Basics of Business Expenses for Individuals

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October 15, 2009

Expenses you incur to generate income are often deductible on your tax return, and can be very valuable at tax time. However, if you don't track your expenses or tax excessive deductions, you can get yourself in a lot of trouble if you're audited. Here are the basics regarding business expenses.

First, there are generally two ways for individuals to deduct business-related expenses:1

• First, if you work for an employer and you incur expenses for your employer for which you weren't reimbursed (travel, training, membership or otherwise), you can deduct them on Schedule A of Form 1040. However, you can only deduct amounts exceeding 2% of your adjusted gross income and, in any case, only if you actually itemize your deductions.
• Second, if you operate a business, you can deduct expenses related to that business on Schedule C of Form 1040. In this way, they directly reduce your net self-employment earnings, thus directly lowering your income and self-employment (social security and Medicare) taxes.

How do I know if I operate a business? Any activity you engage in regularly and for profit may be a business. There are many obvious cases -- you operate a store, you're a self-employed consultant, etc. There are some exceptions -- for example, if you sell items you make as a hobby. And, of course, there are less obvious cases -- say you work part-time as a contractor for a business. If there is an activity for which you receive a Form 1099-MISC and/or file Schedule C of Form 1040, then that activity likely constitutes a business for which you can deduct business expenses (if you aren't sure, let us know and we'll help you figure it out).

What sorts of expenses are deductible? In general, any ordinary and necessary expense related to your business is likely deductible. The most common expenses are:

• Cost of goods sold -- the cost of producing items sold in your business
• Rent -- the cost of renting office or retail space or even equipment used in your business. You may also be able to deduct part of your home expenses if you use your home as part of your business (special rules apply).
• Employees -- the cost of wages, benefits, payroll taxes, etc. for employees. Note that if you are self-employed and pay yourself a salary, you don't get to deduct the cost of paying yourself.
• Travel, meals & entertainment -- the cost of traveling to client sites, meetings, etc. Also includes meals and entertainment, including client meals and entertainment. However, generally meals and entertainment are only 50%-deductible.
• Outside services -- the cost of lawyers, accountants and other professionals you engage.
• Office supplies and miscellaneous -- other ordinary and necessary expenses to run your business -- office supplies, insurance, etc.

What about health insurance and retirement plans? If you pay for your own health insurance and retirement plans, you generally don't take them as a Schedule C deduction. There are special adjustments to income for those two items directly on Form 1040.

What expenses are not deductible? Personal expenses are never deductible. For example, if you use a car for business use, you can only deduct the business-related use. You can't deduct expenses for work clothes, unless they are only suitable for work use (like a uniform). While you can deduct transportation to a client site, you can't deduct your regular commuting costs. There are numerous other examples as well. But, just remember, they must be ordinary and necessary expenses tied to the production of business income.

At the same time, there are lots of potentially overlooked business deductions. For example, if you use a personal mobile phone for work use, you can deduct the work-related portion (including depreciation on the device). The same goes for personal computers and other equipment. And you can sometimes deduct business use of your home (though this is an area the IRS likes to target for examination).

What if I run my expenses through an LLC? This is a good question. Many self-employed individuals form a limited liability company (LLC) and run their business through it, to shield themselves from personal liability. If it's a single-member LLC and you haven't otherwise elected, the LLC is disregarded for tax purposes and all of its income and expenses are included on your Schedule C.

While an LLC is a good thing to have, running expenses through an LLC doesn't make the expenses business-related. If you choose to pay personal expenses through an LLC account, they're still personal expenses.

Likewise, you don't need to set up an LLC in order to claim business expenses. For tax purposes, whether you have an LLC or not, a business is treated as a sole proprietorship.

What about property and other assets? If your business buys property or other assets (like real estate, office equipment, vehicles, etc.) for its use you can't just expense the cost of those assets, even if your business uses the cash method of accounting. Instead, you buy the asset and depreciate it over a determined period of time. The depreciation becomes an expense each year until you've fully recovered the cost of the purchase. This is meant to allow you to recoup the cost of an asset over its life, not just all at once.

However, for certain types of tangible personal property (equipment, etc.) there is a special section 179 deduction. This deduction does allow you to deduct the full cost of business property in the first year, if you choose to. The maximum section 179 deduction in each year is $250,000. To claim it, you must still account for it as an asset and claim the deduction on Form 4562 (as you would with other depreciation expenses).

What sorts of records should I keep? First, it's a good idea to run all business income and expenses through business bank accounts (i.e., don't commingle personal and business income and expenses). That will help you keep track of all your business income and expenses. Second, it's a great idea to track all your income and expenses -- source, amount, purpose, etc. We can help set up bookkeeping for you if you don't have a system for it currently.

Generally, you should keep records showing the payee, amount, date and nature of expenses incurred. These should preferably be accompanied by receipts or invoices from the payee. It can be acceptable to create records where needed -- for example, if you deduct transportation expenses by mileage, you can create a mileage log and use that as your backup (but there are prescribed requirements).

If you make business expenses on a personal account (say personal checking or credit card account), it's a good idea to track all of the business expenses and reimburse your personal accounts out of the business bank account (similar to how an employer would reimburse an employee). If you do this, you should keep with your business records a record of each reimbursement, along with all the items reimbursed, preferably with invoice or receipt copies.

You should keep all records for at least three years (four years for employment taxes). It is acceptable to store them in electronic format, provided they're legible. In fact, we prefer storing receipts and other records electronically.

If you have any questions about these requirements, please let us know and we'll be happy to walk you through the specifics.