5 Differences Between Business and Personal Expenses
Deducting business expenses can lower your taxable income and reduce the amount of tax you owe. However, expensing personal items as business items can cause a lot of headache and heartache as an entreprenuer. Check out these 5 differences between business and personal expenses to help you get it right.
Who is this article for?
Understanding the differences between personal and business expenses is important for small business owners, self employed folks, and gig workers.
For taxpayers who file a schedule C and who also receive Earned Income Tax Credit (EITC) it is even more important to get expenses right. EITC recipients who file a schedule C are in a group that the IRS views as more likely to have errors and fraud and therefore are at higher audit risk.
Regardless of the audit risk, most taxpayers want to get their tax filings right, and this article can help guide you on your small business journey.. Let’s jump in:
1. Expenses that are ordinary and necessary for business being conducted
But what does “ordinary” and “necessary mean? Let’s look at a specific situation as an example. If you provide remote bookkeeping services, staying in a $10,000 per week luxury resort to help you focus on your work is probably not a valid business expense. It would be a personal expense and therefore not deductible. However, if your business is providing immersive group therapy at retreats for CEOs with multimillion-dollar salaries, that expense may very much be valid.
Food is an area people love to use as a business expense. It’s a complicated area, but we’ll talk about the two most common uses.
For example, let’s say you are a realtor. You drive around all day showing houses, and you stop somewhere to buy lunch for yourself. That is a personal expense. On the other hand, if you go to a realtor convention that has a business purpose, and you have to stay overnight due to the distance from home, your meals during the convention are deductible business expenses.
A meal, or even entertainment, with a client or potential client that has a business purpose and has business being conducted, ares valid deductible business expenses.
Normally most business meal deductions are limited to 50% of the cost. However, as part of the provisions passed into law regarding the COVID-19 pandemic, meals can be deducted at 100% through 2022.
I hear it all the time, “I am starting a business, and now I can buy a vehicle and write it off.” It isn’t that simple.
First, while there are times you can fully deduct a vehicle in one year, that usually isn’t what is done, especially if there is personal use of a vehicle. Typically the cost of a vehicle is deducted over the timeframe of years using a process called depreciation. But not always.
Second, if the vehicle is NOT 100% business-use, the IRS wants you to divide it up into business use and personal use. A realtor driving a client around to show houses would be business use. If you decide to go see a movie, driving to the movie theater is considered personal use.
Tracking mileage is how you determine the percentage of business use vs personal use.
Many schedule C filers have had to pay taxes, penalties, and interest when they couldn’t prove their mileage and vehicle use when audited.
Cell phone use is another asset that can be both personal and business. When determining the percentage of personal use vs business use, the IRS wants you to have a reasonable method to make that determination. Your best guess would not be considered a reasonable method. One reasonable method would be to keep track of calls. 1000 personal vs 1000 business means you are 50-50 personal and business use.
Tax Tip: If you claim 100% business use of a car or a phone and you don’t have another car or phone for personal use, you should have solid documentation on the use of each and be able to explain and prove how you get around without a car for your personal activities or be able to show you communicate with others in your personal life without another phone.
5. Business travel vs personal travel
Travel is another area many new business owners have high hopes of big deductions. This tax topic can be very situational so consulting Publication 463 or a tax professional is a good idea.
Let’s go back to the realtor example. What if the realtor travels with family to Orlando, Florida for a week, and the realtor attends a one day realtor conference while there? The rest of the time is spent at a nice resort and theme parks. Which parts of the trip, if any, can be deducted in this instance?
Clearly, most of the time there is for personal purposes. But the cost of the realtor conference and lunch there can qualify as business expenses. There may be some other valid business expenses on that day. However, the cost of air travel to and from Orlando is a personal expense and not deductible.
On the other hand, if the realtor travels to Orlando for a weeklong realtor conference and goes to a theme park alone one evening, the costs of air travel are a business expense. The cost of admission to the theme park and cost for funnel cake are personal expenses.
I tend to focus on the tax reasons for tracking business expenses correctly but it is also important for ensuring your accounting is accurate. To be a successful business owner or gig worker, it is important to know how profitable your business really is and what different categories of expenses are costing you. Go forth and expense correctly.
Jerry Zeigler is a Navy veteran who serves service members with financial counseling and education. As an Accredited Financial Counselor®, he is a member of the Better Financial Counseling Network and is the owner of JZ Financial Management. As a tax professional and Enrolled Agent, he has a passion for helping taxpayers navigate taxes.