There are two basic tax concepts new business owners need to add to their vocabulary: business expenses and capital expenses.
Business expenses are the cost of conducting a trade or business. These expenses are common costs of doing business, and are usually tax deductible if your business is for profit. For example, costs of renting a storefront, business travel, and paying employees are all deductible business expenses.
Capital expenses are the costs of purchasing specific assets, such as property or equipment, that usually have a life of a year or more and increase the quality and quantity of products and services. For example, if you own a landscaping business and you purchase mowers and excavating equipment, these costs are capital expenses and do not qualify as deductible business expenses. However, you can recover the money you spent on capital expenses through depreciation, amortization, or depletion. These recovery methods allow you to deduct part of your cost each year. In this way, you are ableto recover your capital expenses over time.
Figuring business expenses vs. capital expenses is not always clear cut. Consider taking advantage of free tax training opportunities offered by the IRS. If you have hired an accountant, you should also seek his or her advice regarding tax deductions.
The following information provides a brief overview of expenses that quality as tax deductions, with links to resources that provide clear guidance on deducting and capitalizing your expenses.
To be deductible, a business expense must be both "ordinary" and "necessary." An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business.
Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal portions. You can deduct the business portion. For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and is not deductible.
If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. The home office deduction is available for homeowners and renters, and applies to all types of homes, from apartments to mobile homes. There are two basic requirements for your home to qualify as a deduction:
1. Regular and Exclusive Use. You must regularly use part of your home exclusively for conducting business. For example, if use an extra bedroom to run your online business, you can make home office deduction for the extra bedroom.
2. Principal Place of Your Business. You must show that you use your home as your principal place of business. If you conduct business at a location outside of your home, but also use your home substantially and regularly to conduct business, you may qualify for a home office deduction. For example, if you have in-person meetings with patients, clients, or customers in your home in the normal course of your business, even though you also carry on business at another location, you can deduct your expenses for the part of your home used exclusively and regularly for business. You can deduct expenses for a separate free-standing structure, such as a studio, garage, or barn, if you use it exclusively and regularly for your business. The structure does not have to be your principal place of business or the only place where you meet patients, clients, or customers.
Generally, deductions for a home office are based on the percentage of your home devoted to business use. So, if you use a whole room or part of a room for conducting your business, you need to figure out the percentage of your home devoted to your business activities.
Visit the IRS page on Home Office Deductions for a full explanation of tax deductions for your home office.
Generally, you can deduct all of your travel expenses if your trip was entirely business-related. These expenses include the travel costs of getting to and from your business destination and any business-related expenses at your business destination, including tips, cab fare, and other "life on the road" expenses such as dry cleaning. Meals are the only exception. You can deduct only 50 percent of your meals while traveling.
If your business trip includes personal side trips or extended stays for a personal vacation, you can only deduct travel expenses used for business-related activities. For example, suppose you live in Atlanta, and then went on a 5 day business trip to New York. You spent 3 days in business meetings, and two days sight-seeing and visiting friends. You can only deduct the costs of the 3 days you spent on business activities.
If you take your family on vacation to Hawaii, and conduct business there, you can deduct any expenses that are directly related to your business. However, you may not deduct the entire cost of the trip as business expense.
For a full explanation of tax deductions for business travel, entertainment and gifts refer to Travel, Entertainment, Gifts and Car Expenses (IRS Publication 463).
If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. Refer to the Car Expenses Section in IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses. For a list of current and prior year mileage rates see the Standard Mileage Rates.
There are numerous other costs of doing business that qualify as deductions. These include but are not limited to the following:
For a clear and complete explanation of business expense deductions, refer to Business Expenses (IRS Publication 535).
There are two ways to deduct capital expenses. You can "depreciate" them by deducting a portion of the total cost each year over an asset's useful life; or you might be able to deduct the cost in one year as a Section 179 deduction.
If property you acquire to use in your business is expected to last more than one year, you generally cannot deduct the entire cost as a business expense in the year you acquire it. You must spread the cost over more than one tax year and deduct part of it each year on Form 1040, Schedule C. This method of deducting the cost of business property is called depreciation.
You can depreciate property if it meets all the following requirements.
You cannot depreciate repairs and replacements that do not increase the value of your property, make it more useful, or lengthen its useful life. You can deduct these amounts on line 21 Form 1040, Schedule C or line 2 of Schedule C-EZ.
The method for depreciating most business and investment property placed in service after 1986 is called the Modified Accelerated Cost Recovery System (MACRS). MACRS is discussed in detail in How to Depreciate Property (IRS Publication 946).
Purchasing such things as office equipment and computer software would seem like ordinary and necessary expenses, however, the IRS considers these costs to be capital expenses. Unlike assets that are acquired for the production of income (such as investment property), Section 179 of the U.S. Internal Revenue Service Code gives you the option to deduct the costs assets acquired for business use as expenses in the year you purchased the assets, instead of requiring them to be capitalized and depreciated. Eligible property is generally limited to tangible, depreciable property which is acquired for use in the active conducting of a trade or business. Section 179 deductions are subject to dollar amount and deductible limitations.
For a complete, simple explanation of your options under Section 179 refer to Electing the Section 179 Deduction in How to Depreciate Property, IRS Publication 946.
You must follow special rules and recordkeeping requirements when depreciating listed property. Listed property is any of the following.
For more information about listed property, see Publication 946.
Use Form 4562, Depreciation and Amortization, if you are claiming any of the following.
For clear and complete rules for deducting depreciation, refer to How to Depreciate Property (IRS Publication 946).
Where depreciation allows you to deduct the cost of an asset over the asset's life, amortization is a method of deducting certain capital expenses over a fixed period of time. The IRS allows you to amortize costs associated with:
For a clear and complete explanation of amortizing these costs, visit the Amortization Section of IRS Publication 535, Business Expenses
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