What does "deductibility" even mean?
Business owners often ask us which expenses are tax-deductible, or what they can “write-off.”
The good news is that for most startups and small businesses, excessive planning and anxiety over what is or is not tax-deductible is unnecessary and should not take a significant amount of time for either leadership or the accounting/ finance function. This may seem to contradict what most owners hear from CPAs and tax advisors, but as an owner, if you're framing decisions in the lens of the tax code, you're probably focusing on potential savings that will amount to pennies on the dollar versus prioritizing the highest-level strategic investments that will lead to exponential growth.
Let’s start with terminology. When accountants say “deductible,” we mean that it can be counted as a valid business expense according to the Internal Revenue Service (IRS). This means the expense can be deducted from your profit and thus reduce your overall tax liability.
For companies that sell products, one of their largest expense items and corresponding tax deduction is for their Cost of Goods Sold (“COGS”). When a product is sold, the associated inventory is taken off the balance sheet and the cost is run through the income statement as COGS.
These costs are fully deductible. In fact, this deduction is so "sacred" that the IRS even allows companies that are involved in the sale of scheduled substances to deduct it while barring them from other deductions (if you are involved in the cannabis industry, you likely know about this and have heard of the related 280E statute). For most other industries outside those that deal with federally banned substances, many, if not all, of your selling, general and administrative (SG&A) or “overhead” expenditures are also deductible.
For many SaaS companies, labor costs are likely your greatest expense and your COGS — and thus, your largest deductible expense. This applies to the wages, salaries, bonuses, commissions, employer payroll taxes and most related employee benefits that you pay for your employees or the costs you pay to contractors. This is true for both employees that are classified as direct costs involved in generating and employees related to your selling, general and administrative (SG&A) functions.
Some of the most common expenses outside of COGS and labor that are usually fully deductible are advertising, professional service fees, software and subscription costs, lodging and other travel costs (special consideration needs to be made for meals, more on that below) and utilities.
What deductions requires some more consideration?
The above are common expenses that are often "no-brainers" for business owners — easily claimed and easily verified in the event of an audit.
Then there are deductions that are sometimes referred to as context-specific deductions. The below isn't an exhaustive list but touches on those of most interest to startups, starting with the most common and everyone’s favorite:
Business meals are generally only 50% deductible, and this includes meals with clients. However, if the meal is included in employee wages or the meal is provided during a social activity, like a company-wide retreat or party, then it is 100% deductible. If you are involved in the restaurant or catering industry, meals provided to employees on site are 100% deductible.
The Tax Cuts and Jobs Act of 2017 (TCJA) disallowed deductions for expenses that are usually considered recreation or entertainment. Accordingly, when you have entertainment costs that have a meal component you need to keep good documentation showing the portion of the cost that is related to the business meal, so you can at least benefit from the 50% deduction on that portion.
While federal income taxes are not deductible, you can deduct state and local income taxes, business, property and sales taxes. Foreign income taxes and the employer portion of FICA taxes and unemployment taxes are fully deductible, too. Finally, franchise taxes, excise taxes, and occupational taxes are also fully deductible.
Most premiums paid for insurance that is a necessary business expense are fully deductible. This includes liability insurance, vehicle coverage, coverages for fire, storm and theft, group hospitalization and medical insurance for employees, malpractice insurance and workers’ compensation insurance.
But if you're an S-corporation, deductibility becomes a little more complicated. Let's say you're an owner of an S-corporation: you are not able to receive the tax-free benefit applied to health insurance premiums that employees at most companies enjoy. Per the IRS, “Health and accident insurance premiums paid on behalf of a greater than 2-percent S corporation shareholder-employee are deductible by the S corporation and reportable as wages on the shareholder-employee's Form W-2, subject to income tax withholding.” Due to the unique nature of S-Corps, there are many tax implications unique to them that we'll cover in a future post.
Life insurance is deductible unless the business is a direct or indirect beneficiary, in which case it is nondeductible. Some other nondeductible premiums are those paid for loss of earnings, self-insurance reserves or insurance obtained to secure a loan.
Start up Costs
Some business startup and organization costs are subject to limitation. Per IRS Publication 535,
“Business start-up and organizational costs are generally capital expenditures. However, you can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs paid or incurred after October 22, 2004. The $5,000 deduction is reduced by the amount your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized.”
The most common expenses that fall under this category are the legal, consulting and accounting fees incurred for research into market opportunities, acquiring a business and related diligence, and developing corporate bylaws or partnership agreements. Salaries paid for training employees and their instructors as well as marketing of the opening of the business can also be deducted. Costs related to regulatory filing and corporate formation costs also count.
The amortization period for startup capital expenditures is fifteen years and costs should be spread evenly over this period. If your business is disposed before the end of the 15 years then the remaining costs can be deducted to the extent that they qualify for loss from a business.
Gifts that are made to clients, employees or business partners are subject to a $25 limit per person.
Capitalized Equipment and Fixed or Intangible Assets
Businesses will capitalize and depreciate property it owns that is used in its business and it determines will be used for more than one year. Common examples include:
- Equipment and Buildings (you cannot depreciate land)
- Intangibles such as patents, trademarks, or copyrights
- Internally developed computer software
The depreciation treatment for most capitalized assets is governed by the Modified Accelerated Cost Recovery System (MACRS) which specifies the useful life for assets under different property classifications.
What is non-deductible?
As we have seen, most expenses that are made for a valid business purpose are deductible, at least, in some form. However, there are a few things that are never deductible.
- Political contributions and lobbying expenses
- Costs related to illegal activities (as mentioned before, there is a 280E exemption that relates to COGS. Traditionally it is only those in the cannabis industry finding themselves in a situation where they can legally operate within a state but be consider illicit by the federal government)
- Fines and penalties (tax penalties, local code violations, et cetera)
While these costs are non-deductible that certainly does not preclude your business from making these expenditures as are needed. Obviously anything that could be an illegal payment would require a much deeper level of investigation of the legal considerations involved and the expert opinion of an attorney.
The bottom line
Business owners should generally assume that if they are making valid expenses that they will be tax deductible, even if not fully or right away. Good record-keeping will always help you here.
We’ve outlined a few of the high-level rules here to keep at the back of your mind. If you are considering significant expenses that might have questionable tax treatment then by all means seek the advice of a CPA or tax professional for planning purposes.
We also recommend always having a CPA or qualified tax professional prepare your tax returns to cover these issues. Certain industries, such as those that are asset or property-heavy such as manufacturing or real estate, will have more complicated tax treatment (capitalized interest, etc.) and should expect to involve tax attorneys or CPA’s more frequently in order to maximize savings and ensure full compliance.
While taxes can feel like one of the most unfamiliar and daunting issues facing new entrepreneurs, you can feel comfortable knowing that you don’t need to be an expert. Focus on growing your business, have sound company policies to document financial transactions, know the basics of the tax law, and you can be assured that you'll maximize your savings when working with a tax expert.
Phil is the founder of Tesseract Advisory Group, a firm that specializes in outsourced finance and accounting services for startups and small businesses. As a CPA with over 12 years of experience, including Big4 audit, e-commerce, financial services, SaaS, construction, retail and professional services industries, Phil focuses on bringing strategic value to his clients rather than just crunching numbers and filling out tax forms. He has deep expertise with Quickbooks, ERP implementation and maintenance, full-service outsourced operations management and controller services, and treasury/ cash flow management. Phil has served as a fractional CFO for companies up to $25M in revenue and works with early-stage entities to help them develop financial models and valuations and identify the best mechanisms for raising capital.
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