Let’s be frank: it costs money to make money. From the kid on his parents’ lawn selling lemonade to Amazon, offering a service or product in the marketplace requires an upfront investment in materials, labor, and infrastructure in order to provide those offerings to their target consumers. A business only survives if the difference between its cost and sale price is large enough to generate a healthy profit (unless you’re a tech company, anyway).
Businesses pay taxes on their income every year. Congress and state legislatures recognize that not every dollar received is a dollar in profit and draft their respective tax laws to reflect it. This article will focus on deductions and specifically those available to businesses. While both federal and state income taxation schemes allow for deductions, the focus here will be only on the federal system.
What is a Deduction?
Generally, all income received by a business (or a self-employed individual) is taxed by the Internal Revenue Service, known as its Gross Income.[1] The Code, however, determines a business’s tax liability based on its Adjusted Gross Income, or AGI. A business’s AGI is its gross income minus any deductions.
A deduction is, in its simplest form, a reduction of one’s taxable income; some people refer to these as “write-offs.” For example, if your business generates $200,000 in one year but it spent $100,000 to generate that income and all $100,000 are eligible for deduction, your business will only owe tax on the $100,000 in net profit. Your AGI for the year would be $100,000 because your $200,000 was adjusted downward after subtracting your deductions.
Can I Deduct Anything I Purchase?
Unfortunately, not every dollar spent by a business is deductible from its Gross Income. In order to qualify, an expense must be both ordinary and necessary for the business.[2] For an expense to be considered ordinary, it must be common and accepted in your business industry. Necessary expenses are those that are appropriate and helpful for your business itself. Note, however, that the word necessary as used by the Code does not mean indispensable. A laptop computer, for example, can be considered necessary for a writer even though a typewriter or a pack of ink pens may also do the job adequately.
The Code also specifically excludes certain expenses from being deductible. For example, illegal bribes are not a deductible expense even though certain developing nations treat bribes and kickbacks as part of the cost of doing business.[3] Similarly, expenses incurred for both business and personal use are only deductible as they apply to the business. Finally, some otherwise acceptable deductions may have limitations imposed, such as the requirement that business meals not be “lavish or extravagant.”[4]
What Are Some of the Most Common Business Deductions?
- Employee Pay: Generally, you can deduct the amount you pay your employees for services performed, as long as it is “reasonable.”[5] In addition to regular wages, you can deduct bonuses, commissions, and noncash 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.[6] This includes the home you rent, as long as you use part of the home as your place of business. You may, however, 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.[7] There are, however, limits on business debt deductions and certain requirements must be met which vary based on the amount and type of debt.
- Taxes: Federal, state, local, and foreign taxes that are directly attributable to your 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 deducted from your gross income.
- Research Costs: The IRS allows businesses to deduct what it calls “research and experimentation costs.”[8] 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 common 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)
- Home office expenses
For further information, please refer to Title 26 of the Internal Revenue Code (also known as the Internal Revenue Code) and publications published by the Internal Revenue Service, such as Publication 535.
Are you starting a new business or would like professional help with your existing business? Feel free to reach out to our office at (903) 221-9180 or via email at matt@matthewlewislaw.com.
[1] 26 U.S.C. § 61 (Title 26 is also known as the Internal Revenue Code, abbreviated IRC hereafter).
[2] IRC § 162.
[3] Id. at (c).
[4] IRC § 274(k).
[5] IRC § 162(a)(1).
[6] Id. at (a)(3).
[7] IRC § 163.
[8] IRC § 174.
