How Tax Deductions Work

A tax deduction (also called a tax write-off) is an amount of money you are entitled to subtract from your gross income (all the money you make) to determine your taxable income (the amount on which you must pay tax). The more deductions you have, the lower your taxable income will be and the less tax you will have to pay.

Types of Tax Deductions

There are three basic types of tax deductions: personal deductions, investment deductions, and business deductions. This book covers only business deductions -- the large array of write-offs available to business owners.

Personal Deductions

For the most part, your personal, living, and family expenses are not tax deductible. For example, you can't deduct the food that you buy for yourself and your family. There are, however, special categories of personal expenses that may be deducted, subject to strict limitations. These include items such as home mortgage interest, state and local taxes, charitable contributions, medical expenses above a threshold amount, interest on education loans, and alimony. This book does not cover these personal deductions.

Investment Deductions

Many people try to make money by investing money. For example, they might invest in real estate or play the stock market. These people incur all kinds of expenses, such as fees paid to money managers or financial planners, legal and accounting fees, and interest on money borrowed to buy investment property. These and other investment expenses (also called expenses for the production of income) are tax deductible, subject to certain limitations. Investment deductions are not covered in this book.

Business Deductions

People in business usually must spend money on their business -- for office space, supplies, and equipment. Most business expenses are deductible, sooner or later, one way or another. And that's what this book is about: the many deductions available only to people who are in business (sole proprietors, independent contractors, and small business owners).

You Only Pay Taxes on Your Business Profits

The federal income tax law recognizes that you must spend money to make money. Virtually every business, however small, incurs some expenses. Even someone with a low overhead business (such as a freelance writer) must buy paper, computer equipment, and office supplies. Some businesses incur substantial expenses, even exceeding their income.

You are not legally required to pay tax on every dollar your business takes in (your gross business income). Instead, you owe tax only on the amount left over after your business's deductible expenses are subtracted from your gross income (this remaining amount is called your net profit). Although some tax deduction calculations can get a bit complicated, the basic math is simple: The more deductions you take, the lower your net profit will be, and the less tax you will have to pay.

Example: Karen, a sole proprietor, earned $50,000 this year from her consulting business. Fortunately, she doesn't have to pay income tax on the entire $50,000 -- her gross income. Instead, she can deduct from her gross income various business expenses, including a $5,000 home office deduction (see Chapter 7) and a $5,000 deduction for equipment expenses (see Chapter 5). She deducts these expenses from her $50,000 gross income to arrive at her net profit: $40,000. She pays income tax only on this net profit amount.

You Must Have a Legal Basis for Your Deductions

All tax deductions are a matter of legislative grace, which means that you can take a deduction only if it is specifically allowed by one or more provisions of the tax law. You usually do not have to indicate on your tax return which tax law provision gives you the right to take a particular deduction. If you are audited by the IRS, however, you'll have to provide a legal basis for every deduction you take. If the IRS concludes that your deduction wasn't justified, it will deny the deduction and charge you back taxes and, in some cases, penalties.

You Must Be in Business to Claim Business Deductions

Only businesses can claim business tax deductions. This probably seems like a simple concept, but it can get tricky. Even though you mightbelieve you are running a business, the IRS may beg to differ. If your small-scale business doesn't turn a profit for several years in a row, the IRS might decide that you are engaged in a hobby rather than a business. This may not sound like a big deal, but it could have disastrous tax consequences: People engaged in hobbies are entitled to very limited tax deductions, while businesses can deduct all kinds of expenses. Fortunately, this unhappy outcome can be avoided by careful taxpayers. (See Chapter 2 for a detailed discussion on how to beat the hobby loss rule.)

How Businesses Are Taxed

If your business earns money (as you undoubtedly hope it will), you will have to pay taxes on those profits. How you pay those taxes will depend on how you have structured your business. So, before getting further into the details of tax deductions, it's important to understand what type of business you have formed (a sole proprietorship, partnership, limited liability company, or corporation) and how you will pay tax on your business's profit.

This section briefly summarizes some fairly complex areas of law. Although it covers the basic tax consequences of each business form, it does not explain how to choose the best structure for your business. If you need to decide how to organize a new business or want to know whether you should change your current business form, you can refer to LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso (Nolo), or Choose the Best Legal Structure for Your One-Person Business, by Stephen Fishman (available on Nolo's website at www.nolo.com, under eProducts).

Basic Business Forms

Every business, from a part-time operation you run from home while in your jammies to a Fortune 500 multinational company housed in a gleaming skyscraper, has a legal structure. If you're running a business right now, it has a legal form even if you made no conscious decision about how it should be legally organized.

The four basic legal structures for a business are sole proprietorship, partnership, limited liability corporation, and corporation. For tax purposes, corporations are either S corporations (corporations that have elected pass-through tax treatment) or C corporations (also called regular corporations). Every business falls into one of these categories -- and your category will determine how your business's profits will be taxed.

Sole Proprietorship

A sole proprietorship is a one-owner business. You can't be a sole proprietor if two or more people own the business (unless you own the business with your spouse). Unlike the other business forms, a sole proprietorship has no legal existence separate from the business owner. It cannot sue or be sued, own property in its own name, or file its own tax returns. The business owner (proprietor) personally owns all of the assets of the business and controls its operation. If you're running a one-person business and you haven't incorporated or formed a limited liability company, you are a sole proprietor.

Partnership

A partnership is a form of shared ownership and management of a business. The partners contribute money, property, or services to the partnership; in return, they receive a share of the profits it earns, if any. The partners jointly manage the partnership business. A partnership automatically comes into existence whenever two or more people enter into business together to earn a profit and don't incorporate or form a limited liability company. Although many partners enter into written partnership agreements, no written agreement is required to form a partnership.

Corporation

Unlike a sole proprietorship or partnership, a corporation cannot simply spring into existence -- it can only be created by filing incorporation documents with your state government. A corporation is a legal entity distinct from its owners. It can hold title to property, sue and be sued, have bank accounts, borrow money, hire employees, and perform other business functions.

For tax purposes, there are two types of corporations: S corporations (also called small business corporations) and C corporations (also called regular corporations). The most important difference between the two types of corporations is how they are taxed. An S corporation pays no taxes itself -- instead, its income or loss is passed on to its owners, who must pay personal income taxes on their share of the corporation's profits. A C corporation is a separate taxpaying entity that pays taxes on its profits. (See "Tax Treatment," below.)

Limited Liability Company

The limited liability company, or LLC, is the newest type of business form in the United States. An LLC is like a sole proprietorship or partnership in that its owners (called members) jointly own and manage the business and share in the profits. However, an LLC is also like a corporation, because its owners must file papers with the state to create the LLC, it exists as a separate legal entity, and the LLC structure gives owners some protection from liability for business debts.

Tax Treatment

Your business's legal form will determine how it is treated for tax purposes. There are two different ways that business entities can be taxed: The business itself can be taxed as a separate entity, or the business's profits and losses can be "passed through" to the owners, who include the profits or losses on their individual tax returns.

Pass-Through Entities: Sole Proprietorships, Partnerships, LLCs, and S Corporations

Sole proprietorships and S corporations are always pass-through entities. LLCs and partnerships are almost always pass-through entities as well -- partnerships and multiowner LLCs are automatically taxed as partnerships when they are created. One-owner LLCs are automatically taxed like sole proprietorships. However, LLC and partnership owners have the option of choosing to have their entity taxed as a C corporation or S corporation by filing an election with the IRS. This is rarely done.

A pass-through entity does not pay any taxes itself. Instead, the business's profits or losses are passed through to its owners, who include them on their own personal tax returns (IRS Form 1040). If a profit is passed through to the owner, that money is added to any other income the owner has and the owner pays taxes on the total amount. If a loss is passed through, the owner can generally use it to offset income from other sources -- for example, salary from a job, interest, investment income, or a spouse's income (as long as the couple files a joint tax return). The owner can subtract the business loss from this other income, which leaves a lower total subject to tax.

Example: Lisa is a sole proprietor who works part time as a personal trainer. During her first year in business, she incurs $10,000 in expenses and earns $5,000, giving her a $5,000 loss from her business. She reports this loss on IRS Schedule C, which she files with her personal income tax return (Form 1040). Because Lisa is a sole proprietor, she can deduct this $5,000 loss from any income she has, including her $100,000 annual salary from her engineering job. This saves her about $2,000 in total taxes for the year.

Although pass-through entities don't pay taxes, their income and expenses must still be reported to the IRS as follows:

• Sole proprietors must file IRS Schedule C, Profit or Loss From Business, with their tax returns. This form lists all the proprietor's business income and deductible expenses.
• Partnerships are required to file an annual tax form (Form 1065, U.S. Return Partnership of Income) with the IRS. Form 1065 is not used to pay taxes. Instead, it is an "information return" that informs the IRS of the partnership's income, deductions, profits, losses, and tax credits for the year. Form 1065 also includes a separate part called Schedule K-1 in which the partnership lists each partner's share of the items listed on Form 1065. A separate Schedule K-1 must be provided to each partner. The partners report on their individual tax returns (Form 1040) their share of the partnership's net profit or loss as shown on Schedule K-1. Ordinary business income or loss is reported on Schedule E, Supplemental Income or Loss. However, certain items must be reported on other Schedules -- for example, capital gains and losses must be reported on Schedule D and charitable contributions on Schedule A.
• S corporations report their income and deductions much like a partnership. An S corporation files an information return (Form 1120S) reporting the corporation's income, deductions, profits, losses, and tax credits for the year. Like partners, shareholders must be provided a Schedule K-1 listing their share of the items listed in the corporation's Form 1120S. The shareholders file Schedule E with their personal tax returns (Form 1040) showing their share of corporation income or losses.
• LLCs with only one member are treated like a sole proprietorship for tax purposes. The member reports profits, losses, and deductions on Schedule C -- just like a sole proprietor. An LLC with two or more members is treated like a partnership for tax purposes unless the members elect to be taxed like a C corporation (which is rare).

Regular C Corporations

A regular C corporation is the only business form that is not a pass-through entity. Instead, a C corporation is taxed separately from its owners. C corporations must pay income taxes on their net income and file their own tax returns with the IRS, using Form 1120 or Form 1120-A. They also have their own income tax rates (which are lower than individual rates at some income levels).

When you form a C corporation, you have to take charge of two separate taxpayers: your corporation and yourself. Your C corporation must pay tax on all of its income. You pay personal income tax on C corporation income only when it is distributed to you in the form of salary, bonuses, or dividends.

C corporations can take all the same business tax deductions that pass-through entities take. In addition, because a C corporation is a separate tax-paying entity, it may provide its employees with tax-free fringe benefits, then deduct the entire cost of the benefits from the corporation's income as a business expense. No other form of business entity can do this. (Although they are corporations, S corporations cannot deduct the cost of benefits provided to shareholders who hold more than 2% of the corporate stock.)

C corporations may provide their employees (including owners who work in the business) with fringe benefits such as:

• disability insurance
• reimbursement of medical expenses not covered by insurance
• up to $215 (in 2007) per month in parking reimbursements
• the cost of annual medical check-ups
• de minimis fringe benefits (such as small Christmas gifts or occasional meals)
• child and dependent care payments up to $5,000 per year per employee
• $50,000 of group term life insurance
• the cost of a group legal services plan for employees
• up to $5,250 in tuition reimbursements for employee educational expenses, whether or not job-related, and
• death benefit payments of up to $5,000.

Employees do not have to include the cost of premiums or other payments the corporation makes for these benefits in their personal income for income tax purposes. (See Chapter 11 for a detailed discussion.)

The Value of a Tax Deduction

Most taxpayers, even sophisticated businesspeople, don't fully appreciate just how much money they can save with tax deductions. Only part of any deduction will end 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%. (See the chart below.) 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. For example, if you are a single taxpayer, you pay 10% income tax on all your taxable income up to $7,825. If your taxable income exceeds $7,825, the next tax rate (15%) applies to all your income over $7,825 -- but the 10% rate still applies to the first $7,825. If your income exceeds the 15% bracket amount, the next tax rate (25%) applies to the excess amount, and so on until the top bracket of 35% is reached.

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 $60,000 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% x $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. For example, if you're married filing jointly and your taxable income is $129,000, an additional $1,000 deduction will lower your marginal tax rate from 28% to 25%. The first $500 of the deduction will save you $140 in tax (28% x $500 = $140); the remaining $500 will save you $125 (25% x $500 = $125). So your total tax saving is $265, instead of the $280 you would get if, say, your taxable income was $130,000.

The following table lists the 2007 federal income tax brackets for single and married individual taxpayers and shows the tax savings for each dollar of deductions.

[2007 Federal Personal Income Tax Brackets Table] omitted for online sample chapter.

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 www.taxadmin.org/FTA/rate/ind_inc.html.

Self-Employment Taxes

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 2007, the limit was $97,500. 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. The following chart shows the effective self-employment tax rates.

[Self-employment tax chart] omitted for online sample chapter.

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 is a bit less because it 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 about $433 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.

Don't buy stuff just to get a tax deduction. Although tax deductions can be worth a lot, it doesn't make sense to buy something you don't need just to get a deduction. After all, you still have to pay for the item, and the tax deduction you get in return will only cover a portion of the cost. If you buy a $1,000 computer, you'll probably be able to deduct less than half of the cost. That means you're still out over $500 -- money you've spent for something you don't need. On the other hand, if you really do need a computer, the deduction you're entitled to is like found money -- and it may help you buy a better computer than you could otherwise afford.

What Businesses Can Deduct

Business owners can deduct four broad categories of business expenses:

• start-up expenses
• operating expenses
• capital expenses, and
• inventory costs.

This section provides an introduction to each of these categories (they are covered in greater detail in later chapters).

You must keep track of your expenses. You can deduct only those expenses that you actually incur. You need to keep records of these expenses to (1) know for sure how much you actually spent, and (2) prove to the IRS that you really spent the money you deducted on your tax return, in case you are audited. Accounting and bookkeeping are discussed in detail in Chapter 15.

Start-Up Expenses

The first money you will have to shell out will be for your business's start-up expenses. These include most of the costs of getting your business up and running, like license fees, advertising costs, attorney and accounting fees, travel expenses, market research, and office supplies expenses. You may deduct up to $5,000 in start-up costs the first year a new business is in operation. You may deduct amounts over $5,000 over the next 15 years.

Example: Cary, a star hairdresser at a popular salon, decides to open his own hairdressing business. Before Cary's new salon opens for business, he has to rent space, hire and train employees, and pay for an expensive preopening advertising campaign. These start-up expenses cost Cary $20,000. Cary may deduct $5,000 of his $20,000 in operating expenses the first year he's in business. He may deduct the remaining $15,000 in equal amounts over the next 15 years.

Operating Expenses

Operating expenses are the ongoing day-to-day costs a business incurs to stay in business. They include such things as rent, utilities, salaries, supplies, travel expenses, car expenses, and repairs and maintenance. These expenses (unlike start-up expenses) are currently deductible -- that is, you can deduct them all in the same year when you pay them. (See Chapter 4 for more on deducting operating expenses.)

Example: After Cary's salon opens, he begins paying $5,000 a month for rent and utilities. This is an operating expense that is currently deductible. When Cary does his taxes, he can deduct from his income the entire $60,000 that he paid for rent and utilities for the year.

Capital Expenses

Capital assets are things you buy for your business that have a useful life of more than one year, such as land, buildings, equipment, vehicles, books, furniture, machinery, and patents you buy from others. These costs, called capital expenses, are considered to be part of your investment in your business, not day-to-day operating expenses.

Large businesses -- those that buy at least several hundred thousand dollars of capital assets in a year -- must deduct these costs by using depreciation. To depreciate an item, you deduct a portion of the cost in each year of the item's useful life. Depending on the asset, this could be anywhere from three to 39 years (the IRS decides the asset's useful life).

Small businesses can also use depreciation, but they have another option available for deducting many capital expenses: They can currently deduct up to $125,000 in capital expenses per year under a provision of the tax code called Section 179. Section 179 is discussed in detail in Chapter 5.

Example: Cary spent $5,000 on fancy barber chairs for his salon. Because the chairs have a useful life of more than one year, they are capital assets that he will either have to depreciate over several years or deduct in one year under Section 179.

Certain capital assets, such as land and corporate stock, never wear out. Capital expenses related to these costs are not deductible; the owner must wait until the asset is sold to recover the cost. (See Chapter 5 for more on this topic.)

Inventory

Inventory includes almost anything you make or buy to resell to customers. It doesn't matter whether you manufacture the goods yourself or buy finished goods from someone else and resell the items to customers. Inventory doesn't include tools, equipment, or other items that you use in your business; it refers only to items that you buy or make to sell.

You must deduct inventory costs separately from all other business expenses -- you deduct inventory costs as you sell the inventory. Inventory that remains unsold at the end of the year is a business asset, not a deductible expense. (See Chapter 6 for more on deducting inventory.)

Example: In addition to providing hair styling services, Cary sells various hair care products in his salon that he buys from cosmetics companies. In 2008, Cary spent $15,000 on his inventory of hair care product but sold only $10,000 worth of the product. He can only deduct $10,000 of the inventory costs in 2008.

[Types of Deductible Business Expenses chart] omitted for online sample chapter.

Introduction

The tax code is full of deductions for businesses -- from automobile expenses to wages for employees. Before you can start taking advantage of these deductions, however, you need a basic understanding of how businesses pay taxes and how tax deductions work. This chapter gives you all the information you need to get started. It covers:

• how tax deductions work
• how businesses are taxed
• how to calculate the value of a tax deduction, and
• what businesses can deduct.