5 Trickiest Tax Deductions for Small Business
If you can prove it, can you deduct it?
“Aspoonful of tar spoils a barrel of honey,” goes the old proverb. For most entrepreneurs, if there’s one date on the calendar that spoils the sweet month of April, it’s Income Tax Day. Enter 2021, when Income Tax Day falls in the middle of a global pandemic, and things seem pretty sour.
Unlike last year, when taxpayers got a break until July 15th to file their taxes due to the storm of COVID, this year the IRS has been a lot less compliant. The tax season has been pushed to May 17th only for individuals (not sole proprietors), in what seems like an inappropriately early effort to get “back to normal” as the country balances on the brink of a fourth wave of the pandemic.
Precisely because it’s 2021, the last thing small business owners want to do this April 15th is to wreak more havoc in their business lives through grey areas in small business tax affairs.
And for many, those grey areas are tricky deductions on small business expenses. In this delicate matter, the difference between what’s on the menu (on the IRS website) and what’s on the plate (on your tax return) can be a big — and sometimes unpleasant — difference.
To set the matter straight — and hopefully get some sweetness back into April, I’ve talked to Mike Schlect, Tax Partner at Deloitte — the global consulting, tax, and advisory services firm, and Tom Wheelwright, CPA, and author of ‘Tax-Free Wealth’. Here’s their list of small business tax deductions you’ll definitely want expert help with this year, and some you may choose to pass on altogether.
1. Home office
With remote work at a record high and many entrepreneurs having moved business into their homes, the “home office deduction” is the most anticipated one of the 2020–21 tax season.
The IRS guidelines for the home office deduction seem simple enough. They constitute just two points that you have to meet. However, this is where things get tricky, explains Tax Partner at Deloitte Mike Schlect.
“You may be allowed to deduct certain home office expenses for tax purposes calculated on a pro-rata basis. A room or “part” of your home or dwelling will be considered to be occupied for the purposes of trade if both of the following requirements are met:
· Such part is specifically equipped for the purposes of your trade, namely your employment, profession, etc.; and
· Such part is regularly and exclusively used for the purposes of your trade.
Sounds simple enough, but beware of the wording, Schlect points out.
“The concern is “exclusive” use and how one proves to the satisfaction of the government that the home office was not used for any personal purposes.”
Basically, if you plan on getting a home office deduction, you will have to calculate the ratio of your house used for your home office and prove that this space isn’t used for any other purpose than business.
Now, here is the catch — in case of an audit (and the IRS plans on increasing SMB audits by up to 50% this year), every clue as to your office space being anything but immaculately business-driven will disqualify you from a home office deduction. Case in point? Personal financial records stored in a remote corner of your office cabinet.
Small business owners claiming this deduction must be prepared to show photographic proof of their home office, move all personal items (such as non-business books, personal files, and any personal memorabilia) out of the space designated for a home office, and be prepared for an audit.
2. Business gifts
Occasion often demands business partners and clients to exchange gifts and memorabilia. The good news here seems that these expenses seem pretty easy to prove by just storing the receipts, whether paper or electronic. However, the catch lies elsewhere, Schlect says.
“Business gifts are deductible but only to the extent of $25 per person during each year. If you have a spouse, the limit remains $25. Concern is also for gifts that could be construed as entertainment — those cannot be deducted generally.”
Moreover, according to HR Block, tax-deductible business gifts must be:
- Ordinary and necessary to your business
- Given to current or prospective clients
For most business owners, $25 is an awfully minimal amount to spend on business gifts. Even a gift as simple as branded merchandise will usually cost you more to print and produce. Considering the fact that you can deduct no more than $25 of business gift costs, and proving these as necessary may be tricky, it may be worthwhile to skip this deduction altogether.
3. Meals and entertainment
Business meals generally fall into two tax categories: 100% deductible and 50% deductible. Basically, meals for essential business events, charity, and food industry businesses providing meals to employees, are up to 100% deductible. However, coffee, soft drinks, bottled water, donuts, cookies, fruit and similar office snacks provided to employees are 50% deductible.
The harder meals deduction to get is business meals with clients and partners. Lacking meticulous documentation, expenses like these can be brushed off as entertainment, Schlect says.
“For tax year 2020, meals can be deducted at a flat 50% of the expense, but no entertainment expenses are allowed generally. Proper substantiation remains an important factor in documenting the costs of meals.”
To get the deduction for business meals with clients/partners, you must document not only receipts, but the date of meetings, names of meal partners, the reason for the business lunch/dinner (must be beneficial for your business), and even a summary of the conversation. Moreover, the business owner must be present at the meal themselves.
Unless you have records in order for each business lunch, passing on this deduction may be the way to go. While you may not get those $100 dinner bucks back, you’ll at least keep yourself from the nightmare of remembering every business lunch you’ve had and why. Especially since 2020 hasn’t been keen on socializing.
4. Excess business losses / passive loss limitation
As per IRS rules, “an excess business loss is the amount by which the total deductions attributable to all of your trades or businesses exceed your total gross income”. In other words, if your business expenses are higher than your earnings, you’re eligible for a deduction. However, note several changes coming this year, Schlect says.
“For 2020, taxpayers are generally allowed to deduct all losses from their business against non-business (portfolio income). This is a change from prior law under the CARES Act. For 2021, for taxpayers with large non-business income, business losses will be limited to only $500,000 (married filing joint) or $250,000 (single filers).”
According to Schlect, while many businesses are eligible for the excess business losses deduction, be prepared for a thorough IRS inspection and a flat refusal if any documentation is missing.
“To be subject to these rules, the activity carried on by the owner needs to be non-passive (i.e., active). In addition, if the owner does not run/manage the business a significant amount of time each year, the loss will be passive in nature, which will require that loss to offset only other passive income. Proper tracking of hours and substantiation of positions is needed to withstand IRS scrutiny.
An important yet tricky deduction for eligible small businesses, especially in an economically straining year, if you plan to file for the excess business losses deduction, it’s advisable to consult a tax professional.
5. Car miles and business travel
For small business owners that frequently travel, including by personal vehicle, another anticipated deduction is business travel. Another beacon of light from the IRS, in practice it turns out to be another challenge from the IRS.
As Tom Wheelwright, CPA, and author of Tax-Free Wealth says,
“Travel is difficult because you must prove that the primary purpose of your travel was business.. This means showing that more than half of each day was focused on business that could not have been done had you not traveled to the location.”
Once again, the IRS prohibits business travel expenses that fall under the category of “lavish or extravagant, or that are for personal purposes”.
While travel by air, train, bus, or car, and hotel stays are all eligible for a return, most often, small business owners will travel by car and attempt to deduct miles. If that’s you, Wheelwright suggests turning to technology for help, unless you want to do things by hand which may not be as effective.
“Automobile expense requires contemporary mileage logs. While there are many apps to do this, a lot of business owners don’t want the app developers to have the data regarding their travel, so they are left with mileage logs they create by hand.”
While the decision is yours, car miles, unless minutely recorded, are a highly tricky expense that will most probably not show up on your income tax return. However, if applicable to your business, be sure to file for deductions on expenses like airplane travel and hotels as long as they can be proven exclusive to your business needs.
Hands down, what you’ll want to do in a fiscal year as economically strangling as 2020–21 is to get the most deductions out of your small business.
That said, bear in mind that just because it’s on the IRS website doesn't mean it will show up on your income tax return. The IRS does have many loopholes to avoid pulling out those extra funds, and as tax experts note, even if you can prove it, it doesn’t always mean you’ll be able to deduct it.
To keep your sanity in this already sour year — especially in case you haven’t got these tricky deductions on the record — don’t fret. This April 15th, focus on small business deductions with the most important returns, consider building a financial model of your business to project and cut back on costs, and analyze this year’s returns with a tax professional to know what works for you and which deductions just aren’t worth your time.
This story was first published on MightyCall
Bilingual pianist & business journalist. Writing about the Human Experience.