One of the advantages of owning a small business is the opportunity to write off legitimate expenses of operating your company to lower your tax burden. However, there are different approaches to determining exactly what is and perhaps more importantly what isn’t a legitimate tax deduction. Although most businesses have clearly established categories that will pass IRS scrutiny, there are many grey areas that remain open to debate.
An Irvine business attorney can help you understand how the IRS regulations work and advise you on the best ways to keep the most money in your pocket.
Expenses per IRS Forms
Despite what many people may think, the IRS doesn’t really tell you what legitimate expenses are. If you look at IRS tax forms, for example, you may see categories of expenses to report such as “Advertising,” “Contract labor,” and “Office expenses.” The vast majority of businesses will have these types of expenses, but the overriding standard that applies is not the category of the expense you are writing off but whether or not the expense was “ordinary and necessary.”
Because the language of the tax code is vague and not specific, what is considered an ordinary expense has evolved over the years through regulations, publications and case law. Generally speaking, an ordinary expense is one that is typical and generally accepted in the specific business you are in. In other words, if most business like yours deduct this kind of expense, you are probably safe to do so also.
The standards the IRS employs to determine what is necessary are somewhat less strict than those for considering an expense to be ordinary. A “necessary” expense may be defined as one that is appropriate and helpful in conducting your business and trade. An expense need not be required to be deemed necessary. Part of the reason the IRS applies a more relaxed standard to what is necessary is due to the fact that it would be overly burdensome to examine each business decision to see if money were being wasted.
Deductible Business Expenses vs. Other Expenses
The IRS does mandate that you treat certain types of expenses differently, such as:
- Costs of goods sold
- Capital expenses
- Personal expenses
Costs of Goods Sold
If your business involves purchasing goods for resale or the manufacture of goods, you must establish a value of your inventory at the beginning of the year and at the end of the year to determine the cost of goods sold. Expenses such as cost of products, freight, storage, labor cost and overhead are allowed in calculating the costs of goods sold.
Generally speaking, a capital expense is considered an asset in your business, and the IRS requires you to capitalize this cost rather than deduct it. The three major categories of expenses you must capitalize are:
- Business start-up costs
- Business assets
However, as with most IRS rules there are exceptions, particularly in the category of start-up costs, where in many case you have a choice whether to deduct or amortize.
One area of special concern is establishing a clear division between business and personal expenses. Although it is simple to say that business expenses are deductible and personal expenses are not, many small business owners blur the line between the two or co-mingle business and personal funds. For example, just because you use your business credit card to make a purchase doesn’t mean the item is an actual business expense. Similarly, if you were to receive a loan and direct 50 percent of the funds to your business and place the other half in your personal account, only 50 percent of the interest incurred on the debt will be deductible.
Certainly there are ways to arrange your business matters to permit some personal benefits, but you must be careful in doing so.
Areas of Special Scrutiny
The IRS employs different formulas and standards of review based on the type of business you run and its revenues, but particular attention is often paid to the following:
- Business use of your car. Many businesses have dedicated work vehicles, but if you use a vehicle partially for business and partially for personal use, you must segregate the expenses based on the actual mileage for each type of use.
- Business use of your home.
You may be able to deduct a portion of your home’s mortgage interest, insurance, and utility costs if you use a specific area exclusively and regularly as your principal place of business.