This has been excerpted from Tax Planning for Business by By W. Rod Stern and Carol A. Brittain, available from Entrepreneur Press.
Whether or not you've ever owned a business, no doubt you've filed a personal tax return. As April 15 approaches, you and millions of other Americans prepare and file an IRS Form 1040. You report your income to the government, take any deductions that the government allows, and determine how much tax you owe (or how large a refund you will be receiving).
For most taxpayers, determining the amount of money you make each year is easy. Your employer gives you a W-2 at the end of the year, stating exactly how much you earned. That's your income for the year (plus any interest you earn on your savings account or earning from other investments). You start with your earnings for the year, and then Congress lets you deduct certain expenses to arrive at a dollar amount that will be treated as your taxable income. In effect, Congress has decided that you should be able to pay certain types of expenses with untaxed money. By letting you deduct the interest on your home mortgage, Congress is saying you don't have to pay tax on the money that you use to pay a portion of your home loan. When you are allowed to take a deduction for medical expenses that you incur for you and your family (subject to the medical costs exceeding 7.5 percent of your taxable income), that is Congress's way of saying that you shouldn't have to pay tax on the part of your income that you spend on providing health care for your family.
Like you, businesses must report their income to the IRS each year. Like you, businesses are allowed to take deductions against their income to determine the company's taxable income. However, deductions for the business play a slightly different role. The money that a business collects from its customers is a little like a paycheck. Before the owners of the business can take profits out of the company, the business must pay its expenses of operating the business. Most of the rules regarding business deductions define--for tax purposes--what expenses can be subtracted from your business income as a cost of doing business, and when they can be deducted to determine the amount that should be subject to tax. The amount that is left over after permitted deductions are taken is the business's paycheck that is subject to tax.
The types of deductions that a business is allowed to take fall into three basic categories:
- Current expenses
- Amortized costs of long-term investments
- Cost of inventory
Current expenses of operating a business are deductible at the time that the cost is paid or incurred. These expenses include current rent on buildings or equipment, office supplies, and many other general expenses.
Long-term investments in business assets are not deducted immediately. Instead, the deduction must be spread out over time so that the cost of using the business asset is matched better to the lifetime of the asset. This is referred to as depreciation or amortization. When you purchase an asset that will be used in your business for several years, such as a computer, a car, manufacturing equipment, or even an office building, you must gradually deduct the cost of the asset over many years.
Goods that your business purchases in order to offer them for sale to customers (your inventory) are not deducted immediately or over a predetermined schedule. Instead the amount paid for the inventory (cost of goods sold) is deducted against the income generated when the inventory is sold.
Finally, special rules apply to limit when deductions can be taken for the expenses of using a portion of your home for business purposes. As a result of years of abuse of the home-office deduction, rules were developed to make the home-office deduction available to those legitimately utilizing a portion of their home for business purposes, while preventing abuse by those who occasionally work from the easy chair in their den.
W. Rod Stern is a partner at Murtaugh Meyer Nelson & Treglia LLP specializing in business, tax and estate planning. He has more than 20 years of experience as a corporate attorney and holds a master's degree in taxation law from New York University.
Carol A. Brittain has more than 20 years of experience specializing in business and corporate law. She holds an MBA from Thunderbird School of Global Management, ranked No. 1 in international business by The Wall Street Journal. She has taught courses at University of California Hastings College of the Law.