Q: I'm in the process of starting my first business. I've already made a number of expenditures and will be making more soon. I've tried to research the tax code, but it doesn't seem very logical. What is the proper tax treatment of these expenditures?
A: Taxes are neither fair nor logical. This becomes painfully obvious the more you learn about the tax code and the role of the IRS. The only problem this creates for you is that you may not understand the thought process behind the tax code: It is just a set of rules. Fortunately, this in no way hinders your use of the tax code. You can use tax law to your best advantage by merely applying proven tax strategies to your own business life.
There are four important considerations in the treatment of your business's expenditures:
- Match all allowable ordinary and necessary expenses of your business for each tax year against taxable income. Ordinary and necessary business deductions include all the expenses that are required to operate your business. These deductions aren't particularly difficult to understand, nor do they require any special knowledge in order to deduct properly. However, some do require the application of specific tax strategies to maximize their tax advantage. Ordinary and necessary expenses include all your business-related expenditures, such as: accounting, legal and bank services, office expenses, your car, equipment, travel, entertainment, retirement, wages and salaries, employee benefits, marketing, insurance and payroll taxes, to name just a few.
- Deduct ordinary and necessary business expenditures in two ways. First, deduct items with a useful life of less than the current tax year by expensing these items-deducting them all in the current tax year. Second, capitalize on the following two sub-categories by deducting them over a specific period of time in the future (greater than one year):
- Startup expenditures are incurred prior to your business actually beginning its operations; startup ends when your business actively begins to offer products and services to potential customers. These startup expenditures are totaled and deducted over a 60-month time period, beginning when your business actually makes its products/services available for purchase.
- Expenditures for items with a useful life greater than the current tax year-such as equipment, furniture, fixtures and vehicles-are all deducted over 60 months or less. Any commercial real estate property used in your business will be deducted as 39-year property.
- You must allocate expenditures between personal and business use. An expenditure does not have to be either entirely deductible or nondeductible. The personal portion is not tax-deductible; however, the business part is fully tax-deductible as a business expense. This allocation process is referred to as prorating expenditures between personal and business use.
- Avoid the IRS's "hobby rule." You are presumed by the IRS to be in business with the intent to make a profit. If you do not show a profit in three out of five years, you may be required to demonstrate and defend the fact that you are operating with the genuine intent of making a profit. It is generally rather easy to prove this by showing the capability your business has to provide products and services to potential customers and making significant marketing efforts. However, you are better off if you never have to prove anything to the IRS. For that reason alone, you should manage your activity with the idea of creating a profit. Furthermore, if your business is not profitable, why are you still in that business, anyway?
Note: The information in this column is provided by the author, not Entrepreneur.com. All answers are general in nature, not legal advice and not warranted or guaranteed. Readers are cautioned not to rely on this information. Because laws change over time and in different jurisdictions, it is imperative that you consult an attorney in your area regarding legal matters and an accountant regarding tax matters.
David Meier is the founder and COO of Business Development Coaching, a company that provides small-business owners with ongoing business coaching.