Deductible vs. Non-Deductible Business Expenses
If you run a business or work as an independent contractor, you know the pain that comes at tax time. Unlike employees who work on a company’s payroll, you’re responsible for the full amount of your Social Security taxes. This comes as part of the self-employment tax you’ll pay, which is a full 15.3 percent of your earnings. To keep a little more of your yearly income, you can claim your business expenses as deductions, but it’s important to know the difference between what you can claim and what you can’t.
Deductible vs. Non-Deductible Business Expenses
Business owners have a wide range of expense options available, from the supplies they use to do their work to travel costs to meet clients or attend conferences. If you are in business for yourself, whether as a contractor or business owner, it’s important to seek out every possible deduction since you’ll see a large chunk of your income taken for taxes if not.
Expenses you can’t deduct include anything related to personal use. If, for instance, you’re claiming your home internet use because you work from there, you will need to separate out the portion you use for business and claim only that. You also can’t deduct the money you spend commuting to work or the cost of dry cleaning your favorite shirt for an upcoming conference. Certain other expenses are tax deductible but could trigger an audit if you don’t follow IRS guidelines.
What Types of Taxpayers Can Claim Expenses?
At one time, even salaried employees could claim certain business expenses, as long as they weren’t reimbursed by their employers. Unfortunately, the Tax Cuts and Jobs Act changed all of that, and now those who are on a business’s payroll can’t take deductions for work expenses. That leaves only independent contractors and business owners to consider itemizing business costs as deductions.
Unless your business is registered as a corporation, chances are it’s a pass-through type of business. That means you claim income from the business on your own personal taxes. If you operate a partnership, each partner takes a share of the income and tallies his own business expenses as deductions on his personal taxes. If the business is registered as a corporation, owners and shareholders who receive an income are treated as employees, reporting their salaries on their personal taxes with the corporation withholding taxes throughout the year.
Where to Claim Business Deductions
Meticulous bookkeeping is essential if you plan to claim deductions for your business at tax time. Software can be a huge help with this, even letting you snap photos of your receipt and automatically importing the information in for accounting purposes. If you track throughout the year, at tax time you’ll be able to simply pull a report and either use it as you prepare your own taxes or take it to your tax preparer so that they can file it for you. Make sure you save the information so that it’s accessible for at least three years since the IRS can go back that far if they choose to audit you.
Unless you’re filing as a corporation, you’ll itemize your business deductions on Schedule C, Profit or Loss from Business. You’ll see categories like advertising, car and truck expenses, travel, deductible meals and office expenses. Corporations will itemize business deductions on Form 1120, which is also where they file their losses. Unlike sole proprietorships and LLCs, corporations don’t pass their income or expenses through to individual owner’s tax returns. All cash flow is the responsibility of the corporation itself.
Corporations and Deductible Business Expenses
When it comes to deductible and non-deductible business expenses for corporations, the IRS looks at “ordinary and necessary” expenses as acceptable. The first criteria for any expenses your business claims should be that it was necessary in the course of conducting business. All operating expenses are deductible, including rent, payroll and office supplies. You can also deduct the cost of paying your employees, including the amount you pay out for their benefits each year.
One deductible expense commonly seen with large corporations is bad debt, which can be written off on taxes as long as it meets IRS guidelines. If a customer doesn’t pay for a purchase, a corporation may be able to write off the expense, as long as at the time of the transaction, the corporation saw it as a loan instead of a gift. The primary reason for incurring the debt must be business-related. Otherwise, it will be categorized as personal debt and will be non-deductible.
Corporations also have many non-deductible expenses, including anything that can be qualified as personal rather than business. Corporations cannot claim political contributions, including tickets to political events, even if the primary purpose is related to networking. They also are prohibited from claiming volunteer hours, whether those hours are donated by the company’s principals or employees. Businesses of all sizes can, however, claim funds donated to a charitable organization, as long as that organization has 501(c)(3) status with the IRS.
Deductible vs. Non-Deductible Travel Costs
Businesses and independent contractors can deduct travel expenses, as long as they can be pegged to a specific business activity. In other words, if you fly to Hawaii for a week, you’ll need to be able to show that the trip was business related before you can claim it as a deduction. But if you are traveling for business, it will help reduce your taxable income, since you can claim the cost of transportation to and from the location, accommodations and ground transportation once you arrive.
But there are a few non-deductible items that self-employed travelers will encounter. That starts with meals, which are only partially deductible. You can only claim 50 percent of meal costs while traveling or discussing business with a client or colleague. At one time, that deduction extended to entertainment expenses, but that has changed under the Tax Cuts and Jobs Act. You can no longer deduct those expenses, even if they’re related directly to business. This means you can’t deduct the cost of concert tickets or stadium license fees.
The Tax Cuts and Jobs Act also makes a significant change to the deductibility of meals provided to employees on site. If you have a party in your conference room for all of your employees and have it catered, you can deduct 50 percent of the cost. However, that benefit is going away after 2025, making that expense no longer deductible.
Deductibility of Vehicle Costs
There are some instances where vehicle costs can be deducted, as long as the use is for business purposes. If your car is only used for business, you may be able to deduct the entire cost of the car, including purchase and maintenance. However, this most often happens with business vehicles purchased as part of a fleet. In most cases, you’ll use your personal vehicle for business activities or, at the very least, want the freedom to drive your business-designated car whenever you want.
The easiest way to split business and personal use for a vehicle is to simply claim the mileage you drive. You will need to keep records of each trip, so this can be difficult if you use your car every day, throughout the day. In that case, it may be easier to use the actual expense method of accounting, which means calculating the amount you spend on fuel, oil, repairs, tires, insurance, registration fees, licenses and depreciation. You’ll have to proportion those costs out based on the percentage of personal use.
Operating at a Loss
Building a business can take time. In fact, you may operate for several years at a loss before you see positive cash flow. This is a problem not only for your bank account but also for IRS purposes. You can continue to claim business expenses for multiple years, but over time, this may lead the IRS to classify your business as a hobby. This is especially true for sole proprietors running a business from home. If a crafter is selling handmade items on Etsy or a writer is trying to sell her poetry, for instance, the IRS may not see this as a full-fledged business with the possibility of operating at a profit someday.
One way to overcome this is to treat your business as such, no matter how it operates. Have a business plan in place that demonstrates your plan to become profitable. If you’re ever audited, the IRS will see you as an entrepreneur rather than a hobbyist. If your business hasn’t made a profit in three of the past five years, make sure you can answer the question, “Is this a business or a hobby?”
Business Expenses for Hobbies
There’s nothing wrong with operating your venture as a hobby. In fact, it may be something you always plan to do on the side, for a little extra money. Unfortunately, you’ll still have to claim every dime you make from that hobby to the IRS, since it’s considered income no matter what the classification. If you enjoy shopping flea markets and garage sales, then flipping the items for a profit online, for instance, you’ll have to claim the profit you made. But the good news is, you can also deduct the money you spent, as long as you made money on the expense.
In other words, if you spend $10 on a collectible and don’t sell it at a profit, you can’t claim the $10 on your taxes, since you’re indulging a hobby, not running a business. However, if you spend $10 on a collectible and sell it for $40, you’ll claim $40 in income and $10 as an expense. You will claim hobby expenses on Schedule A of Form 1040, as long as the total of your expenses during the year exceeds 2 percent of your adjusted gross income. You’ll also need to have more in total deductions than the standard deduction, which is now $12,000 per person.
Capital vs. Deductible Expenses
In addition to deductible versus non-deductible expenses, businesses must also consider capital versus deductible expenses. A capital expense refers to money spent to buy, maintain or improve its fixed assets. These include buildings, equipment and land. You capitalize an expense rather than deduct it if the changes you made improved the value of the property or adapted it to a different type of use.
There are three types of business capital expenses: startup costs, assets and improvements. Although you can’t deduct these expenses, you may be able to recover the money you put into it through depreciation, amortization or depletion. You depreciate the cost of your asset each year in doing this and get back some of the money you spend. If the property qualifies as disaster assistance property, you may be able to deduct the costs as a section 179 deduction.
- Gusto: How to Calculate Your Self-Employment Tax in 4 Simple Steps
- CNBC: New tax law takes a hatchet to these worker expenses
- Nolo: How Corporations Are Taxed
- IRS: IRS Audits
- IRS: Topic Number 453 - Bad Debt Deduction
- InDinero: 13 Business Expenses You Definitely Cannot Deduct
- Nolo: Deducting Meal Expenses for Business Travel
- IRS: Topic Number 510 - Business Use of Car
- Forbes: What The 2018 Tax Brackets, Standard Deductions And More Look Like Under Tax Reform
- IRS: Business Expenses
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.