There are various "tax schedules" used to report different types of transactions on your Form 1040 throughout the year. Form 1040 is the document U.S. taxpayers use to file their annual income tax return. Schedule C specifically reports the income or loss from a sole proprietorship or single-member LLC. In contrast, multi-member LLCs (partnerships) file Form 1065, while S corporations use Form 1120-S. For those filing Schedule C, this article focuses on what qualifies as a business expense, including assets that serve both personal and business purposes.
Defining a Business Expense
According to the IRS, to be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. It's also important to call out, personal, living, or family expenses are generally not deductible.
Marketing, employee wages, legal and accounting fees are relatively straightforward. They are both ordinary and necessary for your business. The key is to keep these expenses completely separate from your personal accounts. If you're just starting a business, one of the first things you should do is open a business bank account. That said, there may be times when you need to make a business purchase and only have access to personal payment methods, like your personal credit card. In these situations, it’s acceptable to use a personal form of payment, but be sure to reimburse yourself from your business account and keep a detailed record, typically with a receipt.
Converting Personal Assets for Business Use
What if you want to start using a personal asset for your business? As a general rule, if you incur an expense for a tangible or intangible asset expected to last more than one year, you'll need to calculate depreciation, which will determine the allowable business expense. Conversely, if the asset is expected to last less than one year, you can deduct the full amount in that year. For example, let’s say you purchased a computer for personal use and now want to use it for your business. To do this, you’ll need to determine two key numbers: 1. The amount you originally paid for the asset (referred to as the adjusted basis or AB), and 2. Its current Fair Market Value (FMV). If the FMV is unclear, it might be a good idea to get a professional appraisal. Alternatively, you can often find this information with a quick online search for the make and model. Once you have both numbers, you’ll use the smaller of the asset’s FMV or its adjusted basis (AB) as the depreciable base. This base will then be divided by the asset’s useful life to calculate the depreciation expense for the year. The IRS provides guidelines for an asset’s useful life, or you can rrefer to Thomson Reuters Asset Life Table found here: https://cs.thomsonreuters.com/ua/fixa/cs_us_en/ass_life_tbl/hid_help_asset_lives.htm
Example
Ok thanks for staying with me because that was a lot of jargon. Let's make it more concrete with an example. Let’s say you purchased a computer for $2,000 two years ago. Today, you are opening shop for your small business and want to use the computer in your business. After checking online, you find that comparable models are currently selling for $1,500. Using the smaller of the two amounts, $1,500 becomes your depreciable base. Next, divide the $1,500 by the computer’s useful life (in this case, 5 years found on Thomson Reuters Asset Life Table). Now hold on. Because your computer is 2 years old, the remaining useful life is 3. Dividing 3 into $1500, gives you a $500 depreciation expense per year. Now, the hard part is done, and the good news is you can continue to take that $500 depreciation expense each year over the remaining computer’s 5-year useful life (i.e. for the next 3 years).
Handling Mixed-Use Assets
What if an asset is used for both personal and business purposes? For instance, you might use the same computer for work and for watching Netflix. In these cases, you’ll need to track the percentage of time you use the asset for business versus personal activities. For example, if you use the computer for business 70% of the time and for personal use 30%, you would calculate your business depreciation expense based on that ratio. Using the previous example, where the annual depreciation expense is $500, you would multiply $500 by 70%, resulting in a $350 business depreciation expense for the year. Same as above: you can continue to take that $350 depreciation expense each year for the next 3 years.
My Two Cents: First and foremost, always separate your business and personal finances. Open a business checking account. If needed, consider opening a business Amazon or PayPal account as well, so it’s easy to differentiate business expenses come tax time. Keep all your business receipts and document how you calculated the business versus personal usage for any mixed-use assets.
Comments