What is a Business Deduction? The Basics Every Business Owner Should Know.

Running a business is tough enough and it can seem overwhelming trying to overcome the daily hurdles. We say there is absolutely nothing “small” about being a small business owner. One challenge in business is understanding what is legally allowed when claiming deductions and not leaving money in the government's hands by missing deductions.

The key is to understand exactly what a business deduction is, and how you can ensure you're fully optimizing your deductions?

In this guide, we’ll explain what a business deduction is, review common types of expenses, and show you how to make the most of your deductions using the CLEAR EDGE Framework. 

We'll focus on Deduction Optimization and Getting Organized elements of the CLEAR EDGE Framework so you can achieve Efficiency when it comes to your taxes. This means more money stays in your business and your home where it belongs.

And before we get too far, it’s important to state that we’re addressing the general rules of deductions and business expenses here, and there are nuanced changes that can and do occur annually by the IRS and respective state governments.

Use this information as educational and foundational to help you understand the framework around what is and isn’t allowed by the government to help pay less to the government legitimately!

Understanding Business Deductions

When it comes to business expenses, the phrase "ordinary and necessary" is key to maximizing your deductions. The IRS says a business expense must be ordinary (common in your type of business) and necessary (helpful and appropriate for your business). Understanding this means you will consistently capture the right deductions.

But let’s put aside the IRS terms for a moment and hone in on the basic definition of what a business expense is? 

Simply put, business expenses are the costs you have to keep your business running. 

Whether you’re a consultant working from home, a retail store owner, or running a mid-sized company, these expenses help you deliver your products or services. They are called deductions or write-offs because they are "deducted" or "written off" from your income, which lowers the amount of profit that is taxable.

Deductions are great because they help us run our businesses effectively and reduce the amount of taxes we owe. But just because it’s a write-off doesn’t mean it’s a free pass to spend money. Many business owners think, “Oh, it’s a write-off!” and overspend. 

A good question to ask yourself is, "Do I really need this for my business to keep running smoothly?"

If you can answer that question yes, then you have been able to establish the “ordinary and necessary” requirement that is needed by the IRS to count it as a write-off.

Categories of Business Expenses

When having the conversation about business expenses it’s important to understand that there are two main types of business expenses:

Operational Expenses

Operational expenses are the everyday costs needed to run your business. These expenses are directly tied to the daily activities that keep your business going. For example, if you have a t-shirt printing business, the ink you use for printing shirts, the electricity to power your equipment, and the boxes you use for shipping are all operational expenses.

These are necessary costs that happen regularly and are typically fully deductible in the year they are incurred. Tracking operational expenses is crucial because they are essential to keeping the business running smoothly and are a key part of day-to-day operations.

Capital Expenditures

Capital expenditures are investments in assets that will last longer than a year and provide value over time. For instance, if you own a t-shirt printing business, buying a t-shirt press would be considered a capital expenditure. Unlike operational expenses, capital expenditures are treated differently for tax purposes.

Rather than deducting the full cost in the year of purchase, these expenses are often spread out through depreciation over several years. This helps match the expense with the period in which the asset provides value to the business. We’ll go into more detail on depreciation shortly.

Key Categories of Deductible Expenses

Let’s dive deeper into the types of “operational” expenses that are ordinary and necessary and how they are treated.

1. Fully Deductible Expenses: These expenses reduce your taxable income dollar-for-dollar. Examples include:

• Advertising and Marketing: Social media ads, Google Ads, printed flyers, or even sponsoring a local event. Advertising and marketing expenses are crucial because they help your business gain visibility and attract customers.
• Employee Benefits Programs: Contributions to health insurance, retirement plans, and wellness programs. These programs help your employees stay healthy and motivated, which improves productivity.
• Office Supplies: Things like printer paper, pens, or software subscriptions. While these may seem small, office supplies are essential to keep your business functioning smoothly.
• Professional Services: Fees paid to lawyers, consultants, or tax advisors. Professionals bring in their expertise and can save you money in the long run by providing sound advice.

2. Partially Deductible Expenses or specifically excluded deductions: Some expenses are only partly deductible. They may be partially deductible because of rules and regulations imposed by law. The most common examples of partially deductible and excluded deductions are:

• Meals: Business-related meal costs are generally 50% deductible. Meals during a company event might be fully deductible. Always keep receipts and note the business purpose. For instance, if you take a potential client out to dinner to discuss a project, you can only deduct half the cost.
• Entertainment: Entertainment expenses are no longer deductible, even if done with clients. This means things like concert tickets are not write-offs. It’s important to understand these rules to avoid mistakes and unnecessary audits.

As stated before, it’s important to reinforce that we’re addressing the general rules of deductions and business expenses here, and there are nuanced changes that can and do occur annually by the IRS and respective state governments.

3. Mixed-Use Expenses: These are expenses that have both personal and business use, and only the business part is deductible.

• Vehicle Expenses: If you use your car 60% for business and 40% for personal use, you can deduct 60% of your car expenses. There are two methods to deduct these expenses: the Standard Mileage Rate or the
• Actual Expense Method. The Standard Mileage Rate is simpler to use, while the Actual Expense Method can give a bigger deduction if the costs are high.
• Home Office Deduction: If you work from home, you can deduct a part of your rent, utilities, and homeowner’s insurance, but the space must be used only for business. It’s essential to make sure the office space is not used for anything else, like a guest room.

Mixed use expenses can be tricky to navigate but can also be worthy of your attention to carve out and legitimately deduct expenses that are personal but that also have those elements of business to them.

If you’re a corporation, employing the tax strategies of an Accountable Plan can be a powerful way to capture deductions while ensuring compliance with the IRS rules and regulations.

4. Depreciation: Depreciation lets you spread the cost of a big purchase over several years. Recall with me that earlier in this article we addressed the deductions that were called “Capital Expenditures”. These types of expenses can be thought of as investments in assets that will last longer than a year.

Consider the following expenses and how they would clearly last much longer than a year:

A large machine that costs $50,000 to be used in our t-shirt printing business.

A desk that you purchased for $750 for your office.

A laptop computer that cost $1,800 for your business.

Items like computers, office furniture, and vehicles are required by the IRS to be depreciated and are assigned useful life spans by the IRS.

Special rules like Section 179 and Bonus Depreciation may allow you to deduct a bigger portion upfront allowing you to accelerate your deduction and take more of a deduction now.

Section 179 Deduction: This lets you deduct the full cost of qualifying equipment and software right away. However, there are limits to how much you can deduct under Section 179. It’s an excellent way for small businesses to reduce their taxable income quickly when they invest in new equipment.

Bonus Depreciation: This allows you to depreciate a large percentage of eligible assets in the first year. It is useful if you’re investing a lot in new equipment. Bonus depreciation can help in years when your business makes significant purchases.

Amortization: This is the term used to describe the depreciation of intangible assets such as the legal expenses incurred to file a patent, or assets such as the value of a client list (sometimes called goodwill). Intangible assets create value in a business and are often assigned a value separate from the physical assets of a business and these are costs that are required to be spread out over time much like physical assets because the intangible assets will last far longer than a year.

This is a very brief overview of the concept of depreciation and amoritzation but the key takeaway with this topic is that large expenditures may not be allowed to be deducted all at once to reduce your taxes for this year. Careful planning and consideration should be done in respect to depreciation and amortization for your business.

5. Interest Expenses: If you take out a loan for business purposes, the interest on that loan is deductible. For example, if you take a loan to buy equipment, you can deduct the interest you pay on that loan.

Business Loan Interest: Interest on loans for buying equipment, funding payroll, or growing your business is generally deductible. Just make sure to keep business and personal loans separate. Tracking interest expenses properly will help you maximize deductions and avoid trouble with the IRS. If you take out a loan on a personal asset (for example your home in the form of a home equity line of credit) then there are additional documentation requirements and tracking requirements that you need to follow in order to prove that those funds were used for business purposes in order to be able to deduct the interest expense as a business expense.

6. Non-Deductible Expenses: Some things are just simply not deductible, such as:

• Bribes, Kickbacks, and Political Contributions: The IRS strictly doesn’t allow these expenses. Trying to deduct these could get you in trouble.
• Personal Expenses: Anything that benefits you personally and not the business is not deductible, like a family vacation. Make sure to keep personal and business expenses separate. If you mix a business trip with a personal vacation, only the business part is deductible. Keeping records of the split is key to avoiding confusion.

Specifically with relation to the topic of tax deductible travel, there are legitimate ways to ensure that your travel is tax deductible and we provide some resources for how to do this in our “TAX OPTMIZED TRAVEL” guide. 

More About Business Expenses

With those basics covered, let’s take a more detailed look and dive deeper into how you can use these deductions, with examples and tips to avoid mistakes:

Capital Expenditures vs. Operational Expenses

Capital Expenditures are high-cost items that will last longer than a year. Examples include:

• Office Furniture: Things like desks and chairs that you’ll use for years. These items often require a bigger initial investment but pay off over time.
• Technology and Equipment: Computers, printers, or machines you use in your work. For example, a laptop that costs $1,500 would be considered a capital expenditure and depreciated over its useful life.
• Vehicles: If used for business, vehicles are capital expenditures that you can depreciate. Buying a company car can be a smart business move, but you need to track the depreciation correctly.
• Building Improvements: Renovations that improve your office are also capital expenses. For instance, adding a new roof to your office building will add value for many years, so it counts as a capital expense.

Capital expenditures are depreciated over the asset’s useful life, which helps spread out the tax benefit over time. This means that instead of getting a big tax deduction all at once, you get a smaller amount each year until the item’s cost is fully deducted. The useful life is often determined by the IRS as they have asset classes and standards for assets.

Operational Expenses are the costs to run your business day-to-day:

• Rent and Utilities: Payments for office space, electricity, water, and internet. These are essential expenses that keep the business going.
• Employee Salaries: Paying your employees is a key operational cost and fully deductible. Without employees, most businesses wouldn’t be able to function, which makes salaries one of the biggest deductions.
• Office Supplies: Everyday items like pens and paper. These small costs add up, so it’s important to track them for deductions.
• Marketing and Advertising: Ads, website hosting fees, and promotional costs. Marketing is crucial for getting new customers, and these costs can quickly add up, so it’s good that they are fully deductible.

Fully Deductible Expenses

Fully deductible expenses help reduce taxable income right away. Examples include:

• Advertising and Marketing: If you spend $5,000 on a Google Ads campaign, you can deduct the full $5,000. Marketing can also include public relations, website design, and branded items like T-shirts or pens. These expenses are critical for growing your business.
• Employee Benefits Programs: This includes health insurance, retirement contributions, or other perks. These benefits not only help reduce your taxable income but also keep employees happy and engaged. Offering strong benefits can also make your company more attractive to potential hires.
• Professional Services: If you hire a lawyer to draft a contract, that fee is deductible as long as it’s related to your business. This also includes paying an accountant to handle your tax filings, which can help you avoid costly mistakes and penalties.

Partially Deductible Expenses

Some expenses are only partly deductible or can be totally disallowed, like:

• Meals: If you take a client out for dinner to discuss business, you can usually deduct 50% of the cost. Keep track of who attended and the purpose of the meeting. It’s helpful to jot down notes on the receipt so you have all the information in case of an audit.
• Entertainment: Entertainment, like taking a client to a sports event, used to be deductible but is no longer allowed. It’s important to know this to avoid mistakes and make sure you’re not incorrectly claiming deductions that could cause problems with the IRS.

Mixed-Use Expenses

These expenses are used for both personal and business purposes:

• Vehicle Expenses: If you use your car 70% for business, you can deduct 70% of expenses like gas, insurance, and maintenance. You can use either the Standard Mileage Rate or the Actual Expense Method to figure out the deduction. The Standard Mileage Rate is easier, but the Actual Expense Method might be more beneficial if you have high vehicle costs. Using an app like MileIQ can help you track business vs. personal use effectively.
• Home Office Deduction: If you use part of your home only for business, you can deduct a share of your rent, mortgage, and utilities. The IRS offers a simplified option of $5 per square foot, but using the actual expense method may give you a bigger deduction. Make sure the home office is used exclusively for business to qualify for this deduction.

Depreciation

Depreciation helps you recover the cost of expensive items over time:

• Straight-Line Depreciation: You spread the cost evenly over the asset’s life. For example, if a $10,000 desk set has a useful life of 10 years, you deduct $1,000 per year. This method is simple and gives you the same deduction amount each year.
• Accelerated Depreciation: This method allows larger deductions in the early years of an asset’s life. It’s helpful for businesses that need bigger deductions upfront, like when profits are higher in the first few years.
• Section 179 and Bonus Depreciation: You can use Section 179 to deduct the full cost right away, and Bonus Depreciation to take extra deductions upfront. These are great ways to lower taxable income if you’re investing heavily in new equipment. Section 179 is especially useful for small businesses needing a quick deduction for major purchases.

Interest Expenses

Interest on business loans can add up quickly, but you can deduct it:

• Credit Card Interest: If you use a business credit card, the interest is deductible. Make sure it’s a business card since personal card interest isn’t deductible. It’s best to keep business and personal expenses separate to avoid confusion and make tax filing easier.
• Loan Interest: If you took a loan to buy a new piece of equipment for your business, you can deduct the interest you pay on that loan. Make sure to clearly document which loans are for business purposes.

Non-Deductible Expenses

Not everything is a tax deductible expense and that is ok. Folks, we’ve seen it over and over again where business owners get greedy and attempt to write off virtually everything in their life. Keep those rules of “ordinary and necessary” top of mind. Examples of non-deductible things include:

• Personal Expenses: Things like commuting costs are personal and not deductible. Make sure to clearly separate personal and business costs. For example, driving from home to your regular office is considered personal, but driving from your office to a client meeting is a business expense.
• Fines and Penalties: If your business gets fined, like a parking ticket during a meeting, it’s not deductible. The IRS doesn’t allow deductions for breaking the law. Always keep track of these types of expenses separately to avoid mistakenly including them as business deductions.

Tracking Your Expenses: A Tip for Getting Organized

Applying the "ordinary and necessary" rule can feel a bit confusing, so it helps to look at IRS Schedule C for some clues and guidance.

Now, you may have an LLC or a C-Corporation, or a partnership. But don’t discount this or stop reading. The Schedule C is a great source for finding some tips and general guidance. 

This form lists deductible expense categories and gives you a clear idea of what you can write off. So, even if your business is set up as a partnership or corporation, comparing Schedule C to other tax forms (like 1065 or 1120) can help you see which categories apply and you’ll notice a pattern of consistency there.

The Magic Of Record Keeping

Years ago a local radio station called my office and asked if they could interview me for a “tax time” spot to be played on the radio around the tax deadline. I said sure and the first question they asked was “How can people pay less in taxes?” I remember answering: “This isn’t a sexy answer but you can save a ton of money on taxes with one simple thing: Better record keeping!” Keeping good records in real time can make a big difference in how much you save on taxes because you’ll be more accurate in capturing all of your eligible deductions and you’ll have the peace of mind that you’re not missing anything.

So, how do you keep good records?

• Automate The Process: Use accounting software to track every expense. Software like QuickBooks or FreshBooks can make record-keeping easy and help you categorize expenses correctly.
• Establish A Pattern Of Accountability: Dedicate some time weekly and keep the time commitment to yourself to sit down and do the work of record keeping. A little bit of time spent can alleviate a massive amount of headaches later!
• Keep Receipts: Especially for meals and entertainment expenses. Taking a picture of receipts and storing them digitally can help you stay organized. The IRS requires proof for your deductions, and having receipts saved digitally and stored securely will save you massive amounts of stress if you’re ever audited.
• Review Regularly: The more organized your records, the easier it will be to take deductions. Reviewing your expenses every month ensures that nothing gets missed and that everything is categorized properly. Make it a habit to check your records before tax season to avoid surprises.
• FIRE YOURSELF AS A BOOKKEEPER: The highest and best use of your time is NOT to be your own bookkeeper. Hire someone to handle this task for you. Doing this will ensure that it gets done and will put you in the position of reviewing the information instead of doing the nuts and bolts work. That is NOT the best use of your time. 

Tools and Best Practices for Tracking Expenses

• Accounting Software: Tools like QuickBooks or FreshBooks can automate tracking expenses and help you get ready for tax season. They also make it easier to see where you spend the most money.
• Receipt Management Apps: Apps like Expensify let you take a picture of your receipts and log them. This is a great way to ensure you don’t lose track of small expenses that add up over time.
• Mileage Tracking: Apps like MileIQ can automatically track your mileage for vehicle deductions. The IRS requires you to keep records of each trip, including the date, destination, and purpose. Accurate tracking ensures you maximize your vehicle-related deductions.
• Spreadsheets: If you prefer, you can use spreadsheets to manually track expenses. Make sure to update them regularly and back them up so you don’t lose important information.
• Accountability Partner: Find an accountability partner (a business partner, your spouse, another self employed friend) and turn your record keeping efforts into a game. Whenever you get together with that accountability partner you give an honest report of your bookkeeping status and whoever is the furthest behind is responsible for paying for your coffee, beer, lunch, game of billiards, etc. Be accountable to yourself first and find a cheerleader who will encourage you to be accountable for your business!

Optimizing Your Deductions with the CLEAR EDGE Framework

The Make Taxes Fair formula of the CLEAR EDGE Framework includes the pillar of Deduction Optimization and really is about finding every opportunity to lower your taxes by optimizing your write offs and deductions.

This starts with the simple things like tracking your basic expenses and ensuring that none of those things are missed.

Under the Deduction Optimization pillar we employ tactics such as:

• The Use of Accountable Plans: If you own an S-Corp, you can use an Accountable Plan to reimburse yourself for business expenses, making them deductible. For example, if you use your personal car for business, you can reimburse yourself for the expenses and take the deduction at the corporate level. This keeps personal and business expenses separate and ensures you get the proper deductions.
• Conducting Regular Reviews: Reviewing your expense categories every quarter will make sure you’re capturing every possible deduction. Set reminders to go over expenses regularly. During these reviews, check for expenses that you may have missed or miscategorized.
• Engaging in Proactive Planning: Don’t wait until the end of the year to organize your expenses. By staying on top of them throughout the year, you’ll be ready to maximize deductions. Consider meeting with a tax advisor in the middle of the year to strategize and ensure that you’re taking full advantage of available deductions.
• Leveraging Technology: Use apps and tools to make tracking expenses easier. The less time you spend manually recording expenses, the more time you have to focus on growing your business.

Achieving Efficiency: The Ultimate Goal

The main goal of optimizing deductions and getting organized is to reach a state of Efficiency. Efficiency in tax planning means paying only what you need to, without taking risks that might lead to an audit. And, in the event of an audit, you are confident that you are airtight and will pass with flying colors. It also means managing cash flow so tax savings can be used to grow your business.

• Proactive Approach: Don’t scramble during tax season—plan throughout the year. For example, schedule big purchases to maximize their tax benefits. If you know you’ll need new equipment, consider buying it before year-end to take advantage of deductions.
• Work with a Professional: A tax advisor can help you understand your deductions and ensure you’re maximizing them without breaking the rules. A professional will also help you navigate complex tax laws and find opportunities for additional savings.
• Reinvest Tax Savings: Once you've saved on taxes, reinvest those savings into your business. You could hire more staff, boost marketing, or buy better equipment. Tax efficiency allows you to use your money to grow your business instead of giving it away unnecessarily.

Ready to Make Taxes Work for You?

Efficiency in tax planning isn’t just about knowing a few rules; it’s about having a strategy and sticking with it. By keeping good records, understanding your deductible expenses, and using the right tools, you can achieve Efficiency and keep more of the money you earn.

If you need help optimizing your deductions and becoming more efficient, join our FREE Tax Strategy Community. Inside our FREE Community and our VIP Community, we deep dive into strategies such as deduction optimization from the basic to the advanced to finally Make Taxes Fair!