Do you like to deduct whatever you can get away with? Or are you afraid to claim business expenses tax deductions because you’re afraid of getting audited? Either way, here’s what you can deduct and how to reduce your chances of getting audited.
What is the business expenses tax deduction?
There’s no specific business expense tax deduction. Business deductions follow separate rules from personal deductions.
With personal deductions, in order to claim a tax deduction, there has to be a specific deduction such as the HSA contribution deduction or charitable donation deduction.
With business deductions, the general rule is that you only have to pay taxes on your profits. So instead of paying taxes on your gross income, you first subtract your business expenses and then pay tax on your net income after expenses.
Do you have to itemize to claim business expenses?
No, you don’t have to itemize to claim your business expenses. In fact, you should not claim your business expenses as itemized deductions.
Itemized deductions are for personal deductions.
For most independent contractors and sole proprietors, your business deductions go on your Schedule C tax form. Schedule C is the form you use to calculate your business profit and loss.
If you have a corporation, LLC, or partnership that has to file its own tax return, you’ll claim your business expenses on your business tax return.
What business expenses are tax deductible?
Here’s a list of the general categories of business expenses found on Schedule C:
- Car and truck expenses (from Schedule C, Part IV or Form 4562)
- Commissions and fees
- Contract labor (if you hired someone else)
- Depreciation and Section 179 expenses
- Insurance (for your business other than health insurance)
- Legal and professional services
- Office expenses
- Rent or lease for vehicles, machinery, equipment, or business property
- Travel and meals expenses
- Wages (paid to your employees)
- Home office deduction
- Other expenses
That other expenses line at the end is really important. Basically, you can deduct anything that’s an ordinary and necessary cost of doing business.
Instead of trying to find a list of business deductions, what I usually recommend that you do is spend on your business as normal using a separate credit card or checking account. Use accounting software to save your receipts and keep track of what each expense was for.
At the end of the year, all or almost all of what you spent should be deductible.
It’s almost never a good idea to spend money just to get a tax deduction. That’s because your deduction is usually worth between 15 cents to 50 cents of every dollar that you spent.
When you write something off, the IRS reduces your taxes but it doesn’t fully reimburse you.
One thing that you may want to do is if you’re planning to buy something next year, consider it buying it this year to lower this year’s taxes. But then remember that you won’t have that deduction next year.
Business Expenses You Can’t Deduct or That People Often Get Wrong
Ordinary and necessary business expenses is a really broad term that does cover a lot of deductible expenses. There are a few things that the IRS specifically doesn’t allow or that people often push the limits on.
With very, very few exceptions, business entertainment expenses are no longer allowed. That includes things like taking clients golfing or to a football game.
Why? Because people abused them.
You can’t just decide you want to go somewhere and then have a conversation about your business to make it a write-off. That’s what a lot of people did anyway.
If you’re in sales where entertaining clients is important, talk to your accountant about your options. If not, you probably can’t claim entertainment expenses.
There are two things to know about deducting business meals.
First, you can usually only deduct 50% of your business meals. (There was a temporary increase to 100% in 2021 and 2022 to help restaurants recover from the pandemic.)
Second, the meal has to have a business purpose. That’s usually either having a business meeting with clients or while you’re traveling.
Business meeting usually means something like a sales pitch or account review. Social meals with business partners aren’t deductible.
Traveling usually means overnight trips away from home. You can’t deduct lunch or other meals while you’re working just because you left our house to go to work.
While you can deduct mileage or vehicle expenses for business trips, many people make the mistake of including their commuting miles in their business expense deductions.
Trips between your home and a work location are usually not deductible. It becomes a business trip once you’re driving between work locations.
Phone and Internet Bills
You can’t deduct the entire cost of your phone and internet bills just because you use them for business purposes unless it’s a dedicated business line. You can only take a partial deduction if you use them for both business and personal reasons.
Many people will include their internet bill in their home office deduction. So if your office takes up 100 square feet of a 1,000 square foot house, you can deduct 10% of your internet bill.
Phone bills can also fall under the home office deduction. If you use your phone but don’t have a home office, such as rideshare drivers, you’ll usually need to track how much of the time you use your phone for personal versus business uses.
Whether you can deduct work clothes as a business expense depends on the type of clothing.
Generally, if it’s something you can wear in your off hours (even if you don’t), it’s not deductible. That includes things like shirts, shoes, and other regular clothing items.
If it’s a specialized item that you can’t wear in everyday use, such as protective clothing, it’s generally deductible.
How should you track your deductions?
It’s always a good idea to have a separate checking account and credit card for your business income and expenses even if you just have a small side hustle. That makes it easy to track your expenses without having to worry about splitting up your business and personal purchases.
You should also get bookkeeping software or an expense tracking app. The app will total up all of your expenses, help you properly categorize them, and make filing your tax return super easy.
In addition, you always need to save your receipts. You can either save the paper copies or scan them into your bookkeeping app.
Credit card and bank statements don’t substitute for receipts. In addition to showing that you spent money, you also have to show what you bought (and be able to explain to the IRS why you needed to spend that for your business).
How can you avoid getting audited for business expenses?
Your goal should usually be to avoid losing an audit rather than avoiding audits. You can never avoid audits entirely.
If you play by the rules, audits are usually a lot easier than you think.
How does the IRS picks who to audit?
There are three ways the IRS picks tax returns to audit:
- If your tax return is unusual
- If you’ve lost previous audits
The random audits are why avoiding audits is a bad strategy. There’s always a chance the IRS computer can pick your tax return at random.
The IRS also compares tax returns against each other. For example, if you claimed 60% of your gross income in expenses but people with the same job and similar gross income only claim half the expenses, the IRS might take a closer look at your tax return.
There can be legitimate reasons for having unusually high expenses or low profits. If you played by the rules, the IRS will usually just ask a few questions and review your documentation.
But if you tried to use “creative” accounting, the IRS comparing tax returns is how you can get caught.
Finally, if the IRS has denied your deductions in the past, there’s a higher chance they’ll take a closer look at your deductions in the future to make sure you’re now playing by the rules.
(But winning an audit isn’t like jury duty — you’re not automatically free from IRS audits for a few years.)
What happens when the IRS audits your business expenses?
Most IRS audits of business expenses are done by mail. They might ask about specific expenses or your expenses in general.
You’ll usually get asked to provide receipts and documentation of the business purpose of your expenses.
If you’ve kept good records, you’ll often get a letter back in a few weeks saying everything is OK.
If you didn’t keep good records, you could lose your deductions even if they were legitimate business expenses. You have the burden to prove your deductions to the IRS by following the rules such as keeping receipts.
If you lose your deductions, you could owe back taxes and penalties.
Can you just not claim your deductions to avoid audits?
It’s usually not a good idea to leave off deductions because you’re worried about audits. (Unless a specific deduction is questionable or you didn’t save proof.)
First, it will cost you more in taxes. The cost of paying more taxes over the years will almost always be more than the time and cost of responding to an IRS audit.
Second, you can still get audited. Remember, the IRS pulls tax returns randomly. They also look at other things like your reported income, so not having expenses on your tax return doesn’t mean you won’t get an audit letter.