Understand the Types of Small Business Expenses and Be Prepared For Tax Time
There are several types of expenses relevant to small business, and it is important for any entrepreneur to fully understand the distinctions among them. Nearly every type of expense reduces your overall profit, but if your business is taxed as an S-Corp or C-Corp, some can also be deducted from the business's income taxes. If you are self-employed (or own an LLC with pass-through taxation status), many of these expenses can be deducted from your personal income taxes on Schedule C.
Business expenses can be deducted from your taxes. Cost of Goods Sold (COGS) expenses are not deductible, but directly reduce gross receipts into gross profits. Capital expenses cannot be deducted either; they are costs that become the assets of your business. Personal expenses generally cannot be deducted, unless some portion of the expense is used for business purposes. There are also several other categories of business expenses, most of which can be deducted from corporate or business taxes.
Business expenses that can be deducted must be both ordinary and necessary, according to the IRS. Ordinary expenses are defined as those that are common and accepted in your particular business. Necessary expenses are those considered helpful and appropriate for your particular business. Thus, the IRS provides a pretty wide berth for what is considered and acceptable business expense. If you are ever unsure about a specific expense, look for a legitimate business purpose for spending the money. If you can come up with a convincing argument that the expense is "ordinary and necessary," write it down on the receipt or in the file in case you are ever asked about it years down the road.
Any business that purchases product for resale or manufactures product will need to figure an accurate Cost of Goods Sold (COGS). COGS are deducted from gross receipts to find gross profit. That is, the gross profit (before business expenses are deducted) is equal to your total sales minus the total cost of the product sold. It is important to keep COGS expenses and business expenses separate. COGS generally include four categories:
-- Cost of raw materials or inventory, including freight charges
-- Cost of storage
-- Cost of Direct Labor, including pension contributions for any employees who work to produce the product...not sales people
-- Costs of running any manufacturing/factory overhead
These expenses are related only to gross profit and cannot be deducted again with the business expenses. Be sure your accounting system is set up to correctly classify COGS expenses and business expenses.
Capital expenses include startup costs, asset costs, and any improvement costs. Rather than deducting these expenses, they are capitalized, thus becoming assets of the business. Some startup costs can be deducted or amortized, but those details are for another day. Personal expenses, such as home or family expenses, generally are not deductible, unless the expenditure is in some part used for the business. In these cases, the expenses are divided into personal and business percentages, and the amount equal to the business percentage can be deducted. The same method applies to deductions for use of your home or car for business purposes -- the percentage of use for each must be calculated, and only the amount used specifically for business can be deducted.
Other common expenses that can be deducted from your business taxes include employee salaries, the cost of leased space for the business, interest on loans, insurance costs, and any taxes paid on the local, state, or federal level. Generally these are all included under the basic definition of business expenses. Of course, there are other legitimate and deductible business expenses... remember, anything that is an ordinary and necessary cost of doing business! Understanding the various types of expenses is important. As a business owner, you need to know the numbers inside and out, how to keep your accounting system accurate, and how each type of expense affects your bottom line.
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