There are various types of taxes to consider when assessing the overall tax burden for your clients, including federal or income tax and sales tax, which is imposed by states on the sale of goods and services.
The focus of this article is income tax, however it is good to understand that the two taxes are influenced by each other. For example, the 2018 tax reform brings new rules on the sales tax side, like the limit of $10,000 deductible for individuals.
In answer to this, some states are planning to adjust their income tax rules to counter-balance the impact of the changes on the sales tax side. I will leave details about sales tax aside for now.
Most new entrepreneurs ask their accountant this common question: “Which expenses are deductible for my business?” The answer I give to all my clients is: “Any expense that is necessary, ordinary, reasonable, documented, and legal may be deductible.” That is a simple, but accurate answer, but may not cover all of the nuances.
Now, let’s look at some specifics regarding income tax. As I mentioned, there are many nuances in regulations and also in terminology. Let me give you a primer on the more common terms you will encounter:
- Ordinary: it is commonly accepted in the industry and seen often with other businesses in the same trade
- Necessary: the expense was required in order to generate the business income or it was incurred as a consequence of the income producing activities. But it does not need to be indispensable in order to be deductible
- Reasonable: this is very subjective, but in essence it means it is not lavish or extravagant
- Documented: the taxpayer has the burden of proof to prove the expense existed, that the amount reported is accurate, and it has a true business purpose (necessary)
- Legal: the expenditure cannot break any laws, be considered a bribe, or made in connection to an illegal activity / or activity in which the business does not gave the legal capacity to perform
In advising your clients, please consider that there are some deductions that are troublesome. From my years of experience, here are 10 tax deductions that I see are most commonly missed, misused, and/or abused:
- Home Office Expense: Frequently failing to document the square footage of the home, creating a business-only environment, and document its business purpose is the most common issue
- Vehicle Expense: mixing personal and business use of vehicles and not properly tracking mileage is a large are of non-compliance
- Insurance: Specially, with health and life insurance, which have very special rules in order to be deductible, in many cases these may NOT be deductible if rules are not followed
- Charity and Political Contributions: For pass-through entities, such as S-Corporations and Partnership/LLC's, charity is “deductible” only on the persona return, but most taxpayers cannot get any benefit for it because of standard deductions. Political contributions are NEVER deductible
- Meals & Entertainment: the “entertainment” factor really affects the deductibility of this expenses. NOTE: in 2018, there are significant changes in the tax code for Entertainment expenses
- Travel Expenses: frequently combining personal with business travel is a large priblem
- Employees and Subcontractors: not properly correctly categorizing employees or contractors and reporting them as such; which may lead to large payroll tax penalties or disallowance of contractor expenses
- Retirement and Deferred Compensation Plans: failing to include ALL the employees in the company plan and/or not taking advantage of the income deferral tax deductions
- Proper Write-off: of open invoices/receivables that are deemed uncollectible, open bills/payables that will not be paid, and adjusting Inventory quantity/valuation. For ACCRUAL-BASIS taxpayers
- Pre-startup costs: made before the business started and.or in connection to setting up the business. Also some business owners tend to "cover" business expenses with personal funds or personal credit cards (outside of the business bank accounts) and forget to register it in the business books
This brief primer can give you tips on how to better support your client’s income tax needs. And, as mentioned, income tax and sales taxes are linked to each other, so if your client’s state Department of Revenue is impacted by one type of tax, they will likely attempt to adjust the other.
Here is a 55-minute video I recorded to explain all these in detail.
Hector is a CPA practicing as an Accountant and QuickBooks Trainer/Consultant in Davie, FL for his own firm Quick Bookkeeping & Accounting LLC. Before working in public accounting, Hector worked in several accounting & financial departments of past fortune...