Running a small business means you’re in charge of your finances. Compared to traditional employment, you can earn more money as there’s no maximum earning cap. But at the same time, you’re also responsible for handling your taxes.
That could make your tax bill a chunky one. Soundly, you can legally reduce it by claiming a host of attractive small business tax deductions.
Note: This article focuses on federal tax law. State tax laws may differ.
Table of contents
- Two Types of Small Business Tax Deductions
- 2021 List of Small Business Tax Deductions and Tax Credits
- FAQs about small business tax deductions
Two Types of Small Business Tax Deductions
Small business owners can benefit from two types of deductions:
- Business expenses
- Tax credits
Business expenses constitute the “ordinary and necessary” expenses paid or incurred when carrying out a business.
What is “ordinary” is an objective test based on what similar businesses spend to carry on a similar business. What is “necessary” is generally a subjective test based on what the business owner believes is needed to succeed.
Overall, the common business expenses include:
- Owners’ draw or salary
- Employee wages
- Compensation paid to freelancers
- Cost of goods sold
- Marketing costs
- Business trip costs
The Federal tax code also allows business owners to claim tax credits, a certain sum you can subtract from your tax bill, based on your activities.
Usually, these credits incentivize businesses to hire certain employees (e.g., veterans or people with disabilities), invest in sustainable technologies (e.g., solar panels), or operate in a particular industry (e.g., agriculture).
Several business tax credits are available to small businesses:
- Work Opportunity Tax Credit
- Research credits
- Biofuel investment credits
- Credit for introducing an employer pension plan
- Employer-provided child care credit
- And more!
Tax credits may also be available if the business owner pays income taxes to foreign governments with whom the US has a tax treaty.
The calculation of tax credits can be complicated but is usually based on the amount spent by a small business for certain expenses.
You can usually figure these out using your accounting software or by consulting a certified public accountant (CPA).
How much can a small business write off?
For expenses to qualify as deductible, they need to be reasonable in amount and rationally related to the operation of the business.
Essentially, you obtain a tax write-off for any objective company-related expenses, as well as financial losses (e.g., equipment depreciation).
The new Tax Cuts and Jobs Act also allows business owners to deduct up to 20% of qualified business income (QIB) and 20% of qualified real estate investment trust (REIT) dividends.
The IRS provides a detailed explainer of the revised business deductions. Be sure to check it!
2021 List of Small Business Tax Deductions and Tax Credits
Business tax deductions and credits allow small businesses to save big time. With the tax season just around the corner, it’s worth looking into your options.
Depending on the type of business you operate, you may deduct expenses unique to your business. Or benefit from deducting some of the most common expenses most companies incur.
Here are some of the expenses you can write off as a small business owner:
- Startup and company incorporation costs
- Operational business expenses
- Home office spending
- Banking and payment processing fees
- Depreciation of business assets
- Insurance premiums and plans
- Professional services and contractor fees
- Employee salaries, benefits, and retirement plan
- Charitable contributions
1. Startup and company incorporation costs
A business’s start-up costs are generally deductible in the first year of operation or over fifteen years after that.
These expenses fall into one of two categories:
- Startup expenses
- Organization expenses
The first $5,000 of startup expenses and the first $5,000 of organization expenses are deductible in the first year of operations. The remainder is deducted over fifteen years. There can be a limitation on the deduction of these expenses if the total of both exceeds $50,000.
Startup expenses include:
- Market analysis
- Advertising related to the opening of the business
- Pre-opening salaries and wages
- Travel related to securing distributors, suppliers, or customers
Organization expenses for a single-member LLC or partnership include:
- Legal fees to create the partnership or LLC (including the operating agreement)
- Accounting fees incident to the formation of the partnership or LLC
- State filing fees for company incorporation
2. Ongoing operational business expenses
A business may deduct ordinary and necessary expenses incurred in carrying on a trade or business. These expenses will differ from one industry to another.
But as a rule of thumb, you can safely deduct reasonable costs rationally associated with running your business.
Examples of deductible business expenses include:
- Advertising and marketing costs
- Business cards
- Education expenses
- Care-related expenses
- Business hardware and software
- Workspace and office expenses
- Commissions and fees
- Employee benefits
- Interest on business loans
- Pension and profit-sharing expenses
- Rent or lease expenses
- Repairs and maintenance
- Office supplies
- Property taxes
- Business license fees
- Business travel
- Business meals
- Professional dues and subscriptions
- Cost of Goods Sold (COGS)
- Qualified business income deduction
- Tax preparation fees
A sole proprietor will report these business deductions on a Schedule C form.
3. Home office deductions
You can deduct expenses related to your home against business income if:
- Your home is your principal and regular place of business
- A portion of it is exclusively allocated to doing business
If your home office is in a separate detached structure (e.g., a refurbished shed), you don’t have to pass the “principal place of business” test.
There are two methods for calculating the amount of the home office deduction, the “simplified” or the “regular” method.
Under the simplified method, a taxpayer multiplies the size of their home office (in square feet) times $5 up to a maximum of $1,500.
Under the regular method, a taxpayer takes the home office’s square footage divided by the total square footage of his home to obtain the deductible percentage of indirect home office expenses. The taxpayer then multiplies that percentage times the home’s allowable expenses to arrive at the deduction.
Also, you can claim some indirect home office expenses such as:
- Mortgage interest
- Real estate taxes
- Utility payments (to an extent)
- Repairs and maintenance
- Casualty losses
- Carryover of unallowed expenses from the prior year
Allowable expenses directly related to the home office are 100% deductible. The home office deduction is limited to the business income generated by the home office.
4. Banking and payment processing fees
Bank and financial fees related to your business bank account or credit card can add up fast. So you should track and deduct them like there’s no tomorrow.
Examples of deductible bank and financial transaction fees include:
- Monthly business bank account fees
- Business transaction processing fees
- Business wire fees
- Account overdraft fees
Over time property used in business wears down to the point where it’s no longer useful. This period is called its “useful life.”
The useful life for some business properties is longer than others. For example, a desk will be useful for a longer period of time than a computer. A building has a longer useful life than a desk.
Useful life determines the “recovery period” for eligible property (useful life and recovery period are not always the same).
Taxpayers can deduct the cost of eligible property they own and use in their business throughout its recovery period. This deduction is called depreciation.
Examples of property eligible for the depreciation deduction include:
- Machinery and equipment (computers, printers, copiers, etc.)
- Furniture and fixtures
- Leasehold improvements
The land is not eligible for the depreciation deduction.
How is tax depreciation calculated?
The method for calculating the annual depreciation deduction for an eligible property is known as the “modified accelerated cost recovery system” or “MACRS” for short.
The MACRS system provides tables for each category of business property based on its recovery period.
To calculate the depreciation deduction, you must determine the appropriate recovery period for the eligible property based on its type. Then multiply the cost of the eligible property times the percentage in the table corresponding to the year since the eligible property was placed in service.
Sample tax depreciation calculation
For example, the recovery period for a desk is 7 years.
If a taxpayer buys a desk for $1,000 and uses it in business for the first time in 2021, using the table above, the taxpayer will be able to deduct 14.29% of the $1,000 as a depreciation deduction ($143) on their 2021 tax return.
If the taxpayer continues to use the desk in their business for all of 2022, the taxpayer will be able to deduct 24.49% of the $1,000 ($245) on their 2022 tax return.
It continues each year until the taxpayer has deducted the entire $1,000 or until the taxpayer no longer uses the desk in its business.
6. Insurance premiums and plans
Having business insurance is not just important but is often required by law. Fortunately, these expenses are usually deductible.
Examples of deductible insurance expenses include:
- Professional liability insurance
- General business insurance
- Insurance that covers fire, theft, accident, or similar losses
- Credit insurance that covers bad business debt
- Liability insurance
- Malpractice insurance
- Worker’s compensation insurance
- Contributions to a state unemployment insurance fund
- Overhead insurance
- Car and vehicle insurance
- Certain life insurance coverage company officers and employees
- Business interruption insurance
Also, you can claim an attractive Small Business Health Care Tax Credit.
It applies to small business employers with less than 25 full-time employees who offer a qualified health plan to their employees through a Small Business Health Options Program Marketplace and pay at least 50% of the cost of employee-only health care coverage.
The tax credit amount is up to 50% of the premiums paid, depending on the number of employees. If the entire tax credit isn’t used, a taxpayer may carry the credit back or forward to other years. You can also receive a refund of the credit.
Self-employed individuals may deduct their health insurance premiums up to the amount of earned income regardless of whether they itemize deductions if neither them nor their spouse were eligible to participate in an employer-subsidized health plan.
7. Professional service and subcontractor fees
Many business owners need the help of other professionals to run their businesses. Respectively, you can deduct them from your business income.
Examples of deductible professional service fees:
- Web designers
- Accountants, CPA, or tax professional
- Computer network experts
- Software consultants
- Market analysis consultants
- Advertising consultants
Note: If you pay an independent contractor more than $600/year, you must send them a 1099-NEC tax form by January 31st of the following year.
8. Employee salaries, benefits, and retirement plan contributions
You may deduct the reasonable expense of employee salaries and benefits paid for services performed from gross income.
Whether the amount paid is reasonable depends on all the facts and circumstances when you made payment.
Factors considered in determining the reasonableness of compensation include:
- Duties performed
- Volume of business
- Complexity of duties
- Amount of responsibility
- Time needed to perform tasks
Employers may also be eligible for certain tax credits for wages paid to employees, such as the following.
Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips
An employer may be eligible for this credit if they have employees who receive tips from customers in the foodservice industry, and the employer paid social security and medicare taxes on these tips.
The employer must pay the employees at or above the minimum wage level. If so, the credit is 7.65% of the tip income above the minimum wage.
Credit for Small Employer Pension Plan Startup Costs
An employer with 100 or fewer employees who received at least $5,000 in compensation may claim a tax credit up to $5,000 for three years for the ordinary and necessary costs of starting certain retirement plans. At least one plan participant is not a highly compensated employee.
The credit is 50% of eligible costs up to the greater of $500, or the lesser of $250 multiplied by the number of eligible employees who participate in the plan up to $5,000.
If the employer takes the credit, it may not also deduct the costs of establishing the plan in an amount equal to the credit.
Credit for Employer Differential Wage Payments
This credit is generally available to qualified employers who make payments to qualified employees while on active duty for more than 30 days with the uniformed services of the United States. The credit is 20% of eligible wages paid up to $20,000 ($4,000).
The credit may be limited if other certain payroll credits are taken.
Employer Credit for Paid Family and Medical Leave
This credit is available to employers who pay wages to qualifying employees while on family and medical leave for particular reasons. The employer must have a written policy in place meeting certain conditions.
The credit is a percentage of wages paid while the qualifying employee is on family or medical leave for up to 12 weeks per taxable year.
The percentage ranges from 12.5% to 25%, depending on the amount paid.
9. Charitable contributions
Donating is good for business and may be an excellent way to reduce your taxes.
However, charitable contributions made by your business to qualified organizations are not deducted in the same manner as other business expenses.
You have to report these separately on your individual tax return as part of itemized deductions. If you don’t itemize your deductions, you can only deduct up to $300 of your charitable contributions if filing single or $600 if filing jointly. There are additional limitations on the amount which you can deduct.
The chart below summarizes contributions that may qualify for the charitable contribution deduction as part of your itemized deductions:
How much do charitable donations reduce taxes?
How much you may deduct for a charitable contribution depends on the type of property contributed and your adjusted gross income.
If you itemize your deductions, you can deduct cash donations up to 100% of your adjusted gross income.
If you don’t itemize, a single person can deduct up to $300, while those married filing jointly can deduct up to $600.
If you donate property other than cash, then you must itemize to deduct the contribution. Also, the deduction may be limited to between 20-60% of your adjusted gross income, depending on the type of property donated.
As an entrepreneur, you have many opportunities to deduct the true amount it costs you to sell goods and services. But careful record-keeping is required to prove the deductions if questioned by the IRS.
Remember that the amount of the expenses should be reasonable and rationally related to your business activities.
FAQs about small business tax deductions
Here are answers to some of the most frequently asked questions about small business tax deductions.
This material is provided for informational purposes only. The provision of this material does not create an attorney-client relationship between Paul Donovan and/or Donovan Legal PLLC and the reader, and does not constitute legal advice. Legal advice must be tailored to the specific circumstances of each case, and the contents of this article are not a substitute for legal counsel. Do not take action in reliance on the contents of this material without seeking the advice of counsel.