A Guide to Maximizing Tax Deductions and Credits
If you own a small business, why should you care about maximizing tax deductions and credits? With the goal of the small business being profitability to survive and grow, taxes nibble away at those profits. It seems every new tax year that the nibbles are becoming bigger bites.
The smart business owner will not try to go it alone. They will have tax advisors or accountants to help. But tax experts are not experts at your business. They can only advise within the context of the information you give them and the questions you ask.
Having a basic knowledge of the two tax factors that minimize the bite will help in your tax discussions with advisors. Go into your meetings (you should have regular meetings) with this information about tax deductions and credits.
Possibly the most important thing to remember about small business tax deductions is that you should have a system that avoids missing or forgetting any of them. That system starts with knowing every deduction that your business can legally claim and recording related expenses.
Trap every expense, no matter where it is incurred or how. From a cash register receipt at the local office supply to an invoice from a major supplier, catch them all. Your records should group the expenses in the proper tax categories and make it easy to output reports. So, the first step in maximizing small business tax deductions is to take and record every one the IRS allows.
How Small Businesses can Maximize Tax Deductions and Credits
As for that “the IRS allows” thing, there is the IRS Publication 334, Tax Guide for Small Business that deals with deductions and credits. Of course, it’s somewhere over 42,000 words and 54 pages long. The good news is that the links here are bookmarked to the specific place in the document to get more information if you need it.
There are two major groupings of expenses for the business, Cost of Goods Sold and Business Expenses. Depending on your type of business, you may not have any costs of goods sold. If you’re a service business, perhaps a freelancer, you would not be selling or manufacturing products, so this section wouldn’t apply. You wouldn’t have any inventory for resale either.
Cost of Goods Sold
[Inventory start of year + Purchases – Inventory end of year]
Purchases include labor and materials or supplies used to manufacture products.
If you’re selling items in your business, you’ll probably be maintaining an inventory. In this case, you would have a beginning value of your inventory on hand at the start of the year. If you manufacture or assemble products, you’ll also include raw materials and parts in your inventory.
The basic concept is that you are adding to inventory with purchases. So, you’ll find the cost of goods sold when you count your inventory at the end of the year.
Business Expenses and how you categorize and classify transactions is critical to maximizing tax deductions and credits. To be deductible, the IRS requires that an expense be “ordinary and necessary.” The expense should be one that other similar businesses also incur to be considered “ordinary”.
To be considered “necessary”, the IRS requires that the expense be “helpful and appropriate” for the business. It does not have to be indispensable. Even if you can do business without it, if the expense is helpful, it’s generally allowed as a deduction. An example would be free coffee for your customers – it’s not necessary, but certainly helpful for customer relations.
If your business invoices customers or sales on credit, it’s inevitable that sometimes you won’t get paid. If you can’t collect money owed to the business, such as for invoices or credit sales, you can deduct the amount of the bad debt. **Note: this is only if you booked the income. If you’re filing taxes on the cash basis, you’re not reporting the income until you collect it.
If you use a car or truck while doing business, you can generally deduct the cost of owning and operating the vehicle. You can deduct all costs for vehicles used exclusively in the business, delivery vans as an example. If you use a vehicle for both personal and business use, you must keep detailed records of mileage and use for business as separate from personal use.
There are two ways in which you can calculate the deduction:
- Standard mileage rate – This is a rate per mile set each year by the IRS. Your detailed record of miles driven for business gives you a total for business miles and you multiply that total by the business miles driven. This becomes your entire deduction for that vehicle’s expenses in the business.
- Actual expenses – Instead of using the standard mileage rate, you can deduct the actual expenses to own and operate the vehicle for the business use. These expenses include:
- Fuel and oil
- Lease payments
- Interest on purchase loan
If you use the vehicle for both personal and business purposes, you must keep detailed records of mileage driven for each and use the business percentage to calculate the deduction.
If property lasts for more than a year, you may not be allowed to deduct the entire cost in the year purchased. Real estate, vehicles, machinery, and equipment are a few examples. Repairs that improve the property are also depreciated in most cases. When required to depreciate an asset, you would use rules laid out in IRS Publication 946, How to Depreciate Property, to break up the purchase cost over multiple years.
Section 179: This rule allows larger deductions or faster depreciation by allowing taking all of depreciable assets’ cost as a deduction in the year purchased. This includes vehicles in some cases.
You can deduct what you pay employees and the cost of benefits that you provide to them. As with other expenses, the pay and benefits must be reasonable and ordinary for your type of business. Maximizing deductions in this category can include retirement plan contributions for employees and owners.
It’s never too late to begin retirement planning and saving. Besides the deduction mentioned above for qualified employee retirement plan contributions, owner retirement plans create great deductions. If you set up a qualified IRA or other plan, some of your profits can be protected through contribution deductions while saving for retirement.
If you use your home for business, whether an office or for some other exclusive business use, you can deduct certain expenses. The portion of your home must be exclusively used for your business, not mixed with personal use. Example: You may use a spare bedroom or other separately identifiable space as an office.
The Home Office deduction is another easy way to maximizing tax deductions and credits. If you use your space only for that purpose, you could qualify for several deductions:
- First, determine the percentage of the home’s total square footage that is used exclusively for business.
- You can deduct that percentage of:
- Mortgage interest
- You cannot deduct more than you have for taxable income.
- Optional: you can use the simplified method and deduct $5 per square foot for up to 300 square feet.
At least you do not have to pay taxes on taxes! You can deduct most taxes paid by the business to include:
- Sales taxes
- Income taxes
- Fuel taxes
- Employment taxes
- Excise taxes
- Self-employment tax
- Real estate taxes
- Personal property taxes
This can be a moving target, as the rules change often. However, within specified limits, some business-related travel and meal expenses are deductible. Consult with your accountant or tax advisor to be sure that you are staying on the right side of the IRS, as travel and meal deductions can get complicated. This is one deduction that can flag an audit.
For qualified sole proprietorships, partnerships, or those filing as an S-Corporation, this is a 20% deduction allowed against business income and REIT dividends.
This list can get quite long depending on your type of business, but some of the most common include:
- Moving equipment or machinery
- Bank fees
- Office supplies
- Office equipment
- Education expenses
- Professional fees (accountant, lawyer, etc.)
- Repairs and maintenance to business property
- General supplies and materials
- Marketing and advertising
- Licenses and other regulatory fees
- Hiring and interview costs
- Charitable donations
- Professional memberships
There are plenty of other deductions – some are itemized deductions, others are standard deductions. Work with your accountant to determine all that apply to your business and make sure you’re keeping detailed records.
Taking Maximum Advantage of Small Business Credits
While deductions come off your income before figuring the tax you owe, credits are dollar-for-dollar offsets of taxes owed. Example: You’ve finished computing your net profit and have taxable income of $15,000. If you qualify for a tax credit of $6,000, you will subtract that from the taxes owed to reduce the check you send the IRS to $9,000.
Here are some of the most common credits small businesses can use to save a lot of money. You would file Form 3800 to claim credits and each one of these has its own form as well.
Credit for Small Employer Health Insurance Premiums
Form 8941 is used for this credit. If you provide health insurance for employees and meet other qualifications. The credit can only be claimed for two years, and it is equal to 50% of the premiums paid by the business.
Employer Credit for Paid Family and Medical Leave
Form 8994. Congress authorized this credit to encourage employers to provide paid leave for family emergencies, medical issues, or other issues covered by the Family Medical and Leave Act. The credit is equal to 12.5% of the wages paid.
Work Opportunity Credit
Form 5884. This credit is to encourage employers to hire from specified underserved populations, including:
- The long-term unemployed
- Food stamp or other welfare recipients
- Those receiving SSI, Supplemental Security Income
- Certain people living in federal empowerment zones
The amount of the credit depends upon which category listed above and other factors.
Disabled Access Credit
Form 8826. This credit is to incentivize businesses to improve their locations for better accessibility to customers with disabilities. It is available to businesses with $1 million or less in revenue or 30 or fewer employees working full-time. The credit is for 50% of expenses for improvements up to a maximum of $5,000.
Credit for Employer Provided Childcare Facilities and Services
Form 8882. This credit covers a range of services and facility construction or modification. Paying for a portion of employee childcare services is one. Another is construction or remodel of a childcare facility. The credit is 25% of expenditures plus 10% of childcare resource and referral expenses.
Credit for Small Employer Pension Plan Startup Costs
Form 8881. Businesses that meet the size and wage requirements can claim a credit of up to $500 for pension plan setup and administrative costs.
There is a long list of other, some very specialized, credits on this IRS page.
This guide to maximizing tax deductions and credits should help you create a basic tax plan to save more money. There are tons of deductions, credits, and complex strategies to save even more throughout your life.
It might be helpful to think of your tax plan as a triathlon – you have many obstacles to overcome, both short term and long term. Aim for a well-developed strategy for short term and long term savings and revisit and update at least yearly. Talk to your tax advisor or accountant.