Tax deductions are vital to small businesses, as a way to minimize taxes paid on profits. The tax code lets you subtract most expenses you incur in your business, but you have to know about limits, timing, and other rules to claim all the write-offs you're entitled to.
So which deductions are right for your business? And how can you make sure you're maximizing your savings? Here are five things you need to know.
1. Understand what a deduction is.A business deduction is a write-off specifically allowed by the tax law. A deduction is called a "matter of legislative grace," because if it isn't in the law, you can't claim the write-off.
A deduction is worth the savings it gives you, which depends on the tax bracket you are in. For example, if you have a $1,000 deductible expense and are in the 25 percent tax bracket, the deduction saves you $250 in taxes ($1,000 x 25 percent).
It's important to distinguish a tax deduction from a tax credit. A tax credit is a dollar-for-dollar write-off from the taxes you owe (a $1,000 tax credit saves you $1,000 in taxes). The tax law dictates whether an expense is treated as a deduction or credit.
2. Explore the deductions that apply to your type of business.Many deductions are common to most types of businesses. These include advertising costs, repairs, utilities, and compensation to employees, among others.
Some deductions may be unique to your business activities, such as commissions to outside salespeople and equipment rentals.
You can find an extensive list of business expenses and how to deduct them in IRS Publication 535: Business Expenses, at www.irs.gov.
3. Observe limits.The good news is that just about every expense you incur in business can be written off in one way or another. The bad news is that, in some cases, there are limits on how much you can deduct -- and when. Some examples include:
- Percentage limit on meals and entertainment costs. When you take a customer out to lunch, the most you can deduct is 50 percent of the cost. Even though the full cost is a legitimate business expense, the tax law has a 50 percent limit on the write-off.
- Dollar limit on startup costs. You can deduct startup costs up to5,000 in the year you open your doors. If you have more than5,000 in startup costs, you'll have to amortize the excess (meaning deduct it evenly) over 15 years. If you have more than55,000 in startup costs, then all the costs are amortized over 15 years; there's no5,000 upfront deduction.
4. Keep receipts and other records.To prove you're entitled to the deductions you claim on the return, you must keep good records of expenses, including:
- Record expenses, in a ledger or accounting software.
- Receipts, invoices, canceled checks, and other paperwork showing expenses.
- Expense accounts, log books, and other specific records required for travel and entertainment expenses
You can find more information about required record-keeping for your business in IRS Publication 583: Starting a Business and Keeping Records. You can find specific record-keeping rules for travel, entertainment, and car expenses in IRS Publication 463: Travel, Entertainment, Gift, and Car Expenses.
5. Check for new deductions.The tax law is constantly changing, offering new write-off opportunities to business owners, and you'll want to know what the new rules are so you can take advantage of them. For example, the HIRE Act, passed in March 2010, raised the first-year expensing limit for equipment purchases made in 2010 to $250,000 (the limit that had been set for 2010 prior to the law change was $134,000). Profitable small businesses that need machinery, equipment, furniture, and computers can write off the cost in the year of purchase, rather than having to depreciate the cost over a number of years. Working with a CPA or other tax adviser to help you stay abreast of new deductions can be a great way to plan your operations and save on small business taxes.
The original version of this article appeared on AOL Small Business on 5/19/10.