With the availability of the internet and e-commerce, it has become far easier for individuals to start their own business. Starting a business is a big decision. Along with dealing with competition and day-to-day management, every business must comply with various tax laws and reporting requirements. One has to be up-to-date with their tax returns and documentation to claim, deductions, and credits to avoid penalties.
With the number of entrepreneurs growing, many start-up business owners visit our offices inquiring about an appropriate business tax structure and what expenses qualify as business expenses. Being informed in advance turns out to be quite useful as the person is then aware of the expenses which they can claim as either deductions or credits. This allows them to maintain receipts, bills, or other qualifying documents for claiming such expenses, or at times finalize the approval of an expense after considering the tax benefits of it in the long run. Therefore, our business tax professionals have prepared the following article on business expenses accepted as deductions by the Internal Revenue Service (IRS).
However, since each taxpayer’s situation is unique, it is best to consult your personal tax professional for advice or tax measures based on your tax situation.
Difference in Business Income and Hobby Income
As per the IRS, in order for a business to qualify as a business and the expenses to qualify as deductions, the business should be carried out to make profits and not run at a loss on a regular basis.
Often individuals tend to rely on their hobbies for additional income and consider it as their business, but it should be clear that hobby expenses can be deducted only to the level where the hobby income is zero. Any remaining expense amount (loss on hobby) cannot be deducted from other income items. (Click here for more details: Business or Hobby: Factors Considered by the IRS).
Capitalize or Deduct an Expense
The deductibility of an expense also depends on the nature of the expense, which may qualify as tax deductions either in the current year, or in portions over a number of years, as capital expenses through depreciation and amortization.
When determining the deductibility of an expense, it is necessary for an expense to be “ordinary” (a common expense in the particular trade/business) and “necessary” (required to carry out the business activity or helpful for business). Cost of Goods sold is a common deductible business expense, whether the goods have been produced or bought for resale, the cost of production (including raw materials, labour, freight, etc.) or buying from the producer may be deducted from the gross income of the business. Such expenses, including any fee or advertising expense, are all deducted in the same tax year in which the expense is incurred.
Other types of deductible business expenses, which may seem quite obvious, include items such as employees’ salary/wages, employer contribution towards employees’ retirement plans, any insurance premiums paid by the employer, any rent paid for business office premises interest expense, donations, and any taxes paid (taxes paid may be subject to special rules and limitations).
Under capitalization, the expensed amount is generally based on the assets useful life and therefore deducted periodically over such life. Certain expenses such as an initial business investment, heavy machinery, improvements expense, and additions/renovation expenses are capitalized and claimed as depreciation or amortization over several tax years. Often expenses that lead to the creation of an asset, such as a building, or machinery, which can be sold in the future cannot be deducted in the year incurred and must be capitalized until sold or placed in service.
In certain cases expenses which may seem relevant to the current period may not be currently deductible. For instance the portion of direct costs and part of the indirect costs for certain production or resale activities should be capitalized as part of ending inventory, unless it is a personal property acquired for resale by a business with gross receipts of less than $10 million in the last three years.
Personal and Business Expenses
At times, there are certain goods which are used both personally and for business, such as a car, computer, or home-based office. Expenses for such things which are used partially for business and home can be deducted based on the extent of its usage for personal use and business use.
For example: A business owner owns a 1,000 square foot (sqft) house, of which he uses 250 sqft as his office area, leaving the remaining 750 sqft for residential purposes. In this case, 25% of the mortgage payment can be claimed as business expense.
Similarly, other expenses need to be divided on a percentage basis between personal use and office use. These should be validated by proper documents such as receipts, etc.; or a taxpayer may simply use the “Simplified Home Office Deduction” method by which one can easily claim up to $1,500 as home-office deduction ($5 per square foot).
Tax situations can be complex, and managing them can be highly time-consuming. A start-up owner may find the process quite troublesome given the number of other business challenges they need to face. It is a wise decision to consult a business tax professional and have them manage your tax situation so you can concentrate on growing your business.
AG Tax LLP Can Help
If you have any tax-related queries or need assistance with tax planning or filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws, and can provide you with the right guidance to handle your unique tax situation.
Aylett Grant Tax LLP is a full service accounting firm with a dedicated team of experts who are highly-qualified and experienced in handling situations related to U.S., Canadian, and other international tax laws.
We can assist with:
- Canadian Personal and Corporate tax returns
- Cross Border Taxation and Business Planning
- U.S. Personal and Corporate Taxation
- Disclosure of Foreign Assets and other information filings
- Retirement planning
- Estate Planning, Inheritance tax advice
Disclaimer: The information in this publication is accurate as of the time of its publication. AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document. The information provided is for general information purposes only and should not be acted upon without seeking professional advice. If you would like to engage our services, please contact our staff and obtain authorization to send our firm confidential information. A client relationship is not created by the transmission of information. A client relationship is only formed with our firm when a scope and engagement letter signed by the firm and the potential client detailing the terms of engagement is present.