Reducing tax obligation can possibly be the most wonderful experience of doing math calculation. Exploiting the minus-sign when claiming tax exemption, tax deduction and credit is one of the most satisfying moments for every taxpayer. Especially these days when everything is expensive, paying for taxes is a very painful thing to do.
Tax breaks are the real break every taxpayer needs. While everyone yearns for it, failing to take into account the expenses that could have reduced tax debt is one of the most expensive mistakes of your life. You can’t afford to overlook an expense that can deduct your tax obligation.
In this guide, you will get on board the world of Tax Deductions for individual and business taxpayers.
Tax Deductions for Individuals
All About Tax Breaks: Tax Exemption vs Tax Credit vs Tax Deduction
There are three possible tax breaks, a taxpayer can avail of, in order to reduce tax debt.
Let’s start with tax exemption.
Tax Break 1: Tax Exemption
This tax break indirectly reduces tax debt by diminishing the taxable income of a taxpayer.
Tax exemptions are entitlement that the IRS set for a specific year. In 2015, the IRS set $4,050 as the amount of exemption adjusted to the inflation rate. You can claim exemption as a personal taxpayer and for your spouse and each dependents.
Thus, if Bill and his wife have 2 kids, he can cut $16,200 from his taxable income. However, this amount phases out for taxpayers with starting AGI (adjusted gross income) of $259,400 or $311,300 for married couples filing jointly.
Tax Break 2: Tax Credit
Tax Credit on the other hand reduces tax liability directly, dollar per dollar. This means the total amount of credit is deducted from the tax a filer would otherwise owe.
It can be refundable, that is when the credit exceeds the amount of taxes, a filer would otherwise pay. Or it can be non-refundable which means, it will only reduce the tax but the surplus is forfeited. Thus if bill is entitled for a $2,900 tax credit but only owes $2,000 he has to forfeit the remaining $900 balance.
Tax Break 3: Tax Deduction
The third one, Tax deduction is similar to tax exempt because both indirectly reduces tax debt by diminishing the taxable income. This tax break generally arises from a taxpayer’s expenses like mortgage interest, student loan interest, medical expenses etc. Again, it should be noted that it reduces the taxable income and not the amount of taxes that you owe.
There is a plethora of expenses an individual can get tax deductions from. And you will know this shortly after delving into some details of Tax deductions.
Above the Line, Below the Line and Standard Deductions, What are the Differences?
The easiest one to understand is the Standard Deductions.
As the term suggests, the amount of this deduction is standard for all who qualify. For tax year 2016, the IRS set standard deduction schedule as follows
|Heads of households||$9,300|
|Married couples filing jointly||$12,600|
Every filer who falls into any of the above category is automatically entitled for standard deductions. However, you have to choose whether to avail of the standard deductions or the itemized deduction also called below the line deductions.
Below the Line Deductions
These below the line deductions include charitable contribution, home mortgage interest, real estate tax, property tax etc. And as you will surmise, below the line deductions only matter when it exceed the standard deductions. If, for example, Bill donates $3,450 worth of charitable contributions, he will opt to avail of the standard deduction instead, because it is worth 6,300–way better than his below the line deduction.
Above the Line Deductions
The above the line deduction on the other hand is more helpful than the previous one because you can claim them regardless of your choice between standard and below the line deduction.
Now, you may find yourself asking: “what is this ‘line’ we are actually referring to? What is the line that has an above and below deduction?”
The line is actually
the AGI,or the adjusted gross income. This is the total amount of income from salary and wages minus the amount of above the line deductions you are qualified to avail. And everything below this line that can diminish taxable income are the itemized deduction (below the line deduction) and tax exemption.
– Above the Line Deduction
= AGI (The line)
– Below the line deductions
– Tax exemption
After figuring the taxable income, a taxpayer can now calculate his tax obligation according to his Federal tax rate. The forecasted tax rate for 2016 is published in the IRS website. Only after figuring the tax obligation will a taxpayer subtract his tax credit from it. And finally, he can figure the amount of taxes he owes to the government.
How to Claim for Tax Deductions?
Use the schedule A of your 1040 Form to figure your itemized deductions.
Unless you have time to accumulate all your expenses and do the research whether it qualifies for a deduction, you can claim deductions on your own. But because of the intricate details of the instructions of the different types of deductible expenses, you may opt to hire a professional tax preparer to do the job which for self-employed individuals entails filing a 1099 MISC form. Anyway, you can include your payment for tax preparer in your tax return for the year you made the payment as part of Miscellaneous Deduction.
To find out a complete list of the various expenses from where you can claim you tax deduction, you can refer to the IRS website.
Tax Deductions for Businesses
Businesses, however lucrative it is could be expensive, especially for newcomer businessmen who are still waiting for their ROI. One of the things that businessmen are concerned about is how to write off extraneous expenses and taxes.
Fortunately, business taxes can also avail of tax deduction. Most of the expenses incurred as part of trade and business are deductible in full measure. However, there are just some expenses that can’t fit into the box that which businessmen cannot deduct from business tax.
So, what are the expenses business owners cannot deduct from business tax?
The rule of thumb is that you can deduct full amount of business expenses so long as it meets the criteria as being ordinary and necessary expense.
- Necessary expense, means that it is appropriate and helpful for the trade.
- Ordinary expense, means that it is common in the line of business.
This means that not all expenses that are part of trade and business can be deducted to tax. However crucial and indispensable capital expenses are, it is still not part of deductible expenses, also the cost of goods sold, and personal expenses:
Before a business starts its first day of operation, expenses are already incurred to set it up. This includes wages for training employees, advertising expenses, travel, renting or purchasing a land etc.
Generally, businesses must capitalize costs rather than deduct them. These includes:
- Business start-up cost
- Business assets
Cost of Goods Sold. Businesses after having a successful operation, will deduct the cost of the goods sold during the year from gross receipt to figure the gross profit. Every expense included in the cost of goods sold cannot be deducted from business tax. Business expenses incurred that are part of cost of goods sold are:
- Direct labor for workers who produce the product
- The cost of raw materials or products and freights
- Factory overhead or the cost of manufacturing process minus the two previous ones
Personal expenses. Lastly, personal expenses are nondeductible especially those costs that are personal, for family, for living and recreation. However, cases may arise when some of these expenses are incurred in for business practices such as entertaining a business client in which case it can be deductible. And when an expenditure is partly personal, partly business related, it has to be divided, proportional to these parts.
But here comes the best part. There are over a plethora of expenses that are deductible to business tax so long as it is ordinary and necessary to the business. What more, some of your personal expenses can be translated to business expenses if they qualify according to the criteria of the IRS.
Deductible Expenses from Business Taxes
First off, you can deduct the amount of payment you make to your employees for the services they perform. This can be in cash like wages and salary that are non-monetary like vacation allowance etc.
So long as payments made are part of a qualified educational assistance program, this type expenditure can be deducted as part of Employee Benefit Program.
These are fringe benefits spent for the performance of services to the employees. Included in this benefit programs are accidental and health plans, life insurance coverage, welfare benefit funds, etc. However, it is deductible only on the applicable line of tax return.Rule of thumb: to be deductible, payment to employees must be ordinary and necessary expense. Plus, it must be reasonable and for services performed.
Generally, rent payments made for properties you do not own and used for business and trade are deductible. But if you will receive title or equity in the property the rent is not deductible.
Interests that you pay or accrue during the tax year on debts from which the proceeds are spent for a trade or business expense is deductible from the business tax, no matter what type of property secures a loan.
However, there are interest payments that are not deductible some of which are:
- Capitalized interest
- Commitment fees or standby charges
- Penalties and fines
- Interest on loans related to life insurance policies
You can deduct a variety of federal, state, local and foreign taxes with respect to your business as part of business expenses. The following is a quick view of whether an expense is deductible or not:
State and local income tax of corporation or partnership
Real estate taxes of state, local or foreign levied for general public welfare.
Generally, ordinary and necessary cost of insurance are deductible as business expense if it is for trade or business.
There are over 11 deductible premiums listed by the IRS, some of these costs are as follows:
- Liability insurance;
- Credit insurance for business bad debts;
- Vehicle insurance for vehicles used for business
- Overhead insurance
- State unemployment insurance fund
However, not all insurance are deductible, some premiums must be capitalized while others are nondeductible premiums.
Other deductible Business Expenses
Office furniture and supplies
Expenses incurred for the purchase of office supplies and furniture used during the tax year are deductible as business expenses. Costs can be recovered through depreciation.
Meals and Entertainment
Businesses are generally allowed to deduct 50% of the total meal and entertainment expenses that employees reimburse.
You can generally deduct as a business expense the advertising costs you incur that are directly related to business activities.
Legal and Professional Fee
Payments made to lawyers and accountants who rendered services for the operation of business or trade are deductible expenses.
Penalties and Fines
Fines and penalties imposed on businesses that failed to perform a contracted service, or was delayed to finish the work are deductible. But note that penalties and fines paid to the government agency and instrumentality are nondeductible.
Heat, light, water, telephone and sewerage can be deducted from the business tax provided they render service not for personal use.
Costs for domain registration, webmaster consultation and other internet related expenses are deductible.
A long list of business and personal expenses may or may not qualify for tax deduction. Getting acquainted with most of business and person tax deduction if not all, is a leap forward to avoid costly mistake of overlooking deductions. But filling out tax forms is a sure stressful work, and figuring deduction can be long and arduous. A professional help from tax preparer is advised in order not to file and pay your taxes with erroneous data which entails crippling penalty costs.