There are many expenses incurred in starting, running, and growing a business. Luckily for business owners, many of these expenses can be deducted. Knowing which expenses you can deduct helps to lower your tax burden and keep more money in your business. However, inflated business tax deductions can attract the attention of the Internal Revenue Service (IRS).
Small businesses are audited at about twice the rate of individual taxpayers, and the IRS plans to ramp up small business audits in 2021. To catch all of the tax breaks that you qualify for while avoiding undue scrutiny, it is useful to familiarize yourself with the most common small business tax deductions.
How Business Tax Deductions Work
According to the IRS, business expenses are the cost of carrying on a trade or business. If the business operates to make a profit, these expenses should be deductible.
But what does it mean to deduct a business expense? Deducting a business expense does not change your tax rate, but it does allow you to subtract the deduction amount from the total amount of your taxable revenue. For example, if your pre-deduction taxable revenue is $100,000, and you have business deductions totaling $20,000, you end up with $80,000 in taxable revenue. As a result, your tax rate is applied to a lower total revenue amount, thus lowering your tax burden.
The IRS specifies the following rules:
- Eligible business deductions must be ordinary and necessary.
- An ordinary expense is one that is common and accepted in your business.
- A necessary expense is one that is appropriate and helpful for your business. Note that a necessary expense does not have to be indispensable, in the words of the IRS.
- Business expenses must be kept separate from personal expenses. If an expense is used partially for your business and partially for a personal purpose, you can still deduct the business portion.
Qualifying deductions can be made by small businesses as well as self-employed individuals. For a full explanation of qualifying business expenses, refer to IRS Publication 535, Business Expenses.
Eligible Small Business Tax Deductions
If you run your own business or are self-employed, you may be able to make the following business-related tax deductions:
- Employee pay: Generally, you can deduct the amount you pay your employees for services performed, as long as it meets the IRS's criteria for reasonableness (the amount a similar business would pay for the same or similar services). In addition to regular wages, you can deduct bonuses, commissions, and non-cash compensation, such as fringe benefits.
- Rent: You may be able to deduct rent as a business expense if the rent paid is for property you use in your trade or business. This includes the home you rent, as long as you use part of the home as your place of business. However, if you may only deduct rent paid for the part used in your business.
- Loan interest: The interest charged on money borrowed for business activities is a tax-deductible business expense. However, there are limits on business debt deductions and certain requirements must be met.
- Taxes: Federal, state, local, and foreign taxes that are directly attributable to your trade or business can be deducted. This includes real estate taxes, income taxes, employment taxes, excise taxes, franchise taxes, personal property taxes, and sales tax. Typically, you deduct taxes in the year that you pay them.
- Insurance: Insurance premiums related to your trade, business, or profession are deductible. Insurance that covers accident, fire, storm, theft, and losses from bad debts, medical insurance for employees, liability insurance, malpractice insurance, workers' compensation insurance, unemployment insurance, vehicle insurance, life insurance, and business interruption insurance may all be written off on your taxes.
- Research costs: The IRS allows businesses to deduct what it calls “research and experimentation costs.” This category of deductions includes things like the costs of obtaining a patent, including attorneys' fees.
- Start-up costs: Business owners can elect to deduct up to $5,000 of business start-up costs in the business's first year. Potential market surveys, advertisements for opening your business, employee training costs, consulting costs, and travel costs related to securing distributors, suppliers, or customers qualify under this category.
Other tax write-offs for small businesses and the self-employed include the following:
- Professional services, such as legal and accounting fees;
- Internet and phone expenses;
- Business-related meals and travel;
- Vehicles used for business purposes;
- Publications and subscriptions pertaining to your line of work;
- Education expenses (e.g., a realtor taking a real estate continuing education course);
- Advertising and marketing costs;
- Bank and payment processing fees (including fees from platforms like PayPal and Upwork); and
- Home office expenses.
Small Business Tax Audits
The IRS announced in 2020 that it plans to increase audits of small businesses by about 50% starting in 2021. It is always a best practice to exercise care in claiming deductions, but since the IRS will be paying closer attention to small businesses, you should be especially careful from now on. The following list includes deduction red flags that have been known to trigger an IRS audit:
- Taking excessive home office deductions;
- Meal, travel, and entertainment deductions;
- Deduction amounts that seem too high for your income level;
- A large number of deductions or high deductions;
- Claiming more deductions than you have in past years;
- Deductions that are higher than normal for your industry or occupation;
- Claiming hobby expenses as business expenses; and
- Errors when claiming a deduction.
When in doubt about a deduction, a tax law professional can guide you. Remember that fees may be tax deductible for your business!