Donald Malcolm Smith is the Director of the Office of Entrepreneurship Education at the U.S. Small Business Administration. He is responsible for the development and dissemination of...
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Guidance for the Self-Employed and Sole Proprietors
There are two basic tax concepts new business owners need to add to their vocabulary: business expenses and capital expenses.
Business expenses are the cost of conducting a trade or business. These expenses are common costs of doing business, and are usually tax deductible if your business is for-profit. For example, costs of renting a storefront, business travel and paying employees are all deductible business expenses.
Capital expenses are the costs of purchasing specific assets, such as property or equipment that usually have a life of one year or more and increase the quality and quantity of products and services you can provide. For example, if you own a landscaping business and you purchase mowers and excavating equipment, these costs are capital expenses and do not qualify as deductible business expenses. However, you can recover the money you spent on capital expenses through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year so that you are able to recover your capital expenses over time.
Figuring out whether a purchase is a business expense or a capital expense is not always clear cut. Consider taking advantage of free tax training opportunities offered by the U.S. Internal Revenue Service (IRS). If you have hired an accountant, you should also seek his or her advice regarding tax deductions.
The following information provides a brief overview of expenses that qualify as tax deductions, with links to resources that provide clear guidance on deducting and capitalizing your expenses.
To be deductible, a business expense must be both "ordinary" and "necessary." An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business.
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 portions. You can deduct the business portion. For example, if you borrow money and use 70 percent of it for business and the other 30 percent for a family vacation, you can deduct 70 percent of the interest as a business expense. The remaining 30 percent is personal interest and is not deductible.
Home Office Deduction
Are you a home-based business? If you are using part of your home for business, you may be able to deduct some expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. If you are a homeowner or renter, the home office deduction is available and applies to all types of homes, from apartments to mobile homes. There are two basic requirements for your home to qualify as a deduction:
Regular and Exclusive Use. You must regularly use part of your home exclusively for conducting business. For example, if you use an extra bedroom to run your online business, you can take a home office deduction for the extra bedroom.
Principal Place of Your Business. You must show that you use your home as your principal place of business. If you conduct business at a location outside of your home, but also use your home substantially and regularly to conduct business, you may qualify for a home office deduction. For example, if you have in-person meetings with patients, clients or customers in your home in the normal course of your business, even though you also carry on business at another location, you can deduct your expenses for the part of your home used exclusively and regularly for business. You can deduct expenses for a separate free-standing structure, such as a studio, garage or barn, if you use it exclusively and regularly for your business. The structure does not have to be your principal place of business or the only place where you meet patients, clients or customers.
Generally, deductions for a home office are based on the percentage of your home devoted to business use. So, if you use a whole room or part of a room for conducting your business, you need to figure out the percentage of your home devoted to your business activities.
Visit the IRS page on Home Office Deductions for a full explanation of tax deductions for your home office.
Travel, Meals, Entertainment and Gifts
As you know, most companies expense items such as travel costs associated with business, in addition to meals, entertainment and gifts. However, there are rules to follow for these deductions.
Generally, you can deduct all of your travel expenses if your trip was entirely business-related. These expenses include the travel costs of getting to and from your business destination and any business-related expenses at your business destination, including tips, cab fare, and other "life on the road" expenses such as dry cleaning. Meals are the only exception. You can deduct only 50 percent of your meals while traveling.
If your business trip includes personal side trips or extended stays for a personal vacation, you can only deduct travel expenses used for business-related activities. For example, suppose you live in Atlanta, and then went on a five day business trip to New York. You spent three days in business meetings, and two days sight-seeing and visiting friends. You can only deduct the costs of the three days you spent on business activities.
If you take your family on vacation to Hawaii, and conduct business there, you can deduct any expenses that are directly related to your business. However, you may not deduct the entire cost of the trip as a business expense.
For a full explanation of tax deductions for business travel, entertainment and gifts refer to Travel, Entertainment, Gifts and Car Expenses (IRS Publication 463).
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. Refer to the following resources for more information about using your vehicle for business:
The Car Expenses Section in IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses.
For a list of current and prior year mileage rates see the Standard Mileage Rates.
Other Types of Deductible Business Expenses
There are numerous other costs of doing business that qualify as deductions. These include, but are not limited, to the following:
Employees' Pay - You can generally deduct the pay you give your employees for the services they perform for your business.
Interest - Business interest expense is an amount charged for the use of money you borrowed for business activities.
Retirement Plans - Retirement plans are savings plans that offer you tax advantages to set aside money for your own, and your employees', retirement.
Rent Expense - Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent as an expense only if the rent is for property you use in your trade or business. If you have or will receive equity in or title to the property, the rent is not deductible.
Taxes - You can deduct various federal, state, local, and foreign taxes directly attributable to your trade or business as business expenses.
Insurance - Generally, you can deduct the ordinary and necessary cost of insurance as a business expense, if it is for your trade, business or profession.
Business-Related Education - You can deduct seminars, classes, educational tapes or CDs, and convention fees.
For a clear and complete explanation of business expense deductions, refer to Business Expenses (IRS Publication 535).
There are two ways to deduct capital expenses. You can "depreciate" them by deducting a portion of the total cost each year over the useful life of an asset, or you might be able to deduct the cost in one year as a Section 179 deduction.
If property you acquire to use in your business is expected to last more than one year, you generally cannot deduct the entire cost as a business expense in the year you acquire it. You must spread the cost over more than one tax year and deduct part of it each year on Form 1040, Schedule C. This method of deducting the cost of business property is called depreciation.
What property can be depreciated?
You can depreciate property if it meets all the following requirements:
It must be property you own
It must be used in business or held to produce income. You never can depreciate inventory because it is not held for use in your business
It must have a useful life that extends substantially beyond the year it is placed in service
It must have a determinable useful life, which means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes. You never can depreciate the cost of land
It must not be excepted property. This includes property placed in service and disposed of in the same year
You cannot depreciate repairs and replacements that do not increase the value of your property, make it more useful, or lengthen its useful life. You can deduct these amounts on line 21 Form 1040, Schedule C or line 2 of Schedule C-EZ.
The method for depreciating most business and investment property placed in service after 1986 is called the Modified Accelerated Cost Recovery System (MACRS). MACRS is discussed in detail in How to Depreciate Property (IRS Publication 946).
Section 179 Deduction
Purchasing such things as office equipment and computer software would seem like ordinary and necessary expenses, however, the IRS considers these costs to be capital expenses.
Unlike assets that are acquired for the production of income (such as investment property), Section 179 of the IRS Code gives you the option to deduct the costs of assets acquired for business use as expenses in the year you purchased the assets, instead of requiring them to be capitalized and depreciated. Eligible property is generally limited to tangible, depreciable property which is acquired for use in the active conducting of a trade or business. Section 179 deductions are subject to dollar amount and deductible limitations.
For a complete, simple explanation of your options under Section 179 refer to Electing the Section 179 Deduction in How to Depreciate Property, IRS Publication 946.
You must follow special rules and record keeping requirements when depreciating listed property. Listed property is any of the following:
Most passenger automobiles
Most other property used for transportation
Any property of a type generally used for entertainment, recreation or amusement
Certain computers and related peripheral equipment
Any cellular telephone (or similar telecommunications equipment)
For more information about listed property, see Publication 946.
Use Form 4562, Depreciation and Amortization, if you are claiming any of the following:
Depreciation on property placed in service during the current tax year
A section 179 deduction
Depreciation on any listed property (regardless of when it was placed in service)
For clear and complete rules for deducting depreciation, refer to How to Depreciate Property (IRS Publication 946).
Where depreciation allows you to deduct the cost of an asset over the life of the asset, amortization is a method of deducting certain capital expenses over a fixed period of time. The IRS allows you to amortize costs associated with:
Starting a business, including the costs of researching a business idea and creating a legal entity
Getting a lease on business property
Intangible assets defined in Section 197 of IRS Code, including business licenses, permits, patents, trademarks, trade secrets, customer loyalty (goodwill), and the intangible value of physical items such as client lists, and accounting and inventory records
Oil and gas exploration
Pollution control facilities
Research and experimentation
For a clear and complete explanation of amortizing these costs, visit the Amortization Section of IRS Publication 535, Business Expenses.
Go to the following sites for a complete explanation on these business expense topics:
Deducting business and capital expenses, visit Business Expenses (IRS Publication 535)
Deducting the business use of your home, visit Business Use of Your Home (IRS Publication 587)
Deducting travel and entertainment expenses, visit Travel, Entertainment, Gifts and Car Expenses (IRS Publication 463)
Figuring out depreciation of capital assets, visit How to Depreciate Property (IRS Publication 946)