Whilst items that we Depreciate are also written against income to help lessen the burden of income tax, the cost is usually spread over many financial years. This means that you are usually only permitted to claim a portion of the money spent as an expense in the year purchased, the balance of the purchase is spread over certain years.
How Small Businesses Get Into Trouble
Whilst many of us have heard about Depreciation many individuals do not realize its impact, or how it's going to affect their income. I see lots of individuals purchasing equipment thinking they can write off the full purchase cost against their income, so they then go out and spend all the money they earn that week or month and fail to put as any for tax. Then come tax time they suddenly discover that they need to find several thousands of dollars because they spend the money they previously rented thinking that they could write off the purchase as an expense.
The problem is that we get stuck in the mentality that we can lump everything we purchase into the same pile and treat all those receipts as expenses. We all know simple math so it's easy to do a simple equation, Income less Expenses equals Gross Profit. So if a Small Business Owner or Contractor purchases a piece of equipment for a couple of thousand dollars and performances simple math they end up smiling thinking they only need put away a small amount for income tax.
How Not to Get Into Trouble
For many years now I have been using a formula that seems to work for me, it may not be the best answer but it does work for me. Should you use it, I do not know, maybe it's best to seek some advice from an accountant first. However my brother has been using a similar formula in his carpentry business for many years and it works for him; Here is what I do
Any item I purchase over $ 500 and less than $ 3000 I use the ratio of 30/70, I allow for 30% of the purchase price to be added into my math equation. So I simply do my calculation of Income less Expenses using only 30% of the purchase price of the item as an expense.
Obviously in the case of my brother if he spent $ 3000 on timber for a job then this is a different matter and it would normally be an expense, but if he bought a new piece of equipment such as a special drill that cost the same amount he May find that under the regulations he is not able to claim the full price in the year purchased, so he simply allows around 30% as a base figure until his accountant tells him otherwise.
How Does This Affect My Income Tax Liabilities
Obviously the simple formula I use is not always going to be accurate, but in the end it is not meant to be. There are times when I could use more of the purchase price, and there are times when I have allowed for more than I should, this is not an exact formula. But over the years I have found that I have been able to survive without any real income tax liability as I have almost always set aside enough money to cover my tax bill.
In the end I find that simplicity works for me, saving me from running off to the accountant every time I purchase an item, saving more money as I do not have to pay him for that visit. No matter what you choose to do keep it simple and be practical, if you are not sure then exclude the whole item as an expense, put more money as for tax, as in the end its better to be looking at spare left over cash then To be looking around for money to pay a tax bill