Standard Operating Expenses – Understanding Overhead
A lot of people throw around the term “overhead” without really knowing what it means. It’s often considered a catchall for anything that’s not a direct product cost, and that’s partly correct. Sometimes it’s called fixed expenses, and that’s also only partly correct. The true definition is this: Overhead includes any expense your company would incur even if it never sold anything. Those expenses could be exactly the same every month, or never really the same; they’re fixed in the sense that you have to pay them to stay in business, but the dollar amount can change. What overhead does not include are direct and indirect product costs—anything that varies in relation to sales.
This category is where you’ll find the unexpected expenses, things you may not think are tax deductible.
Here are some of the most common overhead expenses that new and small-business owners forget to include:
- Business-related books and magazines (one-time purchase and subscriptions)
- Donations (such as providing T-shirts for a softball team)
- Tolls, parking, and mileage (for any business travel, no matter how far)
- Professional dues (association memberships, for example)
Some overhead expenses come with special rules, courtesy of the IRS; the two most likely to impact your small business are entertainment and home office expenses. Others, such as depreciation and amortization expenses and payroll, come with a side order of math (payroll is complicated enough to get a whole chapter, right after this one).
Home Office Expense
Many new and small-business owners do at least part of their work from home. If you were to rent office space, all of the expenses associated with that would be fully deductible; the home office deduction lets you record the same types of expenses for your business. However, you can deduct only part of the total expense, because part of your home is for personal use. Typically, your deductions can include a portion of your mortgage interest and property taxes, rent payments, utilities (not phone), security system, insurance, and general maintenance and repairs.
In order to qualify for this deduction, you have to use part of your home regularly and exclusively for business purposes. You also have to use that spot as your principal place of business for whatever tasks you do there; for example, if you always do your billing from home, that counts. It also counts if you normally meet with customers there, or if it’s actually a separate structure on the same property (such as a shed).
ALERT!
You can use the home office deduction only if you file Schedule C for your business income. That form is for sole proprietors and single- member LLCs only. For other business types, the associated expenses may be included with the company’s regular expenses. Talk to your accountant for advice on how to treat these expenses.
Once your home office qualifies, you have to figure out how big it is in relation to the rest of your house. You can do that using square-foot measurements. For example, if your workspace is 100 square feet and your whole home is 1,000 square feet, you can deduct 10 percent of the common expenses. Expenses that apply only to the office space (such as special wiring or repainting) will be 100 percent deductible. Expenses that don’t apply to that space at all—for instance, the cost of painting your kid’s bedroom— aren’t deductible.
Entertainment Expenses
Entertainment expenses come with a lot of limitations. For one thing, you can deduct only half of the total expense when you take clients out to lunch. Small gifts, $25 or less per person, can be fully deductible, though— and make just as big an impression on your customers.
FACT
Here’s an entertainment loophole: Give gifts to a company instead of to a person. When you do that, the gifts are 100 percent deductible, with no $25 limit. Instead of giving five guys $60 theater tickets and only getting a $125 deduction, give them to a company and deduct the full $300.
As you might expect, these types of expenses are audit favorites, so save your receipts and document the business purpose whenever possible. Even if you lose track of some, you’ll likely be able to keep the deduction if the lost receipts were for less than $75 each, a fairly new easing of the IRS receipt rules. You are, however, required to keep an entertainment expense log that includes the date, place, dollar amount, client name, and business purpose of each event.