Often times, starting and operating a small business feels more like a do-it-yourself, learn-as-you-go business. While this freedom provides flexibility to adapt to changing market environments, it can also put a lot of weight on your shoulders, especially when it comes to business planning and taxes.
FAQ: Tax Information for Small Businesses
To help you lighten your load, we’ve prepared answers to some common questions you may have about small business taxes.
What is considered a tax deductible expense for small businesses?
Under the tax code, almost any business expense that is “ordinary, necessary, and reasonable” will qualify as a deduction that will reduce the profits of your business for tax reasons. But what are the ordinary and necessary expenses? According to him Internal Revenue Service (IRS), these are expenses that are “useful and appropriate” for your business.
For example, if you buy a new computer for your small business, or buy stationery to send your emails, these expenses would probably be considered ordinary and necessary. However, if you buy a new computer for your child to use in his room, this would not be a business expense even if you ran your small business from home.
There are some expenses that are explicitly prohibited from being considered an ordinary and necessary business expense, such as:
- Bribes to public officials;
- Traffic tickets;
- Home phone expenses; Y
- Clothing that you wear while at work (unless you have to wear a uniform).
I use my personal car in my business – is it a tax deductible business expense?
The short answer is yes, but you will have to do some math to determine how much can be deducted. This can be determined using the standard mileage method or the actual expense method. There are some situations in which you must use the standard mileage rate, such as when claiming a Section 179 deduction in the prior tax year.
The standard mileage method is more commonly chosen due to its easier registration requirements. Under this method, you can deduct a fixed amount for each business mile you drive. For fiscal year 2016, the standard mileage deduction rate was 53.5 cents per business mile.
If you use the actual expense method, you are allowed to deduct the actual costs you incur each year to operate your car in your business, plus depreciation. This may include the costs of:
- Gas;
- Oil changes;
- Repairs / maintenance;
- License rights;
- Insurance;
- Tolls; Y
- Car washes.
However, if any of these expenses were related to your personal use of the vehicle, they could not be included in your deduction calculation.
Regardless of which method you choose, you will need to keep records that justify your business-related expenses in case you are audited. This can be complicated if you use the vehicle for personal and professional use. The easiest way to solve this is to keep a mileage log that shows how many miles your car used for business purposes and how many for personal purposes.
In addition, you are also allowed to write off the depreciation of the cost of the vehicle for several years.
Can I claim a deduction for business-related entertainment?
Yes, but only a limited quantity. Under IRS rules, you are only allowed to deduct 50% of the expenses you incur to entertain clients. Some examples of qualified business entertainment expenses include taking potential customers to a baseball game, dining at fine restaurants, or even bringing some of your best customers home for a barbecue and soccer on television.
When claiming these business related entertainment deductions, you should be aware that you need to have documents proving that the entertainment was related to your business in case it is audited. With this in mind, be sure to keep a guest list (including business relationship) and receipts.
What is the difference between current and capital expenditures?
To answer this, it is best to examine each type of expense. Current expenses are those that can be deducted from the total income of your business in the year in which they are spent. These would include the daily costs of keeping your business going, such as:
- Rent for your office;
- Stationery / supplies; Y
- Utilities.
Any money you spend that helps generate income for your business in the future, such as a copier or a car, is called capital expenditure and must be amortized over its ‘useful life’, which is typically three, five, or seven years.
However, there is an important exception to the normal capital expenditure amortization rules. A Section 179 deduction allows you to fully deduct capital expenses in the year that you incur those expenses.
I am planning to take a trip to a trade show. Can I take my family on vacation and still deduct my expenses?
Yes, however, if you take your family on your business trip, you can only deduct as much as you would if you had taken the business trip on your own. This leads to imaginative planning. For example, if you drive your family to the trade show in one car, and you all stay in a standard hotel room, then you can deduct your car-related expenses as well as the hotel stay. However, you will not be able to deduct the meals your family eats, nor the trips to the local water park. Also, if you plan to stay after the trade show is over so you can enjoy some time with your family, you cannot deduct these non-business expenses.
If my business requires me to work from home, am I allowed to take a tax deduction at my office?
This depends on how you use your home for your business. If you run your business out of your home, you may be able to take your home office tax deduction. This deduction allows you to deduct part of your expenses for rent (or mortgage payments), utilities, insurance, and even remodeling.
However, in order for you to take the home business tax deduction, you must follow strict requirements. For example, you will not be eligible to take the home business tax deduction if you use your office partly for work and partly for personal use.
I am thinking of starting my own small business, so how can I avoid problems with the IRS?
One thing many small business owners learn to stay out of trouble is the importance of keeping good records. In fact, many small business owners end up in trouble with the IRS simply because of poorly kept records, even when there is no attempt to evade or defraud.
Many small business owners choose not to keep their own records and instead hire a professional to do the dirty work. However, if you are a computer savvy, there are a number of programs you can use to keep your own business records.
You should always keep your business records organized and in a safe place. These records may include receipts, canceled checks, or other documents related to business expenses. It’s helpful to keep them organized by category, for example:
- Rent / Mortgage;
- Automobile costs;
- Utility bills;
- Advertising related expenses;
- Travel expenses;
- Entertainment for your business; Y
- Professional fees, such as license costs.
If the IRS ever shows up for an audit, they will most likely focus on your car-related expenses, travel costs, and entertainment. As always, the burden of providing records that verify your deductions falls on you, not the IRS.
Will I receive a tax exemption for incorporating my small business?
The main problem many homeowners face when considering incorporating their small business for tax benefits is that their businesses are not always well established. The tax benefits derived from incorporation are really geared towards profitable companies from one year to the next.
For example, corporations may offer pension plans that are more tax-flexible, but most small businesses rarely have the income to take advantage of this tax break. Additionally, corporations have the option of keeping part of their profits within the corporation to take advantage of the lower level of corporate taxes. However, many small business owners are unable to do so because the business has not demonstrated the ability to maintain a consistent profit.
The process of incorporating and maintaining your corporate status carries costs. Therefore, you really should only think about incorporating for tax benefits if you are confident that your business is profitable and maintaining it’s profitability.
Is it a good idea for me to save my own books for my small business and file my own taxes?
If you are planning to keep your own books, you really should invest in a good bookkeeping program. Also, because these programs can be quite confusing, you should also consider taking a class to help you learn the program. When you are ready to do your taxes, you should also invest in tax software.
Another step you can take to make sure your accounting system is on the right track is to hire a professional accountant to review everything. In fact, many small business owners who keep their own records hire a professional for a few hours to make sure their accounting system is set up properly. Also, many times these professionals can show you how to take your accounting system and apply it to a tax program.
If I hire people for a big upcoming project, are they considered employees or independent contractors?
The answer to this question really depends on how you treat workers. For example, if you are going to tell workers where, when and how to perform their job duties, then you should treat them as employees because that is how the IRS will classify them. You really should only treat workers as independent contractors if they run their own business and offer their services to multiple clients. When in doubt, you should probably err on the side of caution and treat your workers like employees.
Many small business owners are tempted to classify workers as independent contractors to save money in the short term. However, if you have trouble with the IRS for misclassifying workers, you will probably end up losing more money than you saved. If the IRS feels you misclassify workers, they can reclassify them as employees and levy back taxes, penalties, and interest against you.