Lower Your Small Business Taxes
Stephen Fishman, J.D.
November 2013, 10th Edition
Reduce your taxes
Completely updated for 2013 returns!
Deduct It! shows you how to maximize your business deductions—quickly, easily and legally. Easy to read and full of real-world examples, Deduct It! will pay for itself many times over. It covers deductions for:
• start-up and operating expenses
• travel, meals and entertainment
• home offices (including new IRS rules)
• health care
• equipment and inventory
• and more
Deduct It! shows you how to avoid problems with the IRS, including having your business classified as a hobby. It also explains how to amend your tax return if necessary. Whether your enterprise is just starting or well established, this book
is indispensable to your financial success.
“Delves deeply into the complex thicket of available deductions, with real-life examples on deducting everything.”-Accounting Today
“For more information on how to handle inventory and write off the cost of goods, see…Deduct It! Lower Your Small Business Taxes.”-San Francisco Chronicle
“Outlines the many deductions available to small businesses—in plain English.”-National Federation of Independent Business
Add Your Own Review
1. Tax Deduction Basics
- How Tax Deductions Work
- How Businesses Are Taxed
- The Value of a Tax Deduction
- What Businesses Can Deduct
- Businesses That Lose Money
2. Are You Really in Business?
- What Is a Business?
- Tax Consequences of Being a Hobbyist
- Income-Producing Activities
3. Start-Up Expenses
- What Are Start-Up Expenses?
- Starting a New Business
- Buying an Existing Business
- Expanding an Existing Business
- When Does a Business Begin?
- Claiming the Deduction
- If Your Business Doesn't Last 15 Years
- Expenses for Businesses That Never Begin
- Organizational Expenses
- Avoiding the Start-Up Tax Rule’s Bite
4. Business Operating Expenses
- Requirements for Deducting Operating Expenses
- Operating Expenses That Are Not Deductible
- Tax Reporting
5. Deducting Long-Term Assets
- What is a Long-Term Assets
- Methods for Deduction Business Assets
- Rules for Deducting Any Long-Term Asset
- Section 179
- Bonus Depreciation
- Regular Depreciation
- Depreciation Recapture
- Tax Reporting and Record Keeping
- Leasing Long-Term Assets
- What Is Inventory?
- Deducting Inventory Costs
- Maintaining an Inventory
- Determining the Value of Inventory
7. Office Expenses
- Qualifying for the Home Office Deduction
- Corporation Employees
- Calculating the Home Office Deduction
- New Simplified Home Office Deduction method
- IRS Reporting Requirements
- Audit-Proofing Your Home Office Deduction
- Deducting an Outside Office or Workplace
8. Car and Local Travel Expenses
- Deductible Local Transportation Expenses
- The Standard Mileage Rate
- The Actual Expense Method
- How to Maximize Your Car Expense Deduction
- Other Local Transportation Expenses
- When Clients or Customers Reimburse You
- Reporting Transportation Expenses on Schedule C
- Corporations, LLCs, and Partnerships
9. Business Travel
- What Is Business Travel?
- What Travel Expenses Are Deductible
- How Much You Can Deduct
- Maximizing Your Business Travel Deductions
- How to Deduct Travel Expenses
- Travel Expenses Reimbursed by Clients or Customers
10. Meal and Entertainment Expenses
- What Is Business Entertainment?
- Who You Can Entertain
- Deducting Entertainment Expenses
- Calculating Your Deduction
- Reporting Entertainment Expenses on Your Tax Return
11. Hiring Workers
- Employees Versus Independent Contractors
- Tax Deductions for Employee Pay and Benefits
- Reimbursing Employees for Business-Related Expenditures
- Employing Your Family or Yourself
- Tax Deductions When You Hire Independent Contractors
12. Retirement Deductions
- Why You Need a Retirement Plan (or Plans)
- Employer IRAs
- Keogh Plans
- Solo 401(k) Plans
13. Medical Expenses
- The Health Care Reform Bill ("Obamacare")
- The Personal Deduction for Medical Expenses
- Deducting Health Insurance Costs
- Tax Credits for Employee Health Insurance
- Adopting a Medical Reimbursement Plan
- Health Savings Accounts
14. Additional Deductions
- Business Bad Debts
- Casualty Losses
- Charitable Contributions
- Dues and Subscriptions
- Education Expenses
- Insurance for Your Business
- Interest on Business Loans
- Legal and Professional Services
- Taxes and Licenses
- Domestic Production Activities
15. Record Keeping and Accounting
- What Records do your Need?
- Records Required for Specific Expenses
- How Long to Keep Records
- What If You Don’t Have Proper Tax Records?
- Accounting Methods
16. Claiming Tax Deductions for Prior Years
- Reasons for Amending Your Tax Return
- Time Limits for Filing Amended Returns
- How to Amend Your Return
- How the IRS Processes Refund Claims
17. Staying Out of Trouble With the IRS
- What Every Business Owner Needs to Know About the IRS
- Ten Tips for Avoiding an Audit
18. Help Beyond This Book
- Secondary Sources of Tax Information
- The Tax Law
- Consulting a Tax Professional
Tax Deduction Basics
How Tax Deductions Work............................................................. 6
Types of Tax Deductions............................................................ 6
You Only Pay Taxes on Your Business Profits........................... 7
You Must Have a Legal Basis for Your Deductions.................... 8
You Must Be in Business to Claim Business Deductions............ 8
How Businesses Are Taxed............................................................ 9
Basic Business Forms................................................................. 9
Tax Treatment........................................................................... 11
Spouses Who Co-Own a Business........................................... 14
The Value of a Tax Deduction....................................................... 17
Federal and State Income Taxes.............................................. 17
Self-Employment Taxes............................................................ 19
Total Tax Savings...................................................................... 20
What Businesses Can Deduct....................................................... 21
Start-Up Expenses.................................................................... 22
Operating Expenses.................................................................. 22
Capital Expenses....................................................................... 23
Businesses That Lose Money........................................................ 25
Figuring a Net Operating Loss................................................... 26
Carrying a Loss Back................................................................ 27
Carrying a Loss Forward........................................................... 28
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.
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.
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.
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.
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 might believe 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 Entity for a One-Person Business, by Stephen Fishman (an eGuide available on Nolo’s website, at www.nolo.com).
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 company, 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.
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.
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.
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 corporation 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 tax-paying 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 its structure gives owners some protection from liability for business debts.
Your business’s legal form will determine how it is treated for tax purposes. There are two different ways 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 multi-owner 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 an S corporation by filing an election with the IRS. This is rarely done. The rules for spouses who co-own a business are different (see “Spouses Who Co-Own a Business,” below).
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 of Partnership 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 and 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 1120-S) 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 1120-S. 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 $240 per month (in 2012) in parking reimbursements
• up to $20 per month to reimburse employees for the cost of commuting to work by bicycle (2012)
• the cost of annual medical checkups
• 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.)
Spouses Who Co-Own a Business
Prior to 2007, spouses who co-owned a business were classified as a partnership for federal tax purposes (unless they formed a corporation or LLC, or lived in a community property state—see below). Now, married couples in any state who own a business together may be able to elect to be taxed as sole proprietors. This does not reduce their taxes, but it does result in a much simpler tax return.
The rules for electing sole proprietor tax status differ depending on whether you live in a community property state or not. If a couple doesn’t choose or qualify for sole proprietor status, their jointly owned business will be classified as a partnership for federal tax purposes, assuming they have not formed an LLC or corporation. This means they must file a partnership tax return for the business. Each spouse should carry his or her share of the partnership income or loss from Form 1065, Schedule K-1, to their joint or separate Form 1040. Each spouse should also include his or her share of self-employment income on a separate Form 1040, Schedule SE.
Spouses in all states. Spouses in all states who jointly own and manage a business together can elect to be taxed as a “qualified joint venture” and treated as sole proprietors for tax purposes. To qualify as co–sole proprietors, the married couple must be the only owners of the business and they must both “materially participate” in the business—be involved with the business’s day-to-day operations on a regular, continuous, and substantial basis. Working more than 500 hours during the year meets this requirement. It’s likely that many couples will not be able to satisfy the material participation requirement.
A couple elects to be treated as a qualified joint venture by filing a joint tax return (IRS Form 1040). Each spouse files a separate Schedule C to report that spouse’s share of the business’s profits and losses, and a separate Schedule SE to report his or her share of self-employment tax. That way, each spouse gets credit for Social Security and Medicare coverage purposes. If, as is usually the case, each spouse owns 50% of the business, they equally share the business income or loss on their individual Schedule Cs. The couple must also share any deductions and credits according to their individual ownership interest in the business. If the business has employees, either spouse may report and pay the employment taxes due on any wages paid to the employees. The employer-spouse must report taxes due using the Employer Identification Number (EIN) of the sole proprietorship.
Spouses in community property states. Spouses in any of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) may elect qualified joint venture status as described above. However, couples in these states can also choose to classify their business as a sole proprietorship simply by filing a single Schedule C listing one spouse as the sole proprietor. For many couples, this is easier to do than the qualified joint venture status because there is no material participation requirement. The only requirements are that:
• The business is wholly owned by the husband and wife as community property.
• No person other than one or both spouses would be considered an owner for federal tax purposes.
• The business entity is not treated as a corporation. (Rev. Proc. 2002-69).
One drawback to this election is that only one spouse (the one listed in the Schedule C) receives credit for Social Security and Medicare coverage purposes.
What if Your Spouse Is Your Employee?
Instead of being co-owners of a business, spouses can have an employer-employee relationship—that is, one spouse solely owns the business (usually as a sole proprietor) and the other spouse works as his or her employee. In this event, there is no need to worry about having to file a partnership tax return. One Schedule C would be filed in the name of the owner-spouse. The non-owner spouse’s income would be employee salary subject to income tax and FICA (Social Security and Medicare) withholding. (See Chapter 11.)
As far as taxes go, this is an excellent way to organize a small business because the employer-spouse can provide the employee-spouse with tax-free employee fringe benefits such as health insurance, which can cover the entire family (see Chapter 13).
However, a spouse is considered an employee only if there is an employer/employee type of relationship—that is, the first spouse substantially controls the business in terms of management decisions and the second spouse is under the direction and control of the first spouse. If the second spouse has an equal say in the affairs of the business, provides substantially equal services to the business, and contributes capital to the business, that spouse cannot be treated as an employee
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 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%. (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 $8,700. If your taxable income exceeds that amount, the next tax rate (15%) applies to all your income over $8,700—but the 10% rate still applies to the first $8,700. 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 $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.
The following table lists the 2012 federal income tax brackets for single and married individual taxpayers and shows the tax savings for each dollar of deductions.
2012 Federal Personal Income Tax Brackets
Up to $8,700
Up to $17,400
$8,701 to $35,350
$17,401 to $70,700
$35,351 to $85,650
$70,701 to $142,700
$85,651 to $178,650
$142,701 to $217,450
$178,651 to $388,350
$217,451 to $388,350
All over $388,350
All over $388,350
Higher Income Taxes for 2013?
The tax rates in effect in 2012 are scheduled to expire at the end of the 2012 calendar year. These rates were enacted in 2001 and 2003 as part of the so-called “Bush tax cuts,” when income tax rates were reduced across the board. Starting in 2013, the tax rates are scheduled to go back to the higher tax rates in effect prior to 2001. If this happens, the 10% rate will be eliminated and the rates will be 15%, 28%, 31%, 36%, and 39.6%. Most people believe Congress will not allow rates to return to their pre-2001 higher levels. However, as this book went to press it was unclear what the income tax rates would be for 2013 and later.
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 and New Hampshire taxes only gambling winnings and dividends and interest. 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.
Ordinarily, self-employment taxes consist of a 12.4% Social Security tax on income up to an annual ceiling; however, for 2012, this amount has been reduced to 10.4%. In 2012, the annual Social Security ceiling was $110,100. Medicare taxes are not subject to any income ceiling and are levied at a 2.9% rate. For 2012, this combines to a total 13.3% tax on employment or 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.
Higher Medicare Taxes In 2013
Starting in 2013, Medicare taxes for high income taxpayers will go up by 0.9% to 3.8%. The increase applies to self-employed people with net self-employment income over $200,000. If the taxpayer is married and files a joint return, the increase kicks in at $250,000. Thus, for example, a single person with self-employment income of $300,000 would pay a 2.9% Medicare tax on the first $200,000 in income and 3.8% on the remaining $100,000.
Unlike the other self-employment taxes discussed above, you can’t deduct the increased Medicare payments from your income taxes.
The increase applies to employees as well as to the self-employed. Employees will have to pay the entire increase out of their own pockets. Thus, employers will continue to pay a 1.45% Medicare tax on their employees’ wages. Employees will continue to pay 1.45% until their wages reach the $200,000 or $250,000 ceiling. Then they will pay the additional 2.35%.
In addition, also starting in 2013, Medicare taxes will have to be paid by high-income taxpayers on investment income as well as on wages and self-employment income. A 3.8% Medicare contributions tax will be imposed on the lesser of (1) the taxpayer’s net investment income, or (2) any excess of modified adjusted gross income over $200,000 ($250,000 for married taxpayers filing jointly). Net investment income consists of net income from interest, dividends, royalties, annuities, rents not derived from an active trade or business, any other gain from a passive trade or business, and taxable gains from the sale or other disposition of investment property
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) + 13.3% (in self-employment taxes) + 6% (in state taxes). That adds up to a whopping 44.3% 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 about $443 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 more than $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.
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 of more than $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 pre-opening advertising campaign. These start-up expenses cost Cary $25,000. Cary may deduct $5,000 of his $25,000 in operating expenses the first year he’s in business. He may deduct the remaining $20,000 in equal amounts over the next 15 years.
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 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’ worth 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: Under Section 179 of the tax code, small businesses can deduct up to $139,000 in capital expenses for tangible personal property in 2012. 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 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 hairstyling services, Cary sells various hair care products in his salon that he buys from cosmetics companies. In his first year in business, Cary spent $15,000 on his inventory of hair care products but sold only $10,000 worth of the products. He can only deduct $10,000 of the inventory costs.
Frequently Asked Questions About Tax Deductions
• Do I have to pay cash for an item to get a deduction? No. You may deduct the entire amount you pay for a deductible expense whether you pay by cash, check, credit card, or loan. (See Chapter 4.)
• Do I need a receipt to take a business expense deduction? Yes and no. You can claim whatever deductions you want, regardless of whether you have proof of the expense. If you are audited, however, you must be able to prove that you are entitled to the deduction. If you don’t have receipts, you may be able to use other records to prove you shelled out those costs. (See Chapter 15.)
Businesses That Lose Money
Unfortunately, businesses don’t always earn a profit. This is particularly likely to occur when they are first starting out or when economic conditions are bad. If you’re in this unfortunate situation, you may be able to obtain some tax relief. This could provide you with a refund of all or part of previous years’ taxes in as little as 90 days—a quick infusion of cash that should be very helpful.
If, like most small business owners, you’re a sole proprietor, you may deduct any loss your business incurs from your other income for the year—for example, income from a job, investment income, or your spouse’s income (if you file a joint return). If your business is operated as an LLC, S corporation, or partnership, your share of the business’s losses are passed through the business to your individual return and deducted from your other personal income in the same way as a sole proprietor. However, if you operate your business through a C corporation, you can’t deduct a business loss on your personal return. It belongs to your corporation.
If your losses exceed your income from all sources for the year, you have a “net operating loss” (NOL for short). While it’s not pleasant to lose money, an NOL can provide important tax benefits: It may be used to reduce your tax liability for both past and future years.
Figuring a Net Operating Loss
Figuring the amount of an NOL is not as simple as deducting your losses from your annual income. First, you must determine your annual losses from your business (or businesses). If you’re a sole proprietor who files IRS Schedule C, the expenses listed on the form will exceed your reported business income. If your business is a partnership, LLC, or S corporation, your share of the business’s losses will pass through the entity to your personal tax return. Your business loss is added to all your other deductions and then subtracted from all your income for the year. The result is your adjusted gross income (AGI).
To determine if you have an NOL, you start with your AGI on your tax return for the year reduced by your itemized deductions or standard deduction (but not your personal exemption). This must be a negative number or you won’t have an NOL for the year. Your adjusted gross income already includes all the deductions you have for your losses. You then add back to this amount any nonbusiness deductions you have that exceed your nonbusiness income. These include the standard deduction or itemized deductions, deduction for the personal exemption, nonbusiness capital losses, IRA contributions, and charitable contributions. If the result is still a negative number, you have an NOL for the year. You can use Schedule A of IRS Form 1045, Application for Tentative Refund, to calculate an NOL.
Carrying a Loss Back
You may apply an NOL to past tax years by filing an application for refund or amended return for those years. This is called carrying a loss back. (IRC § 172.) As a general rule, it’s advisable to carry a loss back, so you can get a quick refund from the IRS on your prior years’ taxes. However, it may not be a good idea if you paid no income tax in prior years, or if you expect your income to rise substantially in future years and you want to use your NOL in the future when you’ll be subject to a higher tax rate.
Ordinarily, you may carry back an NOL for the two years before the year you incurred the loss. However, the carry-back period is increased to three years if the NOL is due to a casualty or theft, or if you have a qualified small business and the loss is in a presidentially declared disaster area. (A qualified small business is a sole proprietorship or partnership that has average annual gross receipts of $5 million or less during the three-year period ending with the tax year of the NOL.) An even longer carry-back period is provided for disaster losses that occurred during 2008 through 2010. Such losses are carried back for five years, unless you elect not to use this longer carry-back period. For a list of presidentially declared disaster areas, see www.fema.gov/disasters.
The NOL is used to offset the taxable income for the earliest year first, and then applied to the next year or years. This will reduce the tax you had to pay for those years and result in a tax refund. Any part of your NOL left after using it for the carry-back years is carried forward for use for future years.
There are two ways to claim a refund for prior years’ taxes: You can file IRS Form 1040-X, Amended U.S. Individual Income Tax Return within three years, or you can seek a quicker refund by filing IRS Form 1045, Application for Tentative Refund. If you file Form 1045, the IRS is required to send your refund within 90 days. However, you must file Form 1045 within one year after the end of the year in which the NOL arose. Refer to Chapter 16 for guidance on how to file an amended tax return.
Carrying a Loss Forward
You have the option of applying your NOL only to future tax years. This is called carrying a loss forward. You can carry the NOL forward for up to 20 years and use it to reduce your taxable income in the future. You elect to carry a loss forward by attaching the following written statement to your tax return for the year you incur the NOL:
Tax Year: Taxpayer Name:
Taxpayer Identification Number:
Taxpayer elects to waive the carry-back period under IRC Section 173(b)(3).
Need to know more about NOLs? Refer to IRS Publication 536, Net Operating Losses (NOLS) for Individuals, Estates, and Trusts, for more information. You can download it from the IRS website at www.irs.gov, or obtain a paper copy by calling the IRS at 800-TAX-FORM.