You’re probably not making as many tax deductions as you can as a small business owner. With a few exceptions, you should make a deduction whenever you’re eating, sleeping, drinking or thinking about your business.
If you’re not making deductions for any time you’re eating, drinking, sleeping or thinking about your business, then you’re probably not maximizing your deductions.
You’re probably deducting the most obvious expenses, like your office rent, supplies, equipment and charitable donations. Where most small business owners miss out is on the little things they don’t consider business expenses but really are — like the smartwatch you use to check your work calendar or the coffee you buy on the way to work.
You shouldn’t strictly go off a checklist of the most common deductions for small business owners to decide what you’ll deduct, because the answer isn’t always black and white.
There are some clear rules and exceptions — no, you can’t deduct your entire Christmas vacation to New York just because you were thinking about your business — so you have to be careful.
By understanding what the IRS’ rules really mean, you can potentially save thousands of dollars on your next tax bill.
|How do tax deductions work?|
|You can deduct business expenses|
|Some "personal" expenses are actually business expenses|
|How can I tell the difference between business and personal expenses?|
How do tax deductions work?
Tax deductions can save you thousands of dollars on your tax bill at the end of the year by reducing your taxable income. The less taxable income you have, the less taxes you’ll owe.
Here’s how that works for you: You have $100,000 of taxable income. If you spent $30,000 of that on business expenses that were 100 percent deductible, your taxable income would lower to $70,000. If you spend even more, the same concept applies. Your taxable income is then multiplied by your personal income tax rate.
Expenses can be fully or partially deductible. If an expense is fully deductible, that means that none of it is included in your taxable income. If something is 50 percent deductible, only half of that purchase goes toward your taxable income.
That’s why deductions, along with tax credits, are an effective way of lowering your tax bill. As a business owner, you have deduction opportunities that regular employees don’t — so you shouldn’t let those go to waste.
You can deduct business expenses
Business expenses, according to the IRS, are costs for your business that are “both ordinary and necessary.” These are usually, but not always, tax-deductible. They don’t include the cost of goods sold (COGS), capital expenses or personal expenses.
What does “ordinary and necessary” mean to the IRS? Here’s how they define them:
- Ordinary expenses: Common and accepted in your trade or business
- Necessary expenses: Helpful and appropriate for your trade or business
That’s a huge umbrella. Some of the most common expenses that fall under those include:
- Business meals
- Advertising and marketing
- Employee retirement
- Legal fees
- Office supplies and equipment
Small business owners typically don’t miss out on deducting these expenses because they’re so directly related to doing business. Where they miss out on are seemingly personal expenses that may qualify as business expenses.
Some “personal” expenses are actually business expenses
Business expenses need to be both ordinary and necessary to qualify for a deduction, according to the IRS. Those hurdles are easier to clear than you think.
Your coffee, meals, phone, watch, car and more may all be considered business expenses that you can deduct. Under most circumstances, all of those examples are ordinary and necessary — but they might not be what comes to mind when you think about business expenses.
If you want to maximize your deductions, you need to broaden your definition of business expenses. In short, you could make a deduction nearly any time you’re eating, drinking, sleeping or thinking about your business.
In the chart below, you’ll see that a business expense could range from dry cleaning to hotel rooms, depending on the context.
|Expense||Yes, you can deduct this...||No, you can't deduct this...|
|Hotel rooms||For networking events, conventions, conferences, meetings, etc.||For personal vacations|
|Coffee||While you're working or on your way to work||When you're just catching up with a friend|
|Bar trips||With clients or employees||With family and friends who aren’t a part of your business|
|Smartwatch||If you use it to view your calendar||If you don’t check those things|
|Plane tickets||For you to travel for business||For your family’s travel for your business trip|
|Restaurant meals||With clients or employees||With family and friends who aren’t a part of your business|
|Phone||If you use it to make business calls||If you don’t do those things (which let’s be honest, every business owner does)|
|Uber rides||If you’re using it to get to work, a meeting, a networking event, etc.||If you’re using it to get to the beach, a movie, or other non-business event|
|Dry cleaning||Work shirts with your logo||Everything else|
How can I tell the difference between a business expense and a personal expense?
There are likely expenses you have that are in the gray area between business expenses and personal expenses.
These expenses — like meals and travel — can likely be classified as a business expense under the condition that it relates to your business.
The best way to determine if something is a business expense or a personal one is if you were doing something for your business at that time. That can include talking about your business, meeting with clients or traveling for your business — which is why we recommend you should write off any expenses where you’re eating, drinking, sleeping or thinking about your business. You could almost always relate them back to your business.
A common misconception is that you can only deduct expenses that are from your business bank account. You can deduct business expenses even if they’re from your personal card, just as long as you make the right bookkeeping moves afterward. If you have a CPA, that means keeping a list of business expenses that you made from your personal card and passing it off to them. If you don’t, you have to reimburse yourself from your business and code that as a business expense in your accounting software.
Regardless of which cards you use, you need to stay organized. You should have a good accounting software like Xero and an expert to make sure you’re responsibly tracking your expenses. Some best practices that will help you include:
- Keeping receipts for your mileage
- Writing down your big expenses throughout the year
- Tracking your events on a calendar
Those tactics will help you if the IRS ever questions or audits you. If the IRS is ever skeptical about a particular purchase, you can point them to the business event on your calendar that it’s correlated with.
There are also many situations that aren’t up for interpretation.
Entertainment costs for clients, for example, are no longer tax-deductible. Entertainment costs for clients were 50 percent deductible until 2017, when the Tax Cuts and Jobs Act was passed. Ever since the 2018 tax year, they’ve been nondeductible. These include purely entertainment costs, like tickets for sporting events — but not meals associated with it.
Business meals, which are typically 50 percent deductible, are nondeductible if they’re “lavish or extravagant” under the circumstances. The IRS doesn’t define exactly what that means — but you should stay on the safe side if you want to qualify for a 50 percent deduction.
Personal expenses are another broad range of expenses that are nondeductible. Those are expenses that don’t relate in any way to your business, like flight tickets for your family. However, some expenses can be split between business and personal use. In those situations, you can deduct the amount you use for business.
Here’s how the IRS explains it: Let’s say you borrow money and use 70 percent of it for your business and 30 percent for a family vacation. You can deduct the 70 percent, either fully or partially, but the 30 percent isn’t deductible at all. The same concept applies to other things you probably split between your business and personal life, like your home or your car.
The bottom line
Tax deductions can lower your tax bill significantly if you know the full range of deductions you could make. Small business owners shouldn’t stop at the most basic deductions like their office rent or supplies.
As long as your expense is ordinary and helpful to your business, according to the IRS, you can deduct it as a business expense. That includes a trip to the bar with a client, a morning coffee on the way to work or a smartwatch that shows you your calendar.
An expense can be deductible in one context, but nondeductible in another. To save the most on your tax bill and maximize your deductions, talk to your tax advisor — or schedule a free introductory call with a DiMercurio Advisors team member today for free to help you save.