Chapter 1
Some Tax Basics

How Tax Deductions Work............................................................. 4

Types of Tax Deductions............................................................ 4

You Pay Taxes Only on Your Business Profits........................... 5

Claiming Your Deductions........................................................... 6

Make Sure You Are in Business.................................................. 6

How Businesses Are Taxed............................................................ 7

Basic Business Forms................................................................. 7

Sole Proprietorship—The Most Popular Home Business Entity. 7

Tax Treatment............................................................................. 9

What Businesses Can Deduct....................................................... 11

Start-Up Expenses.................................................................... 12

Operating Expenses.................................................................. 12

Capital Expenses....................................................................... 13

Inventory.................................................................................... 13

Adding It All Up: The Value of Tax Deductions............................. 14

Federal and State Income Taxes.............................................. 14

Self-Employment Taxes............................................................ 16

Total Tax Savings...................................................................... 17

Once you start your own business, you can begin taking advan­tage of the many tax deductions available only to business owners. The tax code is full of deductions for businesses—and you are entitled to take them whether you work from home or from a fancy outside office. Before you can start using these deductions to hang on to more of your hard-earned money, 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

what expenses businesses can deduct, and

how to calculate the value of a tax deduction.

How Tax Deductions Work

A tax deduction (also called a 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, including those who work out of their homes.

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 some important limitations. (See “Investing and Other Income-Producing Activities” in Chapter 2 for more on investment deductions.)

Business Deductions

Home business owners usually have to spend money on their businesses—for example, for equipment, supplies, or business travel. Most business expenses are deductible sooner or later. It makes no difference for tax deduction purposes whether you run your business from home or from an outside office or workplace—either way, you are entitled to deduct your legitimate business expenses. This book is about the many deductions available to people who are in business and who happen to work from home.

You Pay Taxes Only on Your Business Profits

The federal income tax law recognizes that you must spend money to make money. Virtually every home 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 home 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, which she operates from her home office. Fortunately, she doesn’t have to pay income tax on the entire $50,000—her gross income. Instead, she can deduct various business expenses, including a $5,000 home office deduction (see Chapter 6) 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.

Claiming 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, interest, in some cases, and penalties.

Make Sure You Are in Business

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 home 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, careful taxpayers can usually avoid this unhappy outcome. (See Chapter 2 for tips that will help you convince the IRS that you ­really are running a business.)

How Businesses Are Taxed

If your home business earns money (as you undoubtedly hope it will), you will have to pay taxes on your 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.

Resource

Need help figuring out how to structure your business? Although most home businesses are sole proprietorships, that may not be the best business form for you. If you need to decide how to organize a new business or you want to know whether you should change your current business form, refer to LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso (Nolo).

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 never made a conscious ­decision about how it should be legally organized.

Sole Proprietorship—The Most Popular Home Business Entity

A sole proprietorship is a one-owner business. According to the Small Business Administration, 90% of all home businesses are sole proprietorships. 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 operations. If you’re running a one-person home business and you haven’t incorporated or formed a limited liability company, you are a sole proprietor. However, you can’t be a sole ­proprietor if two or more people own your home business, unless you are one of two spouses who jointly own and run their home business together. See Chapter 16 for a detailed discussion about how to legally organize a husband and wife home business.

Other Business Forms You Can Use

Only about 10% of home businesses adopt a business form other than a sole proprietorship. These other forms include:

Partnerships. 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. Thus, if you’re running a home business with somebody else, you are in a partnership right now (unless you’ve formed an LLC or a corporation). Although many partners enter into written partnership agreements, no written agreement is required to form a partnership.

Corporations. 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 Companies. The limited liability company (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 these amounts 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, the owner must add that money to any income from other sources, and pay tax 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 from home doing engineering consulting. 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 used to report partnership revenues, expenses, gains, and losses. The partnership must also provide each partner with an IRS Schedule K-1, Partner’s Share of Income, Credits, Deductions, etc., listing the partner’s share of partnership income and expenses (copies of these schedules must also be attached to IRS Form 1065). Partners must then file IRS Schedule E, Supplemental Income and Loss, with their individual income tax returns, showing their ­partnership income and deductions.

S corporations must file information returns with the IRS on Form 1120S, U.S. Income Tax Return for an S Corporation, showing how much the business earned or lost and each shareholder’s portion of the corporate income or loss.

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 ­ordinarily treated like a partnership: The LLC must ­prepare and file IRS Form 1065, Partnership Return of Income, showing the allocation of profits, losses, credits, and deductions passed through to the members. The LLC must also prepare and distribute to each member a Schedule K-1 showing the member’s allocations of profits, losses, credits, and deductions.

Regular C Corporations—Creating Two Taxable Entities

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 corporate tax returns with the IRS, using Form 1120, U.S. Corporation Income Tax Return, or Form 1120-A, U.S. Corporation Short-Form Income Tax Return. 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. However, you might have to pay special penalty ­taxes if you keep too much money in your corporation to avoid having to pay personal income tax on it.

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.)

What Businesses Can Deduct

Business owners, whether they work at home or elsewhere, 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).

Tip

You must keep track of your expenses. You may 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

Start-up expenses are expenses you incur to get your home business up and running—such as license fees, advertising costs, attorney and ­accounting fees, market research, and office supplies expenses. Start-up costs are not currently deductible—that is, you cannot deduct them all in the year in which you incur them. However, you can deduct up to $5,000 in start-up costs in the first year your new business is in operation. You must deduct amounts over $5,000 over the next 15 years. Most home business owners should be able to avoid incurring substantial start-up expenses. (See Chapter 3 for a detailed discussion of deducting start-up expenses.)

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 year when you pay them. (See Chapter 4 for more on operating expenses.)

Capital Expenses

Capital assets are things you buy for your business that have a useful life of more than one year, such as equipment, vehicles, books, office 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 deduct a certain amount in capital expenses per year under a provision of the tax code called Section 179. The Section 179 deduction ceiling is $139,000 for 2012. Section 179 and depreciation are discussed in detail in Chapter 5.

Certain capital assets, such as land and corporate stock, never wear out. What you spend to purchase and improve capital assets is not ­deductible; you have to wait until you sell the asset (or it becomes worthless) to recover these costs. (See Chapter 5 for more on deducting capital assets.)

Inventory

If your home business involves making or buying products, you’ll have an 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 them 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 10 for more on deducting inventory.)

Adding It All Up: The Value of Tax Deductions

Most taxpayers, even sophisticated businesspeople, don’t fully appreciate just how much money they can save with tax deductions. Of course, 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 $8,700 in 2012. 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¢).

The following table lists the 2012 federal ­income tax brackets for single and married individual taxpayers and shows the federal income tax savings for each dollar of deductions.

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. (New Hampshire residents pay tax on gambling winnings and income earned through interest and dividends only.) You can find your state’s tax rates at the Federation of Tax Administrators website at www.taxadmin.org.

Self-Employment Taxes

Everyone who works—business owner and employee alike—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. This makes business tax deductions doubly valuable.

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 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 $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 of the business deductions to which you are entitled—and to take advantage of every one.

CAUTION

Don’t buy things 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 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.