For small business owners, understanding business vs. personal expenses is crucial. Business expenses are tax deductible, so they can lower your taxable income and reduce the amount of tax you owe. However, personal expenses generally aren't considered tax write-offs against business income.
This article explains how personal costs and business deductions work for tax purposes. It also explains how to avoid mixing business and personal costs to ensure that you pay the appropriate taxes while minimizing your financial burden.
Understanding business expenses
The IRS doesn't list all allowable business tax deductions, but it says that to qualify, these costs must be ordinary and necessary. An ordinary business deduction is one that crops up often in your specific industry. To be considered necessary, a business expense is one that is helpful and appropriate for your trade or business.
So, what is deductible as a business expense in practice? These are some common examples of expenses that warrant a business deduction:
- Salaries and employee benefits
- Office expenses and supplies
- Advertising and marketing costs
- Rent or mortgage
- Business insurance
- Travel expenses (most travel costs are deductible for business trips)
- Loan interest payments
- Repairs and maintenance
- Professional subscriptions
There are other expense types that are not business deductible, such as lobbying, political donations, and, of course, any illegal activity. Most other costs are deductible. You must track them to take full advantage of all your business deduction options.
Some business deductions are nuanced. For example, business meals are a tax-deductible expense, but only at 50% of the cost, and only if certain conditions are met (business owners or employees must be present, the costs shouldn't be extravagant, and the meal must be with a business contact).
What is deductible in shared business and personal expenses?
Personal expenses are those that are entirely for personal use rather than for the business. Most of the time, the difference between business and personal expenses is clear, but sometimes, you might buy one item that is used for both business and personal use. You can't simply claim this all as deductible under office expenses.
In these cases, you can claim a deduction for the portion of the costs that are attributable to the business. For example, paying for a computer and using it for business 75% of the time makes 75% of its cost a business deduction.
This rule applies to a wide range of expenses, including interest. If you use 70% of a loan for the business and 30% personally, then only 70% of the money you pay in interest can be a business deduction.
Business and personal expenses in health care
Health care expenses are a painful financial burden for many small business owners. Are your medical expenses and health plan deductible business expenses?
Businesses that take out group coverage for employees can claim covered health care services expenses as deductible against their taxes. To qualify for group coverage, small businesses must insure more employees than just the owner of the business.
Covering health premiums under personal expenses
You can still procure a deductible plan if you don't have employees and cannot provide it through your small business. The IRS supports a Health Insurance Deduction that enables self-employed people to deduct the cost of covered health care plans for themselves and their families. Look for consumer-driven health plan options on Healthcare.gov for individuals and families. All plans found there and created since the Affordable Care Act must support both preexisting condition and chronic condition payments.
Health insurance premiums that you deduct on your personal tax return must not exceed the profits of your business under the self-employed deduction option. That might leave you with outstanding premium payments, which might, in turn, affect your choice of a lower- or higher-deductible plan. Insurers usually levy separate deductibles that the insured must pay themselves before the plan begins to pay for medical services. A lower deductible often involves higher premiums.
Deductibles work into the out-of-pocket maximum, which is the point at which the insurer begins paying 100% of your medical expenses. You will generally not be required to pay any more for medical expenses than this out-of-pocket limit. Note that the Health Insurance Marketplace caps the out-of-pocket maximum to protect insurance customers.
Beware that if you are changing your health care plan, you might have to review any upcoming procedure that you're expecting with the insurer to ensure that the company is prepared to pay for it.
If you are without business or self-employed insurance coverage, you can include many medical care costs as separate deductibles on your tax return. These include visiting the doctor regularly, prescription drugs, and more prescriptions such as eyeglasses and contact lenses.
If you have paid for covered services such as dental and vision, they may also be deductible if they account for 7.5% of your adjusted gross income. The IRS says that you must note these costs as separate items on your tax return.
An alternative to the self-employed deduction is to use a health savings account, which you can use if you have a qualified high-deductible health plan. Taking this out yourself enables you to pay for covered services with tax-deductible HSA contributions. Note that your plan determines your eligibility for a HSA, which is not possible on a low-deductible health plan.
Separating business vs. personal expenses
For tax purposes, it is important to keep a clear record of all business expenses, whether fully or partially related to the business. Ideally, you should use a business bank account and credit card. Whenever possible, buy separate items for business and personal use, even if it means purchasing duplicates, to keep the difference clear. At the very minimum, make sure to keep receipts for any item that is partially or fully deductible as a business expense.
Small business people should always consult tax professionals when calculating their tax-deductible business expenses. Although mixing business with pleasure sounds nice in theory, any good accountant will tell you it's a bad idea. Whenever possible, always keep separate bank accounts, receipts, and records. Accurate recordkeeping is key to staying on the IRS' good side.
Examples of dividing personal and business expenses
Vehicle-related business expense
Vehicular travel is treated differently than travel expenses. You can deduct a portion of what you pay for your vehicle when you use it for business. This includes depreciation or lease payments, gas and oil, tires, repairs, tune-ups, insurance, and registration fees.
However, if you use your vehicle for business and personal purposes, then you can claim only the business portion of your usage. You must calculate business vs. personal expenses based on the mileage traveled for each, and you cannot include commutes between your home and your business location as business-related mileage.
There are two ways to allocate business expenses based on mileage. You can either divide up each vehicle cost based on the business mileage traveled, or you can simplify things by using the standard mileage rate to create a single deduction figure covering all of your vehicle business expense deductions for the year. The IRS provides the most up-to-date mileage rates here. However, note that car insurance is not deductible if you calculate expenses using the standard mileage rate.
Home business costs and personal expenses
The other frequent shared business and personal expense occurs when people use part of their home as office space. You might be able to deduct part of your mortgage interest and insurance, utilities, repairs, and depreciation as a business expense.
Home office deduction typically requires that the business part of your home be used exclusively and regularly for your trade and also that it constitutes your principal place of business or a place where you meet people in the normal course of your work. Your home office can also be a separate structure not attached to your home that you use for your work.
Hobbies as business expenses
A hobby loss is related to the pursuit of a hobby or recreational activity undertaken to generate profit. If the IRS deems your hobby as primarily recreational, then the income it generates is taxable, but hobby expenses aren't deductible. However, if the IRS considers your hobby a business, the net loss would be deductible against other income, similar to any other net business loss.
The IRS lists its hobby loss rules in IRC Section 183. These prevent taxpayers from claiming business losses for activities that are primarily recreational and nonprofit. Business tax deductions are still allowable for those taxpayers who legitimately engage in a hobby-like activity as a form of business.
This significant difference in tax treatment, combined with the fact that conducting a hobby as a business is a trigger for IRS scrutiny, makes it crucial that you understand what the IRS uses to consider a hobby an actual for-profit business.
The IRS considers an activity to be for-profit if it earned a profit in at least three of the past five years (or two out of seven years for horse breeding, racing, and training). While there is no steadfast rule for when the IRS considers an activity to be primarily business or recreational, it looks at various factors that demonstrate your professionalism and intent to establish a profit motive. Some of these include:
- Do you put in time and effort that demonstrate the intent to make a profit?
- Do you depend on income from this activity?
- Do you have the knowledge necessary to carry on this activity as a successful business?
- Have you made a profit in the past from similar activities, and do you expect future profits?
If the hobby is deemed a for-profit business, the IRS allows you to deduct expenses. If the IRS deems the activity to be a hobby, any cost of carrying on the activity isn't deductible.
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