Business Expenses and Tax Deductions Explained – A 101 for Small Business Owners

“There may be liberty and justice for all, but there are tax breaks only for some” (Martin A. Sullivan, Economist).

Well, yes, if you know where to find them and apply them correctly.

For small business owners, these tax breaks often come in the form of tax deductions – which can offer a nice little instant cash savings – if you know how to navigate tax law and claim the deductions you deserve (not what you believe you are entitled to).

Large tax deductions are a notorious red flag for the IRS, with home-based businesses, in particular, facing an increase in tax audits due to suspicious deduction activity on income tax returns.

To help you navigate the complex world of business tax deductions, here is some foundational guidance that will help you take the deductions you deserve.

1. Understanding Terminology: Business Expenses vs. Capital Expenses

Before you even start, knowing the difference between these two tax concepts is vital.

- Business expenses are expenses associated with the cost of doing business, e.g. property rental costs, business travel, client entertainment, etc. If you are a for-profit, these expenses are usually tax deductible.

- Capital expenses are the costs associated with purchasing fixed business assets, such as property and equipment, and must be capitalized rather than deducted as expenses.

2. Common Business Expenses

Below are the most typical types of business expenses that qualify for deductions.

Car Expenses – To take the business deduction for the use of your car, you must determine what percentage of the vehicle was used for business. Deductible costs can include the cost of traveling from one workplace to another, making business trips to visit customers or to attend meetings, or traveling to temporary workplaces. Be sure to maintain complete mileage records. When it comes to claiming car expenses there are two methods:
a) Actual Expenses – Add your annual car operating expenses (including gas, oil, tires, repairs, license fees, lease payments, registration fees, insurance, and deprecation). Multiply the car operating expenses by the percentage of business usage to get your deductible expense. Business-related parking and road tolls are fully deductible and don’t have to be reduced by the percentage of business use.

b) Standard Mileage Rate – The standard rate changes each year, for 2010 it is:

- 50 cents per mile for business miles driven

- 16.5 cents per mile driven for medical or moving purposes

- 14 cents per mile driven in service of charitable organizations

Business Use of Your Home – If you use part of your home for your business, you may be able to deduct expenses for items such as mortgage interest, insurance, utilities, repairs, and depreciation. To qualify you must meet the following criteria:

a) The business part of your home must be used exclusively and regularly for your trade or business. However, there are exceptions for daycare facilities or storage of inventory/product samples.

b) The business part of your home must be:

- The principal place of business, or

- A place where you meet or deal with patients, clients, or customers in the normal course of your business, or

- A separate structure (not attached to your home) used in connection with your business

For a full explanation of tax deductions for your home office refer to Business Use of Your Home (IRS Publication 587) or take a look at this quick video on the Business.gov YouTube* channel to understand more about the home office business deduction*.

Entertainment Expenses – This includes any activity considered to provide entertainment, amusement or recreation. To be deductible, you must generally show that entertainment expenses (including meals) are directly related to, or associated with, the conduct of your business. Record keeping is essential – you will need to keep a history of the business purpose, the amount of each expense, the date and place of the entertainment, and the business relationship of the persons entertained. Entertainment expenses are usually subject to a 50 percent limit.

Travel Expenses – These are “ordinary” and “necessary” expenses while away from home when the primary purpose is conducting business. Again, you must keep all receipts and travel records for lodging, transportation and meals (save receipts for amounts of $75 or more). You can either track the actual costs of your meals, or use the standard meal allowance, if you qualify. You can only claim a deduction for 50 percent of the reimbursed cost of your meals. The IRS provides more detail on business travel expenses.

Gift Expenses – If you give gifts in the course of business, you can deduct all or part of the cost. Generally, you can deduct no more than $25 for business gifts you give directly or indirectly to each person during the tax year.

3. How to Deduct Capital Expenses

There are two ways to deduct capital expenses. You can "depreciate" them by deducting a portion of the total cost each year over an asset's useful life; or you might be able to deduct the cost in one year as a Section 179 deduction. For more information on depreciation refer to the Business.gov Small Business Expenses and Tax Deductions guide (scroll halfway down the page).