How Tax Deductions Work for Small Business
Small business owners have the advantage to reduce their tax liability with tax deductions from varying tax-deductible expenses. Tax deductions are amounts a company deducts as business expenses to reduce its tax liability. Here, tax liability is the amount of tax a business will owe from its net income. Tax deductions help small businesses lower tax bills by reducing their net income.
The Australian Taxation Office (ATO) requires businesses to report income and settle tax liability periodically or face penalties for not meeting ATO tax guidelines. However, small businesses may find tax complexities daunting, and while also managing small business operations, are left with little time to maximise their tax benefits. Follow this guide to small business tax deductions that can help you make the most of your tax time.
What Are Small Business Expense Categories?
Different expense categories allow small businesses to identify the costs they can deduct from their annual revenues. Not all expenses are tax-deductible, so it is crucial to use a bookkeeping system to categorise expenses.
The different types of expense categories include:
- Start Up Expenses [incurred if business is being started from scratch and can include licensing, registration and legal fees]
- Advertising & Marketing Costs
- Business Transport & Vehicles
- Payroll & Employee Benefits
- Training & Organisational Development
- Research & Development
- Meals & Recreational Expenses
- Office Supplies
- Utilities [electric, water, phone, internet]
- Loan Interest Payments
- Other [professional service, repairs, softwares, subscriptions, shipping]
Costs allowed by the ATO as tax deductible can include some operating expenses and capital expenses:
- Office Supplies
- Office Space
- Hardware and Software
- Training & Organisational Development
- Advertising and Marketing
Day-to-day expenses include most expenses the business has to conduct business. Meals and entertainment may be included in this if they are not personal.
- Machinery and Equipment
- Land and Property Development
Capital expenses are considered long-term expenses. A tax accountant is skilled in categorising and placing the current term expenses from this in the accounting books – some capital expenses, such as a vehicle purchase, can be expensed all at once or through a process called depreciation.
Tax Deductible Expenses for Small Business
The ATO defines deductible expenses as expenses that result in revenue from operations and has a set of requirements for record-keeping for all tax reporting. It is strict about identifying personal and business expenses and following these rules:
No private expenses can be deducted. They must be for business-related reasons only.
Mixed expenses, where the expense is used privately and for the business, such as a car, must be divided based on the percentage of use. Therefore if you use a truck for business twenty-five percent of the time and the rest for personal use, you can only deduct twenty-five percent of its value as a tax-deductible expense.
Expenses cannot be arbitrary. You must have records to prove the cost occurred and that the expense is related to business.
Consider the following tax deductible expenses for your business:
Tax Depreciation Incentive
The ATO introduced a tax depreciation incentive that gives businesses special incentives to help them cover the impact of the coronavirus pandemic. Incentives can be applied in four areas. Businesses should apply them to maximise their deduction potential:
- Temporary Full Expensing
- Instant Asset Write-Off
- Backing Business Investment
- General Depreciation Rules
1. Temporary Full Expensing
Temporary full expensing (TFE) allows businesses in Australia to take a break from the cost of a depreciating asset in the first year of its use or installation.
- A small business must have less than five billion dollars in aggregated turnover (total income of the small business) and be a tax entity that meets the alternative income test.
- Small businesses can take this expense for the financial years 2020-21, 2021-22, and 2022-23.
- TFE covers new assets obtained or installed between October 6, 2020, through June 30, 2023. Assets secured, used, or installed in the same date range are eligible.
- The ATO also allows assets that were improved during the same period to be deducted. These assets must have been owned before October 6, 2020.
2. Instant Asset Write-Off
The instant asset write-off incentive encourages small business owners to write off new and used depreciating assets as a tax deduction. The rule applies to assets in the year it was first used or installed for use.
- The instant asset write-off allows multiple assets to be included if the total of those assets is less than a threshold determined by the ATO based on the business type.
- Assets purchased between October 6, 2020, to June 30, 2023, are not eligible for instant asset write-off.
- Additional qualifications must be met to use the instant asset write-off incentive. Your aggregated turnover must be below $500 million.
This incentive is similar to TFE. If an asset does not qualify for TFE, instant asset write-off is the next incentive small businesses should consider. The asset must be purchased by December 31, 2020, and first used or installed before June 30, 2021 in that case.
The ATO applies thresholds for businesses that apply simplified depreciation rules in their accounting for assets. These thresholds are measured by the aggregate turnover and date range of the asset's purchase.
Not all assets are eligible for this incentive and there are also additional limitations such as car limits. You should consult a tax professional to determine your thresholds.
3. Backing Business Investment
The ATO allows small businesses to deduct the cost of new depreciating assets by following accelerated depreciation rules – this is where small businesses deduct the cost of a new asset from the year of purchase or installation for use in the standard depreciation deduction method over the years after the purchase or installation.
- Businesses that do not use the simplified depreciation method can opt out of backing business investments but must notify the ATO on their tax returns.
- Small businesses with an aggregate turnover of less than $500 million are eligible to use this deduction.
- The deduction is only available for the financial years 2019-20 and 2020-21.
- The asset cannot be held or owned by another company except for trading stock.
- The asset must be held on or after March 12, 2020, used or installed on or after March 12, 2020, through June 30, 2021.
- Assets such as second-hand depreciating assets, certain production assets, and assets that will never be located or used primarily in Australia, or acquired before March 12, 2020, are not eligible.
4. General Depreciation Rules
The general depreciation rules follow traditional depreciation deduction procedures. These rules apply when instant asset write-offs or simplified depreciation incentives are not eligible.
- The deduction amounts will be based on the asset's life.
- Some specifications are required based on how the asset was acquired:
- Businesses that gain new assets that have never been used can choose between the prime cost method or the diminishing value method of depreciation.
- If an asset is purchased from a previous owner, the method used by the previous owner must be used by the new owner until the depreciation is exhausted.
- The prime method must be used for certain intangible assets.
Use the depreciation and capital allowances tool on the ATO website to calculate and compare which method works best for your business. Different rules for different assets could change how the general depreciation can apply, such as improvements to buildings or assets used in mining exploration.
The ATO website defines prepaid expenses for small businesses as expenses incurred for work to be done gradually or totally over a future time or a set date within a later financial year. Prepaid expense deductions cannot be taken for expenditures completed in the current financial year.
The expense types are the same as regular expenses allowed during a current financial year. For example, building a structure for business operations is an allowed expense. If that structure takes five years to build, the cost becomes a prepaid expense for the portion of the build that has not taken place in the current financial year.
Prepaid expenses can only be claimed during the time of the expenditure. Using the previous example, a business cannot deduct prepaid expenses for year six if the expenditure was completed in year five.
Business Travel Expenses
Business travel expenses can be deducted for you and your employees for travel expenses related to operating the business. Record keeping is crucial to accurately track small business costs. The ATO recommends you keep a business travel diary – this helps you remember when parts of a trip are for business purposes. The ATO has restrictions on business travel expense deductions.
- Small business owners can claim airfare, train, bus, taxi, ride-share, or metro train fares.
- Private car hire fees or rental car expenses are deductible.
- Business owners and employees can deduct fuel, toll, and parking expenses.
- If you are away overnight, hotel accommodations and meals are tax deductible but some overnight stay restrictions apply.
The ATO restricts businesses from including personal affairs conducted during a business trip. Trips to see family or business travel expenses strategically planned around holidays will face restrictions. Therefore do not include costs such as gifts and souvenirs as business expenses, as these do not qualify. Start-up travel costs may not apply as well. The business must be in operation before travel expenses can be taken.
Costs for employee travel must be managed carefully. If employees pay for expenses themselves, they will deduct this from their tax filings unless you have reimbursed them for the expense.
Fringe benefits taxes incur if a business travel expense is associated with leisure – this is common for lavish sales trips to popular tourist areas. While the trip may be for business, there are fringe benefits that should be reported to the ATO.
This is usually claimed in income tax returns excluding the GST paid in case GST is claimed as credit on the Business Activity Statement [BAS].
Business Vehicle Expenses
Motorised vehicles can be a business expense tax deduction. If a business needs the vehicle to carry out its operations, all or a part of the vehicle can be expensed. The small business must own the vehicle through a direct purchase, a lease, or a rental agreement.
Businesses can expense cars that carry less than nine passengers and a load of less than one tonne. Other vehicles, such as motorcycles, utility trucks, vans of one tonne or more, and passenger vans or trucks that carry nine passengers or more are also included.
Certain entity types can claim expenses for vehicles offered for employee use. These are separate for vehicles used primarily for operations. Usually, executives are given employee-use vehicles. Along with the vehicle itself, a business can claim:
- Fuel and Oil
- Repairs and Maintenance
- Loan Interest
- Insurance Premiums
- General Depreciation
General Operating Expenses
These are simple deductions related to the day-to-day operations of your business that help in generating business income. The ATO provides guidelines on what general operating expenses can be included in your annual tax filing. Operating expenses can be current or prepaid.
Operating expenses include advertising, public relations, tender, and other transaction fees and expenses, uncollectible accounts receivables, legal and other professional expenses, such as accounting, governmental fees, taxes owed, and insurance premiums. In addition, building and car leases, payroll, office maintenance, and supplies are included. Consult with a tax professional for all eligible operating expenses for your business.
Home Office Expenses
If you run your business from home, the ATO allows special provisions for home office expense deductions. These provisions apply to business owners who are self-employed or run an entity from home and employees who work for an entity from their own homes.
Employees must conduct most of their work duties from home, and their work must be significant. Answering emails or taking calls does not qualify.
Employees can deduct additional expenses when working from home, such as:
- Operating Costs: electricity, heating and cooling, office equipment, depreciation of office equipment, internet and phone expenses.
- Occupancy cost: interest on mortgage, rent, house insurance premium
- Travel costs for travelling between home and other work related locations
A home-based business is different from an employee who works from home. If your small business has employees that work from home, the employee can take the deductions mentioned above. However, the small business cannot. The small business can expense equipment and reimbursements they've provided to the employee to conduct their job.
If a business owner runs a home-based business, similar to employees, they can deduct a range of expenses such as office equipment, utilities, and some depreciation on equipment. In addition, home-based business owners can deduct occupancy expenses such as rent, mortgage interest, lease costs, and other property taxes.
Home-based businesses can also include motor vehicle expenses for trips from the home to business-related destinations. Home-based businesses do not have to register at the home address. The ATO defines home-based businesses as those that are worked at home [primary place of work] or worked from home [offering services at other premises or people’s houses but storing tools at or performing bookkeeping from home].
Capital gains tax may still have to be paid if the small business owner sells their home and GST needs to be excluded again if eligibility for input tax credits for GST is there.
Salary & Super Contributions
Salary and super contributions are considered payroll expenses. The ATO has an expansive payroll reporting process. You can deduct employee wages, your wages as a self employed sole trader, and contributions to employee superannuation costs.
A sole trader is a business owner who operates with no other members, partners, or employees. The sole trader would take an expense for wages paid to themselves through their tax filing. The ATO doesn't consider sole traders to have payroll. Any "payments" you make as a sole trader to yourself or your bank account are considered an equity withdrawal. The same rules apply to partnerships.
If your business is an entity however, it can pay wages to owners if those owners are on the payroll. Your wages as an employee of the entity can be deducted as a payroll expense.
Bad Debt Write-Off
Bad debts are accounts receivables, or payments from sales owed to you by a customer that cannot be collected. The ATO qualifies bad debt based on how the account receivable is removed from your assets.
Certain provisions, except payment, must apply, such as a debtor's balance being released or waived. The debt is removed through the accounting reconciliation process done by your bookkeeper or accountant. It is important to write of all bad debts for the tax year as this can prevent that debt to be considered as taxable income and owner will not be required to pay taxes on this amount
Bad debts can be expensed if the debt is too old to legally pursue, the debt has been sold to a private company, or if other agreements release the debtor from the debt.
How to Claim Your Tax Deduction?
Each entity can claim expenses in a variety of ways. Every entity does not enjoy the same tax small business deduction benefits. Here is the lowdown for small business tax deductions for dummies.
- Sole Traders can claim deducted expenses in individual tax returns under the business and professional items section. They cannot deduct payroll expenses because they do not pay wages. Sole traders who perform as personal services (PSI) are limited in many small business tax deductions that can be expensed that other sole traders could. Generally, sole traders can deduct home-based operations or facility expenses, leaves, rents, cost of goods sold, and general operating expenses.
- Partnerships can claim expenses in their partnership tax returns. They are similar to sole traders: they cannot deduct payroll wages and can deduct expenses related to general operations.
- Trust and Companies are treated as stand-alone entities that can claim expense deductions in their trust or company tax return. They can claim payroll expenses, the cost of goods sold, and all other general operating expenses.
All entity types must file annual tax filings with the ATO.
Get Expert Advice
As you grow your business, you will need proper and timely record-keeping to ensure you maximise your tax deduction and improve your small business savings. Hire a bookkeeping service or tax professional to help document, record, and reconcile your account accurately to get the correct deductions on your business taxes.