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While running a small business and claiming tax deductions are essentially synonymous, most small business owners don’t have an accurate understanding of how most tax deductions actually work or the limitations the IRS imposes around certain benefits. This means that, come tax time, a lot of business owners are a bit disappointed when they either get an unexpected tax bill or a much smaller refund than they were counting on.
Maximizing tax deductions is a key component to any successful business, but it can be complex and time-consuming if you don’t have the necessary knowledge and experience. So to give you some insights into the basics, here are 7 misunderstood tax deductions.
Meals you eat while working are not business meals
For meals to be counted as a business expense, they must have the primary purpose of conducting business. Generally business meals will be eaten with a client and the primary purpose of the meal is to discuss business. These meals must also not be “lavish or extravagant,” or the IRS might disallow them if they are ever called into question. So eating that burger and fries from the local fast food joint at your desk while working on your social media campaign is not a deductible expense. There are of course some exceptions, such as travel-related food expenses, but it would be best to discuss those with your tax advisor.
You may not be able to write off that computer you just bought
Even though the IRS allows you to write off 100% of your asset purchases (up to a certain limit that many small businesses never reach), those write-offs cannot create or increase an overall loss in your business. Many small businesses do not have profits in the first few years and will therefore not be able to write off the entire purchase of items like computers, office furniture or other fixed assets. In 2013, small businesses were able to take a 50% write off regardless of profitability, but the future of that tax incentive is still being debated in Congress. So before you go on a gadget spending spree, it is always a good idea to check in with your tax advisor first to see if it might make more sense to hold off on large asset purchases until next year.
You may not be able to write off your home office expenses
The IRS is very strict on its definition of home office. For a space in your home to be classified as a home office for IRS purposes, it needs to be 100% used for business purposes. This means that if your home work space also doubles as a kids’ playroom, this disqualifies the space from receiving deductions associated with a home office. In a 1994 tax court case, a business owner was denied home office expenses because he had a TV and VCR (yes, a VCR) in his office and could not prove that they were not used for personal use (TC memo 1994-27). Also, similarly to the above profitability limitation on fixed assets, home office expenses cannot create or increase a business loss. Any unused deductions will carry forward to future years.
Those fancy shirts you bought to impress your clients are not business expenses after all
You might look fabulous while capitalizing on your fashion sense to impress and win clients, but that Armani suit is not a business expense. However, if you have actual uniforms for yourself and your employees, those can be considered business costs. But if you ever wear the uniform for personal use, it’s likely that if the IRS questions it you’ll lose the deduction.
Think twice before buying a car for your business, even if it is used exclusively for business purposes
Depreciation deductions on automobiles, even if used exclusively for business, is severely limited. A vehicle that costs you even $30,000 could take up to 12 years to completely write off (assuming you do not dispose of it first). If you use your vehicle for business and personal use, you can expect to deduct even less but will also have to keep accurate records of your business use of the vehicle. There are certain vehicles you can purchase to get around some of these rules, so it would be best to consult your tax advisor before any purchase.
Just because you sunk money into the business, you may not be able to deduct all of it
Cash you have spent on your business could be tied up in unsold inventory, fixed assets, prepaid expenses and many other areas. The downfall is they may not be allowed as a deduction in the year you put the money into the business. It is possible that some of the cash you put into the business might be an investment and not an expense, yet.
Money you pay yourself from your business may not be a business expense
Aside from S and C corps, owners of small businesses are not allowed to be employees of their business. All payments to the owners are simply distributions to the owners, not business expenses. This would be very similar to withdrawing cash from your bank account at an ATM; you are simply transferring money from one location (your bank account) to another (your wallet).
While tax deductions are usually complex and confusing, having a better understanding of them and their limitations will only help you run your business more efficiently by allowing you to make better financial decisions. Take the time needed each month to do your research or bring in outside help to understand your transactions. This will ensure you are not missing out or misunderstanding your business expenses and potential tax deductions or credits.