One of the most common questions we get from our business owners is what deductions they can and cannot make for their businesses.
Deductions are an important part of running a business. You want to be sure that you're maximizing these deductions to realize tax savings, but you also want to be careful to deduct just the right things.
So, what's a business deduction? And more importantly, what's not?
The most important benchmark that we use when telling our clients what is and is not deductible is that business deductions should be ordinary in your course of business (common and accepted in your industry), necessary in your course of business (one that is helpful and appropriate for your trade or business), and should not be considered personal.
This benchmark leaves a little room for interpretation, and will vary from business to business, so let's dive into some specific expenses.
Generally, you cannot deduct any personal, living, or family expenses for your business. These include (but are not limited to) your housing, clothing, everyday meals, personal care, personal cell phones, and utilities. Exceptions are made for items that are used partially for personal and partially for business. A good example of this might be your cell phone bill. If you're using your cellphone for 50% business and 50% personal, you can allocate 50% of the bill towards your business.
Home office deduction
It is important to note that the home office deduction is for homes that you OWN, not rent.
As work from home has risen in popularity, there have been a lot of questions about deductions that you can take if you work from home. So what about deducting a portion of your mortgage, electricity, wifi, and other home-related expenses that would otherwise be considered personal? The IRS has mandated that you are eligible for a tax deduction for a home office under the following rules:
1. The business part of your home must be used exclusively and regularly for your trade or business.
2. The business part of your home must be:
a. Your principal place of business;
b. A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business; or
c. A separate structure (not attached to your home) used in connection with your trade or business.
The important part here is the exclusive use part. Working from your couch, kitchen counter, or bed unfortunately does not qualify you for a home office deduction.
If you do have an exclusive area of your home that is used for nothing else but work, there are two methods to calculating the home office deduction.
1. The optional safe harbor method allows for $5 per square foot up to 300 square feet
2. The actual allocation method does just that - allocates all actual expenses, including mortgage interest/rent, insurance, utilities, repairs, and depreciation.
Most digital nomads aren't going to be claiming a home office deduction, as by our very nature we're moving around and don't own homes that we work from. So, what's available as an option for those of us who rent our homes?
The same rules apply to homes that you own and homes that you rent - in order to deduct a portion of your rent and utilities, you must have an exclusive area that's used for business only. The percentage of this area is the percentage of expenses that you can deduct as business.
You're also able to take a business deduction of 100% for any office or co-working space that you rent.
As a firm that serves a decent number of digital nomads, one of the most frequent business expenses we get asked about is travel. In order for travel to be deductible, it requires you to travel away from your tax home. Your tax home is considered your regular place of business. Traveling away from this tax home allows you to deduct mileage, airfare, meals, transportation, baggage, rental cars, hotels, SIM cards, and other necessary expenses of your trip.
The catch here with digital nomads is that we're usually not traveling away from our tax home, but rather to our tax home. I like to use these examples with my clients:
1. I decide to move to Merida, Mexico to live and work for 4 months during tax season. There are no significant business opportunities for this move, and the move is personally motivated. These travel expenses are not deductible for tax purposes.
2. While living in Merida, I travel to Tbilisi, Georgia, to live and work for a month. Tbilisi has a thriving digital nomad community, and I plan to do seminars and immerse myself in the community in order to gain recognition. I'm also visiting friends while traveling Georgia, and I plan to return to Merida once I'm done. This trip is partially deductible for tax purposes.
3. While living in Mexico City, I travel to Cancun to present at a conference. There is no other reason for my trip other than the conference. I fly in the day the conference starts, and I fly out the day it ends. This trip is 100% deductible.
You can read more about travel expenses here in IRS Publication 463 (2019)
In order for a meal to be deductible for business purposes, there must be a clear business purpose to the meal. We recommend having notes on who you met with and what you talked about in order to substantiate any expenses claimed of the IRS ever comes asking about it. Meals are subject to a 50% limitation on the total deduction.
Contract labor can be a common expense for business owners, and it's not uncommon to have expenses related to both domestic and international contractors. All of these expenses are 100% deductible, as are the fees associated with paying these contractors (think, Transferwise fees, Upwork fees, payroll services, etc).
It is important to note that you are required to issue 1099s to any domestic contractor receiving payments over $600 in one year. You should collect a W-9 form on any contractor that you engage to do work. For international contractors, there are no 1099 requirements, but you are required to have a W-8BEN (foreign individuals) or W-8BEN-E (foreign companies) on file.
As stated earlier, maximizing deduction is the goal of every business owner. If it is ordinary and necessary in your business, it qualifies as a business deduction. Advertising, software subscriptions, legal and professional fees, continuing education, supplies, licenses and much more are deductible. Use your Audible subscription for professional development? Listen to podcasts related to your business on Spotify? These subscriptions can be partially deductible.
At the end of the day, if it is ordinary, necessary, and you'd feel comfortable defending it as a business expense to an IRS auditor, it can be considered a business expense.
Still have questions? Feel free to book time with our team here for a more in depth dive to your particular business.
You can also read more about business deductions in IRS Publication 535 (2020)