A common thread among business owners that we work with in our financial planning firm is that basically everyone wants to minimize taxation. While we should all pay our fair share, there’s no reason to leave the IRS or your local tax authority a tip. Fortunately businesses and their owners have substantial opportunity to reduce taxes owed through pro active planning.
Over the years we’ve found that a few tax questions tend to come up very frequently surrounding whether or not an expense is deductible. With that in mind, here’s a quick cheat sheet of self-employed tax deductions.
What Does the IRS Allow Us to Deduct?
The governing document outlining legitimate business deductions is IRS Publication 535. The first section of the opening paragraph includes the stipulation that to be deductible, a business expense must be both “ordinary and necessary”. The document describes this further, stating that “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.”
As always, the devil is in the details. Expenses don’t need to be considered indispensable to be considered necessary, but several ordinary business expenses have a great deal of nuance. Be sure to speak with a tax professional for further clarification, if you need it.
Advertising & Promotion
Marketing, advertising, and promotion costs are usually considered ordinary and necessary, and thus deductible business expenses on your return. This can even include sponsorships of local sports teams in the right circumstances. There are a few nuances, which the IRS lays out here.
Auto Expense & Mileage
Business travel expenses can add up – especially when you’re self-employed. To help offset this expense, the IRS offers a healthy deductions for self-employed people based on mileage traveled. For each mile you drive for your business and record in a logbook, you can deduct 54 cents up to $3,000 total annually. Driving 5,000 miles for your business, for example, would work out to a $2,700 deduction. (Note that your commute to and from the office does not count).
Hopefully your bank is not charging you much in fees since they’re already making money on their deposits. Nevertheless, your business may occasionally bounce a check or pay a credit card bill late. Fortunately these bank fees are all deductible.
Business Licenses & Permits
Most businesses have some sort of licensing or permitting process specific to their industry. These are all deductible expenses.
Cost of Goods Sold
If your business sells physical products, you’ll be able to deduct cost of goods sold in a separate section of Schedule C on your tax return. Cost of goods sold generally includes products or raw materials used to manufacture or assemble items for resale, storage, direct labor costs, and other overhead used for manufacturing and assembly. The fact that there’s a separate section on your Schedule C to report cost of goods sold should tell you that there are a good number of rules and guidelines to follow here. Make sure to review Publication 535 or speak with a professional for specifics.
Dues & Subscriptions
Most membership dues and subscriptions paid to vendors are deductible. This might include professional organizations or newsletters & other media. A very common questions is whether dues to country clubs or other social clubs are deductible. Country club dues are very clearly NOT deductible expenses in the eyes of the IRS. Same goes for other social clubs unnecessary to business operations.
Most education costs related to your business are deductible. This could include professional education, training on new products or systems, and even undergraduate or graduate program tuition if it’s relevant.
Employee Wages & Payroll Tax
In general you’re free to deduct any amounts paid to employees for services they perform. This includes wages, salaries, bonuses, commissions, or other noncash compensation like paid vacation or other fringe benefits. The key points the IRS considers here are whether the services performed by employees are reasonable and whether they were actually performed. See Publication 535 for more details.
Anything your business pays to rent equipment is deductible in the year of the expense. This is a little different than outright purchases of the same equipment. In most cases the IRS has businesses capitalize equipment purchases and amortize them over time. Since you get to deduct the full cost of an equipment rental up front, the decision of renting vs. buying equipment should play into your overall tax strategy.
Giving gifts is commonplace when it’s related to your business. But don’t stretch this too far. Sending a vendor a gift card for their efforts is likely acceptable. “Gifting” your brother-in-law tickets to the football game because he’s a nice guy is not. See the guidelines in Publication 535 surrounding how expenses must be “ordinary and necessary” for more clarification.
The home office deduction can be a great way for self-employed individuals to lower their tax bill, but it is important to make sure that you are taking it correctly. If you use part of your home exclusively for business purposes, then you may be able to deduct the corresponding expenses from your taxes. Your home must also be the principal place of business. The home office deductions has some nuance and two methods to choose from, so it’s typically best to confirm with a tax advisor whether you qualify. You can also view the IRS guidelines here.
Most businesses carry some form of insurance, which may include errors & omissions, malpractice, general liability, or other types. Premium costs are all deductible for these types of policies. You may also be able to deduct the premiums on personal insurance policies as well under certain circumstances. Examples here are health insurance and qualifying long term care policies. There are many details surrounding when and how these deductions should be claimed, making this a good topic to discuss with a professional.
Interest costs on bank loans and other liabilities are all deductible. Be sure to keep sufficient records here though. Monthly and/or annual statements are typically sufficient.
Legal & Professional Fees
Any fees paid for tax prep, legal advice, financial advice, or other areas are all deductible business expenses. They must be related to the business though. Deducting the fees an attorney might charge you and your spouse for drawing up a family trust would not be deductible.
Meals & Entertainment
Unfortunately, entertainment expenses are generally not deductible as a result of the Tax Cut & Jobs Act of 2017. You’re still able to deduct 50% of business meals though, provided you or an employee is present and the food & drink isn’t considered lavish or extravagant. See the details in IRS Publication 463.
Merchant Processing Fees
Much to many business owners’ chagrin, Visa charges 2-3% of every sale to process credit card transactions. Though this is a hefty chunk of revenue, you’re entitled to deduct merchant processing fees in full.
General office expenses are mostly all deductible. Paper, software & technology, stamps, and other costs should be tracked to ensure you claim the full deduction you’re entitled to.
Repairs & Maintenance
Repairs and maintenance costs for equipment, machinery, computers, etc. are all deductible in the year the expense occurred.
Payments made to subcontractors are deductible, and don’t even need to be for construction work. You may decide to hire a part time executive assistant as a 1099 independent contractor or to help with other items, all of which would be deductible. Be sure not to run afoul of labor laws though. There are national and state specific rules surrounding who must be hired as a w-2 employee and who may be considered an independent contractor.
Like equipment rentals, rents paid for workspace is all deductible in the year the expense is incurred. Also like equipment, if you decided to build or purchase a building for your business to operate in, the costs would need to added to your balance sheet and amortized over time.
Not only are business telephone expenses deductible – you can deduct part of your personal cell phone bill too. Estimate the portion of your phone’s usage that’s for work versus personal reasons. That’s the portion of your annual cell phone costs that’s a deductible business expense. Keep your statements though. If you’re ever pulled for an audit the IRS will likely want you to substantiate the deduction using phone records.
All business travel expenses are deductible. The “hack” for this deduction is to incorporate your personal travel as well. While personal travel costs are not deductible, you can still find ancillary benefit. For example let’s say there’s a trade show in Arizona coming up, which is an area you and your wife like to visit. You purchase a round trip plane ticket for both of you and reserve a hotel for seven consecutive nights. If the trade show runs for three days, you could deduct your airfare and three nights of hotel expenses. Your wife’s airfare and the other nights are unrelated to the business and would not be deductible.
Utility bills are straightforward if you maintain a work location apart from your home. If you work out of the house it’s a little more complex, and depends on whether you use the simplified version for determining your home office deduction. The simplified method incorporates utility costs already. If you use the alternate method you’ll take the portion of your house occupied by the business and multiply it by your annual utility bill.
If you plan to claim any of the deductions above, be sure to keep appropriate records. If the IRS comes knocking on your door they’ll expect you to substantiate any expense you claim that offsets business revenue. Generally this includes documents showing the date the expense was incurred, the location, amount, how it was paid, and business purpose. Here are a few examples:
- Bank statements
- Canceled checks
- Credit card statements & receipts
- Interest statements
- Loan documents
- Mortgage documents