Common Business Deduction Errors and Clarifications

The following are the most common errors and misunderstandings I find in the books and records of businesses. If you are sending me information on income and deductions for the purposes of preparing a tax return please review this list. If you find items you believe to be present in your accounting records, either correct those items or alert me to their presence.

Personal expenses mixed with business expenses

This is the error that often takes the most time to resolve. They fall into two categories:

  • Personal deposits

  • Personal expenses

  • Mixed use expenses

Personal Deposits happen when you put your own money into your business accounts. If you record this into a revenue or expense account on your Profit and Loss statement you wind up recounting that already taxed income as new business revenue. This error results in higher taxes. To avoid this, review all the deposits into your business accounts and confirm they are all from customers, not from your personal funds. If there are deposits of personal funds into the accounts, either move those to equity accounts, or let me know about each deposit, so I can classify those transactions correctly.

Personal Expenses happen when you use your business account for an expense which is not business related. For example, say you forget your personal credit card at home and so instead you use your business card at the grocery store. Listing this as a business expense is incorrect, and overstates your business expenses putting you at risk in the event of an audit. To avoid this, review the expenses that are showing up on your Profit and Loss statement, if there is any spending that was for personal, not business purposes, move those transactions to equity, or alert me to each transaction that should be moved.

Mixed use expenses these occur when you spend money on something that is partially for business, partially for personal use. For example, lets say you use your cell phone to take business calls. Unless you keep a separate cell phone line specifically for business purposes, most likely your cell phone is also what you use for your personal communications. With expenses like these, an allocation must be made. For example, if you estimate that about 30% of your use of your cell phone is for business purposes, you should take the total spent on the cell phone for the year, and move 70% of the expense to an equity account. Or, alert me to each account that has a personal component, and let me know the % personal use in each one.

Home Office Expenses As Business Expenses

Many businesses operate either partly or completely out of a home office. Businesses that do so are entitled to a Home Office Deduction under certain conditions. If those conditions are met, however, they process for allocating home office expenses is more complicated than simply adding HOD expenses to the Profit and Loss. There are two correct methods to handle HOD expenses:

  • Highlighted account method

  • Equity method

The Highlighted Account Method simple makes clear the accounts on the Profit and Loss that are Home Office expenses. These may include rent, mortgage payments, utilities, insurance, repairs and maintenance, or others. To use the Highlighted Account Method make sure that any account that relates to the home office is marked as such. So for example if you pay utilities for your home from your business account, classify them in an expense account “Utilities -HOD” or some other marking system so it’s clear they are not regular expenses. You can also alert me to all expense accounts that relate to the Home Office Deduction, and I will reclassify them correctly.

The Equity Method classifies all expenses related to home office deductions into Equity accounts. Then, when I am preparing the tax return you deliver to me separately from the business income and expense records the totals for each Home Office Expense Category.

Meals and Entertainment (minus entertainment)

The IRS understands that taking a client or colleague out to lunch or dinner is for many businesses an important part of networking and business communications. So, businesses, including self employed individuals, are allowed to take a deduction for certain meals. (Note, as of the Tax Cuts and Jobs Act entertainment costs are no longer deductible. “Meals and Entertainment” remains in colloquial usage because this deduction was called that for so long, but only meals are allowed as of the writing of this article.)

The IRS allows a 50% deduction for Meals, as long as it meets the following criteria:

  1. The expense is an ordinary and necessary expense paid or incurred during the taxable year

  2. The expense is not lavish or extravagant

  3. The taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages

  4. The food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact

  5. In the case of food and beverages provided with entertainment, the food or beverages are purchased separately or otherwise isolated from the entertainment cost (so that only the food can be deducted)

Items 3 and 4 are the most relevant to the majority of taxpayers. Be sure that when you are including a meals in your business deductions, that you or an employee is present with a current or potential customer, or business contact. In the event of an audit, the IRS may ask you to prove this. The easiest way to create evidence to support this deduction is, each time you spend money on a meal that you intend to deduct, take the receipt and on the back write who was present at the meal, and a summary of what was discussed (even a very short one, like “payroll” or “new client”)

Health Insurance

You can deduct the cost of your health insurance and dental insurance against your self employment income with two caveats:

  1. You must not be eligible for health insurance coverage provided by an employer. This includes coverage you are eligible for through your spouse. This means if you have another job or your spouse has a job and they offer you coverage even if you do not accept the offer you can’t take the Self Employed Health Insurance Deduction

  2. The Self Employed Health Insurance Deduction can’t reduce your taxable income from the business below $0. So if you earned $5 and you have $10 in deductible Self Employed Health and Dental Insurance, your taxable income would be $0 not -$5. This is important because if you could reduce your income below zero, you could use that negative income to offset other income on your return, like income from a W2 or another business.

Business Gifts

You can deduct the cost of business gifts to clients or vendors throughout the year with the following limitation:

  1. Gifts per year to each individual cannot exceed $25*

*The $25 does not include things like gift wrapping.

You can gift items costing more than $25, but only the first $25 will be deductible.

Uniforms

The IRS allows deductions for uniforms or work clothing only if the clothing is unsuitable for use outside of work. So for example, a mascot or cheerleader’s costume would be unlikely to be worn outside of work, and so those are deductible. Work attire such as suits, dresses, T shirts for a construction worker that are intended to get very dirty, none of these qualify because they are suitable for wearing outside of work. It does not matter if you never wear such clothing outside of work, only the suitability (possibility) of wearing outside of work matters.