For small business owners, understanding the difference between business and personal expenses is crucial. Business expenses are deductible, so they can lower your taxable income and reduce the amount of tax you owe.
You can't use personal expenses to reduce business income. That's why it's so crucial to avoid mixing business and personal expenses by using the same checking account or credit card for both purposes. It might be convenient, but you risk losing out on valuable tax deductions.
Business expenses explained
For tax purposes, it is important to keep a clear record of all business expenses, whether the expenses are fully or partially related to the business. Ideally, you should open a business bank account and credit card. Whenever possible, buy separate items for business and personal use, even if it means purchasing duplicates. At the very minimum, make sure to keep receipts for any item that is partially or fully deductible as a business expense.
The IRS does have a comprehensive list of all allowable business deductions. Instead, it offers the general rule that any expense that is ordinary and necessary for running your business is deductible.
Common deductible business expenses include:
- Salaries and employee benefits
- Office expenses and supplies
- Rent or mortgage
- Business insurance
- Loan interest payments
- Repairs and maintenance
- Professional subscriptions
Some business expenses are never deductible, such as lobbying, political donations, and of course, any illegal activity, but most others are deductible. It is important to understand and track them to take full advantage of the deductions they offer.
Most of the time, the distinction between business and personal expenses is clear, but sometimes you might buy one item for both business and personal use. In these cases, you can claim a deduction for the portion of the item that is attributable to the business. For example, if you purchase a computer that is used for business 75% of the time, you can deduct 75% of the cost as a business expense.
Particularly for small business owners, various expenses are likely to be shared between business and personal use. For example, small business owners may use one vehicle, phone, or computer for both personal and business use. However, only the business use portion of each item is deductible as a business expense.
A significant deduction available to small business owners is the home office deduction. It allows small business owners to deduct the business portion of their home mortgage or rent, insurance, taxes, utilities, repairs, and depreciation.
Hobby loss: Personal or business deduction?
A hobby loss is related to the pursuit of a hobby or recreational activity undertaken to generate profit. If the IRS deems your hobby to be primarily recreational in nature, then the income you earn from the hobby is taxable, but hobby expenses aren't deductible. However, if the IRS considers your hobby to be a business, the net loss would be deductible against other income, similar to any other net business loss.
Hobby loss rules
The IRS enacted hobby loss rules (outlined in IRC Section 183) to prevent taxpayers from claiming business losses for activities that are primarily recreational and not-for-profit. For those taxpayers who legitimately engage in a hobby-like activity as a form of business, a business deduction is still allowable.
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 considerations the IRS uses to consider a hobby an actual for-profit business.
Hobby loss tax treatment: Profit or pleasure?
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). For businesses that do not meet this criteria, the IRS offers this handy guideline on its website. While there is no steadfast rule for when the IRS considers an activity to be primarily business or recreational, the IRS 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 aren't deductible.
Although mixing business with pleasure sounds nice in theory, any good accountant will tell you otherwise. Whenever possible, always keep separate bank accounts, receipts, and records.for