Personal vs. Business Expenses
Whether you are running an ultra-small business that focuses on services such as pet grooming, or one that deals with inventory and making, such as being a crafter, one of the first questions you probably want answered is whether expenses you incur for your business are deductible. Deducting business related expenses is one of the biggest advantages of running a small business. Business owners can maximize profits by taking the proper business deductions. In this article we will talk about the basic questions to ask when determining business vs. personal expenses.
What is a Deductible Business Expense?
A business expense is an expense you make on behalf of your business in the hopes that it will help your business make more money. A deductible business expense is an expense that you can use to reduce the amount of income the IRS can tax.
For example, if you have $100,000 in business income for the year and have $40,000 worth of deductions, the IRS will only tax you on $60,000 worth of income. As you can see, business deductions can be quite valuable in minimizing the amount of taxes your small business pays each year.
The first step in determining if a business expense is deductible is to ask yourself if the expense is reasonable, ordinary, and necessary to your business operations.
The Expense Must Be Reasonable, Ordinary, and Necessary
Reasonableness
Now that we have seen how powerful business deductions can be, we can move on to figuring out what determines if a business expense is deductible. First, we look at whether the expense is reasonable. If the expense is directly related to increasing business activity, and not overly excessive, it will likely qualify as deductible.
For example, for craftswomen, purchasing a new canvas or tool to help produce better pieces would qualify as reasonable. However, if she buys an expensive sports car to drive to work, she would likely be unable to deduct expenses related to the sports car. Driving an expensive sports car is highly unlikely to increase business activity for the crafter, and therefore not be deductible.
Ordinary and Necessary
The question of whether an expense is ordinary and necessary is similar to the question of reasonableness.
An expense need not be essential to the operation of your business to qualify as ordinary and necessary. As long as the expense is for something that is helpful to the operation of your business, the IRS will likely deem it ordinary and necessary.
Simply put, does the expense directly relate to your business operations and would a reasonable business owner make the purchase to increase business activity? Common sense can be a helpful guide in making this determination.
How Much of the Expense Is Deductible?
After determining that an expense is deductible, you must calculate the allowed deduction. If the purchase is used solely for business purposes, you can deduct 100% of it. For businesses involved in manufacturing, making, or similar activities, the IRS applies a slightly unique approach to handling business-related expenses.
While not technically a deductible business expense, you can subtract the cost of raw materials, shipping, and other processes used to create your finished product from your income using a method called the cost of goods sold.
Is Business Rent Deductible?
If your small business carries inventory or is seasonal, you likely rent a separate space to store inventory and conduct business. As long as you don’t receive anything extra in return for paying rent, business rent is a deductible expense. If you operate your small business out of a home office, you are allowed to deduct a percentage of your mortgage or rent.
For example, if your home office takes up 25% of your home’s square footage, 25% of your rent or mortgage is deductible. A similar calculation should be done for expenses such as utilities.
Best Practices For Separating Business & Personal Expenses
After reading about how to determine if a business expense is deductible, you might be wondering the best way to make sure you don’t accidentally deduct personal expenses from your business income.
As a starting point, one of the first things you should do is have separate bank and credit card accounts for your business. Many business owners find themselves in an overly complicated and time-consuming situation trying to separate business from personal expenses when using the same account for both.
Next, it is important to make sure that the expenses you want to deduct are supported by documentation. Keeping good records can help reduce the time and stress involved if you find yourself needing to answer questions from the IRS.
We hope that this short article has helped streamline the process for you and take some of the guesswork out of determining whether a small business expense is deductible. Following the guidelines and best practices we have discussed above will go a long way in helping you determine business vs. personal expenses. If you’d like additional information, contact us today!