Do you have legitimate tax deductions? Why over-deducting hurts you

Are you a self-employed professional or business owner looking to reduce your tax liability? While claiming as many business expenses on your tax returns as possible may seem like a good idea, it's important to be aware of the dangers of over-deducting business expenses. In this article, I'll provide tips for avoiding excessive deductions and explain the right way to approach your business expense deductions.

Why it’s important to stick to legitimate business deductions

Over-deducting business expenses means claiming expenses that aren't legitimately deductible or claiming too many deductions on your tax returns. This can result in a lower taxable income but can hurt your financial situation in the long run.

A low EBITDA impacts the market value of your business

The value of a business is often based on its earnings after interest, taxes, depreciation, and amortization (EBITDA). When a business owner over-deducts expenses, they lower their taxable income, which can result in a lower EBITDA. This can make the business less attractive to potential buyers, as they may perceive the business as having lower earnings potential. Ultimately, overdeducted expenses can potentially limit your exit value when your company is sold.

Too many expenses raise a red flag during IRS audits

If the IRS determines that you have over-reported deductions during an IRS audit, you may be subject to penalties and back taxes. Penalties can be severe and can include a percentage of the unpaid tax amount, which can add up quickly. In some cases, you can even face criminal charges and significant fines.

Less access to capital needed for business growth

The biggest issue with over-deducting expenses is it screws up your debt service coverage ratio both personally and for the business.  Most businesses leverage debt for growth and lower income reduces your access to capital.

How to take legitimate tax deductions

Claiming expenses that aren't legitimately deductible leads lower taxable income, which can be a good thing in moderation but can hurt a business owner's financial goals if done in excess. Here are some tips that you can use to avoid over-deducting:

1. Understand what expenses are legitimately deductible: If you need a refresher on the rules surrounding deductible business expenses, I’d recommend IRS Publication 535. It outlines the ways in which you can legitimately deduct business expenses.
2. Keep accurate records: This includes receipts, invoices, and any other relevant documentation. Properly substantiating your deductions prove invaluable during an IRS audit.
3. Consult with a tax professional: Working with a tax professional can help ensure that you're claiming all the deductions you're entitled to while avoiding over-deducting. A tax professional can help you understand the rules surrounding deductible expenses and provide guidance on how to maximize your deductions without putting your financial goals at risk.
4. Avoid mixing personal and business expenses: Every business owner, even sole proprietors and freelancers, should avoid claiming personal expenses as business expenses. This is known as commingling and can lead to problems if audited by the IRS.

More tax deductions aren’t always better 

You can avoid excessive tax deductions by  understanding which expenses are legitimately deductible, keeping accurate records, and working with a tax professional. If you need help with tax planning, contact us to discuss our year-round tax planning services.