Deduction or Expense...what's the difference?
One of the biggest confusions that I often hear when it comes to bookkeeping for small businesses, is the difference between an expense and a deduction. Often times, most business owners believe that just because they bought it with business money, it automatically means that they can write if off on their taxes. However, this is not always the case. So how do you know which purchases will lower that pesky tax bill at the end of the year? Before we can explain the difference, first we must define the two scenarios:
Investopedia defines an expense as - An expense consists of the economic costs a business incurs through its operations to earn revenue. In simple terms, this means that anything that it costs for you to start, operate and grow your business is classified as an expense.
Investopedia defines a deduction as - A deduction is any item or expenditure subtracted from gross income to reduce the amount of income subject to income tax. This means that the expenses that the IRS allows you to use to lower your tax bill are deductions. Deductions not only lower your business taxable income, but may also lower your personal taxable income. These deductions are called Standard Deductions and Above-the-Line deductions (well go into more detail about those in a different blog post!).
HOW DO I KNOW IF MY EXPENSE IS DEDUCTIBLE?
This is a great question! And one that you should consult your tax professional about. For now though, a simple list of deductions include office supplies, meals (in excess of 50% of the full expense amount), home office space, interest expense for loans, advertising, inventory and payroll.
Certain expenses , such as vehicle loans, large purchases, buildings/land purchases, large equipment and start up costs in excess of $5000 can be deducted off your taxes in different ways than just the full expense amount. The reasoning for this is that the IRS believes that the business owner will be able to use these purchases for a longer period of time, therefore, allowing them to deduct a portion of the cost each year over the "useful life" of the purchase. What is useful life? Well for now, the useful life is the amount of time the IRS believes you can use an asset for before it looses all value. This method of tax deductions is called Depreciation.
DO I NEED TO KEEP TRACK OF ALL EXPENSES?
Even if your purchase is not deductible at the end of the year, a business owner must still keep accurate records of all expenses. Knowing your expenses gives the business owner an insightful view of what's going on in their company. It allows you to analyze where your money went, plan for your business growth in the future and know if you are really as profitable as you want to be. Plus, Publication 583 from the IRS deems that we must keep accurate records while we run our business.
So what can you take from this?? Expenses are everything that you spend money on in your business. Not all expenses are deductible. You must keep track of all expenses. Deductions lower the amount of money you owe in tax. And the IRS deems what is and is not taxable. I hope that clarifies these two business terms a little more for you!
Want JMW Financials to help you organize your expenses, maximize your deductions and help your business grow to it's full potential? Schedule your free consultation today! We can't wait to grow with you!
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