Business deductions are just that. They are expenses incurred in the operation of your business. The IRS says they have to be ‘ordinary and necessary’ for your business.
The IRS doesn’t define ‘ordinary and necessary’ well but common sense is a good guide. Think of it as, ‘If I had to incur this expense for my business and it was an ordinary expense for my type of business, it’s probably deductible.’ Here’s an example. n my business, i sign up for a lot of webinars for training purposes. If it’s tax-related, it’s definitely deductible. If I sign up for a cruise so that I’m not disturbed while training, I wouldn’t call that an ordinary expense. The training would still be deductible, while the cruise expenses would not. A lot of what is ordinary and necessary is defined by court cases.
But what if you’re not in business yet? You’ve decided to start a business, you’re incurring expenses but you’re still in the building stage. There is no business activity yet. You’ve not had any business or maybe haven’t even tried to get business yet. You may have incurred some or all of the following: qualification expenses, start-up expenses and organizational expenses. Here is a very short summary of a fairly complicated topic.
First you need to understand that qualification expenses are not deductible business expenses. You spent $20,000 on an auto mechanic certificate and now want to start your own business. That is a qualification expense and is not deductible as a business expense.. You went to school to become a CPA and now want to open an accounting firm. The school expenses are qualification expenses and are not deductible as business expenses. (Note that some education expenses may be deductible after your business starts if they ‘maintain or improve skills needed in your business).
But now you’e thinking about opening a business. Maybe you’re investigating the market, conducting surveys, hiring a lawyer to discuss liability or business structure, etc. These are examples of startup and organizational expenses. You’re not in business yet but your business to be is starting to cost you money.
That’s a good thing but you need to recognize that there are strict rules on how and when and how much of these expenses are deductible.
First, they are not deductible until the year you actually are in business.
Second, startup and organizational expenses are limited to $5000 for each category taken in the year you first open your business.
Lastly, if your expenses exceed $5000 in each category, then the amounts over $5000 need to be amortized over 15 years beginning in the year you started your business.
If you have depreciable items, those purchases that you expect to use for more than one year, they would typically be expensed starting in the year your business opens using normal depreciation rules.
So timing is important.
Startup and organizational expenses are claimed on the tax return filed in the year the business starts. You want to try and limit these by timing as many of your necessary purchases as possible to the period after you are actually in business. Most small businesses will have no problem planning and starting their business within a one or two year period so that startup expenses are only deferred one year.
Note that these rules also apply to rental properties. Generally, your residential rental doesn’t rise to the level of an active business until the property is rented or actively seeking renters.
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