Welcome back to the Hedgi AI blog! Today, we’re going to talk about something every small business owner needs to know: how much can you deduct on your business expenses?
What is a Business Expense?
Business expenses are the costs you incur while operating your business. These can significantly reduce your taxable income, saving you money when tax season comes around.
Criteria for Deductible Business Expenses
To be deductible, a business expense must be both ordinary and necessary:
Ordinary Expense: Common and accepted in your field. For example, office supplies for a marketing agency.
Necessary Expense: Helpful and appropriate for your business. For instance, a subscription to design software for a graphic designer. It doesn’t have to be absolutely essential, just useful.
How Much Can You Deduct?
Generally, you can deduct the full amount of a business expense if it meets the criteria above and is not a capital expense. However, here are some important details to consider:
Recoveries and Tax Benefit Rule
If you recover part of an expense in the same tax year it was deducted, reduce your current year expense by the recovery amount. If the recovery happens in a later year, you must include the recovered amount in your income for that year.
Payments in Kind
If you provide services or goods to pay a business expense, you can only deduct your out-of-pocket costs, not the value of your own labor or the goods you provide.
Limits on Losses
If your business expenses exceed your income, you have a loss. Some limits include:
Not-for-Profit Limits: If your business isn’t intended to make a profit, you can’t use the loss to offset other income.
At-Risk Limits: Deductible losses are limited to your investment at risk in the activity.
Passive Activities: Losses from passive activities can only offset income from passive activities.
When Can You Deduct an Expense?
This depends on your accounting method:
Cash Method
Under the cash method, you deduct expenses in the tax year you pay them.
Accrual Method
Under the accrual method, you generally deduct expenses when they are incurred, meaning when all the events have occurred to fix the liability and the amount can be determined with reasonable accuracy, and economic performance has occurred.
Example Scenarios
Example 1: Cash Method You pay for office rent in January 2023. You deduct it on your 2023 tax return.
Example 2: Accrual Method A plumber completes repair work in December 2022, but you receive and pay the bill in January 2023. You deduct the expense in 2022 when the work was completed.
Capital vs. Business Expenses
Capital Expenses: Investments in your business, like buying equipment, must be capitalized and depreciated over time, rather than deducted all at once.
Business Expenses: Every day running costs, like utilities or office supplies, are fully deductible in the year they are incurred.
How Hedgi AI Can Help
Hedgi AI simplifies identifying and categorizing business expenses, ensuring you don’t miss out on any potential deductions. Our AI-driven platform automates bookkeeping, provides monthly audits, and helps with easy tax filing.
Sign up for Hedgi AI today and start simplifying your business finances!