Understanding Tax Deductions: What Businesses Need to Know

A tax deductible expense is any expense that is considered “ordinary, necessary, and reasonable” and that helps a business to generate incomeTaxable IncomeTaxable income refers to any individual's or business’ compensation that is used to determine tax liability. The total income amount or gross income is used as the basis to calculate how much the individual or organization owes the government for the specific tax period.. It is usually deducted from the company’s income before taxation. According to the U.S. Internal Revenue Service (IRS), in Publication 535, Business Expenses, “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.”

Any business, regardless of industry, incurs a wide range of expensesFixed and Variable CostsCost is something that can be classified in several ways depending on its nature. One of the most popular methods is classification according. From starting a business to maintaining it, various expenses keep the operation running smoothly. However, many expenses are deductible and can lower tax liabilities. Sole proprietors can reduce not only the regular income tax, but also the self-employment tax. As for incorporated businesses, deducting expenses will enable them to lower business taxes.

For home-based businesses, owners can include some expenses on insurance, property taxes, rent or mortgage, electricity, and maintenance. However, business owners need to keep in mind that all expenses incurred within a fiscal year should be claimed against the income generated in that same year.

Tax-deductible Expenses

Not all expenses are tax deductible; some may only be partially deductible. Specifically, allowable expenses include:

• Advertising/marketing5 P's of MarketingThe 5 P's of Marketing – Product, Price, Promotion, Place, and People – are key marketing elements used to position a business strategically. The 5 P's of
• Transportation/travel
• Interest
• Insurance
• Fuel costs
• Administration and management feesSG&ASG&A includes all non-production expenses incurred by a company in any given period. It includes expenses such as rent, advertising, marketing
• Delivery
• Maintenance and repair work
• Office-related expenses
• Office supplies
• Professional fees (legal, accounting)Retainer FeeA retainer fee is an upfront cost paid by an individual for the services of an advisor, consultant, lawyer, freelancer, or other professional.
• Salaries of workers
• Utilities

Deducting Personal vs. Business-related Expenses

One common problem that arises is determining whether an expense is personal or partly related to conducting business, especially for freelancers or sole proprietors who work at home. How will you know the deductible amount that is spent on rent, insurance, heat, and electricity?

You can find the percentage of the square footage of a home office vs. that of the entire home. Once you get the percentage, you can use it to determine the business portion of certain expenses in such a way that a portion of the expenses will be part of the home office deduction, while the rest will be considered for personal use. For example, if your home office occupies 20% of your home, then you may deduct 20% of your mortgage/rent and utility expenses.

From the same IRS document (Publication 535, Business Expenses), specifically on the section about personal versus business expenses, the agency generally prohibits deducting personal, living, or family expenses. However, an individual can deduct the business part of an expense that is incurred partly for personal purposes and partly for business.

Keeping Track of All Business-related Tax Deductible Expenses

One important thing to remember is to always maintain records of all expenses, whether they are personal or business-related. You can then go back to all the receipts or invoices and ask your accountant which expenses are tax deductible. This can be done the traditional way by keeping a ledger or envelope containing all receipts. However, to make the process more convenient, business owners can use accounting software programs or apps that are designed to help track income and expenses.

Many of the online accounting tools available today are pretty easy to use and understand, though it is still essential to spend some time making sure that you use the right categories of expenses. The programs also enable you to generate profit and loss reports, making it easier to understand the amount of money that comes in, together with expenses. Should you consider hiring a tax accountant, your accounting reports will come in handy when preparing tax returns.

Related Readings

Thank you for reading CFI’s guide to tax deductible expenses. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• How to Use the IRS.gov Website?How to Use the IRS.gov WebsiteIRS.gov is the official website of the Internal Revenue Service (IRS), the United States’ tax collection agency. The website is used by businesses and
• Permanent/Temporary Differences in Tax AccountingPermanent/Temporary Differences in Tax AccountingPermanent differences are created when there's a discrepancy between pre-tax book income and taxable income under tax returns and tax
• Prepaid ExpensesPrepaid ExpensesPrepaid expenses represent expenditures that have not yet been recorded by a company as an expense, but have been paid in advance. In other
• Schedule ASchedule ASchedule A is an income tax form that is used in the United States to declare itemized deductions.It is attached to Form 1040 for taxpayers that pay annual income taxes. Taxpayers can choose to claim either a standard tax return deduction or itemize their qualifying deductions line by line.