Business today is cutthroat; half of all businesses fail in their first five years.
If you are a business owner, you need every advantage you can get. That includes taking all possible tax deductions to reduce your taxable income.
To get a better understanding of your taxes and what exactly you can deduct, you need to understand the difference between two items: costs and expenses.
In everyday conversation, many may toss around these two terms as though they are interchangeable. For tax purposes, they are not.
Read further to find out why.
The Fundamental Difference Between Costs and Expenses
- Business expenses—money you spend to help your business run—are usually tax-deductible. They reduce your adjusted gross income (AGI) and thus your tax liability, which is the total amount of tax debt owed to the IRS. Rent and payments to employees and contractors are among the many things that can be deducted as expenses on a business’s tax bill.
- There are various types of costs. For example, this may include the costs of goods sold, costs of assets, costs of improvements and costs of starting a business. In some cases, costs are used to determine depreciation and amortization expenses, and in others, they may be deductible in the current year as business expenses.
A business expense must be “both ordinary and necessary” in order to be deductible.
“Ordinary” means it is an expense commonly acceptable in your type of business.
“Necessary” means it is appropriate or helpful to the business, but it doesn’t have to be indispensable.
Keep in mind business expenses that may be directly deducted are not the same as expenses used to figure the cost of goods sold or capital expenses (money used to purchase business-related equipment).
While some costs may be expended on your business tax return, others must be capitalized.
You cannot expense a capitalized cost immediately—you must do so over time through depreciation or amortization.
To sum up the difference between costs and expenses, business expenses may always be deducted in the current year.
Some costs may be deducted in the current year, but others must be capitalized. Let’s take a look at what costs must be capitalized and what may be deducted in full.
Costs of Goods Sold
“Cost of goods sold” (COGS) refers to all the costs that go into producing a product. This may include the cost of:
- Labor to create the product
- Raw materials
- Parts to make the product
- Inventory bought for resale
- Factory overhead
The cost of goods sold may be deducted from your gross receipts (the total amount of money received) to figure your gross profit for the year.
If you include something under the cost of goods sold, you cannot deduct it again as a business expense.
Unless you have a small business, you must capitalize the direct costs and some of the indirect costs for certain production and resale activities.
Small business taxpayers get special dispensation. According to the IRS, a small business taxpayer “(a) has average annual gross receipts of $25 million or less for the 3 prior tax years and (b) is not a tax shelter.” For more information, see Publication 334, Tax Guide for Small Businesses.
Business Assets and Improvements Costs
“Cost of an asset” refers to the actual cost of buying an asset, say a new printer or new manufacturing equipment.
Cost of an asset includes the amount it cost to purchase it, ship it, set it up, and train people on how it works.
This is its “cost basis,” which is used to set up a depreciation schedule for tax purposes.
Under the new tax law that went into effect on January 2018, businesses may elect to expense the cost of an asset that qualifies under Section 179 and deduct it in the year it is placed in service. The maximum deduction for 2018 is $1 million.
Property that may be deducted includes:
- computers, computer software
- personal property of a type used in business
- security systems
For property that does not qualify under Section 179, you cannot deduct business asset costs— you must capitalize them. They are part of your business investment and are recorded on a business’s balance sheet.
As they depreciate, the depreciation is subtracted to determine an asset’s book value.
Costs of Starting a Business
If you are starting a business, you will have a particular need to understand the difference between costs and expenses. Business start-up costs, as part of the investment in your business, generally must be capitalized and amortized over several years rather than deducted immediately as expenses.
However, some start-up costs may be deducted in your first year of business.
You may deduct up to $5,000 in start-up costs in your first year in business if your start-up costs don’t exceed $50,000. Additional start-up costs may be amortized over 15 years.
If it doesn’t make a profit in your first year, you may not want to take this $5,000 deduction. Speak with your tax expert about how to reduce your taxes in future years when you are more profitable by not taking the $5,000 in your first year. For example, you may want to amortize all start-up costs over 15 years.
Keep in mind that “organizational costs” are not the same as “start-up costs.” You can take another $5,000 deduction for your small business taxes for organizational costs such as those involved in forming a corporation.
Structure Your Business to Maximize Your Tax Benefits
Talk with your tax expert about how your business can reduce taxable income and take advantage of every tax benefit. Here are a few ideas:
- Temper offering higher salaries to your employees by offering more benefits. Higher salaries mean higher employment costs for your business. Instead, offer tax-exempt benefits such as educational help, transportation, and meals.
- Consider putting an accountable plan into place for reimbursing employee expenses such as travel and meals. Accountable plans are those that meet IRS requirements, where the business deducts the expenses but does not report the reimbursements as income to employees. Under the new tax law, employees cannot deduct unreimbursed business expenses, so they will be expecting you to somehow reimburse them if you do not already.
- Talk with your tax expert about what is right for your circumstances. For example, it makes no sense to take a deduction if your business made no money for the year in question. You may want to amortize or choose another option that will give you a tax advantage.
Taxes are complicated, and many businesses are still not up to speed on the tax law changes that went into effect in 2018.
Knowing the difference between costs and expenses is just a start.
If you have not recently sat down with an experienced tax expert to discuss your business, now is the time to make an appointment.
Nathan Wade is a licensed attorney for the State of Hawaii and the U.S. District Court of Hawaii. He holds a law degree with a focus in business and has extensive experience in entrepreneurship and international business. He is also a Managing Editor for WealthFit, a financial education blog dedicated to curating advice on investing, entrepreneurship and money.
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