People are paying WAY too much in taxes because they are missing out on tax deductions.
More than 2 million people overpay on their income taxes every year because they are missing out on tax deductions that can LEGALLY lower their tax liability.
We even recently had a client who made over $500,000 in revenue and paid taxes on the FULL amount of revenue he received.
Later, we learned that he had missed over $250,000 in eligible tax deductions that would have cut his tax liability in HALF.
What we’ve learned over the years is that many business owners do not know what tax deductions are.
And we get it – unless you got a CPA license and Master’s degree in accounting as we do, you’ll likely never learn this stuff.
That’s why in this post, our goal is to give you the BEST explanation of tax deductions so you DON’T miss out on another deduction again.
In this post, we’re going to fully explain tax deductions and tax write-offs.
With that said, let’s get started.
How Do Taxes Work?
In order to fully understand what tax deductions are, you need to understand how taxes work.
So here’s a quick guide on how the tax system works.
Now obviously, taxes are something EVERYONE pays.
Without taxes, we’d have no government.
We’d have no military, no social security, no Medicare, Medicaid, and other programs.
But fortunately, you pay taxes. And collectively, we’ve all paid over 3 trillion dollars in taxes to the government in recent years to fund these programs.
But not equally of course.
Everyone pays taxes based on their income.
The more money you earn, the more taxes you pay. There are tax brackets based on each tier of income that you’re in.
This brings us to our first deduction – the standard deduction.
How the Standard Deduction Works
The standard deduction is a deduction that EVERYONE gets when filing their taxes.
So if you’re a single individual that earned $50,000.00 a year, then you’d automatically get a tax deduction of $12,000, lowering your income that is subject to taxes to $38,000.00
This means you’d only be in the 12% tax bracket instead of the 22% tax bracket that starts at $40,000 in income.
This single deduction could cut your tax liability by thousands of dollars.
And the best part is, there are several different types of tax deductions. There are:
- standard deductions
- itemized deductions, and
- business tax deductions
Because standard deductions and itemized deductions are very straightforward, the remainder of today’s post will be spent on business tax deductions.
What are Business Tax Deductions?
Tax deductions are ELIGIBLE expenses that you can deduct from your income for tax purposes.
For businesses, these would be business expenses that you incur.
But wait, does this mean you can deduct all business expenses?
No. The IRS only allows you to deduct business expenses that are ordinary and necessary to run your business.
Ordinary means that it is common and accepted in your industry.
Necessary means that it is helpful and appropriate to run your business.
For example, an ordinary and necessary expense for a car dealership might be buying car parts.
While for our accounting firm, it might be technology and software. Surely, we couldn’t deduct car tools for our accounting business.
Anyway, the biggest thing you need to know about is that it LOWERS your tax liability.
So let us explain how it works so you can fully understand how it can lower your tax liability.
How Tax Deductions Work
Here’s how they work from A-Z.
First, you need to understand 5 things – taxable income, tax deductions, tax write-offs, tax liability, and tax credits.
This is the amount of business income you have received that is subject to taxes.
Technically, all money received is considered taxable. Therefore, all business revenue would be considered taxable income.
Tax Deductions and Tax Write-offs
Tax deductions and tax write-offs mean the EXACT same thing and are often interchangeable.
So when you hear tax write-offs, just know they are really talking about tax deductions.
And we’ve already defined tax deductions as ordinary and necessary expenses that you incur to run your business.
So, in short, taxable income MINUS tax deductions EQUAL Adjusted Gross Income, also known as AGI.
AGI is basically the income that you will report to the IRS. In other words, the income you are reporting AFTER taking advantage of tax deductions.
It is derived by applying the applicable tax rate to your AGI. Then, you’ll know the exact amount of taxes you owe.
Misconceptions About Tax Deductions
Now, let’s discuss a very common misconception about tax deductions.
Many people think that these deductions are applied directly against your tax liability.
So basically they think that if you owe $15,000 to the IRS and have $15,000 in tax deductions, then you would owe $0.
That is NOT how tax deductions work. That is how tax credits work.
These are applied against your taxable income.
On the other hand, tax credits are applied directly to your tax liability or the amount you owe.
Here’s a simple example.
If you had $10 in taxable income, and you could deduct $2 as a tax deduction, then your remaining income would be $8.
If we assume your tax rate is 25%, then you would owe $2 in taxes.
On the other hand, if you had $10 in income, and your tax rate is 25%, you would owe $2.50 in taxes.
BUT WAIT, if you had a $2 tax credit, then you would only owe $0.50 in taxes.
So again, remember that tax deductions reduce your taxable income that is SUBJECT to taxes. While tax credits are only concerned with reducing your actual tax liability.
Tax credits are dollar-for-dollar reductions in what you owe in taxes. They only come into play AFTER your tax liability has been determined.
To learn more about how to get tax credits, then check out this post on “Small Business Tax Credits”.
How to Take Business Tax Deductions
So now you understand what tax deductions are and how they work, let’s discuss how you can take advantage of them.
Here are the three steps to writing off your business expenses as tax deductions.
1. Make sure you have a business bank account
Be sure to separate your personal expenses from your business expenses by utilizing business bank accounts for your business.
By having this in place, if you are ever audited by the IRS, you can pull your business deposit statements that clearly show all of your business income and expenses.
You don’t want to have a bunch of personal expenses mixed in, making it more difficult to audit and more importantly, harder to trust.
2. Make sure your business bookkeeping is done
Writing off your business expenses should be a very simple process during tax time.
You should already have your business expenses organized in financial statements and categorized by eligible expenses.
For example, ideally, your income statement would list all of your advertising expenses, overhead expenses, and so on by line item.
That way, your accountant can quickly and easily prepare your tax return to ensure you take advantage of all these deductions you’re eligible for.
If you need some help with getting started with your business bookkeeping, then be sure to check out this post on bookkeeping 101 for business.
3. Retain Proper Documentation of Expenses
You’ll need to maintain proper documentation of expenses that you are writing off. That way, in the event of an IRS audit, you can show them proof of the expenses you have written off.
Now, an IRS audit shouldn’t scare you from writing off VALID expenses that you incurred to run your business.
Their job is to make sure you are complying with the rules and regulations that exist.
So instead of missing out on these deductions, just make sure you keep your ducks in a row.
- Have your vendors submit W-9 forms.
- Keep up with your employees’ W-4 forms.
- And also keep up with the receipts and invoices of things you buy so you can also display this whenever needed as well.
If you do these three things, you should be able to take full advantage of these deductions and SAVE BIG on taxes.
There’s SO MUCH you can write-off, like your expenses for your home office, technology, cell phone, business mileage, interest expense, and so much more.
If you want to know the BIGGEST tax write-offs for small businesses, then read this post on the 14 Biggest Tax Write-Offs for Small Businesses next.
With that said, let’s go ahead and recap this post.
Today’s post was about one thing and one thing only – tax deductions. What are they?
As discussed, these are ELIGIBLE expenses that you can deduct from your income for tax purposes.
These are the standard, itemized, and business tax deductions.
It’s important to remember that these are applied to your taxable income, not your tax liability.
Tax deductions can lower your income that is subject to taxes. While tax credits, on the other hand, are dollar-for-dollar reductions in the taxes you owe.
And if you need more help with your business taxes, our team of reliable tax professionals is just a call away. Contact us here.