One of the most common headaches small business owners face involves their taxes; mercifully, US businesses can apply deductions to reduce their tax liability. According to the IRS, in order for an expense to qualify as a business deduction, it must be incurred in the ordinary course of the business and must be necessary.
It is important for business owners to identify expenses directly associated with the goods and services they provide. These expenses are called cost of sales or services. This includes cost of raw materials, labor costs of workers directly involved in the production process and factory overhead such as proportionate share of the production area for rent, utilities and other miscellaneous expenses. Once these expenses are in the cost of sales, the taxpayer cannot use them again as operating expenses.
The most common deductions that small businesses can use are administrative and selling expenses. Administrative expenses include the expenses the company pays regardless if they produce or sell. This type of expense includes rent, admin salaries & wages, office supplies, insurance, legal & professional fees and utilities. Selling expenses, on the other hand, include sales commission, advertising, marketing and promotional materials.
You can also deduct taxes and other financial expenses. Taxes include state and local income tax, sales tax, property tax and excise tax. Interest paid for business loans is also tax deductible but not the business loan itself. Losses from sale or disposition of business property also forms part of your business deduction.
Depreciation is another income tax deduction which allows taxpayers to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration or obsolescence of the property. In the US, taxpayers can elect qualifying properties under Section 179. This section allows them to deduct the full depreciation for the year the equipment begins its service. The limit for 2018 has a cap of $1,000,000. In addition to Section 179, taxpayers have a separate option to claim special depreciation allowance. By using this special allowance, taxpayers can deduct 50% of the costs of qualifying properties as a depreciation expense in the year they are placed in service.
Organization costs—initial costs incurred to create a company—are also tax deductible up to $5,000. Any amount over $5,000 capitalizes and amortizes over a period of 180 months. Capital expenditures are not deductible as business expenses; instead, they capitalize and depreciate over time.
Though most business expenses are tax deductible, there are few the law prohibits. These include penalties and fines, federal income tax payments, clothes which are non-uniforms and political contributions.
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