Tax Deductions for Small Businesses

Why This Matters

Tax deductions are the foundation of strategic tax planning—they directly reduce taxable income and, consequently, the amount of tax a business owes. You're being tested not just on what qualifies as a deduction, but on how deductions interact with business decisions: timing strategies, entity choice implications, and the trade-offs between immediate expensing and capitalization. Understanding deductions means understanding how the tax code shapes business behavior.

The concepts here connect to broader themes you'll encounter throughout the course: marginal tax rates, implicit versus explicit taxes, organizational form, and the time value of money. Don't just memorize which expenses are deductible—know why the tax code allows them, when timing matters, and how different deduction methods create different incentive structures. That's what separates a surface-level answer from an exam-ready one.

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Operating Expense Deductions

These are the bread-and-butter deductions for ongoing business operations. The underlying principle is simple: ordinary and necessary expenses incurred in carrying on a trade or business are deductible under IRC §162.

Employee Wages and Benefits

• Compensation expenses are fully deductible when paid—this includes salaries, wages, bonuses, and commissions for services rendered
• Fringe benefits like health insurance, retirement contributions, and educational assistance create double tax advantages: deductible to the employer, often excludable to the employee
• Reasonable compensation is the key constraint—excessive payments to owner-employees in closely held businesses invite IRS scrutiny

Rent and Utilities

• Lease payments for business premises are fully deductible in the year paid or accrued, making leasing attractive compared to ownership in some tax situations
• Utilities (electricity, internet, water) qualify when used for business operations—mixed-use requires allocation
• Prepaid rent generally cannot be deducted until the period to which it applies, illustrating the economic performance requirement

Office Supplies and Equipment

• Supplies used and consumed during the tax year are immediately deductible as ordinary business expenses
• De minimis safe harbor allows businesses to expense items up to $2,500$ (or $5,000$ with audited financials) per invoice without capitalizing
• Section 179 expensing permits immediate deduction of qualifying equipment purchases up to annual limits, accelerating tax benefits

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Capital Cost Recovery

When businesses purchase long-lived assets, the tax code doesn't allow immediate deduction—instead, costs are recovered over time through depreciation or amortization. This creates timing differences that affect the present value of tax savings.

Depreciation of Assets

• MACRS (Modified Accelerated Cost Recovery System) is the default method, assigning assets to recovery periods (e.g., 5-year for computers, 7-year for furniture, 39-year for commercial buildings)
• Accelerated methods front-load deductions, increasing present value of tax savings compared to straight-line depreciation
• Bonus depreciation (currently 60% for 2024, phasing down) allows first-year expensing of qualified property—a powerful timing strategy

Startup Costs

• Up to $5,000$ of startup expenditures can be deducted in the first year of business operations
• Phase-out applies when total startup costs exceed $50,000$—the $5,000$ allowance reduces dollar-for-dollar
• Remaining costs must be amortized over 180 months (15 years), illustrating how the tax code distinguishes between operating and pre-operating expenses

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Financing Cost Deductions

The deductibility of interest creates a fundamental asymmetry in the tax code that influences capital structure decisions. Debt financing generates deductible interest; equity financing does not.

Interest on Business Loans

• Interest expense is deductible when paid or accrued on debt used for business purposes—this is the source of the debt tax shield
• Business interest limitation under §163(j) caps deductions at 30% of adjusted taxable income for businesses exceeding gross receipts thresholds
• Tracing rules matter—interest deductibility depends on how loan proceeds are used, not how the loan is secured

Insurance Premiums

• Business insurance premiums (liability, property, malpractice) are deductible as ordinary and necessary expenses
• Self-employed health insurance is deductible above the line, reducing AGI—a valuable benefit not available to C corporation shareholders
• Key person insurance premiums are generally not deductible when the business is the beneficiary, illustrating limits on deductibility

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Mixed-Use and Allocation Deductions

Some expenses serve both business and personal purposes, requiring allocation. The tax code imposes strict substantiation requirements to prevent abuse.

Home Office Deduction

• Exclusive and regular use test requires a dedicated space used only for business—passing through your office doesn't count
• Two calculation methods: simplified ($5$ per square foot, max 300 sq ft) or actual expenses (proportionate share of mortgage interest, utilities, depreciation)
• Principal place of business or meeting-clients test must be satisfied—employees working remotely generally cannot claim this deduction post-TCJA

Vehicle Expenses

• Standard mileage rate (67 cents/mile for 2024) offers simplicity; actual expense method may yield larger deductions for expensive vehicles
• Substantiation is critical—contemporaneous logs documenting date, destination, business purpose, and miles are required
• Luxury auto limits cap depreciation deductions on passenger vehicles, creating implicit taxes on high-end business cars

Travel Expenses

• Transportation, lodging, and 50% of meals are deductible for business travel away from the tax home
• Primary purpose test determines deductibility for mixed business-personal trips—if primarily personal, transportation is nondeductible
• Foreign travel has stricter allocation rules when trips exceed seven days or include significant personal time

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Professional and Development Expenses

Investments in expertise and external services support business operations and are generally deductible, though timing rules vary.

Professional Fees

• Legal and accounting fees for ongoing business operations are currently deductible under §162
• Fees for acquiring assets (e.g., legal costs in purchasing property) must be capitalized into the asset's basis
• Tax preparation fees for business returns are deductible; personal return preparation is no longer deductible post-TCJA

Education and Training Expenses

• Maintaining or improving skills in your current trade qualifies for deduction—the expense must relate to your existing business
• Qualifying for a new profession is not deductible—law school for a business owner isn't a business expense
• Employer-provided education up to $5,250$ annually can be excluded from employee income, creating tax-efficient compensation

Advertising and Marketing Costs

• Ordinary advertising is immediately deductible—this includes digital ads, print materials, and promotional events
• Institutional advertising that creates long-term goodwill may require capitalization under certain circumstances
• Website development costs follow software rules—some elements are immediately deductible, others capitalized and amortized

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Benefit and Contribution Deductions

Certain payments benefit third parties while generating deductions for the business—but qualification rules vary significantly.

Retirement Plan Contributions

• Employer contributions to qualified plans (401(k), SEP-IRA, defined benefit) are deductible when made, subject to annual limits
• Contribution limits vary by plan type—2024 limits include $23,000$ employee deferrals for 401(k)s, $69,000$ total additions
• Timing flexibility exists for some plans—SEP contributions can be made until the extended filing deadline

Charitable Contributions

• C corporations can deduct charitable contributions up to 10% of taxable income (computed before the deduction)
• Pass-through entities don't deduct at the entity level—contributions pass through to owners' individual returns
• Qualified organizations only—donations to individuals or political organizations are never deductible

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Quick Reference Table

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Self-Check Questions

1. Which two deductions require strict allocation between business and personal use, and what substantiation does each require?

2. A business owner is deciding between leasing equipment and purchasing it with Section 179 expensing. What tax factors should influence this decision, and how does the time value of money affect the analysis?

3. Compare and contrast the deductibility of interest expense versus dividend payments. How does this asymmetry influence capital structure decisions?

4. An entrepreneur incurs $60,000$ in startup costs before opening her business. How much can she deduct in Year 1, and how is the remainder treated? What if costs were only $45,000$?

5. A manager wants to attend law school while continuing to run her consulting business. Is tuition deductible? What if she instead attended an executive education program to improve her management skills? Explain the principle that distinguishes these scenarios.