Top Ten Missed Small Business Tax Deductions

The Major Tax Deductions Missed

• Home Office Deduction

  Of the 23.4 million returns filed by sole proprietors for tax year 2011 (the latest year for which statistics are available), only 7.6 million filers claimed a home office deduction. This is about 32 percent of eligible filers, a figure well below the 52 percent of all small businesses that operate from home. Why the discrepancy? Many believe that claiming a home office deduction is an audit red flag, so they forego a deduction they’re legally entitled to.

  While the IRS hasn’t reported audit statistics regarding the home office deduction, it’s likely this write-off isn’t the red flag some believe it to be, at least not anymore. After all, the majority of businesses today are home-based and the IRS has created a simplified home office deduction method.

  The only caution: If you take a home office deduction, make sure you’re truly entitled to it. This means satisfying two conditions: using the space as your principal place of business or for some other acceptable purpose and using the space regularly and exclusively for business. Find more details about this deduction in IRS Publication 587.

• Startup Costs

  Costs you incurred before you opened your doors for business, such as expenses to explore business opportunities, may entitle you to a deduction in your first year of business. Although you have to be operating a business in order to deduct business expenses, you’d think that costs you had before you actually began wouldn’t be deductible, but you’d be wrong. You can deduct up to $5,000 of the startup costs you incurred before you began operations in your first year of business. If the costs exceed $5,000, they can be amortized as a proportion over a period of 15 years. However, if these costs exceed $50,000, there are certain limitations that apply. Get more information about this deduction in IRS Publication 535.

• Depreciation

  Depreciation is a method used to allocate a portion of an asset’s cost to periods in which the tangible assets helped generate revenue. A company’s depreciation expense reduces the amount of taxable earnings, thus reducing the taxes owed.

• Inventory

  Normally, inventory items aren’t immediately deductible. Instead, a business with inventory uses the accrual method of accounting and includes inventory items in the cost of goods sold, which reduces the amount of income recognized on the sales. Under a special rule, however, certain small businesses can use the cash method of accounting and opt to treat inventory items as materials and supplies, which are currently deductible.

  The IRS defines small businesses in this instance as those with annual average gross receipts not exceeding $10 million for the three prior years (or the years in business if less than three years). These businesses also can’t be in certain industries. Eligible small businesses are essentially service-based but keep inventory, such as a beauty salon that provides hair-cutting services but also sells shampoos and conditioners.

  If you’ve been treating inventory as part of your cost of goods sold and now want to treat it as materials and supplies, you must file for a change in accounting method on IRS Form 3115. However, there’s an automatic IRS consent procedure to simplify this process. Learn more about this deduction in Rev. Proc. 2002-28.