Steve started a business three months ago providing personal training services online. Like many new business owners, Steve didn’t start with any accounting or tax knowledge, and has had to pick it up on the fly. Last week, while discussing his tax compliance with his CPA, he asked what he can and can’t deduct. Instead of a clear response, Steve received a list of hundreds of possible business deductions, which he found vague and overwhelming.
The issue is not with the CPA but rather with the generally broad definition that the IRS uses to determine if a business expense is deductible. Unlike personal tax deductions which are very narrowly defined, the business expense definition has to be broad because it needs to apply to all businesses. It’s up to Steve and his CPA to interpret and apply the definition to Steve’s business.
A summary of the IRS definition can be found here. First, the business has to be operating with the intent to make a profit; non-profit entities follow a different set of rules. Second, the expenses must be ordinary and necessary to carry on a business, meaning that any business owner would logically come to the same conclusion regarding a business expense. In order to make a correct determination, business owners can ask themselves these questions:
Question 1: Does someone in a corporate job get this expense reimbursed?
Typically, if an expense is reimbursed in your industry (i.e., travel expenses), then it’s likely ordinary and necessary. Otherwise the large companies in your industry would avoid incurring the expenses. If you’ve worked a corporate job in the past, this can be a quick and useful litmus test.
Question 2: If you didn’t have the business, would you have this expense?
Failing this question does not automatically mean the expense is not deductible, but it’s a good start. If you need a professional camera for your business, which you would otherwise not purchase, then it’s very likely that that purchase is deductible. If you buy a boat, which you would buy anyway, but want to use it for business too, it’s likely not deductible.
Question 3: Is it an expense that is never deductible?
There are some expenses that the IRS almost never allows. Examples include anything related to personal grooming or personal use items. Additionally, large investments or asset purchases have special rules so they are not immediately deductible. The list of what’s never allowed is smaller in comparison to what might be deductible, so it’s easier to remember.
Question 4: Is it a special situation like business use of your home and auto?
Just like with expenses that aren’t deductible, there are a few special situations that fail the second question. These are the use of your home or auto for business. If you have a home office, you’d still have to pay rent even if the home office was not there, but the IRS still lets you take a deduction; the same applies for your vehicle. Be sure to discuss with your accountant the specific rules around business use of home and auto.
Question 5: Is it a contribution to a qualified retirement plan?
Most people know that you can contribute to an IRA or 401(k) and deduct it on your taxes. Business owners have some advantages over regular employees besides the contributions being tax deductible. Depending on how much you want to set aside for retirement, there are some great opportunities for tax planning with your retirement contributions that should be discussed with your financial advisor or planner.
After a week of research, Steve has a better grasp of what he can and can’t deduct. Based upon the advice of his CPA, Steve tracks all of his spending and periodically emails over a list of questions. Thankfully Steve has a CPA that knows his business and can give him advice as needed on what is deductible or not. This is a learning process that most business owners go through. It takes time but with experience and a good system, identifying deductible business expenses will become second nature.
This article originally appeared on Forbes