Small Business Taxes FAQ

Answers to common tax questions on tax deductions for small businesses.

1. What is—and isn't—a tax-deductible business expense?
Just about any "ordinary, necessary, and reasonable" expense that helps you earn business income is deductible. What's ordinary and necessary? The IRS has defined this as anything that's "helpful and appropriate" for your business. For example, buying a computer, or even a sound system, for your office or store can be an "ordinary and necessary" business expense. Buying the same items for your family room cannot be a business expense, however.

A few things are specifically prohibited by law from being deducted even if the expenses are for the purpose of conducting business—for instance, a bribe paid to a public official. Other deduction no-nos are traffic tickets, your home telephone line, and clothing you wear on the job, unless it is a required uniform.

2. If I use my car for business, how much of that expense can I write off?
You can calculate your vehicle deduction using the standard mileage method or the actual expense method. The standard mileage method is more commonly used because the record-keeping requirements are much simpler. Under this method, the IRS determines the amount you can deduct per mile. (For the tax year 2005, the rate is 40.5 cents per mile. In 2004, the rate was 37.5 cents per mile).

Under the actual expense method, you deduct the actual costs you incur each year to operate your car, plus depreciation you pay for gas and repairs (according to a tax code schedule). Your deductible costs include gas and oil, repairs and maintenance, license fees, insurance, tolls, and even car washing. If you use the car partly for personal use, you must multiply your actual expenses by your percentage of business use.

Most people use the standard mileage rate because they don't want to bother with a lot of record keeping. But this ease comes at a price—you usually get a lower deduction using the standard mileage rate than you would with the actual expense method. You must use the standard mileage rate, however, if you claimed certain related deductions (such as under Section 179 of the IRC) in previous years. (For more information on Section 179 depreciation, see Understanding Small Business Tax Deductions.)

To use either of these methods, you must keep track of how much you use your car for business. (And you'll need to produce your records if you are audited.) Keep a log showing the miles for each business use, always noting the purpose of trip.

You can also depreciate (write off) the cost of the vehicle over a number of years.

3. Can I claim a deduction for business-related entertainment?
You may deduct only 50% of expenses for entertaining clients or customers for business purposes, no matter how many martinis or Perriers you swigged. (Yes, this is a change. In the old days you could write off 100% of every entertainment expense, and, until a few years ago, 80%.)

Qualified business entertainment includes taking a client to a ball game, a concert, or dinner at a fancy restaurant, or just inviting a few of your customers over for a Sunday barbecue at your home.

Keep in mind that if you are audited, you must be able to show some proof that the entertainment expense was either directly related to, or associated with, business. So, keep a guest list and note the business (or potential) relationship of each person entertained.

Parties, picnics, and other social events that you put on for your employees and their families are an exception to the 50% rule—such events are 100% deductible, and you need not prove it was directly related to a business goal.

4. What is the difference between current and capital expenses?
Current expenses can be deducted from your business's total income in the year you incur them. They include the everyday costs of keeping your business going, such as office supplies, rent, and electricity.

Expenditures for things that will help generate revenue in future years—a desk, a copier, or a car, for example—are called capital expenses and must be written off over their useful life. Usually that period is three, five or seven years, according to IRS rules.

There is one important exception to this rule, called the Section 179 deduction, which may let you fully deduct capital expenses in the year you incur them.

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