Tax FAQs for Small Business

1. What is a tax deduction?

A tax deduction is an amount you are allowed to deduct from your gross income (all the money you make) to determine your taxable income--the amount of income you have to pay tax on. The greater your deductions, the smaller is your taxable income and the lower are your taxes.

2. What business operating expenses are deductible?

Virtually any business expense is deductible so long as it is:

• ordinary and necessary (that is, common, accepted, helpful and appropriate for your business)
• directly related to your business  (not a personal expense), and
• for a reasonable amount.

3. What is a business?

For tax purposes, a venture is a business if you engage in it to make a profit. It’s not necessary that you earn a profit every year. All that is required is that your main reason for doing what you do is to make a profit. Any activity you engage in mainly for a reason other than making a profit—for example, to incur deductible expenses or just to have fun--is a hobby. Tax deductions for hobby expenses are extremely limited. If a venture earns a profit in three out of five consecutive years, the IRS must presume it is carried on with a profit motive.

4. Do you have to pay cash to get a deduction?

No. When you buy stuff for your business, such as a computer or automobile, the cost is deductible through depreciation or expensing. Some people are confused about what constitutes “cost” for tax purposes when a purchase is financed. This includes not only the purchase price, but also sales tax, delivery charges, installation, and testing fees, if any. You may depreciate the entire cost, no matter how you paid for the property—in cash, with a credit card, or with a bank loan.

5. How do small businesses usually report their income and expenses to the IRS?

Most small business owners are sole proprietors who report their business income and expenses on IRS Schedule C, Profit or Loss From Business. A sole proprietor’s net profit (or loss) is then transferred to the first page of Form 1040. Business deductions are above-the-line deductions that are deducted from gross income.

6. What are capital expenses?

Capital assets are things you buy for your business that have a useful life of more than one year, such as land, buildings, equipment, vehicles, books, furniture, machinery, and patents you buy from others. These costs, called capital expenses, are considered to be part of your investment in your business, not day-to-day operating expenses. Such expenses must be depeciated over several eyars or expensed in one year under Section 179 of the Internal Revenue Code.

7. What are operating expenses?

Operating expenses are the ongoing day-to-day costs a business incurs to stay in business. They include such things as:  advertising costs—for example, the cost of a Yellow Pages advertisement, brochure, or business website; attorney and accounting fees for a business; bank fees for a business bank account; business start-up costs; car and truck expenses; costs of renting or leasing office space, vehicles, machinery, equipment, or other property used in business; education expenses—for example, the cost of attending professional seminars or classes required to keep up a professional license; and expenses for the business use of a home.

8. What are start-up expenses?

The first money you will have to shell out will be for your business’s start-up expenses. These include most of the costs of getting your business up and running, like license fees, advertising costs, attorney and accounting fees, travel expenses, market research, and office supplies expenses. You may deduct up to $5,000 in start-up costs the first year a new business is in operation. You may deduct amounts over $5,000 over the next 15 years.

9. What is inventory?

Inventory includes almost anything you make or buy to resell to customers. It doesn’t matter whether you manufacture the goods yourself or buy finished goods from someone else and resell the items to customers. Inventory doesn’t include tools, equipment, or other items that you use in your business; it refers only to items that you buy or make to sell.

You must deduct inventory costs separately from all other business expenses—you deduct inventory costs as you sell the inventory. Inventory that remains unsold at the end of the year is a business asset, not a deductible expense.

10. Do you need a receipt to deduct a business expense?

Yes and no. You can claim whatever deductions you want, regardless of whether you have proof of the expense. If you are audited, however, you must be able to prove that you are entitled to the deduction. If you don’t have receipts, you may be able to use other records to prove you shelled out those costs.