Today we welcome a guest post from Katie Tejada, “Get to Get to Know Misunderstood Business Tax Deductions Before Your Year-End Planning“.
This post offers interesting angles that I thought might benefit the readership of MoneyByRamey.com, especially those of you who own businesses or side hustle your way to Financial Freedom.
Get to Know Misunderstood Business Tax Deductions Before Your Year-End Planning
The tax code for small businesses is a complicated, confusing mountain of rules and requirements. In particular, business tax deductions are often misunderstood, leading many small businesses to inadvertently violate the rules. No one wants to deal with an audit, let alone any penalties that the IRS may subsequently impose if it finds wrongdoing.
If you’re an extremely small business or are operating at a loss, you’re less likely to become an audit target. That’s because the IRS tends to prioritize actions that will lead to a recovery of substantial funds. Shoestring one-person operations or businesses teetering on the brink of insolvency aren’t likely to have deep pockets.
But if your small business is well-established and turning a regular profit, you should take extra care when preparing your taxes and performing your year-end planning. The best way to deal with tax problems is to avoid making mistakes in the first place.
Let’s take a look at some of the most commonly misunderstood business tax deductions for small business owners since the passage of the 2017 Tax Cuts and Jobs Act.
Deductions for the Depreciation of Capital Assets
The depreciation rules changed with the new tax law, making it easier for businesses to claim more substantial write-offs upfront in some circumstances. However, this is possibly the most frequently misunderstood tax deduction of all.
When purchasing business assets—from large purchases like a company vehicle or real estate to smaller purchases like a company computer or office equipment—you can take a depreciation tax deduction for the cost. This deduction reflects the fact that the value of the asset will depreciate (lose value) over time. Essentially, the deduction creates an incentive for businesses to make purchases that will generate more income.
Usually, the deduction must be spread out over the lifespan of the asset, but in some cases you can accelerate the depreciation process, using either the Section 179 method (on new or used assets) or the Bonus Depreciation method (on new assets only). This reflects the fact that some assets (like automobiles) lose most of their value early in their overall lifespan. Additionally, for small purchases, you can sometimes claim the full deduction in a single year.
These instances of full deductions within a single year vary from industry to industry. To find out which purchases apply to your business, you should consult a tax attorney to get personalized advice.
Meal & Entertainment Deductions
The 2017 tax law eliminated the 50% deduction for entertainment expenses, such as taking clients out to the golf course.
The 50% deduction for meal expenses remains.
Additionally, a 100% deduction on both meal and entertainment expenses remains available in situations where the costs are part of a marketing campaign or are part of an effort to build goodwill in your local community.
These deductions are covered in IRS Publication 535, Chapter 11.
Home Office Deductions
This tax deduction is commonly misunderstood and abused. Additionally, the 2017 tax law eliminated this deduction for employees working from home.
It is now only available on a very limited basis: You must be self-employed and have a dedicated home office as your principal place of business. You must use this space on a regular basis, and you cannot use it for anything but work.
If you work from home but don’t meet all of these stringent requirements, you will not qualify for the deduction. Note that gig economy drivers don’t qualify either, as their principal place of business is their car.
Bad Debt Deductions
Businesses have two ways to count income: accrual accounting and cash accounting. This choice has major impacts on your ability to make deductions.
In accrual accounting, a business counts revenue as income as soon as it is earned. That means you can deduct bad debt If your business uses the accrual accounting method, you can deduct bad debt that arises as a result of non-payment—for instance, by a vendor who goes out of business.
You can generally deduct business expenses when three conditions apply:
- All events have occurred that fix the fact of liability
- The liability can be determined with reasonable accuracy
- Economic Performance has occurred
For businesses that deal in goods, economic performance refers to transactions. For expenses related to property or services provided to you, “economic performance occurs as the property or services are provided, or the property is used.” If you provide the property or service, then economic performance occurs as you provide that property or service.
However, many businesses claim this deduction incorrectly because they use a cash accounting method rather than the accrual method.
Cash accounting means that business expenses are deducted in the tax year that you pay for those expenses. You can also only deduct a contested liability during the same tax year when you pay for that liability.
You can’t deduct bad debt if you use the cash accounting method because with cash accounting you can’t claim income until payment is received.
The cash accounting method is easier and is the default for most small businesses, but if you run into a lot of bad debt, it may be worth switching to accrual accounting so that you can deduct these losses.
Unlike cash accounting, with accrual method accounting you can deduct contested liabilities either in the tax year you pay the liability or in the tax year you settle the contest as laid out by the IRS.
To switch from cash accounting to accrual accounting or vice-versa, you’ll need to fill out Form 3115.
Let a Tax Professional Help You with Misunderstood Deductions
There are many other misunderstood tax deductions and credits as well. As your business grows in revenue and complexity, your taxes will become more complicated, and more of these questions will arise.
In many cases, businesses accidentally make mistakes on their taxes right from the beginning, but they don’t realize it until years down the line when they’re big enough to trigger an audit.
That is not a place you want to end up.
By consulting with a tax attorney in your year-end planning and tax preparation, you can potentially spare your business from enormous penalties down the road, while also earning peace of mind that your taxes are being done right.
About the Guest Writer
Disclosure: I am/We are long $AAPL $ADM $ALL $BG $BGS $BP $BUD $CALM $CAT $CLX $CMI $COF $CSCO $DAL $DFS $F $FAST $GD $GE $GT $HBI $IBM $INGR $INTC $IRM $JNJ $JPM $KHC $KMB $KO $KSS $LHX $LUMN $MMM $MSFT $NWL $O $PEP $PFE $PG $SBUX $SJM $SPTN $STX $SYY $T $TSN $UL $UPS $WFC $WPC $WRK $WY $XOM
Disclaimer: All the information above is not a recommendation for or against any investment vehicle or money management strategy. It should not be construed as advice and each individual that invests needs to take up any decision with the utmost care and diligence. Please seek the advice of a competent business professional before making any financial decision.
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