A Guide to Maximizing Tax Deductions for Small Business Owners

Article Highlights:

• Maximize Expenses
• New Businesses
• Legal and Professional Fees
• Spousal Joint Ventures
• Self-Employed Health Insurance
• Self-Employed (SE) Tax Deduction
• Insurance
• Home Office
• Qualified Business Income Deduction
• Advertising Expenses
• Website Costs
• Financing
• Vehicle Expenses
• Meal Deductions
• Entertainment
• Deducting the Cost of Business Supplies and Equipment
• Pension Plans
• Pension Start-Up Credit
• Employee Payroll
• Hiring Your Children
• Research Credit
• Accounting and Bookkeeping Fees
• Effects of TCJA Sunsetting After 2025

To reduce your tax obligation as a small business owner, one of your main objectives should be to maximize your business deductions. Your bottom line may be greatly impacted by effective tax preparation, which frees up more cash for further business investments. The strategies and deductions available to small business owners will be covered in detail in this comprehensive guide, along with topics such as starting new ventures, paying legal and professional fees, filing for spousal joint ventures, self-employed health insurance, utilizing home offices, purchasing business equipment, advertising, financing, vehicle expenses, entertainment, depreciation, de minimis safe harbor expensing, routine maintenance, bonus depreciation, Section 179 expensing, business meals, and the impact of the Tax Cuts and Jobs Act (TCJA) sunsetting after 2025.

New Businesses

Many of the expenses associated with launching a new firm can be written off to lower your taxable income. Typically, startup expenditures need to be spread out over 15 years and amortized (deducted ratably). In the first year, you may choose to deduct up to $5,000 for start-up costs and an additional $5,000 for organizational expenditures. Among the qualified startup expenses are:

• Surveys/analyses of potential markets, labor supply, products, transportation facilities, etc.

• Wages paid to employees, and their instructors, while they are being trained.

• Advertisements related to opening the business.

• Fees and salaries paid to consultants or others for professional services; and

• Travel and related costs to secure prospective customers, distributors and suppliers.

The $5,000 sums are divided by the amount that brings the total start-up or organizational costs beyond $50,000. Expenses that cannot be written off in the initial year of company must be spread out over a 15-year period.

Legal and Professional Fees

The $5,000 organizational expenditure deduction for the first year of business setup covers legal and professional fees; the remaining amount is amortized over 15 years. These fees can be deducted from your business's operating expenses as they are incurred. This covers the price of consulting services, accounting services, and legal counsel—all necessary for preserving compliance and streamlining corporate operations.

Spousal Joint Ventures

It is normal, but improper, for married couples operating an unincorporated business together to record all income as sole proprietorships of one spouse. A spousal joint venture, which permits both spouses to record income and expenses on separate Schedule C forms, is a better option. With this strategy, both partners can fund retirement accounts and get Social Security benefits.

Furthermore, unless the non-Schedule C spouse has another source of earned income, the couple would not be eligible for a childcare credit. This is because both spouses on a joint return must have earned income to claim a childcare credit (or imputed income if one of the spouses is a full-time student or is disabled). There exist two methods to address this circumstance, either: either (1) by forming a joint venture (each spouse files a Schedule C with their share of the income, deductions, and credits), or (2) by forming a partnership.

Self-Employed (SE) Health Insurance

Self-employed individuals can deduct 100% of health insurance premiums for themselves, their spouses, and dependents above the line, reducing your adjusted gross income (AGI) and possibly qualifying you for other tax benefits. This is an alternative to deducting health insurance as an itemized deduction medical expense subject to the 7.5% of AGI reduction. Nevertheless, the business's net income is the only amount that can be deducted. Even if the self-employed person chooses to itemize deductions on Schedule A instead of using the standard deduction, the deduction for SE health insurance is still permitted.

Self-Employment Tax Deduction

If a sole proprietorship generates more than a minimal profit, they must pay self-employment tax, which is similar to employee payroll taxes but represents their contribution to the Social Security and Medicare systems. This tax has a deduction component. You may deduct 50% of your SE tax due for the tax year if you are a self-employed person. The SE tax deduction is claimed as an above-the-line deduction in calculating adjusted gross income (AGI), just as the self-employed health insurance deduction. To claim the deduction, you are not required to itemize your expenses.

Insurance

If they are considered normal and essential for your business operations, a variety of insurance premiums are deductible for sole entrepreneurs. This covers liability, health, property, and motor insurance for any vehicles used for commercial purposes.

Home Office

Small company owners may be able to deduct expenses for their home offices, which may improve their cash flow and allow them to save money on taxes. In general, taxpayers who regularly and solely utilize a portion of their house for business purposes are eligible to claim this deduction. Furthermore, both homeowners and renters are eligible for this benefit. The amount of a home-office deduction can be calculated using one of two methods:

• Actual-Expense Method - The actual-expense method prorates home expenses based on the portion of the home that qualifies as a home office, which is generally based on square footage. Aside from prorated expenses, 100% of directly related costs, such as painting and repair expenses specific to the office, can be deducted. Unlike the simplified method, the business-use percentage for the calculation is not limited to 300 square feet.

• Simplified Method - The simplified method allows for a deduction equal to $5 per square foot of the home used for business, up to a maximum of 300 square feet, resulting in a maximum simplified deduction of $1,500.

An individual taxpayer has the option to choose between the actual-expense technique, also known as the normal method, or the simplified method on an annual basis. As a result, a taxpayer is allowed to alternate annually between the two approaches. Furthermore, in calculating the gain when and if the home is sold, the taxpayer employing the simplified approach is exempt from accounting for the depreciation of the home office.

When using the simple technique, additional office expenditures like utilities, insurance, upkeep of the office, etc., are prohibited. Neither prorated rent nor house interest and taxes are deductible; however, if the taxpayer itemizes deductions, 100% of home interest and taxes are written off as non-business costs.

Qualified Business Income Deduction

Eligible pass-through organizations are now able to deduct up to 20% of their qualified business income thanks to the Qualified Business Income (QBI) deduction, which was created by the TCJA. Various restrictions and phase-outs related to income levels and company kinds apply to this deduction. It takes careful preparation to get the most of this significant deduction.

Advertising Expenses

All types of advertising, including promotional items like business cards and print or digital adverts, are now deductible costs once the firm is up and running. On the other hand, any promotional costs paid before the firm opens for operation are considered startup costs. Trade exhibitions serve as a platform for promotion, and if a company buys a bespoke booth for one of these events, it may often be fully or partially expensed utilizing bonus depreciation or Sec 179 expensing in the year of purchase.

Website Costs

Website development and maintenance costs are deductible as business expenses. Initial development costs can be amortized over three years, while ongoing maintenance and updates can be expensed in the year incurred. A well-maintained website is crucial for attracting and retaining customers in the digital age.

Financing

You can deduct interest paid on business loans from your taxable income. Interest on loans taken out to buy machinery, real estate, or other necessities for the firm is included in this. Managing your company's finance well helps maximize cash flow and assist with expansion plans.

However, take care not to combine spending for personal and corporate interests. Typically, banks are hesitant to provide loans to newly established businesses. Even so, an equity loan secured by your house would often have a cheaper interest rate because the money is deductible as business interest.

Vehicle Expenses

You can deduct the cost of driving your automobile for business travel by applying either the actual expense method or the ordinary mileage method, which allows you to claim a deduction per mile. Nevertheless, you must record your business and annual miles using both approaches. If you want to use the actual mileage approach, you will need to prorate the real operating expenditures, such as fuel, insurance, maintenance, and depreciation, by the percentage of business miles to total miles. If you choose to use the standard mileage method, you must know the amount of business miles driven. With either approach, tolls and parking costs can also be written off.

• Record Keeping - Both the standard mileage and the actual expense methods offer unique advantages and requirements, but one common thread is the necessity of meticulous record keeping. To claim the standard mileage rate, you must be able to substantiate the business use of your vehicle. This means keeping a detailed log of each trip, including the date, destination, purpose, and miles driven.

• Business vs. Personal Use - If you use your vehicle for both business and personal purposes, you must allocate expenses based on the percentage of business use. Accurate records of both business and personal mileage are essential to calculate this percentage correctly.

In the event of an IRS audit, your mileage log serves as evidence to support your deduction claims. Without proper records, you risk having your deductions disallowed, which could result in additional taxes, penalties, and interest.

Meal Deductions

Meal expenses are deductible under certain conditions. These expenses must be ordinary and necessary for carrying on a trade or business, and not lavish or extravagant under the circumstances. However, the percentage of a qualified business meal that is deductible has varied in recent years.

• Prior to 2021 - Businesses were only allowed to deduct 50% of the cost of a qualified meal.

• 2021 and 2022 - In response to the COVID-19 pandemic, the Consolidated Appropriations Act, 2021, introduced a temporary provision allowing a 100% deduction for business meals provided by restaurants. The aim was to support the struggling restaurant industry by encouraging businesses to spend more on qualified meals.

• After 2022, the allowable deduction has reverted to 50% of the cost of a qualified meal.

Qualified meal deductions are basically in two categories, business meals and away from home meals:

• Business Meals - The taxpayer or an employee must be present at the meal. Additionally, the meal must be provided to a current or potential business customer, client, consultant, or similar business contact.

• Away From Home Meals - When there is travel away from home on business, the traveler may deduct 50% of the cost of their own meals. For instance, if a self-employed individual goes on a business trip and incurs meal expenses, they can deduct 50% of those costs. If they dine with a business contact, they can also deduct 50% of the cost of the contact's meal. The temporary 100% deduction for restaurant-provided meals in 2021 and 2022 also applied to away-from-home meals.

Instead of actual meal costs, self-employed individuals can use an optional rate method, also called the standard meal allowance, in effect for the year, with the rate generally higher for major cities, resort areas and other locations in the U.S. The per diem rates for 2024 range from a low of $59 to $79. The applicable rates can be found at the following web site: www.gsa.gov/perdiem

• Recordkeeping and Compliance - To claim business meal deductions, taxpayers must maintain detailed records. This includes keeping receipts, invoices, or other documentation that substantiates the expense. The IRS requires that the records clearly indicate the amount, date, location, and business purpose of the meal, as well as the identities of the individuals involved.

• Entertainment - The Tax Cuts & Jobs Act (TCJA) essentially eliminated the deduction for most entertainment expenses, but you can still deduct 50% of business meals if they are directly related to your business. This includes meals with clients, prospects, and employees. Proper documentation is essential to substantiate these deductions.

Away From Home Lodging Expenses

Self-employed individuals are not entitled to use the federal per diem rates to substantiate lodging expenses under any circumstances. There is no optional standard lodging amount like the standard meal allowance. The allowable lodging expense deduction is the taxpayer's actual cost as documented by receipts.

Deducting the Cost of Business Supplies and Equipment

From time to time, an owner of a small business will purchase equipment, office furnishings, vehicles, computer systems and other items for use in the business. How to deduct the cost for tax purposes is not always an easy decision because there are several options available, and the decision will depend upon whether a big deduction is needed for the acquisition year or more benefit can be obtained by deducting the expense over several years using depreciation. The following are the write-off options currently available.

• Material & Supply Expensing - IRS regulations allow certain materials and supplies that cost $200 or less, or that have a useful life of less than one year, to be expensed (deducted fully in one year) rather than depreciated. This simplifies accounting and provides immediate tax benefits for necessary business purchases.

• De Minimise Safe Harbor Expensing - The de minimise safe harbor rule allows businesses to expense purchases up to $2,500 per item or invoice, or $5,000 if the business has an applicable financial statement. This rule simplifies record-keeping and provides flexibility in managing smaller capital expenditures.

• Routine Maintenance - IRS regulations allow a deduction for expenditures used to keep a unit of property in operating condition where a business expects to perform the maintenance twice during the class life of the property. Class life is different than depreciable life. Here are examples of the class life and depreciable life differences for some items commonly used in business:

• Depreciation - Depreciation is the normal accounting way of writing off business capital purchases by spreading the deduction of the cost over several years. The IRS regulations specify the number of years for the write-off based on established asset categories, and generally for small business purchases the categories include 3-, 5- or 7-year write-offs. The 5-year category includes autos, small trucks, computers, copiers, and certain technological and research equipment, while the 7-year category includes office fixtures, furniture and equipment. The cost of nonresidential real property (buildings) used in business is depreciated over 39 years.

• Bonus Depreciation - The tax code provides for a first-year bonus depreciation that allows a business to deduct 100% of the cost of most new or used tangible property if it is placed in service during 2022. This provides a larger first-year depreciation deduction for the item. Bonus depreciation is a temporary provision and for eligible business property bought after 2022, the rates drop to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026 and nothing after 2026. When the bonus depreciation rate is less than 100%, the difference between the cost of the item and the bonus write-off amount is eligible for regular depreciation.

• Sec 179 Expensing - Another option provided by the tax code is an expensing provision for small businesses that allows a certain amount of the cost of tangible equipment purchases to be expensed in the year the property is first placed into business service. This tax provision is commonly referred to as Sec. 179 expensing, named after the tax code section that sanctions it. The expensing is limited to an annual inflation adjusted amount, which is $1,220,000 ($610,000 for taxpayers filing as married separate) for 2024. To ensure that this provision is limited to small businesses, whenever a business has purchases of property eligible for Sec 179 treatment that exceed the year's investment limit ($3,050,000 for 2024), the annual expensing allowance is reduced by one dollar for each dollar the investment limit is exceeded.

An undesirable consequence of using Sec. 179 expensing occurs when the item is disposed of before the end of its normal depreciable life. In that case, the difference between normal depreciation and the Sec. 179 deduction is recaptured and added to income in the year of disposition.

• Mixing Bonus and Section 179 Expensing - Businesses can combine bonus depreciation, regular depreciation, and Section 179 expensing to maximize deductions. This flexibility allows businesses to tailor their tax strategy to their specific needs, optimizing cash flow and tax savings.

• Pension Plans - Contributions to retirement plans, such as SEP IRAs or solo 401(k)s, are deductible. These plans allow for significant contributions, reducing taxable income while saving for retirement. For example, in 2024, the contribution limit for a SEP IRA is up to 25% of compensation (20% of the net business profit) or $69,000, whichever is less. If you have employees, your contributions to their retirement plans are deductible from your business income. However, your contributions to your own plan, while deductible from your adjusted gross income, are not an expense of your self-employment business.

• Pension Start-Up Credit - Where a small employer does not already have a pension plan, there is a tax credit for the costs of establishing a retirement plan, up to $500 per year per eligible employee for the first three years of the plan, maximum $5,000 per year. This can include setup and administrative costs.

• Employee Payroll - Wages paid to employees, including salaries, bonuses, commissions, and certain fringe benefits, are deductible business expenses. This encompasses all forms of compensation given to an employee for services performed, regardless of how the compensation is measured or paid. In addition. employers can also deduct the costs associated with payroll taxes. These taxes include the employer's share of Social Security and Medicare taxes, federal unemployment taxes (FUTA), and state unemployment taxes.

• Hiring Your Children - Where they can provide meaning services, hiring your children can be a smart move for both your business and your family. Not only does it provide your children with valuable work experience and instill a strong work ethic, but it also offers significant tax advantages. By employing your children, you can shift income from your higher tax bracket to their lower one, potentially reducing your taxable income and saving on taxes.

• Research Credit - The Research and Development (R&D) Tax Credit allows businesses to deduct expenses related to research and development activities. This can include wages, supplies, and contract research expenses. For a sole proprietor developing a new product, the costs associated with design, testing, and prototyping could be eligible for this credit.

• Accountant and Bookkeeping Fees - Including those related to tax preparation, payroll services, bookkeeping and other financial management activities, are generally deductible expenses for businesses. These costs are considered necessary and ordinary expenses incurred in the operation of a business.

It's important for business owners to maintain detailed records of these expenses to substantiate their deductions during tax filing. Consulting with a tax professional can provide further insights into how to maximize these deductions while adhering to the IRS guidelines.

Effects of TCJA Sunsetting After 2025

Many provisions of the TCJA, including the QBI deduction and increased bonus depreciation, are set to expire after 2025. Business owners should be aware of these changes and plan accordingly. Strategies may include accelerating deductions and income recognition to take advantage of current tax benefits before they expire.

Maximizing business deductions requires careful planning and a thorough understanding of the tax code. By leveraging available deductions and credits, small business owners can significantly reduce their tax liability and reinvest savings into their business.

Please contact this office to ensure compliance with the latest tax laws and to tailor these strategies to your specific business situation. With the right approach, you can turn tax season from a time of stress into an opportunity for financial optimization.