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What You Need to Know About Business Tax Deductions

by
Frank Jenkins Jr
on
7/20/2017
What You Need to Know About Business Tax Deductions

It seems sensible enough that any expense you incur in connection to running your business is tax-deductible. But the tax code is complex, and things aren’t always as cut and dried as just taking a write-off for whatever you spent. Some deductions require a great amount of documentation to prove that you have a genuine business purpose for them. Others depend on timing and how your business operates. Here’s what you need to know about business tax deductions and how you may wish to factor taxes into your business decisions.

The Difference Between a Tax Credit and a Deduction

First, it’s integral to know the difference between a tax credit and a deduction. Deductions reduce your taxable income which is what your tax is based upon, while credits are a dollar-for-dollar reduction of your tax liability. For instance, if your taxable income is $50,000 and your tax liability is $8,200, a $5,000 deduction would reduce your taxable income to $45,000 and your tax liability would be reduced to $7,000 for a tax savings of $1,200. On the other hand, a tax credit of $5,000 would reduce your tax liability from $8,000 to $3,000.

Ergo, tax credits are more beneficial than deductions. However, there are two types of credits: nonrefundable and refundable. A majority of business-related credits are nonrefundable, which means that they can only reduce your tax to zero and the excess is lost.  In some cases the portion of the credit in excess of your tax liability can be carried back the prior year and/or carried forward to future years. There are also two types of deductions, above-the-line and below-the-line. Above-the-line deductions are more beneficial because anyone who is eligible for those deductions can take them and they reduce your adjusted gross income (AGI).  Your AGI is also used to limit other tax benefits, so above-the-line deductions reduce your AGI and thereby allow greater portion of other tax benefits. Below-the-line deductions are only available to taxpayers who itemize their deductions

This is particularly important for business taxpayers who are paying self-employment tax and paying for their own health insurance, because, depending on the type of business entity you have, these deductions can have a significant impact on the results of your tax return.

Cash vs. Accrual Methods and How They Affect Nonpayment and Bad Debt

There are two accounting methods that business taxpayers typically employ: cash and accrual. Cash method means that you recognize income as you constructively receive it and deduct expenses as they are paid. If you use the accrual method, your income is recognized when your client is invoiced or the goods or services have otherwise been provided. You recognize expenses when you’ve been billed for them opposed to when those bills actually get paid.

For example, if you invoice a client for $1,000 toward the end of the year but don’t get paid until the next year, a cash taxpayer won’t recognize the $1,000 until the next year, while an accrual taxpayer needs to recognize the income in the same year they invoiced the client.

Both cash and accrual taxpayers may keep records of bad debt, which is when your invoices have gone unpaid for so long that you don’t think you’ll ever collect the money. However, only accrual taxpayers take a deduction for bad debts because the income was previously recognized. Cash taxpayers can only deduct expenses related to performing the job and trying to collect the debt, not the value of the nonpayment.

Common Deductions vs. Deductions Requiring Substantiation

Many of your simple business expenses like office supplies, maintaining your website, buying software and so on only necessitate proof of payment to be deductible. But other expenses require additional steps.

Travel, business meals and entertainment are heavy audit targets. Many people try to deduct family vacations or dining al desko, so you need to keep significant records of the purpose of your trip, meal or excursion. What were you doing there? Who was there, and what did you discuss? Having a record of paying the expense alone isn’t enough. You must keep records of these things, or else, your deduction will be disallowed.

For traveling away from home, you need to prove that there was a bona fide business purpose, and it wasn’t incidental: Just stopping in at a seminar while you visit your folks doesn’t turn that trip into a tax deduction. If your family joins you on trips to conventions, you also can’t deduct the cost of their lodging, airfare, meals and so on.

Car expenses are another major item often subject to audits. Download some mileage apps and keep manual logs, so you can prove how much you use your car for business and also compare the mileage to actual costs to see which method nets you a greater deduction.

There are miles of tax court cases relating to these deductions and not having the proper record-keeping done for them. You should definitely consult with a tax professional to find out what your record-keeping requirements are for specific deductions.

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Frank Jenkins Jr

Frank Jenkins Jr

Frank Jenkins Jr. is the managing partner of Adams, Jenkins & Cheatham, a CPA practice based in Midlothian, VA. Frank specializes in Consulting services, tax planning, accounting, audit & assurances. "I genuinely care about our clients because I have a personal connection with them. This job requires me to multi-task and work under tight deadlines. I get great professional satisfaction from balancing firm and client commitments while building a strong team here at AJC."

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