rent paid on property used in the business (if not deducted elsewhere)
-Utilities used in operating the business
-Insurance premiums paid for protection against risks associated with the business (such as fire or theft)
Even if these things do not apply directly to your situation, there are still other expenses that are deductible – just ask an accountant!
What Are Business Expenses?
According to the Internal Revenue Service (IRS), business expenses are ordinary and necessary costs incurred to operate your business. Examples include inventory, payroll and rent. Fixed expenses are regular and don’t change much — things like rent and insurance. Variable expenses are expected, but they can change. Some examples include sales commissions, gas for business vehicles and shipping costs. You expect variable expenses each month, but the actual amount will vary. Tracking your business expenses helps you keep an eye on whether you’ll see profits or losses.
How Do Business Expenses Impact or Reduce Taxes?
Any expense that meets the IRS definition of ordinary and necessary can be deducted. To be written off, an expense needs to be incurred by a business intending to make a profit. Some expenses may be fully deductible, whereas others are partially deductible or won’t be fully deducted the year they’re incurred.
What Are Examples of Deductible Business Expenses?
The following business expenses may be fully or partially deductible:
- Advertising and marketing
- Bank fees and interest
- Business mileage
- Commissions
- Educational expenses for employees
- Employee benefits
- Equipment maintenance and repair
- Furniture
- Home office (you’ll need to meet certain requirements such as that it is your main place of business)
- Insurance
- Membership dues (business-related expenses only)
- Legal fees
- Office supplies and equipment
- Payroll (employees and contractors)
- Rent or office lease
- Mortgage payments
- Software
- Some costs of business travel
- Utilities
What Are Examples of Non-Deductible Business Expenses?
Not all business expenses are tax-deductible.
Here are some examples:
- Demolition expenses or losses
- Educational expenses incurred to meet requirements to conduct business
- Government fines and penalties
- Illegal activities
- Lobbying expenses
- Political contributions
Understanding Business Expenses and Which Are Tax Deductible
Understanding Business Expenses
Section 162 of the Internal Revenue Code (IRC) discusses guidelines for business expenses. The IRC allows businesses to report any expense that may be ordinary and necessary.1
Business expenses need not be required to be considered ordinary or necessary. Generally, ordinary means that the expense is common in the industry and most business owners in the same line of business or trade would potentially expense these things. Necessary means that the expenses help in doing business are appropriate and a business owner might not be able to handle the business if they did not make the expenditure.2
An expense that meets the definition of ordinary and necessary for business purposes can be expensed and, therefore, is tax-deductible. Some business expenses may be fully deductible while others are only partially deductible.3 Below are some examples of allowable, fully deductible expenses:
- Advertising and marketing expenses
- Credit card processing fees
- Education and training expenses for employees
- Certain legal fees
- License and regulatory fees
- Wages paid to contract employees
- Employee benefits programs
- Equipment rentals
- Insurance costs
- Interest paid
- Office expenses and supplies
- Maintenance and repair costs
- Office lease
- Utility expenses3
Income Statement Reporting
The income statement is the primary financial statement used by entities to record their expenses and determine their taxes. Entities will typically have three categories of expenses which are broken down by direct costs, indirect costs, and interest on the income statement.
Direct Costs
The value of inventory on-hand at the beginning and the end of each tax year is used in determining the cost of goods sold (COGS), which is a large direct expense for many companies.
COGS is deducted from an entity’s total revenue to find the gross profit for the year. Any expenses included in COGS cannot be deducted again. Expenses that are included in calculating COGS may include direct labor costs, factory overhead, storage, costs of products, and costs of raw materials.4
Indirect Costs
Indirect costs are subtracted from gross profit to identify operating profit. Indirect costs typically include things like executive compensation, general expenses, depreciation, and marketing costs. Subtracting indirect costs from gross profit results in operating profit which is also known as earnings before interest and tax.
Depreciation
Expensing of business assets is usually done by deprecation. Depreciation is a tax-deductible expense on the income statement that is classified as an indirect expense. Depreciation expenses can be deducted over a number of years and include costs of computers, furniture, property, equipment, trucks, and more.5
Gifts, Meals, and Entertainment Costs
There are several costs that the IRS has some restrictions on, primarily costs associated with gifts, meals, and entertainment. Generally, you can deduct only 50% of the cost of providing meals to employees, although certain meals may be fully deducted.6
Interest Expenses
The last section of the income statement involves expenses for interest and tax. Interest is the last expense a company subtracts to arrive at its taxable income, sometimes called adjusted taxable income.
Personal Expenses
In some cases, expenses incurred by a business owner may be both personal and business-related. For example, a small business owner might use his car for both personal purposes and business-related activities.
In this case, the portion of miles used for business purposes can be deducted. In the case of home offices, costs associated with the portion of the home that is exclusively used for business are generally deductible.7
Non-Deductible Expenses
Some expenses incurred by a business are not reportable. These expenses include bribes, lobbying costs, penalties, fines, and contributions made to political parties or candidates.8