The Difference Between a Tax Deduction and a Tax Credit
A tax deduction reduces the amount of your income that's subject to tax, thereby potentially lowering your tax bill. Think of it as a discount on the income you're taxed on.
On the other hand, a tax credit is a dollar-for-dollar reduction of the actual tax you owe. It's like a coupon that takes off charges directly from your tax bill. So, if you owe $1,000 in taxes and have a $200 tax credit, you only end up paying $800.
Both tax credits and tax deductions can save you money, but they do so in different ways. Here are 11 deductions small business owners should be familiar with.Remember to always consult with a tax professional for specific advice for your business.
1. Contributions to Employee 401(k) Plans
If you offer a 401(k) retirement plan to your employees with matching contributions, like a Safe Harbor plan, you can deduct up to 25% of the total contributions made as long as it doesn’t exceed the limitations set by the IRS in section 404. In other words, by helping your employees save for their future, you also lower your tax bill. This deduction is applicable for both matching contributions and profit-sharing options.
Related Reading: Tax Credits for Small Businesses That Offer Retirement Plans
2. Home Office
Do you have a dedicated workspace at home?
The IRS lets small business owners write off some of the expenses associated with a home office space. But the key is that you must have a dedicated business (home office) space to be eligible for the write-off. In other words, your office cannot be the dining room table, but rather a space in your home that’s set aside and used "exclusively and regularly for conducting business," according to the IRS.
If your space meets this criteria, you may be eligible to deduct expenses such as mortgage interest, insurance, utilities, repairs, and depreciation for the area. To do this, you'll need to figure out the exact percentage (in square feet) of your home that's used for business activities.
3. Advertising and Marketing
Advertising and marketing is an essential expense for many small businesses, helping to bring in new customers and revenue. Here too, tax law allows businesses to deduct expenses. But it's important to understand exactly what's allowed. The IRS explains that "advertising and marketing costs must be ordinary and necessary to be tax deductible."
An ordinary expense is one that's common and accepted in your industry. A necessary expense, meanwhile, is one that's "helpful and appropriate" for your trade or business, according to the IRS.
Need further clarification? The IRS says reasonable advertising expenses are those that are directly related to the businesses' activities. Additionally, "the cost of institutional or goodwill advertising to keep the business name before the public, if it relates to a reasonable expectation to gain business in the future" is also an acceptable write-off. Small businesses can also write off the cost of providing everything from meals to entertainment or recreational facilities to the public.
All of these things are considered a form of advertising and "promoting goodwill in the community" and thus are allowed to be written off on your small business tax return.
4. Mileage
Using a vehicle for business purposes also provides write-off opportunities. The IRS allows small business owners to choose one of two methods to calculate deductible vehicle expenses.
The first approach is to add up the total business miles driven with your vehicle and take the IRS' standard mileage rate deduction. For 2023, the standard mileage rate is 65.5 cents per mile. In 2024 the milage rate will increase to 67 cents per mile. This deduction is often seen as the easier of the two options. But if you intend to claim the mileage write-off, be sure to keep a log of your business trips, including the date of each trip, miles driven, and purpose.
The second approach is to take a deduction for "actual vehicle expenses." Your actual expenses related to a business vehicle would include maintenance, fuel, oil, tune-ups, tires, registration fees, and other related costs.
5. Office Supplies
One of the more obvious deductions, perhaps, but the cost of business supplies can also be deducted on your tax returns. "In general, the cost of materials and supplies used in the course of a trade or business may be deducted as a business expense in the tax year that they are used," the IRS explains.
But be careful not to overstate this expense. Billions of dollars in taxes go unpaid each year because of overstated deductions, according to the IRS.
6. Insurance Premiums
Businesses are required to maintain various types of insurance, such as worker's compensation insurance and general liability insurance, among others. If the insurance is necessary for your business, the expense can likely be deducted from your tax bill.
The IRS provides a long list of examples of the types of insurance costs that may be written off by businesses. Some further examples include insurance that covers fire, storm, theft, or accidents, as well as credit insurance that covers losses from bad debts. Additionally, malpractice insurance can be written off for those in the medical profession.
7. Startup Cost Deduction
An average of 4.4 million businesses are started every year, according to the U.S. Census Bureau. If your business is among that number, you may be able to write off some of the money you spent getting off the ground.
"Startup costs are amounts the business paid or incurred for creating an active trade or business, or investigating the creation or acquisition of an active trade or business," explains the IRS. "Startup costs include amounts paid or incurred in connection with an existing activity engaged in for profit, and to produce income in anticipation of the activity becoming an active trade or business."
Examples of some of the startup costs you can deduct range from training expenses to travel costs related to obtaining either employees, suppliers, or customers. Market research, advertising, and wages paid to contractors or consultants are also allowable.
8. Employee's Salaries
Depending on the size of your small business, you may have employees. The salary you pay these individuals, including any bonuses or commissions, is tax deductible.
"You can generally deduct the amount you pay your employees for the services they perform. The pay may be in cash, property, or services. It may include wages, salaries, bonuses, commissions, or other non-cash compensation such as vacation allowances and fringe benefits," explains the IRS.
Just be sure that the payments are deemed ordinary and reasonable and that the salary is being paid for services that were clearly rendered. Importantly, this deduction can also be used for payments to independent contractors.
9. Rent
Do you pay to rent office space? If the answer is yes, then here too, you may have a valuable tax deduction. Rent is a legitimate write-off as long as the payment is for the use of a property you do not own. "In general, you can deduct rent as an expense only if the rent is for the property you use in your trade or business," the IRS explains. "If you have or will receive equity in or title to the property, the rent is not deductible."
It's also worth noting that if you rent your home and you also use part of your home for your business space, you may be able to deduct a portion of the rent as a business expense.
10. Bad debts
If, as a small business, you're unable to collect money owed to you, be sure to add that to your list of tax write-offs as well. The IRS considers this bad debt. To further clarify, the IRS explains: "Business bad debt is one that comes from operating your trade or business."
Examples of bad debt include credit sales to customers for goods or services that have been sold but not yet paid for. These items must have been recorded in your books as accounts receivable or notes receivable. If, after a reasonable period of time, you're unable to collect the amount due, it becomes a bad business debt. Loans to clients or suppliers that are not repaid are also considered bad debt for tax return purposes.
These types of debt can be deducted on the Schedule C (Form 1040) of your business income tax return.
11. Internet expenses
It can be difficult to conduct a profitable business these days without internet-related expenses. If your business operates from a store or dedicated office space, you can claim 100% of your internet service. If you're working from home, you can still deduct a portion of your internet bill, but it should correlate with how much you use it for business purposes. Many businesses maintain an online presence via a website and pay domain registration fees, as well as webmaster design and consulting costs. All of which can be deducted from your tax bill each year, says the IRS.
The Takeaway
These 11 examples are just some of the most common types of write-offs available to small businesses. It's important to work with a tax professional to ensure that you're taking advantage of all opportunities to minimize the tax burden for your small business, but doing so within established IRS guidelines.
Interested in starting a retirement plan for your employees to claim additional tax deductions? Tell us about your business, and a retirement specialist will recommend which Penelope retirement plan is a fit for your business!
Penelope Team
Mia Taylor