Excerpted from Tax Planning for Business (Entrepreneur Press)
In order to maximize your business deductions and minimize the tax you must pay-either directly from the business or due to flow-through income reportable on your personal tax return-[it's critical to] familiarize yourself with the following deductions. Remember, each dollar not paid in tax is an extra dollar that may be taken out as profits.
The deduction for automobile expenses isn't limited to automobiles. It applies to all the vehicles used in your business, including cars, vans, pickup trucks, trucks, buses and anything else that serves the same purpose of transporting people or things for your business. There are special rules, however, that apply to automobiles, as opposed to heavier commercial transportation equipment like specially equipped trucks, big-rig tractor-trailers, etc. By the way, some of the larger SUVs-those heavier than 6,000 pounds-are not subject to the limitations applicable to automobiles.
Business-related use of an automobile or other vehicle is deductible. Personal use, including commuting to and from work, is not. The burden is on your business-or you personally if the income and expenses of the business flow through to your individual tax return as a sole proprietor, partner, LLC member or S corporation stockholder-to keep sufficient records to document your allocation of the vehicle use between deductible business use and non-deductible personal use. To meet this burden, you should:
. Keep records to support your business mileage. Record all business use of the vehicle at or near the time you drive anywhere for business reasons. Keep a log reflecting the date, your starting location, your destination and a brief description of the business purpose. It's best to also record your starting and finishing odometer reading, but it may be difficult to train yourself and your employees to be that careful. If you don't record odometer readings from every trip, be prepared to provide proof of the distance traveled on each trip, such as computer maps reflecting route and mileage. These records can be an automobile logbook kept on the dashboard of the vehicle, or your daily calendar (if you keep it with you when you drive for business reasons). What is important is that you make entries at or about the time that you make each trip in the vehicle and that you keep the records readily available for seven years (in case the business is audited).
. Determine what percentage of the vehicle's usage is business related, and what percentage is personal. Keep in mind that commuting from your home to and from your office is personal use, just as much as taking family trips or driving to the grocery store. Perhaps the easiest way to determine the percentage of business and personal use is to record the odometer reading on the vehicle on January 1 of each year (or the first day of your business's taxable year if it uses something different than a calendar year). That will tell you how many total miles (business plus personal) the vehicle was driven during the year. Next, add up the total number of business miles reflected in your log (or the entries on your calendar). That will determine the total number of business miles driven during the year. Divide the total business miles driven for the year by the total combined miles driven. That will give you a number that is your business use percentage. Subtract your business use percentage from 100, and you will have your personal use percentage.
. Compare your deduction using the standard mileage rate method and the actual expenses method to determine which will give you the best tax result. The IRS rules allow you to simply multiply the number of business-related miles driven during the year times a standard, per mile rate (48.5 cents per mile in 2007). Alternatively, you're allowed to add up the actual costs that you incur in operating the vehicle-gasoline, license fees, registration fees, maintenance and repairs, car insurance, etc., as well as an estimate of the reduction in value of the vehicle each year (known as depreciation). The standard mileage rate method is beautifully simple (fewer receipts to save, just keep the mileage log on the dashboard), and if you drive very few business-related miles or if the vehicle you buy for the business is a relatively inexpensive used car, the result may be as good or better than the actual expenses method. However, in most cases where there is more than incidental business use of the vehicle, the actual expenses method will result in greater tax savings. For the first year or two, you should keep complete enough records (and all those gasoline, repair and maintenance receipts) so that you can compare both methods and determine which saves the most money in your situation. Then you can decide which method to use going forward.
The cost of compensating your employees-whether the direct cost of paying salaries or such indirect costs as training employees or providing fringe benefits-is a deductible expense for your business.
Compensation. The salary and bonuses that your business pays to its employees is deductible to the company, and included in each employee's taxable income (except for tax-free or tax-deferred fringe benefits). This is equally true whether the compensation is paid in cash, in property or in services. Of course, the compensation is only deductible if it's an ordinary and necessary business expense. In addition, the pay must be:
. Reasonable under all the facts and circumstances. If the pay is excessive, the deduction will be partially disallowed. Factors to consider in determining whether the pay is reasonable include duties performed by the employee, volume of work handled by the employee, type and amount of responsibility, complexities of the business, hours involved, local living costs, the employee's skill level and pay history, your general policies regarding pay for all your employees, and whether the pay represents a reasonable portion of the business's gross and net income (especially when compared with distributions to owners of the business).
. For services performed by the employee. In particular, compensation paid to an owner-employee should not be unreasonably high considering the services actually performed, or the excessive portion of the salary will be recharacterized as "disguised dividends."
Keep in mind that the business can pay a portion of the employee's compensation as tax-free fringe benefits, such as awards for the employee's safety achievements, or length-of-service awards given after at least five years of employment (and then after intervals of five years or greater). Length-of-service awards can't be given to managers, administrators, clerical or professional employees, and can't be given to more than 10 percent of the business's employees in any one year. Your business also can't deduct more than $1,600 for such awards to any one employee (and that amount is reduced to $400 unless the award is made as part of a written plan that does not improperly favor "highly compensated employees").
Health Insurance and Other Fringe Benefits. In addition to direct compensation to your employees, the business may also deduct the cost of fringe benefits such as health and accident insurance, dependent care assistance, life insurance coverage, and adoption assistance. Although deductible to the company, many of the fringe benefits can be provided to the employee free of income tax (or, at least, tax deferred).
The cost of health insurance provided to employees is deductible, as long as the expense is not greater than the business's net profit. When paid by a C corporation, the deduction is always taken by the business. When paid by other types of entities, the deduction is taken by the business if paid to provide insurance for non-owner employees, and is deducted by each owner on his or her individual tax return if paid to provide insurance for an owner of the business. Remember, owner can mean sole proprietor, partner, LLC member or S corporation stockholder. In addition, the company can deduct the cost of providing life insurance coverage (up to maximum coverage limits), dependent care assistance, or adoption assistance.
Retirement Plans. Contributions can be made to 401(k)s, SIMPLE IRAs, profit-sharing plans, or defined contribution plans. The company can deduct the amount of the contribution, and the employee receiving the benefit of the contribution is not taxed until the funds, including the earnings accumulated in the retirement account, are withdrawn from the retirement account.
Vacation Pay, Sick Pay and Disability Benefits. Any amount that your business pays to employees as vacation pay, sick pay or disability benefits-whether paid as salary continuation on ordinarily scheduled paydays or as a larger lump-sum benefit-is deductible to the company as long as the employee doesn't also receive compensation for the same loss of pay from insurance or any other source. Of course, the sick pay or vacation pay is taxable to the employee as ordinary income.
Education Expenses. Educational expenses paid directly on behalf of an employee, or reimbursed to an employee, can be deducted by the company if the expenses are ordinary and necessary to maintain or improve the employee's skills for the business, or if incurred by the employee pursuant to a written educational assistance program. Any educational expenses that are deductible only as part of an educational assistance program (because they aren't related to the employee's job duties) are limited to a maximum of $5,250 per employee per year, and must be part of a qualified, written plan that does not discriminate in favor of highly compensated employees.
Office Operation Expenses
Ordinary and necessary expenses incurred to maintain and operate the company's business office and other general overhead expenses are deductible on the business's income tax return. Several of the most common such expenses are discussed below.
Rent. The cost of renting property that you use in your business-office space, equipment, etc.-is deductible. However, rent is not deductible if, and to the extent that, it exceeds a reasonable rent under all the facts and circumstances. The issue of unreasonable rent ordinarily arises only when the property is being rented from a related party (such as a closely related relative or a business entity that is owned by common owners). Rent can be a set dollar amount, or it can be a variable amount calculated as a percentage of gross sales. The fact that some portion of the rent is determined as a percentage of gross sales does not, in and of itself, make the rent unreasonable.
As a general rule, the rent paid is deductible by the business in the year that it is paid or incurred. If rent is paid in advance, the company can deduct only the portion that is paid for the use of the property during the current taxable year, and the portion of the rent applicable to future years will be deductible over the future period of time to which the prepaid rent applies. For example, if your company is taxed based upon a calendar year, and enters into a new lease on September 1, 2007, requiring it to pay $12,000 up front as the first year's rent, the rent for September 1 through December 31 ($4,000; calculated as $12,000 x 4/12 of a year) is deductible in the current year. The remaining $8,000 will be deducted as rent in 2008, since it is the rent for January 1 through August 31, 2008.
An amount paid to terminate a lease early is properly deductible as rent paid. On the other hand, rent payments may not be deductible where the total rent paid in a relatively short period of time equals a large part of the price the business would normally pay to purchase the property and the company is granted an option to purchase the property for a nominal price upon termination of the lease. In that situation, the property would be treated as a capital asset being purchased by the company that must be depreciated over its useful life (unless the option expires without being exercised).
Home Office Expense. You may deduct some of the expenses associated with a portion of your home used in your business if the part of your home used in the business is used exclusively for business purposes on a regular basis, and it is either your principal place of business, a place where you meet or deal with clients or customers in the normal course of your business, or a separate structure that is not attached to your home.
In general, the exclusive-use rule prohibits a deduction for use of part of your home in the business if the space used for business is also sometimes used for a non-business purpose. Your home office space does not need to be behind a closed door, or even marked off by any permanent partition, but you or your family cannot use the space for anything other than the business use. The exclusive-use rule does not apply, however, if the business use is either storage of inventory or product samples, or operation of a day care facility.
Miscellaneous Office Expenses. Examples of other office-related expenses that can be deducted include:
. fire, flood, theft or similar insurance on the business premises
. legal and professional fees directly related to the operation of the business
. workers' compensation insurance
. supplies and materials used in the business
. bank fees incurred by the business
. licenses and regulatory fees
. repairs and maintenance to equipment and to the office
The expenses that you incur in promoting your business are deductible, subject to certain limitations. This includes formal advertising expenses, as well as the costs of meals and entertainment incurred in promoting the business.
The company may deduct business-related meals or entertainment expenses for entertaining a client, customer, or employee. However, in most cases, the deduction is limited to 50 percent of the actual food or drink expense incurred. To be deductible, the expenses must be an ordinary and necessary expense for an activity that is neither lavish not extravagant under the circumstances. In addition, the activity must meet either the directly related test or the associated test in order to qualify for the deduction.
Meals or entertainment satisfy the directly related test if the entertainment takes place in a clear business setting, or if the main purpose of the entertainment is to actively conduct business and is engaged in with more than a general expectation of generating income or some other specific business benefit. The directly related test is satisfied, for example, when business negotiations or demonstrations are conducted while a meal is being served.
If the entertainment does not meet the directly related test, the expense will be deductible only if it is associated with your trade or business and the entertainment immediately precedes or follows a substantial business discussion. A meal immediately before or after a substantial business meeting or negotiation would satisfy this test.
Finally, modest gifts to clients or customers may be deducted, but only up to $25 of value per client per year.
Many other deductions may be taken for expenses that do not readily fit into the categories of vehicle expenses, employee-related expenses, office operation expenses or marketing expenses.
Start-Up Costs. The first $5,000 of costs of starting up your business-investigating and acquiring a new business, or forming an entity for your new business-can be deducted in the beginning. However, if your total start-up costs exceed $50,000, then no portion of the expense can be deducted. Any portion that you are not permitted to deduct immediately must be amortized over five years.
Start-up costs include:
. Amounts paid to analyze potential markets, products or other aspects of the business.
. Pre-opening advertising to promote the business.
. Wages paid related to training employees prior to opening.
. Attorney and accounting fees incurred during the formation of the business.
. All expenses related to securing suppliers, customers or distributors for the prospective business.
The rules applicable to start-up costs apply to all costs incurred prior to the day that you actively engage in business activity. If you can actively engage in the business on a modest scale prior to incurring a substantial portion of the start-up expenses, they will be characterized as ongoing business expenses, rather than start-up, and may be deductible immediately.
Investigation Costs. When you investigate a business opportunity but decide not to go forward with the business venture, the general costs of investigating a general type of business (such as conducting a study to determine whether or not a particular type of business is viable in your geographic area) are not deductible. However, investigative expenses and professional fees incurred in a failed effort to purchase a particular business may be deductible as investment expenses.
Research and Development. Research and development costs are costs you incur in the business to learn information about the development or improvement of a product. Product is broadly defined to include formulas, inventions, patents, process, techniques, and similar property. Research and development costs do not include the cost of quality control testing, consumer surveys, advertising or the cost of purchasing someone else's process or patent.
You can elect to deduct the costs of research and development in the year that you pay or incur the expenses by taking the full deduction for such costs in the first year that you incur the expenses. If you don't make the election to take the full deduction in the first year, then you must treat the expense as a capital expense related to the product or process, and amortize the deduction over the anticipated life of the product or process.
If you choose to deduct the expenses in the very first year, then you must continue to deduct research and development expenses in the future years in the same way (unless you get IRS approval to treat the expenses as capital expenses in future years). Conversely, if you treat your research and development costs as capital expenses in the first year, you must continue to use that method unless you get IRS approval to change.
Taxes. Taxes may be deductible when they are paid or incurred in the operation of your business. However, not all taxes can be deducted immediately; some must be capitalized and then amortized over the life of the asset that was taxed. The most common taxes incurred in business, and the proper treatment for each type of tax, are discussed below.
. Payroll taxes (Social Security and Medicare tax) can be deducted when paid. Keep in mind, however, that the company will deduct only the portion of the payroll tax that is paid by the company (7.65 percent of the initial $97,500 of pay for each employee, and 1.45 percent of any pay in excess of $97,500). An equal amount is withheld by the company from each employee's paycheck and sent to the government. Because the portion withheld from the employee's paycheck is paid by the employee (not by the company), no deduction is available to the company. The payroll tax incurred on the earnings paid to the owners of a business other than a C corporation (sole proprietors, partners, LLC members or S corporation stockholders) is paid by the owners as self-employment taxes. Because they are paid by the owner, no deduction is taken by the company. Instead, each owner may deduct one half of the self-employment tax paid as a deduction on his or her personal income tax return.
. Real property taxes paid on property used in the business are fully deductible.
. Sales taxes paid on supplies that are used in the business are included as part of the total price of the supplies and deducted immediately, except that sales taxes incurred on capitalized assets (such as a motor vehicle or substantial equipment) must be capitalized and amortized over the expected life of the asset. If you sell retail goods and collect state or local income tax on your sales to customers, the sales taxes collected by you is not included in the business's gross revenues, and also should not be taken as a deduction.
. Federal income taxes paid by a C corporation are not deductible to the company, but state and local income taxes are deductible when paid. Federal income taxes resulting from profits generated by businesses that are operated as something other than a C corporation-for example, sole proprietorship, partnership, LLC, or S corporation-are paid by each owner on his or her individual tax return, since the income (or loss) flows through to each owner in proportion to his or her interest. There is no deduction available to the company, or to each owner, for the federal income tax incurred.
Other Deductible Expenses. Other expenses-some recurring, some infrequent-can be deducted by your business. Expenses that are commonly deductible include:
. Interest paid or accrued during the business's tax year on debts related to the business is deductible as long as the company is legally liable for payment of the debt. Interest paid or accrued for personal (non-business debt) cannot be deducted. Where proceeds of a loan are used in part to pay the business's operating expenses or acquire a business-related assets, and in part for non-business purposes, the interest accrued on the loan must be allocated between the business and non-business use of the proceeds. The rules for tracing proceeds of a loan to allocate the interest, and for allocating partial repayment of the loan, are complex. Work with a qualified CPA when dealing with loans that are used for both business and non-business purposes.
. Travel expenses incurred while you are away from your primary business home (your primary office, not your family home) can be deducted if your job duties require you to be away from your primary business home and you need to sleep or rest in order to meet the demands of your work while away from your office. Allowable travel expenses include transportation costs such as a tickets for air, rail, or bus travel, or costs of taking your car. In addition, travel costs include the cost of taxis or other local transportation during the trip, lodging and meals, tips, business calls, cleaning and laundry during the trip, and other similar ordinary and necessary expenses related to the trip.
. Bad debt losses may be taken as a deduction when a customer fails to pay an account receivable due to the company, if the company has already treated the sales related to the account receivable as taxable income because the company determines its taxable income on the accrual basis. In addition, the bad debt deduction may be taken when money lent for a business purpose (for example, a loan to a customer of the company to assist the customer in expanding the customer's business in hopes that it will increase the customer's need for the company's products or services) cannot be repaid by the borrower. The bad debt deduction can be taken only after the company has taken reasonable steps to collect the debt and it has become clear that there is no longer any chance the amount owed will be paid.
. Charitable contributions can be deducted by a C corporation, but the deduction taken each year cannot exceed 10 percent of the corporation's taxable income (calculated before taking the charitable deduction). Charitable contributions made by businesses that are not C corporations flow to each owner's individual tax return and can be deducted by each owner.
. Moving expenses may be deducted by the company when paid to any employee, including an owner-employee, when the employee is moving because the new job location is at least 50 miles from his or her prior job location (or, if not employed at the time of the move, 50 miles from his or her residence).
. Tax credits-that is, dollar-for-dollar reductions against the tax payable-may be available for many different various actions taken by the company, such as:
- Purchasing an alternative-fuel, or hybrid, vehicle.
- Payment of certain employee childcare expenses paid by the company.
- Increasing research activity.
- Payment of small employer pension plan start-up costs.
- Hiring long-term recipients of family assistance (welfare) as employees of the company.
The list of available credits is long and changing constantly (for example, a credit was available to assist employers impacted by Hurricane Katrina). Work with a good CPA who can advise you of any credits that may be available for your type of business or in your geographic location.