The Bureau of Internal Revenues provides business owners and self-employed PRC licensed professionals and non-PRC licensed professional with two types of income tax deduction schemes. These are the Itemized Deduction and Optional Standard Deduction.
For taxpayers who want to minimize their tax dues legally, it is important to understand the difference between these two deduction schemes, as well as their respective advantages and disadvantages.
Which Is Better: Itemized Deduction or Optional Standard Deduction?
The Pros and Cons of Itemized Deduction
The Itemized Deduction scheme decreases the taxable income of a taxpayer based on actual allowable expenses supported by receipts. These allowable expenses include utility bills, rents, amortizations, marketing expenditures, and salaries and allowances, among others.
Unlike Optional Standard Deduction, the primary advantage of Itemized Deduction is that the taxable income can be made significantly lower with proper accounting of allowable expenses. In addition, there is no income tax to be paid if these expenses are higher than the income.
However, it has disadvantages and limitations. Take note of the following:
• Of course, one con of Itemized Deduction is that one has to have a full understanding of the allowable expenses under the Tax Law of the Philippines. Some of these expenses are straightforward, while others have specific considerations.
• This deduction scheme can be time-consuming depending on the extent of the operation. The taxpayer needs to keep a record of all expenses in the Books of Account. Hence, Itemized Deduction can be disadvantageous for small businesses and most self-employed professionals or freelancers.
• Note that aside from recording all allowable expenses, the taxpayer needs to keep all the receipts as proof. BIR mandates that these receipts should be kept within 10 years from the date of their issuance.
• There is always an option to hire an accountant to keep track of all the expenses and tax obligations. However, the retainer fee for taxpayers who opted for Itemized Deduction is higher than the Optional Standard Deduction.
• For gross sales or income exceeding PhP 3 million, the taxpayer is required to hire an independent Certified Public Accountant to audit the Books of Accounts, Income Tax Returns, and other pertinent documents.
The Pros and Cons of Optional Standard Deduction
The Optional Standard Deduction scheme is a simple way to compute the taxable income. Under this option, the allowable expense is based on the fixed 40 percent of the gross sales of an individual taxpayer and General Professional Partnership organization; or the gross income of corporate taxpayers and co-partnerships.
Below are the advantages of Optional Standard Deduction:
• It is straightforward and thus, can save taxpayers time and effort because they do not need to record all of their expenses in the Book of Accounts and keep receipts of their expenses. Note that this is very beneficial for small business owners and self-employed professionals.
• The retainer fee for accountants who are working on the books and tax obligations of taxpayers who have opted for Optional Standard Deduction is lower than Itemized Deduction because of lesser paperwork.
• Another advantage of this deduction scheme is that there is no need to hire an independent Certified Public Accountant even if the gross sales or income exceeds PhP 3 million.
• The income statement of taxpayers who opt for Optional Standard Deduction is always positive even if expenses exceed income. Note that this can be beneficial when applying for loans. Of course, note that the income statement would not be positive if the taxpayer has declared “no income” for the entire tax year.
Despite the advantages mentioned above, this deduction scheme has a critical disadvantage. To be specific, the Optional Standard Deduction will always show that a taxpayer is always profitable even if he or she is not.
Another disadvantage is that higher income tax for taxpayers who have equal or almost similar amounts of income and real expenses.
Conclusions: Itemized Deduction vs. Optional Standard Deduction
The respective pros and cons of Itemized Deduction and Optional Standard Deduction should be weighed carefully. In a nutshell, a business or individual taxpayer with minimal expenses can benefit from Optimized Standard Deduction scheme.
However, if expenses are high, Itemized Deduction may be a better option. This scheme allows taxpayers to minimize their taxable income beyond the fixed 40 percent. Furthermore, this scheme is beneficial for taxpayers with almost equal income and expenses.
As an example, if a business has earned PhP 3 million while incurring allowable expenses amounting to PhP 2.5 million during a specific tax year, then the taxable income is still 40 percent of PhP 3 million or PhP 1.2 million under the Optional Standard Deduction scheme.
On the other hand, under the Itemized Deduction scheme, the taxable income would only be PhP 50000 because the PhP 2.5 million total expense has been deducted from the gross income of PhP 3 million.