U.S. federal tax laws allow you to subtract certain costs from your business income so you only pay tax on the net amount. Failing to use these deduction options effectively can really hike your tax bill, so be sure not to overlook any write-off you're entitled to claim.
Following are three big deductions you may have overlooked and seven smaller ones you want to be sure you take advantage of, if you're eligible.
1. Home office deduction.
Of the 23.4 million returns filed by sole proprietors for tax year 2011 (the latest year for which statistics are available), only 7.6 million filers claimed a home office deduction. This is about 32 percent of eligible filers, a figure well below the 52 percent of all small businesses that operate from home. Why the discrepancy? Many believe that claiming a home office deduction is an audit red flag, so they forego a deduction they're legally entitled to.
While the IRS hasn’t reported audit statistics regarding the home office deduction, it's likely this write-off isn't the red flag some believe it to be—at least not anymore. After all, the majority of businesses today are home-based and, what’s more, the IRS has created a new, simplified, home office deduction method (it's available for the first time on 2013 returns).
The only caution: If you take a home office deduction, make sure you’re truly entitled to it. This means satisfying two conditions: using the space as your principal place of business or for some other acceptable purpose and using the space regularly and exclusively for business. Find more details about this deduction in IRS Publication 587.
2. Startup costs.
Costs you incurred before you opened your doors for business, such as expenses to explore business opportunities, may entitle you to a deduction in your first year of business. Although you have to be operating a business in order to deduct business expenses, you’d think that costs you had before you actually began wouldn’t be deductible, but you’d be wrong.
You can deduct up to $5,000 of the startup costs you incurred before you began operations in your first year of business. If the costs exceed $5,000, they can be amortized ratably over a period of 15 years. However, if these costs exceed $50,000, there are certain limitations that apply. Get more information about this deduction in IRS Publication 535.
Normally, inventory items aren't immediately deductible. Instead, a business with inventory uses the accrual method of accounting and includes inventory items in the cost of goods sold, which reduces the amount of income recognized on the sales. Under a special rule, however, certain small businesses can use the cash method of accounting and opt to treat inventory items as materials and supplies, which are currently deductible.
The IRS defines small businesses in this instance as those with annual average gross receipts not exceeding $10 million for the three prior years (or the years in business if less than three years); these businesses also can't be in certain industries. Eligible small businesses are essentially service-based but keep inventory, such as a beauty salon that provides hair-cutting services but also sells shampoos and conditioners.
If you’ve been treating inventory as part of your cost of goods sold and now want to treat it as materials and supplies, you must file for a change in accounting method on IRS Form 3115. However, there's an automatic IRS consent procedure to simplify this process. Learn more about this deduction in Rev. Proc. 2002-28.
4. Accounting fees.
What you pay someone this year to prepare your 2013 tax return will be deductible by you in 2015, so you'll need to determine what you paid to have your 2012 return prepared. This payment is deductible on your 2013 return.
5. Bad debts.
If you lent money to an employee, a vendor or someone else and haven’t yet been repaid, you may be able to deduct the loss. How you treat the loan depends on whether the debt is a bad business debt or a bad nonbusiness debt.
6. Bank fees.
Charges for checking accounts, ATM withdrawals and other bank services are fully deductible.
If you weren’t able to use certain deductions in prior years, you may be entitled to do so now. Check for carryovers of capital losses, charitable contributions, home office deductions and passive activity losses.
8. Health insurance premiums.
Premiums paid for yourself, your spouse, your dependents and any child under age 27 are deductible as a personal expense on Form 1040 (not as a business expense) if you're self-employed or own more than 2 percent of your S corporation.
9. Interest payments.
If you financed the purchase of business equipment on your credit card, the interest is a deductible business expense.
10. Self-employment taxes.
If you’re self-employed, one-half of the Social Security and Medicare taxes you pay on your net income is a personal (not business) deduction that you can take on Form 1040.
For more information on these seven write-offs, check out IRS Pub. 334.
Be sure to review last year’s return to remind you of deductions you previously claimed so you don’t overlook them now if you qualify to claim them. Also talk with your tax advisor for other suggestions for your particular situation.
Barbara Weltman is an attorney and author of J.K. Lasser’s Small Business Taxes and J.K. Lasser’s Guide to Self-Employment. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com. Follow her on Twitter @BarbaraWeltman.
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