Most inventors, even those who are sophisticatedbusinesspeople, don’t fully appreciate just how much money they can save with tax deductions. Only part of any deduction ends up back in your pocket as money saved. Because a deduction represents income on which you don’t have to pay tax, the value of any deduction is the amount of tax you would have had to pay on that income had you not deducted it. So a deduction of $1,000 won’t save you $1,000—it will save you whatever you would otherwise have had to pay as tax on that $1,000 of income.
Federal and State Income Taxes
To determine how much income tax a deduction will save you, you must first figure out your income tax bracket. The United States has a progressive income tax system for individual taxpayers with six different tax rates (called tax brackets), ranging from 10% of taxable income to 35%. The higher your income, the higher your tax rate.
You move from one bracket to the next only when your taxable income exceeds the bracket amount. The tax bracket in which the last dollar you earn for the year falls is called your “marginal tax bracket.” For example, if you have $70,000 in taxable income, your marginal tax bracket is 25%. To determine how much federal income tax a deduction will save you, multiply the amount of the deduction by your marginal tax bracket. For example, if your marginal tax bracket is 25%, you will save 25¢ in federal income taxes for every dollar you are able to claim as a deductible business expense (25% × $1 = 25¢). This calculation is only approximate because an additional deduction may move you from one tax bracket to another and thus lower your marginal tax rate.
Income tax brackets are adjusted each year for inflation. For current brackets, see IRS Publication 505, Tax Withholding and Estimated Tax.
You can also deduct your business expenses from any state income tax you must pay. The average state income tax rate is about 6%, although seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) don’t have an income tax. You can find a list of all state income tax rates at the Federation of Tax Administrators website at www.taxadmin.org.
Everyone who works—whether a business owner or an employee—is required to pay Social Security and Medicare taxes. Employees pay one-half of these taxes through payroll deductions; the employer must pony up the other half and send the entire payment to the IRS. Business owners must pay all of these taxes themselves. Business owners’ Social Security and Medicare contributions are called self-employment taxes.
Self-employment taxes consist of a 12.4% Social Security tax on self-employment income up to an annual limit; in 2013, the limit was $113,700. Medicare taxes are levied on all self-employment income at a 2.9% rate. This combines to a total 15.3% tax on self-employment income up to the Social Security tax ceiling. However, the effective self-employment tax rate is lower, because (1) you are allowed to deduct half of your self-employment taxes from your net income for income tax purposes, and (2) you pay self-employment tax on only 92.35% of your net self-employment income. Like income taxes, self-employment taxes are paid on the net profit you earn from a business. Thus, deductible business expenses reduce the amount of self-employment tax you have to pay by lowering your net profit.
Total Tax Savings
When you add up your savings in federal, state, and self-employment taxes, you can see the true value of a business tax deduction. For example, if you’re in the 25% federal income tax bracket, a business deduction can be worth as much as 25% (in federal taxes) + 12.3% (in self-employment taxes) + 6% (in state taxes). That adds up to a whopping 43.3% savings. (If you itemize your personal deductions, your actual tax savings from a business deduction are a bit less because the deduction reduces your state income tax and therefore reduces the federal income tax savings from this itemized deduction.) If you buy a $1,000 computer for your business and you deduct the expense, you save over $400 in taxes. In effect, the government is paying for almost half of your business expenses. This is why it’s so important to know all the business deductions you are entitled to take—and to take advantage of every one.