That one word that makes adults jump under their bed and new college graduates run crying to their mommies. However, if you maintain proper records, taxes don’t have to be as scary as they could be this tax season. I’m going to cover why it’s important to keep track of all your business expenses, with receipts, and how you can make sure you’re utilizing an important tax deduction properly.
What is a business expense?
The IRS defines a business expense as a cost of carrying on a trade or business. If you’re looking to save on income tax, one of the most important things you can do is to make sure you’re capitalizing on all your business expenses. The IRS has set specific rules for small businesses and farmers, so what applies to one group may not necessarily be the same for the next. Deductible expenses cover costs such as fuel, repairs, vet costs, interest, electricity, and many other costs. The importance of utilizing these costs is to reduce the amount of taxable income at the end of the year.
What is the value of a business expense?
Here’s where things get tricky. We’ve already identified certain costs farmers and other business owners can use to reduce their taxable income. The U.S. has a marginal tax bracket, which means that as your income increases through the tax brackets, you will be paying more on your last dollars earned than your first dollars earned in the year. Let’s say you’ve subtracted your costs and all other deductions the IRS will allow. Now let’s assume that your taxable income falls somewhere around $50,000 and you’re single. State and FICA taxes aside, this would mean you’re left to pay $12,500 in federal income tax.
If you forgot to deduct a repair expense that costed $10,000, you could be paying $2,500 more than you should in taxes. Therefore, it’s important to comb over every expense to make sure you can’t use it as a business deduction. If you can keep your living expenses at $50,000 and have the option to either walk home with $150,000 or to spend $100,000 on tax deductible expenses or other investments that would contribute to the growth of your business, you would save around $25,000 just in federal income tax. For many business owners, advertising costs are one way to increase their tax deduction while promoting the growth of their business.
Depreciation as a tax deduction
Assets that have a useful life longer than one year are subject to depreciation, a method of estimating the reduced value of that asset over time. Now let’s say you’re interested in a new, larger tractor valued at $100,000. If you purchase this tractor, you’re increasing your efficiency and decreasing your personal workload, allowing you to get out of the field faster or possibly expand your operation. You could assume that in 10 years, you’ll be trading up to another tractor and the estimated value of your current tractor will be around $40,000. The IRS would allow you to deduct that $60,000 of reduced value of the tractor from your taxable income over 10 years, or roughly $6,000 per year.
Now remember above we made $50,000? We can now subtract $6,000 for this year, meaning our new taxable income would be around $44,000. At a 25 percent tax rate, we would now be paying $11,000 in federal tax. This means we would be saving roughly $1,500 a year from a tractor purchase.
New farmers and other business owners would be wise to use as much of their revenue as they can to put towards growing their operation. Typically living expenses increase as time goes on, so devoting as much to business expenses as possible should contribute to the growth of your operation early on, which should lead to increased revenue in the long run.
Business expenses are an important factor in the economy. If farmers paid income tax without business deductions, a farmer could possibly end up paying more in taxes than they had in income. This is due to the nature of farming where a large amount of money is spent to produce a marginally larger revenue.
During this tax season and for this fiscal year, keep in mind any expense you could use to reduce your taxable income. It makes a difference!
Ryan Kuster, the force behind the informational and insightful YouTube channel How Farms Work, is a beef and crop farmer based in Wisconsin. He created his channel in 2012 to help show non-rural people how farming is done in the Midwest. Ryan’s website can be found here, and he’s on Facebook, and Twitter.