Small Business Tax Information FAQ
Here are answers to the most common questions about small business tax information.
What is considered a tax deductible small business expense? What isn't?
According to the tax code, just about any business expense that is "ordinary, necessary and reasonable" will qualify as a deduction that will decrease the profits of your business for tax reasons. However, the question arises, what exactly is ordinary and necessary? According to the Internal Revenue Service (IRS), any expense that is "helpful and appropriate" for you business will be considered ordinary and necessary. For example, if you purchase a new computer for your small business, or buy stationary to send out your mailings, these expenses would probably be considered ordinary and necessary. However, if you buy a new computer for your son to use in his room, this would not be a business expense even if you ran your small business from home.
However, there are a few expenses that are explicitly prohibited from being considered an ordinary and necessary business expense. For example, bribes to public officials are not considered ordinary and necessary. Other examples of expenses that you cannot deduct as being ordinary and necessary are traffic tickets, your home telephone line and any clothing that you wear while on the job, unless you are required to wear a uniform.
I use my personal car in my business -- can I deduct that from my business taxes as a tax deductible expense? If so, how much?
The short answer is yes. However, you will need to do some calculations. In general, you can calculate how much you are allowed to deduct from your business taxes by either using the standard mileage or the actual expense method. The standard mileage method is the most commonly used method because the record-keeping requirements are much less strict than the actual expense method. Under the standard method mileage, the IRS allows you to deduct a certain amount for each business mile that you drive. For the 2010 tax year, the standard mileage rate is 50 cents per business mile. This represents a 5 cent per mile decrease from the 2009 year and reflects the generally lower cost of transportation.
If you choose to use the actual expense method, you are allowed to deduct the actual costs you incur each year to operate your car for your business, plus depreciation. You are allowed to deduct your costs for gas, oil changes, repairs and other maintenance, licensing fees, insurance, tolls and even car washes.
If you use the car partly for your personal use as well, you will have to take the expenses related to your personal use out of your deduction calculation.
As we previously mentioned, most people opt to use the standard mileage deduction because they have to keep fewer records. However, you will have to make your own choice. It is worthwhile to keep in mind that you will often receive a smaller discount by using the standard mileage rate versus using the actual expense deduction. You should also remember that there are some occasions when you must use the standard mileage rate, such as when you claimed a Section 179 deduction in the previous tax year.
Remember that, whichever method of deduction you use, you will have to keep records relating to how much you use your car for business versus personal use in case you get audited. The simplest way to do this is to keep a mileage log showing how many miles you used your car for business reasons, and how many miles you drove for personal reasons.
In addition, you are also allowed to write off the depreciation of the cost of the vehicle over a number of years.
Am I allowed to claim a deduction for business-related entertainment?
Yes, but only a limited amount. Under the IRS rules, you are only allowed to deduct 50% of expenses that you incur for entertaining clients or customers. Some examples of qualified business entertainment expenses include taking potential clients to a baseball game, dinner at fine restaurants, or even bringing over some of your best customers to your home for a BBQ and football on TV.
When claiming these business-related entertainment deductions, you should keep in mind that you need to have documents showing that the entertainment was related to your business in case you are audited. With this in mind, be sure to keep a guest list (including the business relationship), and any receipts.
However, you may be able to deduct 100% of entertainment expenses if the entertainment you provide is for your employees and their families. So, you should seriously think about holding that company picnic you've been planning.
What is the difference between current and capital expenses?
To answer this, it's best to look at each type of expense. Current expenses are expenses that can be deducted from your business' total income in the year that they are expended. These expenses include the everyday costs of keeping your business going, such as the rent for your office, stationary and other supplies, and utilities.
Any money that you spend that will help generate revenue for your business in the future, such as a copier or a car, are called capital expenses and must be written off over their "useful life." The "useful life" period is normally 3, 5 or 7 years.
However, there is an important exception to the normal capital expenses write off rules. A Section 179 deduction allows you to fully deduct capital expenses in the year that you incur those expenses.
I bought a new computer system for my business this year. Can I deduct the entire expense on this year's taxes, or do I have to deduct the cost of over a five-year period?
It is really up to you. Although the "normal" way to deducting the cost for your computer would be to deduct it over a five-year period, Section 179 may allow you to deduct the entire cost of the computer in the year you bought it. Section 179 provides an exception to the normal rule for deducting the cost of capital equipment (equipment that has a "useful life" or more than one year, such as a computer system).
However, there is a limit for the total amount of business property expenses that you can deduct from your business taxes for the year under Section 179. For the 2010 tax year, the limit is $134,000. In addition, if you purchased more than $800,000 worth of capital equipment in 2010, you may be subject to a phase-out. However, this phase out limit does not apply to many small businesses that can normally fit all of their capital expenditures within the $134,000 limit. Keep in mind that the Section 179 limit is expected to decrease in the coming years.
Section 179 does not apply to all capital expenditures that a small business may make. For example, Section 179 does not apply to land, buildings, inventory, intangible assets, or climate control (air conditioning and heating). However, Section 179 does apply to automobiles that you purchase for your business, but there are special rules in that case.
I am planning on taking a trip to trade show. If I take my family along as a vacation, can I still deduct my expenses?
Yes, however, if you take your family along on your business trip, you can only deduct as much as you would if you had taken the business trip on your own. This leads to some imaginative planning. For example, if you drive your family to the trade show in one car, and you all stay in one standard hotel room, then you can fully deduct your expenses related to the automobile as well as the hotel stay. However, you will not be able to deduct for the meals your family eats, nor any trips to the local water park.
In addition, if you plan on staying after the trade show ends so that you can enjoy some time with your family, you cannot deduct these expenses (they are "nonbusiness" expenses). However, if you extend your stay to get a discounted airfare (the "Saturday overnight" requirement), you may be able to deduct your hotel room and meals for that extended stay.
Lastly, you should watch out for airline specials. If you find a "two for one" ticket, you can purchase one airline ticket and have your spouse fly along with you for free. In this case, you would be able to fully deduct the cost of your airline ticket.
Part of my business requires me to work from home. Am I allowed to take a home office tax deduction?
The answer to this really depends on how you use your home for your business. If you run your business out of your home, you may be able to take the home office tax deduction. This deduction allows you to deduct part of your expenses for rent (or mortgage payments), utilities, insurance and even remolding.
In order for you to take the home business tax deduction, however, you must follow strict requirements. As an example, you will not be eligible to take the home business tax deduction if you use your home office partly for work and partly for personal use.
You should talk with your tax professional if you are curious about whether you qualify to take a home business tax deduction.
I am thinking about starting my own small business. What steps should I take to avoid trouble with the IRS?
One thing that many small business owners learn in order to stay out of trouble with the IRS is the importance of keeping records, and keeping them well. Indeed, many small business owners end up in trouble with the IRS simply because of poorly kept records (notice that this does not mean dishonest records). Poor record-keeping often leads to failure to file accurate tax returns, which can lead to audits. And if you have poorly kept records when you are audited, you can land in big trouble.
Many small business owners decide not to keep their own records and instead hire a professional record keeper to do the dirty work. If you decide to hire a professional record keeper, be sure to keep an eye on their work. However, if you are computer savvy, there are a number of programs you can use to keep your own business records.
You should always keep all receipts and records, canceled checks and other documents related to business expenses. Keep these documents organized in a safe place. In addition, it is helpful to keep them organized by category, such as:
- Automobile costs
- Utility bills
- Expenses related to advertising
- Travel costs
- Entertainment for your business
- Professional fees, such as license costs
Once you have your file cabinet divided up nicely, make sure to put the right documents in the right folders. If the IRS ever shows up for an audit (according to some sources, small businesses are three times more likely to be audited than individuals), they are most likely to focus on expenses related to your car, travel costs, and entertainment. As always, the burden of providing documentation that verifies your deductions falls on you, not the IRS. If you are unsure about what you should keep, you should get in touch with a tax professional.
If I incorporate my small business, will I get any tax-breaks?
The main problem that many small business owners run into when they think about incorporating for tax benefits is that their businesses are not always well established. The tax benefits that come from incorporating are really geared towards companies that are profitable from year to year. For example, corporations can offer pension plans that are more tax flexible, but most small businesses rarely have the revenue to take advantage of this tax break.
In addition, corporations have the option of keeping some of their profits inside the corporation in order to take advantage of the lower corporate tax bracket. However, many small business owners do not have the option of leaving funds inside of their business because the business has not shown the ability to maintain a steady profit.
Lastly, you should keep in mind that the process of incorporating and maintaining your status as a corporation also comes with costs. Therefore, you should really only think about incorporation for the tax benefits if you are sure that your business is profitable and will maintain is profitability.
Is it a good idea for me to keep my own books for my small business and file my own taxes?
If you are planning on keeping your own books, you should really invest in a good bookkeeping program. In addition, because these programs can be quite confusing, you should also think about taking a class to help you learn how to use the bookkeeping program. When you are ready to do your taxes, you should also invest in a tax program.
Another step that you can take to make sure your bookkeeping system is on the right track is to hire a professional bookkeeper to take a look. Indeed, many small business owners that keep their own records hire a professional for a few hours to make sure their bookkeeping system is set up well and will function. In addition, many times these professionals can show you how to take your bookkeeping system and apply it to a tax program.
When your small business is making a steady profit, you should really think about hiring a bookkeeper, at least part time, to take care of your day-to-day expenses. You can then take your books to an outside tax professional when it is time. Remember that at some point it will become more profitable for you to assign these tasks to others.
I have a big project coming up with my small business. If I hire people to help with the project, are they considered employees or independent contractors?
The answer to this question really depends on how you treat the workers. For example, if you are going to be telling the workers where, when and how to perform their job duties, then you treat them as employees because that is how the IRS will classify them. You should really only treat workers as independent contractors if they have their own business and offer their services to several clients. When you are in doubt, you should probably err on the side of caution and treat your workers as employees.
Many small business owners are tempted to classify workers as independent contractors in order to save money in the short run. However, if you run into trouble with the IRS for misclassifying workers, you'll probably end up losing more money than you saved. If the IRS feels that you misclassified workers, they can reclassify them as employees and impose back taxes, penalties and interest against you.