Can I expense that, and should I?
This blog was written from episode 62 of Business by the Numbers. Click here if you prefer to listen to the episode.
Grey area expenses, what can you write off? What should you? We’ll also explore the general idea around expenses, and what threshold you should not surpass. This is not to advocate writing off expenses that aren’t legitimate or dodge paying your taxes, but to help you have a better understanding of what expenses are for and how they can affect your business and taxes.
Are the expenses ordinary and necessary? What will get me audited?
Audit risks for small businesses are very low. The reason the IRS would look at your business is for large expenses that aren’t typical. The IRS can be tricky about telling you why they are auditing you. The biggest thing that causes this is an unusually large expense. Some categories of expenses are scrutinized more than others, but they’re looking for an expense outside the normal range. This would trigger a message where they would ask you about it. These mail audits are usually just requests for more information (often called a bench or desk audit). The IRS is trying to figure out if they need to pay you a visit.
The thing to keep in mind is that the IRS is a business. They are trying to make money, if you look at it from their perspective, think about what they stand to gain. If your business has $10,000 in sales and maybe $10,000 in expenses, the IRS will likely never to come to your door because even if they throw all your expenses out, they might make $2000 max. If they’re sending people out, they need to recover the cost of performing the audit in the first place! In the future, there’s a good chance there will be even lower percentages of income audits. Likely, we will see scrutiny in other areas of the tax code. Employee Retention Tax Credits, for example. There are people who have gotten thousands of dollars in these tax credits, and it will likely be useful for the IRS to focus on this.
“Ordinary and necessary” just means these are typical for your shop, and other businesses similar to yours also buy and use these same things (such as scan tools). For example, if you go to your accountant and ask if you can write off a four-wheeler or a flat screen TV for your business, you will likely receive no for an answer. The only way to truly answer the question is with another question: “What are you using this for?” If your four-wheeler is being used at the shop (such as to push or pull dead vehicles or to plow a parking lot of snow for example) then if the IRS audits you, the four-wheeler needs to be at the shop with the snowplow attached. If your flat screen TV is being used for training and workflow, then it’s probably able to be written off as an expense. What you truly want is to have a defensible position if the IRS asks. At worst, the IRS doesn’t agree with you, and you’ll pay taxes and interest on that item.
Grey area expenses
The biggest reason to write things off is the tax benefit. Rule of thumb is 25% of whatever you spent on the item. As an example, let’s say you buy an item (such as a TV for $1,000). If you buy it for your house, you’ll pay $1,000 + $200 or $300 as tax. If you buy it through your business, you’ll not only pay $1,000 (gross price), but you’ll get back $250 potentially (so you’re truly only paying $750).
Loaner cars are used exclusively by customers when their cars are being serviced. This would be a black and white expense. It’s obvious that you can write it off. It’s 100% used in business and for nothing else and won’t usually be questioned by the IRS.
Let’s talk shop vehicles, shop trucks, loaner cars, etc…
One grey area expense would be the owner’s truck. Let’s say you’re using this to shuttle customers, but it’s also your personal truck that you use on the weekends for your family. You might be able to allocate some percentage of it as a tax write off, but you’d still have to allocate the rest of it for personal use. If you have 3 vehicles for your family all owned by the company and you use all 3 for everything, how will you argue a 100% write off for all 3 cars? You can’t. If you park the truck for the weekend and only personally use the other cars, then you can make the argument to only write off the truck, but not the other 2 cars your family owns.
One thing the IRS doesn’t like to see is writing off a truck that is registered to your personal name. So, if you try to purchase a truck or a car and the car salesman wants to register it to you, do not listen to them if you are planning on writing this off as an expense. The other thing to consider is the type of car you are buying. It is FAR easier to convince the IRS to let you write off a truck (that clearly tows, holds tools, and can handle the demands that a shop requires of a vehicle) than a Corvette Z06.
What if you have a vehicle in your personal name and you’re using it for business? There is a cost associated with transferring your vehicle to your business name. If you’re planning on keeping this vehicle for a long time, it may be worth it, but if you aren’t, it might not be worth the cost of transferring it. Some states will have you pay registration, tags and taxes on this vehicle and some states make you pay a hefty sum.
Now, if you want to buy a vehicle from yourself to have in your business, that can be very beneficial from a tax standpoint. Let’s say you start a business, and you happen to have a Corolla that you think would be a great loaner car. If it stays in your personal name, you carry the liability personally AND you likely can’t write it off. How do you go about buying it from yourself? You write a check from your business to you personally, for the fair market value of the car. Check the condition, comparable sales, Kelly Blue Book, etc… to make sure you’re paying a fair market value. Pretend you’re buying it from a stranger. Write the check and code it into QuickBooks as a fixed asset exactly like you would if you bought the car from a stranger. Now you have a $10,000 deduction for your vehicle and all the registration is deductible as well. Personally, you don’t have to report it or pay tax on it, because you’re selling it for less than you bought it for. If you bought it for $20,000 and sold it for $10,000, it’s a loss that you don’t have to recognize. So, it’s a deduction that personally you don’t have to recognize. Not only did you put $10,000 in your pocket, but you also saved $2500 in taxes and thereby generated around $12,500 in value.
Meals are another grey area that I’ve talked about a lot in the past. The higher the price gets, the larger the area of scrutiny. This will also be in relation to what your sales are. $10,000 in meals looks worse on a business that does $100,000 in sales versus $100,000,000. The IRS is a business looking to profit, so they most often focus on areas that look fun, like racecars, planes, boats, wine, etc… They scrutinize these because it’s very likely that taxpayers are getting personal benefits.
Travel and Vacation
The IRS has clear rules. To qualify as a business trip versus vacation, you must leave home and more of the trip must be business than personal. It also must be an ordinary expense that is typical for your industry and it must be necessary or helpful for you to go on this trip. Ask yourself what you stand to gain by going. Because that is what the IRS will ask.
Also, you must plan your travel in advance. Why does the IRS care about this? If you’re going on a business trip, you’ll usually plan it in advance to make sure you accomplish a business goal (I’m going to go to this place, to see this vendor, for this reason). What the IRS doesn’t want to see is you having planned on a vacation, but you happen to fall into something related to your business. Let’s pretend you were going to California to sightsee, but you happen to run into a client or two and you hangout (less legitimate in the IRS’ view). The alternate, more “IRS legitimate” situation would be planning to go to southern California to see some clients, for a certain reason, and you happen to go to the aquarium or go sightseeing.
Tools and Equipment
When the IRS looks at these expenses, they will have you print out a ledger that shows your expenses, dates, amounts, etc… They want to see how much you paid for it and who you bought it from. Walmart, Amazon, Home Depot, Lowes are going to be pretty typical for shop owners to use to pick up equipment and tools, as well as stock the pantry for the technicians. Based on the name alone, sometimes the IRS will mark it legitimate. However, if you do get audited, it’s highly advisable to have all your ducks in a row in terms of documentation.
I Can, but Should I?
The risks and downsides to writing off grey area expenses are that you might get audited! The IRS employees are not typically sharks. Typically. You are, however, going against the government so be aware that if you do get someone exceptionally sharp and motivated, you can really be in for a nightmare.
You’re also adding variables to your financial statements when you write off grey area expenses. This can muddy the overall financial picture of your business. If you’re running your entire life down through your business, it can look like your overhead is bigger than it is, or your percent margins are lower than they actually are (ex: you’re only showing 25% on your parts margins when you think you’re making 50%). Sometimes, if you have no discrepancy between you buying your race car parts personally and your techs making purchases for your shops, you’ll get a totally different impression of your books than what they should reflect.
Another aspect of grey area expenses is that banks don’t care about this. If you show a lower profit than you should because of running personal expenses through your business, your chances of getting financing can be hurt. Underwriters for loans usually go straight from your tax returns (specifically the SBA is very strict about the line and number from your tax return that underwriters can use). If you’re looking to expand your business, this is especially valuable to remember.
The last thing here is what if you want to sell your business? If your profit shows $20,000, someone would wonder why you’re asking $500,000 for your business. The business owner coming back and explaining their expenses could look shady to a buyer, depending on what they are. There’s an enormous level of trust when it comes to buying and selling businesses. You never want to tell a buyer that you’re pocketing a large amount of cash because you’re essentially saying you have no problems lying to the government. The buyer might ask “who else is the seller comfortable lying to?” Also, even if you convince the buyer that this business is a good deal, the buyer’s bank might look at your numbers and decide not to give the loan.
If you can package and explain your expenses in a clear way and they are common to closely held businesses, then it’s generally fine. If you truly want to sell your business for top dollar with no questions asked, then it’s best to run it as squeaky clean as possible.
In summary, minimizing tax exposure and taking advantage of the benefits of being self-employed is good, but you want to proceed with caution. You don’t want to lose sight of your true business operating costs or hurt the actual value of your business.
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