Small business owners struggle every year with what deductions they can take on their income taxes. If a business is a sole proprietorship, then the owner is usually served best by deducting most business expenses on federal tax Schedule C. Some business owners use federal tax Schedule A. Owners of sole proprietorships usually get more mileage and bang for their buck out of Schedule C.
The Internal Revenue Service (IRS) defines a business expense as an expense that is both ordinary and necessary for the operation of a business. An ordinary expense is one that is commonly accepted in the running of a business. A necessary expense is one that is both appropriate and helpful in the running of the business but it does not have to be absolutely necessary for the survival of a business.
Cost of Goods Sold
The first expense a small business must consider is cost of goods sold. This expense is only applicable if the business sells a product that it manufactures. If the business sells a service, chances are the cost of goods sold line on Schedule C will be left blank since it deals with inventory. In order to value inventory, determine its value at both the beginning and end of the accounting period. The cost of the raw materials to manufacture the inventory plus any freight to ship the raw materials and any storage is included in the cost.
The direct labor costs paid to the workers who manufacture the inventory is also included in cost of goods sold. This includes their wages and any contributions you make to employee pension plans.
Indirect costs to manufacture the product are also included in cost of goods sold. Indirect costs include factory overhead such as rent, interest, taxes, and administrative costs. IRS Publication 538, Accounting Periods and Methods, goes into detail about figuring Cost of Goods Sold.
There are some expenses that small businesses incur called capital expenses. Think of these expenses as long-term or fixed expenses as opposed to short-term expenses, or expenses used in the daily operations of the business firm. These capital expenses usually include business assets that you may purchase. This category can include everything from computer equipment for the office to large pieces of manufacturing equipment for the factory floor or a building for your plant.
These expenses are actually for the purchase of assets for the firm; thus, their long-term status. Unless the purchase is small, capitalize the cost of these assets since they are an investment in the business. Generally, the rule is that if the cost of an asset is minor or the life of the asset is less than one year, capitalize it. If these conditions apply, deduct it as a business expense.
Examples would be buying one printer for your office. Another example would be purchasing a minor part for a piece of equipment to keep it in good working order. The section on Capital vs. Deductible Expenses in Publication 535 - Business Expenses is helpful and gives information on what is deductible and what is a capital expenditure.
Personal and Business Expenses
Sometimes, in a small business, an owner will have expenses that are partly business and partly personal. One example is the business use of the home or a home office. If an owner has a home office, then part of the expenses of running the home are deductible on Schedule C for business purposes. The IRS used to look at the home office deduction as a questionable deduction but that is no longer true. Many small businesses are run out of the home now and it is an accepted deduction for tax purposes.
The small business owner calculates the square footage of the home used for business purposes and uses that information to determine how much of the mortgage payment, utilities, and other home expenses to claim on Schedule C as business expenses. Extensive information on the home office deduction can be found by looking at IRS Publication 587, Business Use of Your Home.
Another example of an expense that small businesses often must divide between business and personal use is an automobile. If a small business owner does not have a vehicle dedicated to the business, then the personal vehicle is presumably used for both business and personal use.
You must keep mileage records each calendar year for the number of miles you drive for business use and the number of miles you drive for personal use, based on your odometer readings. You, then, determine what percentage of miles you drive for business use and expense your vehicle for business use based on this information.
Other Business Expenses
There are many other necessary and ordinary expenses that you can deduct on Schedule C as business expenses. These run the gamut from office expenses to travel and entertainment expenses. Take a look at Schedule C, also called the Profit or Loss from Business form, to get an initial idea of what you can deduct for your business. Good recordkeeping is important from calendar year to calendar year as you can only deduct those expenses for which you have records.
Some business owners deduct some of their business expenses on Schedule A instead of Schedule C under Unreimbursed Employee Expenses and Other Expenses. Be aware that those Miscellaneous Expense categories on Schedule A have to add up to 2% or more of your Adjusted Gross Income in order to be deductible on Schedule A. If they do not, then they will not help you at all if you try to deduct them on Schedule A. You are better off to list them on Schedule C.
Here's a list and explanation of all your deductible business expenses from A to Z!