By definition, business expenses are the cost of carrying on a trade or business. They are usually deductible if your business operates to make a profit.
According to the IRS, in order to be a deductible business expense, it must be both “ordinary and necessary.” An ordinary expense is one that is common and accepted in your trade or business. 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. This is as close to a definition of ordinary and necessary as the IRS gets. Fortunately, most business expenses are obvious. For instance, office equipment and supplies used in the business are clearly deductible.
While there may not be many irrefutably clear guidelines from the IRS, renting office space is a good example of an ordinary and necessary expense for many businesses. However, the space must actually be used for the business or the expense won’t qualify. Ordinary has been determined by the courts to mean “normal, common, and accepted under the circumstances by the business community” and necessary has been interpreted to mean “appropriate and helpful.”
Clear as mud? Below are some common deductions, right from the IRS website. For a more thorough list check out website that follows, and it’s also recommended that anyone in business enlist the help of a professional tax accountant.
Cost of Goods Sold
If your business manufactures products or purchases them for resale, you must value inventory at the beginning and end of each tax year to determine your cost of goods sold. The cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. Some of your expenses may be included in figuring the cost of goods sold. If you do include an expense in the cost of goods sold, you cannot deduct it again as a business expense.
Here are some types of expenses that often go into figuring the cost of goods sold:
• The cost of products or raw materials, including shipping
• Storage finished goods and raw materials
• Direct labor costs (including contributions to pensions or annuity plans) for workers who produce the products
• Factory overhead
Under the uniform capitalization rules (see below), you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.
This rule does not apply to personal property you acquire for resale if your average annual gross receipts (or those of your predecessor) for the preceding 3 tax years are not more than $10 million.
Some costs must be capitalized rather than deducted. These costs are a part of your investment in your business and are deemed capital expenses. Capital expenses are treated as assets in your business. In general, there are three types of costs you must capitalize.
• Business start-up costs
• Business assets
Personal versus Business Expenses
Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.
For example, if you borrow money and use 70% of it for business and the other 30% for improving your home, you can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and is not deductible.
Business Use of Your Home
If you use part of your home for business, you may be able to deduct a percentage of expenses, usually based on square footage, for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Refer to Home Office Deduction and Publication 587, Business Use of Your Home, for more information.
Business Use of Your Car
If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage and keep accurate records for each. Refer to Publication 463, Travel, Entertainment, Gift, and Car Expenses. For a list of current and prior year mileage rates see the Standard Mileage Rates.
The IRS.gov website does provide some assistance. You can find out more from Publication 535 (2015), Business Expenses, at their website at https://www.irs.gov/publications/p535/index.html
ENSO Accounting is an accounting firm positioned to respond to clients’ expectations for clarity, transparency, and support. They are well versed in deductible business expenses and their expertise can ease your day-to-day workload in tracking them. Call for a free consultation.
643 Liberty Road, Suite 101
Eldersburg, Maryland 21784