We are a country of ideas: we have the freedom to act on them and form our own business if we choose. Many of us have done so, which makes the United States a country of many small businesses. You can structure your own business in several ways:
- Sole Proprietorship
But no matter how you structure it, a business will have tax deductions, according to IRS tax code. This is what IRS Publication 535 is all about. It explains how to tell a personal expense from a business expense. It tells you how to tell if a business expense is deductible, and how to claim the deduction. If you own a business, chances are you have some deductions to claim. Pub 535 helps you sort through your business expenses and claim the deductions you can, no matter if you’re using Schedule C as a Sole Proprietor or you’ve formed a corporation and you use IRS Form 1120 to file income tax returns for your business.
Business Expenses: Ordinary & Necessary
First off the bat a business owner must sort through business expenses and separate the ordinary & necessary expenses from the ones that are neither. These IRS terms are defined in Pub 535 as follows.
This would be an expenses that anybody in the same field as you might also have. It’s to be expected. For example, a restaurant owner would be expected to have cooking oil as an expense. But 20 laptops? Maybe not.
This would be an expense that is helpful to the business but it doesn’t have to be absolutely necessary. Maybe a laptop would be necessary if it helps the chef to have his recipes handy on the counter.
Business Expenses: Cost of Goods Sold
Now, just because a business expense is necessary and ordinary, doesn’t mean it’s deductible yet. Some expenses don’t count towards your deductions and these are called cost of goods sold. These are expenses your business incurs to build up its inventory or keep the business running. Examples would be storage of your inventory or expenses you have that go towards your labor who produce your product.
Let’s go back to our restaurant example. Your product is the meals you prepare. Your kitchen staff produce the product. If you supply free meals to your staff, then the cost of those free meals gets included in cost of goods sold. Therefore, you cannot deduct the cost also. The cost of goods sold of your business gets subtracted from your gross receipts so you’ve already used those costs for reducing your taxable income. To also deduct them as business expenses would be double dipping.
Business Expenses: Capital Expenses
If something your purchase for your business is meant to last for more than a year (a new oven for your restaurant, for example) then it’s called a Capital Expense. Capital expenses are not deductible either. Another example would be a company car. Meant to last a long time, this expense gets amortized or you can claim depreciation, both of which will help you out on your tax bill.
Go Straight to the Source for More Information
IRS Publication 535 is 50 pages of useful information. Therefore, I’m going to refer you to the IRS website’s online version of Pub 535 here. Business expenses are a major trip-up point for small business owners on their federal income tax returns, so the IRS loves to audit people who claim lots of business tax deductions. This type of tax deduction is actually a red flag for “mistakes” so the IRS may select your tax return to be further scrutinized. Usually this means nothing more than a delay in processing while the IRS looks more carefully at your return. However, if you didn’t understand Pub 535 when you filled out your return, “mistakes” will cause problems.