To minimize the amount of taxes you legally owe, it’s important to understand both business expenses and other tax deductions. If you don’t educate yourself on these issues, you may pay more tax than is necessary.
This discussion includes several business expenses that are misunderstood, and some common tax deductions that impact many businesses.
3 Misunderstood Business Expenses
The tax laws for business expenses are complicated and can change frequently. Some expenses require extensive documentation, and those records need to be monitored throughout the year. Here are some common business expenses that are misunderstood:
- Retirement accounts: Investors have several types of retirement accounts that can be set up and funded, but the rules are complex. Sole proprietors deduct their retirement plan contributions on Schedule C of their personal tax return. Generally speaking, the amount that a company contributes to an employee’s retirement plan is a business expense.
- Health insurance: The premiums for health insurance are also deductible as a business expense. Many sole proprietors find that paying for their own health insurance is far more expensive than the cost they pay as an employee in a large organization. If you’re considering a sole proprietorship, take a hard look at the cost you’ll incur for health insurance.
- Home office expenses: Be careful here, because the IRS may closely review any deduction you take for a home office. Using this deduction requires careful recordkeeping. If you don’t spend a large amount of your time working in a home office, don’t use this deduction.
Work with a CPA to get a clear understanding of these expenses. A tax professional can explain how each expense applies to your personal situation.
Tax Deduction Lessons for Every Business
Corporations pay taxes using a set of corporate tax rates, and those rates are different from individual income tax rates. On the other hand, if your business is a pass through entity, you’ll pay tax on your company profits based on your personal tax rates. Here are some common tax issues that businesses of all types must address:
- Depreciation expense: If you own an asset that you’ll use in your business for more than a year, that asset should be capitalized. Rather than expense the cost of office furniture, for example, you create an asset account for office furniture and depreciate the cost over the asset’s useful life. Consult with a CPA to determine the useful life and rate of depreciation for your asset purchases.
- Cost of sales vs. operating expenses: The cost to produce a product is posted to cost of sales expense when the items are sold. The same rule applies when a company purchases inventory and sells items to a customer. Other costs, such as shipping and storage costs, are also posted to cost of goods sold. Costs not directly related to the product, such as utility costs, are expensed as operating costs as they are incurred.
- Income vs. capital gains: When you’re paid a dividend as a shareholder, or you take a distribution of company profit, you generally pay ordinary income taxes on the dollars you received. If, on the other hand, you sell your ownership interest, you may incur a capital gain or loss on the sale. There may be different tax rates for ordinary income and capital gains, depending on your personal tax situation.
- Salary vs. profit distribution: Some business owners earn a salary and also receive a share of profits and losses at year-end. The business must withhold federal and state taxes from salary, along with FICA and Medicare taxes. When an owner receives a profit distribution, however, the owner must plan for any required estimated tax payments on the distribution. This can be challenging, since the income tax bracket is based on total income, which includes both the salary and any profit distributions. Find an expert to estimate your total earnings and plan your estimated tax payments.
With careful planning, you can file an accurate tax return and avoid any interest, penalties and fees.
Get Help and Plan Ahead
Starting a business requires many important decisions. When it comes to accounting and taxes, get some help. An accountant and a cloud-based accounting tool will go a long way towards reducing the administrative overhead of running your business.