What does it mean to deduct business expenses

Deducting a business expense is a phrase used all the time among entrepreneurs and business people. It’s framed like this magical thing that is always “good” and is going to “save you money” at tax time. I’ve seen many business owners make irresponsible purchases or outright waste money, based on the justification that it’s a “business expense so i’ll get it back at tax time.” I’ve even had clients who were given “advice” from other business owners to “maximize expenses so that you can save on business taxes.

As a practicing accountant, it’s become clear to me that there are misconceptions about what it means to deduct a business expense. In this article, we’re going to explain what it means to deduct business expenses by looking at three key themes:

 

  1. Profit is more important than tax deductions
  2. Deducting a business expense does not mean it is free
  3. Including all deductible expenses is a good thing

Profit is more important than tax deductions

 

A business pays income taxes on the profit it generates. Putting it simply, profit is sales minus your deductible business expenses. This is shown as net income on financial statements. So, logically speaking, deducting business expenses means that you reduce your profit and pay less taxes.

If you earn a profit, you pay income taxes.

If you break even or lose money, you pay no income taxes.

 

So, would you rather earn a profit and pay income tax, or lose money and pay no tax? Most people start a business with the objective of turning a profit, so I would wager that you’d rather make a profit and pay your fair share in taxes.

The key point here is that profit comes first – in nearly all cases, you would rather pay tax on profit as opposed to paying no tax but losing money. So don’t go spending all of your money on unnecessary expenses just so you can “save on taxes” – profit comes first. Until your business is generating a profit or on track to being profitable, there is no value in creating tax losses through business deductions.

 

Deducting a business expense does not mean it is free

 

Another misconception that I’ve come across is the belief that when you are deducting a business expense, you’re getting whatever you are buying for free. This is false and is a pretty weak tax plan. I’m not sure where this idea comes from. We can show this with some math. We’re going to use made up numbers to make it as simple as possible.

Let’s assume you run a business that has a tax rate on profits of 10%. In other words, for every $1 of profit you make, you pay $0.10 in taxes.

Let’s pretend your business makes $1,000 in profit. At tax time, you will have to pay 10% (tax rate) of $1,000 (profit) in taxes, which is $100 (taxes).

 

Now, imagine you have a friend that is confused about how deducting business expenses works. They tell you to spend $500 to go to a conference so you can deduct the cost and bring your profit down to $500 which makes the conference “practically free.”

So, there are two scenarios here to look at.

In scenario 1, you have $1,000 in profit. You pay $100 in taxes. You are left with $900 after taxes.

In scenario 2, you go to the conference. You have $500 in profit. You pay $50 in taxes. You are left with $450 after taxes.

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Scenario 1 Scenario 2
Profit $1,000 $500
Tax Rate 10% 10%
Tax Paid $100 $50
After-tax Profit $900 $450

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You’re a smart person – I’m sure you can see the point here already. But, i’ll lay it out for you anyway. By spending $500 to go to the conference, you only saved $50 in taxes. You end up walking away with half of the after-tax profit you would have walked away with in scenario 1. By our definition and likely by yours as well, this does not qualify as free.

 

Including all deductible business expenses is a good thing

 

Spending money on unnecessary things based on the idea that deductible businesses expenses are always a good thing is incorrect. However, including all deductible business expenses that are necessary to run your business is a good thing.

When you don’t deduct something that you could have deducted, it does increase your taxes at the end of the year. Those receipts that your accountant hassles you to hold on to have cash value. When you lose receipts or don’t track your expenses, you are burning money by losing out on deductible business expenses.

 

Let’s do some more math to illustrate this (yay!). Again, we’ll make some assumptions to make it easier because really we are just trying to illustrate the concept.

Pretend that you run a business that is taxed on profits at a rate of 10%. Let’s say that you bought some materials to do some work for a customer that cost you $1,000. This was a necessary expense to do business. In other words, you bought something that was truly valuable to your business.

What is the value of that $1,000 receipt from a deductible business expenses perspective? Well, at a tax rate of 10%, assuming you are profitable, it would reduce your taxes by $100. So, if you lose the receipt and can’t deduct it, you’ll end up paying $100 more in taxes than you would have paid if you could deduct it.

 

Tying it all together

 

So, what did we learn? To put it simply, you should focus on profit before you start worrying too much about tax deductions. That means you shouldn’t go spending money on things for your business that you don’t really need.

However, when you do buy something, make sure you keep a receipt and track it. That receipt is worth money in the form of a reduction in taxes.

 

If you need help understanding how to handle corporate tax or sales tax, let us help you with that. We can help you keep all of your records straight, too. All you have to do is get in touch with us – we’re here to provide you with the insight and information you need for success.

 

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