A Guide to Maximizing Tax Deductions for Small Business Owners

As a small business owner, one of your primary goals should be to maximize your business deductions to minimize your tax liability. Effective tax planning can significantly impact your bottom line, allowing you to reinvest more into your business. This comprehensive guide will cover various strategies and deductions available to small business owners, including those related to new companies, legal and professional fees, spousal joint ventures, self-employed health insurance, home offices, business equipment, advertising expenses, website costs, financing, vehicle expenses, entertainment, depreciation, material and supply expensing, de minimis safe harbor expensing, routine maintenance, bonus depreciation, Section 179 expensing, business meals, the qualified business income deduction, and the effects of the Tax Cuts and Jobs Act (TCJA) sunsetting after 2025.

New Businesses - Starting a new business involves various costs, many of which can be deducted to reduce your taxable income. Typically, the costs of starting a business must be amortized (deducted ratably) over 15 years. However, you can deduct up to $5,000 of startup expenses and $5,000 of organizational expenses in the first year. Qualified startup costs include:  

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

• Wages are 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 are needed to secure prospective customers, distributors, and suppliers. 

Each of the $5,000 amounts is reduced by the amount by which the total startup expenses or organizational expenses exceed $50,000. Expenses not deductible in the first year of the business must be amortized over 15 years.

Legal and Professional Fees—Legal and professional fees incurred in setting up your business fall under the organizational expense first-year deduction of $5,000, and the balance would be amortized over 15 years. After your business is operational, these fees can be expensed as incurred. This includes costs for legal advice, accounting services, and consulting fees, which are essential for maintaining compliance and optimizing business operations.

Spousal Joint Ventures - For married couples running an unincorporated business, reporting all income as one spouse's sole proprietorship is common but needs to be corrected. Instead, it would help if you considered a spousal joint venture, allowing both spouses to report income and expenses on separate Schedule C forms. This approach lets spouses accumulate Social Security benefits and contribute to retirement accounts.

In addition, to claim a childcare credit, both spouses on a joint return must have earned income (or imputed income if one of the spouses is a full-time student or is disabled), so unless the non-Schedule C spouse has another source of earned income, the couple would not be allowed a childcare credit. There are two ways to remedy this situation: (1) by establishing a partnership or (2) a joint venture (each spouse files a Schedule C with their share of the income, deductions, and credits).

Self-Employed (SE) Health Insurance – Rather than deducting health insurance as an itemized deduction medical expense subject to the 7.5% AGI reduction, self-employed individuals can deduct 100% of health insurance premiums for themselves, their spouses and dependents above the line, reducing their adjusted gross income (AGI) and potentially qualifying you for other tax benefits. However, this deduction is limited to the business's net income. The deduction for SE health insurance is allowed even if the self-employed individual uses the standard deduction rather than itemizing deductions on Schedule A. 

Self-Employment Tax Deduction– Sole proprietors with more than a minimal profit from their business are required to pay self-employment tax (their contribution to the Social Security and Medicare programs, like the payroll taxes of employees). There is a deduction element to this tax. You may deduct 50% of your SE tax liability for the tax year as a self-employed individual. Like the self-employed health insurance deduction, the SE tax deduction is claimed as an above-the-line deduction in computing adjusted gross income (AGI). You do not need to itemize deductions to claim the deduction.

Insurance - A range of insurance premiums are deductible for sole proprietors if deemed necessary and ordinary for your business operations. This includes health, liability, property, and auto insurance for vehicles used in your business.

Home Office - Small business owners may qualify for a home-office deduction, which will help them save money on their taxes and benefit their bottom line. Taxpayers can generally take this deduction if they use a portion of their home exclusively for their business and regularly. Plus, this deduction is available to both homeowners and renters. There are two methods to determine the amount of a home-office deduction: 

• Actual-Expense Method – The actual expense method prorates home expenses based on the portion of the home that qualifies as a home office, generally based on square footage. Aside from prorated expenses, 100% of directly related costs can be deducted, such as painting and repair expenses specific to the office. 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 300 square feet, resulting in a maximum simplified deduction of $1,500.

A taxpayer may elect to take the simplified method or the actual expense method (also called the regular method) annually. Thus, a taxpayer may freely switch between the two methods each year. In addition, when using the simplified method, the taxpayer does not need to account for the home office depreciation when computing the gain when and if the home is sold. 

Additional expenses, such as utilities, insurance, office maintenance, etc., are not allowed when the simplified method is used. Prorated rent or home interest and taxes are not either, although 100% of home interest and taxes are deductible as non-business expenses if the taxpayer itemizes deductions.

Qualified Business Income Deduction - The TCJA introduced the Qualified Business Income (QBI) deduction, allowing eligible pass-through entities to deduct up to 20% of their qualified business income. This deduction is subject to various limitations and phase-outs based on income levels and business types. Proper planning is essential to maximize this valuable deduction.

Advertising Expenses - Once the business is operating, all forms of advertising are generally currently deductible expenses, including promotional materials such as business cards, digital or print advertisements, and other forms of advertising. However, any advertising expense incurred before a business begins functioning would be treated as a startup expense. Trade shows are a form of advertising, and if a company purchases its custom trade show booth, that booth can generally be totally or primarily expensed in the year purchased using bonus depreciation or Sec 179 expensing.  

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 attracts and retains customers in the digital age.

Financing - Interest on business loans is deductible, reducing your taxable income. This includes interest on loans for purchasing equipment, real estate, or other business needs. Properly managing your business financing can optimize cash flow and support growth initiatives.

But be careful not to mix personal and business interest expenses. Banks are usually reluctant to lend money to a startup business. However, an equity loan on your home will generally achieve a lower interest rate anyway, and the interest can be traced to and deductible as business interest.

Vehicle Expenses - If you use your car for business purposes, you can deduct its business use by using either the standard mileage method, which allows a per-mile amount, or the actual expense method. However, both methods require that you track your business and total mileage for the year. If using the standard mileage method, you need to know the number of business miles driven. If using the actual method, you must prorate the operating expenses, including fuel, insurance, repairs, and depreciation, by the percentage of business miles to total miles. You can also deduct tolls and parking fees using either method.

• Record Keeping—Both the standard mileage and 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 trip log, including the date, destination, purpose, and miles driven.

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

In the event of an IRS audit, your mileage log serves as evidence to support your deduction claims. With proper records, you can avoid 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 a trade or business, not lavish or extravagant. However, the percentage of deductibles for qualified business meals has varied in recent years.

• Before 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 of 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 attend 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 meals. For instance, if a self-employed individual goes on a business trip and incurs meal expenses, they can deduct 50%. 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 website: www.gsa.gov/perdiem

• Recordkeeping and Compliance—Taxpayers must maintain detailed records to claim business meal deductions. This includes keeping receipts, invoices, or other documentation substantiating the expense. The IRS requires that the documents indicate the amount, date, location, business purpose of the meal, and the individuals' identities.

• Entertainment - The Tax Cuts & Jobs Act (TCJA) essentially eliminated the deduction for most entertainment expenses. However, 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 significant deduction is needed for the acquisition year or more benefits 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 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 Minimis Safe Harbor Expensing - The de minimis safe harbor rule allows businesses to expense purchases up to $2,500 per item or invoice or $5,000 if the company has an applicable financial statement. This rule simplifies recordkeeping and provides flexibility in managing smaller capital expenditures.

• Routine Maintenance – IRS regulations allow a deduction for expenditures to keep a property unit in operating condition where a business expects to perform the maintenance twice during the property's class life. 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 usual 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 specific 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 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, commonly called Sec. 179 expensing, is named after the tax code section that sanctions it. The expensing is limited to an annual inflation-adjusted amount of $1,220,000 ($610,000 for taxpayers filing as married separately) for 2024. To ensure that this provision is limited to small businesses, whenever a company has purchases property eligible for Sec 179 treatment that exceeds 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 its everyday depreciable life ends. 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 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 plan, while deductible from your adjusted gross income, are not an expense of your self-employment business.

• Pension Startup Credit—Where a small employer does not already have a pension plan, there is a tax credit for establishing one, up to $500 per year per eligible employee for the first three years of the plan, a maximum of $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. 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 meaningful services, hiring your children can be a smart move for 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. These 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—These fees, including tax preparation, payroll services, bookkeeping, and other financial management activities, are generally deductible expenses for businesses. They are considered necessary and ordinary expenses incurred in operating a business. Business owners must maintain detailed records of these expenses to substantiate their deductions during tax filing. Consulting with a tax professional can provide further insights into maximizing 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 businesses.

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