Businesses pay tax on their profits (their income less costs), but for tax purposes, you are not allowed to deduct all your costs from your income, when working out what your profits are. Too many entrepreneurs, pay for things on the basis that they will get a tax deduction, and then are annoyed to be taxed on a higher profit figure than that shown in their accounts.

Profits of a business are taxable. How they are taxed depends on whether you are running your business through a company (corporation tax) or whether you are operating as a sole trader (income tax).

In both cases, there are some costs that you cannot deduct when working out your taxable profits. These are often referred to as non-deductible or disallowable expenditure, or add-backs. The term add-backs arises as your accountant will take the profit figure per your accounts, and then add-back any disallowable expenditure to work out a taxable profits figure.

There may be many possible add-backs, if expenditure is not wholly for the purpose of the business, but some common ones are:

Entertaining

While taking potential customers or suppliers out for lunch may be necessary for you to win new sales etc, tax law says such expenses are disallowable. You can claim deductions for entertaining employees, but you need to be careful that they are not personally taxed on these costs.

Fines etc

Generally any expense caused because the business has been naughty (not a technical term!) in some respect, will not be allowed. So fines and penalties are disallowable.

Capital purchases

If you buy equipment e.g. a computer to use in your business, then you will not get a deduction for the total cost of this in the year that you buy it. In any case, your accounts would probably not show this as a deduction from accounting profits. Instead, your accountant would show this as an asset of the business, and charge depreciation as a cost reducing profits. For tax purposes, depreciation is a disallowable expense and is added back. Instead, capital allowances can be claimed. Capital allowances are prescribed in tax law. They dictate how deductions can be claimed for the cost of the item, splitting the total cost over the current and future years.

Sometimes it is difficult to tell whether a cost is a capital purchase. This is particularly the case when repairs are made. These may actually enhance the item, and so may be treated as capital items, and the cost disallowed. This can be a complex area, so speak to your accountant, if, for example you are overhauling your computer system.

Legal expenses

Some of these may be disallowable, in particular if they relate to allegations against the business (which may fit into the “naughtiness” category above), or if they relate to capital purchases, and it is worth checking with your accountant whether such costs will be allowed. If not, this will made a legal action even more expensive to you.

Proprietor expenses

If you operate as a soletrader or partnership (but not a company), then the money which you take out of the business (referred to as “drawings”) will not reduce your taxable profits.

There are many more examples, but it is not all bad news. As a one-man business, working out of your house, there may be additional expenses which you have incurred but do not realise can reduce your taxable profits. See our article “Tax implications of working at home”.

As with all our information in The Business Lounge, this is not comprehensive tax advice and may not apply to your specific circumstances; to discuss how these comments affect you, contact your accountant.