Looking Toward Tax Season: Writing Off Business Expenses
March 26, 2020
A big part of your wealth management strategy is keeping the hard-earned money that you and your business bring in. There are a lot of ways to reduce the amount of taxes you owe — see our previous entry on charitable deductions here — and one of the most common is the deduction of business expenses.
Roughly half of all millionaires are self-employed. Self-employment is a double-edged sword — owning and running your business can be expensive, but you’re also eligible for a lot of deductions that can significantly bring down the amount of tax you’ll owe on April 15.
Which Expenses Can You Claim?
Generally speaking, an expense has to be “ordinary and necessary” in order to be eligible for a tax deduction. An “ordinary” expense is one that is commonly incurred by other people in your line of work. A necessary expense is one without which you wouldn’t be able to conduct business. Common “O & NE” as they’re often known, include:
- The wages and salaries of your employees
- Money allocated to employees’ retirement plans or pensions, including 401(k)s, 403(b)s, SIMPLE (Savings IncentiveMatch Plan for Employees) plans, and SEP (Simplified Employee Pension) plans
- Rental expenses paid for property that you rent but do not own. If you hold the title to the property or receive equity in the property, it’s not eligible for deduction
- Any local, state, or federal taxes attributable to your business
- Interest paid on money borrowed for the purpose of your business
- Any insurance acquired for your business
Your Home as a Business Expense
A lot of self-employed, high-net-worth individuals conduct their business largely or entirely from their own home, but that doesn’t mean you can write off your new pool as a business expense. However, there’s a provision in the tax code for your home office — you’ll just have to be specific about which parts of your home are for work.
In order to take a deduction for your home office, you have to use some part of your house exclusively in one of the following ways:
- Exclusively and regularly for your business. If you also use a home office or dining room for personal reasons, it doesn’t qualify under this rule.
- As the main location of your business or as a place where you regularly meet with customers or clients. If you’re a consultant or do remote work and your home office is the place you do most of your work, you qualify for a deduction.
If you have a home office or separate structure on your property that you use for your business dealings, you can then calculate what percentage of the square footage of the property constitutes a business. If your home is 5000 square feet and your home office is 20 feet by 30 feet (600 square feet), then you can deduct 12 percent of your utilities, rent, and homeowner’s insurance as business expenses, in addition to any equipment or furniture you purchase for use in that office.
The IRS also offers you the option to claim a flat $5 per square foot of your home office, capped at 300 square feet. Talk to your tax preparer to see which option nets you the best savings.
Cost of Goods Sold
If your business is a manufacturer, wholesaler, or retailer of goods, you’ll need to track the cost of the products you produce or purchase for resale. According to IRS Publication 535, the general rule is as follows: “If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring the cost of goods sold.”
Business Interest Expenses
Another potentially major source of tax deduction is the interest that your business pays. Your business can incur considerable interest on new equipment, vehicles purchases, property, business debts like credit card debt, or investments, and the amount you can deduct will depend on the type of debt.
The IRS says that three criteria must be met for interest on business debts to be tax-deductible:
You must be legally liable for the debt in question. In the event that you’re audited, you’ll need to be able to show documentation that proves the terms of the debt and the signatures.
Both you and the lender must intend that the debt be repaid. You’ll need to show that you’re making payments on your debt and that the lender is depositing those payments. If your debt is to a bank or credit card company, this is straightforward — the rule is mainly to crack down on person-to-person loans that are simply designed to create interest.
You and the lender must have a true debtor-creditor relationship. Again, for most debts, this will be easy to show. If it’s a family member who’s lent you money, the loan will look more suspicious.
Reinvest in Your Business
Depending on your situation, reinvesting in your business might be the perfect win-win when it comes to your taxes. Buying new vehicles, expanding into new office spaces, granting your employees raises, expanding benefits, and purchasing equipment are all likely to be tax-deductible expenses that can considerably offset the taxes you owe in other areas.
As an added bonus, you’ll be creating jobs, stimulating the local economy, and providing for your community. Just as some people save their charitable giving for the end of the year in order to specifically offset the tax they owe, you can do the same when you invest in your own company.
Other Tax Deductions You Might Not Know About
There are dozens of deductions you can take in the course of running a business, and some of them might surprise you:
- The lunch you eat by yourself every day isn’t tax-deductible, but if you take a client out for lunch or you’re traveling for business, 50 percent of it can be deducted. Hang on to your receipts to make sure you get the amounts right.
- Business travel — defined as travel that lasts longer than a typical workday and requires you to sleep outside the city where your business is located — is 100 percent deductible. If you have to drive a long way to meet a client or attend a seminar, it might save you more money to spend the night in a hotel than to drive back that day.
- Driving your car — If you regularly drive for business, you’re eligible to deduct either your actual expenses or the IRS’ standard mileage rate (58 cents per mile in 2019). If you use the standard rate, simply record how many miles you drive and on which days.
- Publications and subscriptions — if you run a restaurant and subscribe to various food-oriented publications, you can deduct the cost of those subscriptions from your tax bill.
Talk to a Financial Planner
It’s no secret that the tax code is overwhelmingly complicated, and it becomes even more so when you have to deal with both your own taxes and those of your business. That’s why First Western Financial is here for you.
We’re not tax advisors, and the information in the article above shouldn’t be construed as official tax advice. Rather, our goal is to make sure you’re as informed as possible about your options when it comes to managing your money. Our financial experts bring knowledge of every aspect of wealth management, including optimizing your tax bill to ensure that you retain as much of your wealth as you can.
We believe that your wealth is about more than just your bottom line — it’s about cementing your legacy, providing for your family, and supporting the causes and principles that are most important to you. For a truly holistic, completely personalized look at your money and what to do with it in order to meet your goals, contact First Western Financial today.