Do you ever notice that there are a million words people use to talk about their small business but no one ever stops to explain them to you? Yea, me too. Which is why I’m going to stop that right now and get way deep into one word that you always hear in small business: tax deductions.
You’ve probably heard about “deductions” “write offs” and “deductibles” for years but maybe haven’t gotten the full low down. Or you have a vague idea that they are kinda important and you need to keep track of them, without fully understanding why.
Girl, I got you.
Here’s everything you need to know about tax deductions and why you need to know it:
What are Tax Deductions?
First of all, let’s start with what these little buggers are. Simply put, tax deductions are business expenses. AND the IRS requires that these expenses are “ordinary” and “necessary”.
Ordinary means that the expense is common in your industry or is common business practice.
For example, if you run an online business about beauty products and go out for a business meeting over lunch- this is a common practice for all businesses and the expense is deductible.
If, after lunch, you go on a shopping spree for hiking gear- this expense is not common to your industry and would not be considered deductible.
Necessary means anything that you need to run your business. Now, I think necessary should look more like this: Anything you need (within reason) to run your business.
We could justify just about anything and why we need something for our business. But the IRS isn’t going to buy our excuse that a 50-carat diamond ring makes us look more professional.
So, necessary needs to be within reason.
What are some examples of necessary business expenses?
Meals with potential clients or customers
Supplies, like paper and ink
Workshops and training
The list goes on! This is just a small sampling. Remember, deductions vary by industry so what is necessary for a tattoo artist is not the same as what is necessary for a blogger.
Why Do I Need Them?
You’ve got the 411 on what tax deductions are, now let’s talk about why you need them.
Deductions directly impact how much you are taxed on your business income. So you def need to make tracking your deductions a priority.
Here’s how it works:
When you do your taxes you report all your income for your business. This is all the money your business brought in for your rad products or services. Then, you report what you spent money on to keep your business operational. These are your deductions.
The next step is that your deductions are subtracted from your gross income and- voila– you have your taxable business income.
The more deductions you have (i.e. the more money you spend on your business) the lower your taxable income.
This IS NOT an excuse to spend a bunch of money on random stuff for your business. You still want your business to be profitable and you still want to be thoughtful about your spending.
This IS a good excuse to be meticulous about tracking your deductions and tighten up your record keeping practice.
How Do I Know If It’s Deductible?
If you’re stuck wondering if something is a deduction or not there are three questions you can ask yourself:
Does this have anything to do with my business?
Obviously, if the answer is no then you shouldn’t be deducting it.
What does this have to do with my business?
Really think this through. How does the expense benefit, support, or help your business? What would not be possible for your business without the expense?
Could I justify this to the IRS?
Have an imaginary conversation with an IRS agent. What would you say to justify the expense? Would they believe you? Do you believe you?
You can also check out this epic cheat sheet I wrote on small business deductions. I go through the most common deductions and you can download a cheat sheet to keep handy when you need a refresher.
How Do I Keep Track of My Tax Deductions?
Now that you know all the things about tax deductions it’s time to get to the most important question- how do you keep track of it all?!
One of the easiest ways to corral your tax deductions in one place is to open a separate business checking account and credit card. If you only use these accounts to pay for your business expenses, it will be waaaaaaaaaaaay easier to keep track of your deductions.
You won’t spend hours sorting through statements trying to find that thing you bought that you think is for business. Instead, you’ll gloriously glide through a list of your deductions (aka your statements) and all you have to do is categorize them.
If you already have a business bank account and want to level up your tracking game, then you have three options:
Get a notebook and make a page for each of your deduction categories- write down every expense that belongs in that category
Start a spreadsheet with different tabs for your deduction categories and track your expenses on the spreadsheet
Move into a digital accounting program (this is my recommendation!). Wave is a free digital accounting program that syncs with your bank account, making it even easier to track your tax deductions.
Finally, remember to keep your business receipts! You can keep the physical receipts stashed in envelopes or folders or take pictures of your receipts and store them on your computer or in a receipt tracking app.
Whatever you decide to do, make sure you keep records of exactly what you bought so that, if you are ever audited, you can prove that your purchases were business related.