Whether you are just launching your small business, or have been in business for a few years, this is perhaps the most crucial tax question you can ask: what are the tax-deductible expenses to maximize your bottom line?
Your bottom line is all-important. Small businesses have less room for error – in fact, no room for error – when it comes to profit and losses. Your business depends on positive cash flow. The first few years of a business’s existence are its make-or-break years.
Statistics show that most small businesses fold within five years, usually due to a lack of capital. It is for this reason that knowing what expenses you can deduct on your tax returns is essential – so you can keep as much money as possible in your business.
It’s always a good idea to consult a tax professional before starting your business, or even in the first year or so, to ensure that you are taking all the deductions you are legally entitled to. If you feel comfortable doing your business taxes, nevertheless, make sure you check out the information provided by the official IRS website.
One reason to do this is that the tax code is modified practically every single year. It’s not necessarily that some deductions are removed while others are added, but rather that the amount of a deduction you can take will change.
In this article, we’ll give you a good idea of which expenses you incur are deductible.
For tax-deductible expenses, that expense must match the following criteria:
- It must be “ordinary”.
Ordinary expenses are those that are “common in your trade or business.” All businesses can take these deductions – wages or salaries that you pay your employees; any funds you allocate to match employee retirement plans such as a 401K or SIMPLE (Savings Incentive Match Plan for Employees).
If you rent an office from a different company, you can deduct that cost. Any local, state, or even foreign taxes you pay, in purchasing goods or services for your business, can be deducted. If you borrow money to fund your business, the interest is deductible. The interest on any money you borrow to cover the cost of your business activities is deductible, as is the cost of business insurance.
- It must be “necessary”
The terms “ordinary” and “necessary” are interchangeable. If you have employees, then their wage expense is necessary as well as ordinary!
Let’s say you are a sole proprietor and do business out of your house. You can deduct the cost of your home office – as long as it is set aside in the house, and you only conduct your business there. If you prefer to rent an office elsewhere, that would still be considered “necessary.”
- It must be “reasonable”
The typical example here is that of a company car. If you, or your employees, need to drive a company car, it typically does not need to be a Ferrari – unless your business is in the motorsports sector, of course.
If you own a dry-cleaning business, is it reasonable to purchase a helicopter, even if the helicopter has your business name plastered all over for advertising purposes? Probably not.
- It must be “well-documented”
As a business owner, you must save all receipts for all business-related purchases. Have a checking account for your business and make all business-related payments on that account rather than on your personal account.
Make it a habit to save all receipts and place them in an appropriate folder so that when tax time rolls around, you have your receipts at your fingertips.
- It must be “legal”
You cannot use tax-deductible expenses for the cost of any unlawful activity.
In addition to keeping track of your expenses for income tax purposes, it’s also essential to track all of your small business expenses for your knowledge of how it affects your bottom line.
It’s quite simple. It is only by knowing where, when, and how you are spending money that you will be able to estimate your future cash flow correctly.
There’s an old saying – and it’s as true today as when it was first crafted – knowledge is power. When it comes to income and outgo – you must know it down to the penny to ensure that you are not throwing your pennies away. Pennies have a way of adding up to dollars very, very quickly.
Let’s trot out another truism – don’t be penny-wise and pound-foolish. Hiring an expert to help you with your taxes will save you money in the long run (even though the deduction for the fee you pay your tax expert was removed in the tax “reform” laws passed in 2018!)
