Taxes are a top financial challenge for small businesses surveyed in NFIB’s annual Problems and Priorities report—taking up four spots among the top 10 challenges. Federal taxes on business income and state taxes on business income both rank high. By keeping up with all the deductions available for business expenses, a small company can ensure it’s taking full advantage and lower its tax burden while ensuring its tax filings are compliant—especially in light on new deductions and changes put in place by The Tax Cuts and Jobs Acts. The Tax Cuts and Jobs Acts, which was signed into law in December 2017, figuring it all out can be confusing. The changes added new deductions, such as a provision allowing small businesses to write off up to 20% of qualified business income from their federal income taxes; changed some deduction percentages; and took away some deductions entirely.
What are Small-Business Tax Deductions?
All businesses have to file tax returns—but how they actually pay taxes depends on how they’re structured. Most small businesses are what are called “pass-through” entities. They don’t, like C-corps, pay corporate taxes. They instead “pass” the business income (its profit or loss) to the owner, and that money is taxed under the owner’s individual income tax rate on the owner’s tax return.
Tax deductions reduce the amount of business income that is taxed. The business owner subtracts all the deductions from the business income (or gross income) to determine the taxable income before figuring out the amount of tax owed.
The IRS defines “business income” as income received from the sale of product or services.
What Can I Deduct?
With some exceptions, the IRS allows for the deduction of the full amount of business expenses.
The IRS says, “to be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.”
Many operating expenses, interest payments, taxes and depreciation are deductible business expenses. But there are exceptions: If an expense was factored into the cost of goods cold (COGs), it cannot be deducted again as a business expense. Capital expenditures and personal expenses are likewise not deductible.
Some of the more prominent changes under the Tax Cuts and Jobs Act no longer allow businesses to deduct entertainment expenses or transportation (commuting) benefits, such as public-transit passes, parking or transportation in a commuter highway vehicle.
11 Top Small Business Expense Tax Deductions
IRS Publication 535 provides extensive guidance and details on deductible business expenses. Some of the ones most relevant for small businesses include:
There are two basic IRS requirements for the home office deduction: Part of the home must be used regularly and exclusively for business and be the principal place of business. If those criteria are met, the business owner can qualify for other deduction expenses, such as mortgage interest, insurance, utilities, repairs and depreciation for that space.
Because all of this can be challenging to itemize, a new simplified option allows a qualified taxpayer to multiply a standard rate (currently $5 per square foot) by the allowable square footage (not to exceed 300 square feet) of the office to determine the deduction amount.
Business can deduct rent as a business expense, providing, the IRS says, that the owner does not have or will not receive equity in or title to the property. If the business leases business property, the business can deduct taxes paid to or for the lessor. Rent and lease expense guidelines are provided in detail starting on page 10 of IRS Publication 535.
Businesses can generally deduct wages, salaries, bonuses, commissions and other noncash compensation, such as vacation allowances and fringe benefits. To be deductible, employees’ pay must be an ordinary and necessary business expense and the business must pay or incur it. In addition, the IRS says pay must meet both of the following tests: it must be reasonable and it must be for services performed. Deductions include:
- Sick pay. Business can also deduct amounts paid to your employees for sickness and injury, including lump-sum amounts, as wages.
- Vacation pay. Businesses can deduct vacation pay, but only in the tax year in which the employee receives the vacation.
- Employee benefit programs. With some exceptions, accident and health plans, adoption assistance, cafeteria plans and dependent-care assistance programs can be deducted. Given they meet certain conditions, expenses by employees for training and education can be deducted.
Reimbursed business expenses.
When reimbursed under accountable plans, the business can deduct expense reimbursements to employees. These include:
- T&E expenses. The business can deduct 50% of certain meal expenses and 100% of certain lodging expenses reimbursed to employees for business travel. IRS rules on reimbursement for meals and lodging are provided in detail in IRS Publication 463.
- Professional use of a personal vehicle. When using the same vehicle for business and personal use, expenses must be divided. This can be based on actual mileage of personal vs. business use or the actual expenses for gas, oil, tires, repairs, insurance and depreciation or lease payments. The deduction amount is the actual expenses or the mileage multiplied by the standard mileage rate.
The rules for deducting interest vary, depending on whether the loan proceeds are used for business, personal or investment activities. The IRS says that if the proceeds of a loan are used for more than one type of expense, the business must allocate the interest based on the use of the loan’s proceeds.
Businesses must generally limit business interest expense paid or accrued during the tax year, unless an exception to the limitation is met. Full details are provided on page 14 of IRS Publication 535.
Businesses can deduct various federal, state, local and foreign taxes directly attributable the business in the year in which they are paid. Businesses cannot deduct federal income tax. A full list of details is available on pages 18 and 19 of IRS Publication 535.
In general, businesses can deduct premiums paid for business insurance that covers fire, storm, theft, accident or similar losses; credit insurance that covers losses from business bad debts; group hospitalization and medical insurance for employees, including long-term care insurance, liability insurance, malpractice insurance; workers’ compensation insurance; and automobile insurance if this expense has not already been included as part of the vehicle deduction.
In general, the entire cost of a capital expense cannot be deducted in the year in which it is acquired. There are some temporary changes to that rule with the Tax Cuts and Jobs Act. But depreciation is a deductible expense. The IRS says business property that must be depreciated includes office furniture, buildings, machinery and equipment. Examples include:
- Motor vehicles. While cars and trucks are typically capital purchases, the business can recover the cost through annual deductions for depreciation, within certain dollar limits.
- Tools and parts. If the tools have a life expectancy of less than one year or cost $200 or less per item, they are deductible. Regular maintenance on machinery, including scheduled parts replacement, is also a deductible business expense.
The most relevant part of this tax category for small businesses is a provision that allows deductions for business startup and organizational costs—typically capital expenditures. The IRS allows businesses to deduct $5,000 of startup and $5,000 of organizational costs paid or incurred after October 22, 2004. That amount is reduced by the amount your total startup or organizational costs exceed $50,000, and any remaining costs must be amortized.
Miscellaneous deductions are tax breaks that generally don’t fit into a particular IRS tax category. They include:
- Advertising expenses. Companies can deduct advertising expenses directly related to business activities.
- Credit card convenience fees. This fee, which credit card companies impose on businesses that accept their cards, can be deducted when paid by the business.
- Legal and professional fees. Fees by attorneys that are ordinary and necessary and directly related to operating your business are deductible as business expenses.
Section 199A deduction or Qualified Business Income Tax Deduction.
Under the Tax Cuts and Jobs Act, pass-through owners within certain income thresholds qualify to deduct up to 20% of their qualified business income (QBI) to reduce their taxable income. The IRS offers explanations on the limitations and stipulations around this new deduction.
Automation can greatly ease recordkeeping for small businesses. For example, AP automation solutions can reduce errors related to manually typing in invoice headers, automatically preserving tax information for the IRS’s recommended seven years, and automatically send out invoices.
Consider creating a budget that covers these five elements:
- Fixed costs
- Variable costs
- One-time costs
- A cash flow statement
- Profits (what’s left after all of the above are factored in)
We also recommend building in some savings for unexpected events and consulting with an adviser who can help you develop a financial plan suitable for small businesses.
Finally, get help when you need it. The NSBA says that one in three small businesses report spending more than 40 hours each year on federal taxes. The majority of small businesses—63%—spend more than $1,000 each year on the administration of federal taxes alone.
It’s not surprising then that roughly two-thirds of small businesses pay an external tax practitioner/accountant to handle their taxes. There are even more benefits here as a sole proprietor: The cost of hiring a tax professional to prepare that part of the tax return relating to business is deductible.