- A small business tax deduction is an allowable expense that you use to lower your business's taxable income. These deductible business expenses are often referred to as tax write-offs.
- The Internal Revenue Service taxes businesses on their net income, which is calculated by subtracting your business expenses from gross income. Business expenses are often tax-deductible, but some are not.
- Some of the most common tax-deductible business expenses are for home office and startup costs, with deductions also available for vehicles driven for business.
Most business owners try to save money anywhere they can. One area they should pay close attention to is tax deductions.
Figuring out which business expenses you can deduct from your taxable income can save you money. This is why it's important for small businesses to consult accountants and other experts to ensure they're maximizing their financial options.
New tax changes have included some changes to what expenses are tax-deductible. You'll need to understand these changes if you wish to save money on your taxes. Look no further – we've gathered a list of the top small business tax deductions of 2020. [Read related article: Small Business Taxes: Changes in 2020]
What are small business tax deductions?
Small business tax deductions are allowable expenses that you use to lower your business's taxable income. These deductible business expenses are often referred to as tax write-offs.
The IRS taxes businesses on their net income, which subtracts your business expenses from your gross income. Operating expenses are often tax-deductible, but it's important to note that some are not.
How do small business tax deductions work?
Most small businesses operate as a sole proprietorship, partnership or limited liability company (LLC). These entities are required to file a separate tax return unless the company operates as a single-member LLC. Small business tax deductions are reported on the business tax return, reducing the amount of taxes the business has to pay.
According to the IRS, to be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that's common and accepted in your trade or business, while a necessary expense is helpful and appropriate for your trade or business. If your business expenses align with IRS requirements, you can claim them on the business tax return and lower your business's taxable income.
How can small businesses maximize tax deductions?
It's important for small businesses to find out which tax deductions are acceptable in their industry. Tax codes and laws can be challenging to understand, so you'll want to consult a tax professional who can provide expert insight into which deductions your business can and cannot claim. And what was allowed in a previous tax year may not be deductible in the current tax year.
Many small businesses hire a bookkeeper or an accountant to help them stay up to date with federal, state and local taxes. By storing receipts, using debit or credit cards, and separating your business bank account from your personal bank accounts, you can help maximize your tax deductions and keep good records of all your business expenses.
What do new tax laws mean for small businesses?
Here are three of the main new tax changes for small businesses.
- Many sole proprietors, partnerships, LLCs and other pass-through businesses may be eligible for a qualified business income deduction, also known as Section 199A. This provides a deduction equal to 20% of a business owner's qualified business income. There are numerous limitations and rules for this deduction, however.
- Under the Tax Cuts and Jobs Act, bonus depreciation has increased to 100% (previously 50%), and Section 179 expensing has also increased. This allows you to make significant purchases of equipment, machinery, and furniture and write off up to the total value.
- More businesses can use the cash-basis method of accounting instead of the accrual method, according to U.S. Code Section 448(c). The previous limit for gross receipts was up to $10 million annually. Now, businesses with average annual gross receipts of up to $25 million aren't required to account for the cost of goods sold using inventories under Code Section 471(c).
What small business expenses are deductible?
Many business expenses are deductible, but as every company operates differently, available deductions for one industry may not be considered necessary expenses in another. It's far easier to speak about deductible expenses in terms of what isn't deductible – but let's start from the beginning.
One of the starting points for figuring out what is deductible is to determine what legal structure your business will operate under, according to Bret Scholl, a certified public accountant and chartered global management accountant at Scholl & Company LLP.
"There are some expenses that a business owner can deduct on their corporate tax return that they may not be able to deduct as an unincorporated business," Scholl told business.com. "Therefore, one question that must first be answered is what's the best legal form for operating the business – corporation (regular or S corporation), sole proprietorship, partnership, limited partnership, limited liability company, etc."
Once you've chosen the best legal structure for your business, it's important to know what deductibles most businesses take advantage of. Here are a few commonly deducted business expenses, according to Jessica Smith, an enrolled agent at DuFord Law.
- Home office: If you use a portion of your home exclusively and regularly for business, you can deduct certain expenses for the business use of your home. These expenses may include rent or mortgage interest, insurance, utilities, repairs, and depreciation. You must know the square footage of the space that you use exclusively and regularly for business as well as the total square footage of your home to calculate the office deduction.
- Startup costs: If you paid expenses related to the creation of an active trade or business, you can deduct up to $5,000 in startup costs for your first year of business. Startup costs include advertising, employee training, supplies and other expenses you paid to launch a new active trade or business. This deduction is limited in the event that you paid more than $5,000 in startup costs. Costs over this threshold must be capitalized over a 15-year period.
- Organizational costs: The same rules used to determine the deduction for startup costs can be used to deduct up to $5,000 in organizational costs in your first year of business. This amount is in addition to the $5,000 deduction available for startup costs. Organizational costs include the expenses of forming your business structure, such as fees for forming a legal entity.
- Interest: If you borrowed money to cover your startup costs and/or to operate your business, the interest you paid is deductible.
- Advertising and promotions: Tax liability can be lowered if you include certain advertising and promotional marketing costs on your return. Advertisements are usually defined as visual or audio strategies to spread awareness about your business. Examples of deductible advertisements include newspaper ads, radio ads, business cards, flyers and email marketing campaigns. Promotions, on the other hand, are typically event-oriented, but still build brand awareness. Examples of promotions to list on your taxes include charity sponsorships, sponsored galas, giveaways and free sampling.
- Depreciation: Depreciation is a type of deduction permitted on a tax return that allows businesses to claim a fixed asset over time. According to the IRS, in most cases, you can't deduct the total cost of a business item if the property is a capital expenditure. Instead, depreciation recovers the cost of the property over the course of several years. Each year, a portion of the cost is claimed on your tax return until the total price is fully recovered. Examples of items that could be claimed through depreciation include buildings, equipment pieces, computers, furniture and business vehicles.
- Employee benefits: The cost that an organization pays toward employee benefits is almost always tax-deductible. Many business owners find deductions increase by offering a more attractive benefits package as an alternative to increasing employee wages. According to Paychex, deductible employee benefits include health insurance, retirement plans, educational assistance, childcare assistance, health savings accounts, life insurance premiums and transportation reimbursements.
- Charitable donations: Keep track of all donations made on your company's behalf to any type of nonprofit. Hold onto receipts to calculate total charitable contributions made annually.
- Moving expenses: If your company has changed locations within a tax year, you could deduct any moving expenses paid. Moving expenses incurred could include the cost to relocate equipment pieces, furniture and inventory. The cost to lease or own the new location is another potential deduction. Self-employed individuals may also deduct certain personal moving expenses in some incidences. However, any of these expenses must prove to directly relate to the business move. The IRS requires two tests for eligibility: the distance test and the time test. According to the IRS, the new job location must be a minimum of 50 miles from your old location and the individual must work at least 39 full-time weeks over the course of a year.
- Entertainment: Although the IRS still permits food and drink provided to employees as a tax deduction, new laws limit what other forms of entertainment could be deducted on a tax return. The 2017 TCJA eliminated deductions related to entertainment and recreational activities. Currently, businesses are permitted to deduct up to 50% of food and beverage costs related to the business. Meals must be purchased separately from any entertainment for eligibility as a deduction.
- Commissions: Commissions may be deductible on your year-end taxes. However, not all commissions paid are eligible for this deduction. Commissions for selling and issuing stocks, mortgage commissions and commission bonuses on commercial leases are not tax-deductible. However, all commissions paid by employers to employees and independent contractors are eligible for the deductions. Keep in mind that taxes must be withheld from the checks of any employees of your organization. You're not responsible for withholding taxes for independent contractors.
- Janitorial services: Janitorial services apply to all expenses related to keeping your business sanitized. These services may include building cleaning supplies, trash removal, recycling and sanitation practices. All properties cleaned are eligible for this deduction. As an example, if you own a retail store and an office, both are eligible for deductions related to the cleaning of the properties. Home offices are eligible too. For instance, if you hire a maid service to clean your house, you can calculate the expense by using the square footage of the office.
More small business tax deductions you need to know about
There are many more deductions – we've done the research for you. This complete list of small business tax deductions will make filing your tax return much simpler. [For more information on small business taxes, read our review of the best online tax software for 2020 on our sister site, Business News Daily.]
This deductible is for businesses that require the use of a motor vehicle in order to function properly. It's best to check your vehicle owner's manual to know which maintenance services your warranty covers. Some reimbursements are null and void if a lack of vehicle maintenance is found. There are two general methods for deducting vehicle expenses:
- The expense method requires you to track all the costs of operating your company vehicle for the year, including gasoline, oil, repairs, new tires, insurance and registration fees. Then, multiply these business expenses by the percentage of miles driven for business.
- The standard mileage deduction is a simpler method. Just multiply the number of miles driven for business for the year by the standard mileage rate. The IRS says that the standard mileage rate for the use of a vehicle (cars, vans, pickups or panel trucks) in 2019 was 58 cents per mile driven for business use, 20 cents per mile driven for medical or moving purposes, and 14 cents per mile driven in service of charitable organizations.
Salaries and wages
If your business operates as an LLC, you may not be able to deduct the income you take from your business; however, the salaries and wages you pay to your employees are deductible.
Work opportunity tax credit
The federal work opportunity tax credit is available to employers for hiring target groups that have faced barriers to employment, such as ex-felons, qualified veterans and Supplemental Security Income (SSI) recipients.
Office supplies and expenses
This office deduction covers small business expenses ranging from desks and chairs to paper and ink. Even if your business doesn't have a traditional office space, you can still deduct office supplies and expenses so long as the supplies are used within the year of purchase. In many cases, you can deduct the cost of postage, shipping and delivery services as well.
Many small businesses use freelancers, independent contractors and self-employed individuals to support their workforce. The cost of this contract labor is deductible. Form 1099-MISC is an IRS form that taxpayers use to report nonemployee compensation. The form is also used to report miscellaneous compensation, such as prizes, awards, healthcare payments and attorney fees.
The cost of transportation and lodging is fully deductible. However, you must meet IRS requirements as listed in Publication 463 to claim any travel deductions.
You can deduct numerous taxes and licenses related to your small business. Here are some examples:
- Business licenses
- Fuel taxes
- Sales tax
- Real estate taxes paid on business property
- Payroll taxes
- Personal property taxes
- State income taxes
Child and dependent care expenses
You can claim the child and dependent care expense credit if you pay someone to care for your dependent (a child under the age of 13 or a spouse or other dependent who isn't able to care for himself or herself). The credit can cover up to 35% of your expenses. To qualify, you'll have to file Form 2441, along with Form 1040. For more information, refer to Publication 503.
Computer software deduction
Under the IRS Section 179 deduction, you can deduct the full cost of business software as a small business tax deduction rather than depreciating it as in previous years. This includes POS software and any other software used to operate your business.
Retirement plan contributions
You can deduct contributions to employee retirement plans as business expenses; however, small business owners who contribute only to their own retirement funds claim the deduction on Schedule 1 attached to their Form 1040.
If you're a self-employed individual calculating your retirement plan compensation, you must calculate self-employment tax by the amount of your net earnings. You can learn more about calculating your own retirement plan contribution and deduction here.
Each insurance premium you pay for coverage on your small business is potentially tax-deductible. To qualify, your insurance must provide coverage that's "ordinary and necessary." This could include the following:
Many work-related educational expenses can be deductible, especially if they're required to keep a professional license. According to the IRS (Publication 970), there are several new deductions and tax benefits for education.
- Tuition and fees deduction: This deduction has been extended to cover qualified education expenses paid in 2018, 2019 and 2020.
- Qualified tuition program: For distributions made from QTPs after 2018, qualified higher education expenses may include certain expenses required for a beneficiary's participation in apprenticeship programs, and no more than $10,000 can be paid as principal or interest on a qualified student loan of the designated beneficiary.
- Standard mileage rate: If you claim a business deduction for work-related education and you drive your car to and from school, you can deduct 58 cents per mile driven from Jan. 1 to Dec. 31, 2019.
The Tax Cuts and Jobs Act eliminated most small business tax deductions for entertainment purposes in 2018 under Section 274. Recently, the IRS issued a notice clarifying that taxpayers can continue to deduct 50% of eligible business meal expenses. Meals and entertainment expenses can be 100% deductible if they're considered compensation to employees or income to non-employees.
If you rent office space for your business, the cost is fully deductible.
Costs for electricity, phone, internet, water, gas, heating and other utilities for your office or place of business are fully deductible.
Legal and professional fees
Accountant, attorney and licensing fees are some of the many legal and professional fees that are fully deductible.
If you have business debt, you can deduct the interest paid on the loan. According to the IRS, there are two types of bad debts – business and nonbusiness.
Business bad debts are deductibles on the business tax return of the taxpayer as an ordinary loss and can generate a net operating loss. Nonbusiness bad debts are considered short-term capital losses. These may include personal investments, activities or personal loans that are in default.