Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part IV. Business Income and Deductions
Owning your own business can be tremendously satisfying. It can also be amazingly confusing and frustrating. One area that is particularly confusing to business owners is how to use the tax code effectively to their advantage. When you start dealing with business issues, taxes can become very complicated very quickly.
On a positive note, one of the greatest opportunities to reduce your taxes is found in converting your personal (non-deductible) expenses into deductible business expenses. The ability to recognize these opportunities can bring huge savings. With careful planning and record keeping, you will be able to use these deductions to your advantage and actually keep more of the money you work so hard for.
Part IV is full of money-saving opportunities—so many, in fact, that if you don’t own a business you may find yourself considering it after reading these chapters. There is no other circumstance with more opportunities for saving money on taxes than by owning a business.
Chapter 16. Business Taxation
Some Things You Should Know
Who says you can’t mix business and pleasure? Owning a business provides one of the greatest opportunities to reduce your taxable income by transforming non-deductible personal expenses into deductible business expenses. There are a multitude of opportunities to do so with personal expenses such as meals, transportation, travel, health care, education, your home, and so on. The key to doing this is in understanding what constitutes a legitimate business expense and the appropriate way of accounting for it.
What if you don’t own a business? Are all of the opportunities in this section out of your reach? Never fear. Owning a business can be very simple and easy. All you really have to do be in business is to say that you are. In fact, many times a person’s hobby or pastime can be converted into a legitimate business without much effort at all. Once you establish that you are pursuing an activity with a profit motive, all of the strategies in the seven chapters of Part 5 are opened up to you.
There are a few things about running a business, from a tax perspective, that you should know before diving into the individual strategies that are outlined in the following chapters. This chapter is devoted to helping you understand two key concepts:
· Income and expense recognition
· Losses and hobby rules
Income and Expense Recognition
There are two main methods of accounting that are used for the taxation of businesses. The first method is called the “Cash Accounting” method. Basically this method recognizes income when it is received and expenses when they are paid. A simple way of understanding this method is by thinking of your checkbook. If you write one check on December 31st, Year 1 and a separate check on January 1, Year 2, the first check would be an expense on Year 1’s tax return and the second check would appear as an expense in Year 2.
The second method of accounting is known as the “Accrual Accounting” method. With this method, income and expenses are recognized when they are incurred, not necessarily when they are paid or received. For example, if you purchase a new item for the business on December 15th, Year 1, but do not actually pay for the item until the vender sends you a bill on January 10th, Year 2, you would recognize the expense in Year 1 for accrual accounting purposes even though you did not pay for it until Year 2. The same scenario applies to income – you must recognize the income when you have earned it, not when you are paid for it.
Most sole proprietors can choose which method of accounting they will use. However, once you choose a method you may not change that method without permission from the IRS. This prevents businesses from bouncing back and forth between methods each year in an effort to game the system.
In addition, you cannot simply play games with invoices and income at the end of the year in order to manipulate the recognition of income. For example, if a cash-based business received a bunch of checks at the end of the year, it cannot simply wait until the following year to deposit them in the bank and count them as income for the following year. If you have control over the receipt of income it is considered the same as having been received.
To claim an expense as deductible for business purposes it must meet three criteria. It must be:
· Ordinary and necessary
· Paid or incurred during the taxable year
· Connected to the conducting of the trade or business
“Ordinary and necessary” has been interpreted by the tax courts to mean “reasonable and customary.” To be customary, an expense needs to be customary to the industry that you are in, as well as for the location where you operate your business. It doesn’t mean that the expense needs to be customary in your own business (meaning something you do all of the time), only that it is not unusual for a business similar to yours. In fact, it is okay even if you have only had the expense one time in the history of your business.
The expense must also be connected to the conduct of your trade or business. For example, even if you are a florist who buys hundreds of flowers every day to sell in your store, you cannot deduct the purchase of a dozen roses for your wife as a business expense because those particular flowers are not connected to conducting your trade or business.
Losses and Hobby Rules
Income sources are separated into different categories, such as investment income, passive income, earned income, and so on. In many cases a loss in one income category cannot be used to offset income in another category. This is not the case with business income. If your business loses money, that loss will reduce your total income and help reduce your taxes. In fact, if the loss is greater than your total income from other categories it can be carried back to offset income from the two previous years, or carried forward to offset income in a future year.
With that said, there is one catch. The IRS does not allow you to continuously claim a loss from a business year after year after year. If it were not so it would be easy to claim your favorite pastime as a business and write off all of your expenses as losses, since you have little or no income. What a fantastic way to reduce your taxes by deducting personal expenses! Too bad it doesn’t work.
Example Dean operates a mountain expedition business where he takes tourists on week-long backpacking trips. Mike isn’t very good at marketing, so he rarely finds anyone to go on the trips. Each year, however, Mike takes four week-long trips (by himself) in places around the world in order to become familiar with the locations in case he ever has a customer who would like to go there and claims all of his expenses for the trip as deductions for his business. These expenses add up to thousands of dollars in losses each year since he has no income to offset them. After four years of claiming these losses for his “business” the IRS caught up to him and determined that he was not really running a business—he was really just pursuing a hobby—and they disallowed all of the previous losses from his “business.”
Of course, your business does not have to make a profit every year to be considered a legitimate business. The IRS and the courts only need to see that you have a true profit motive in your business in order to allow you to claim a loss. As a rule of thumb, the IRS will automatically presume that you have a profit motive if you earn a profit in three years out of any five-year period. In fact, if you lose money in the first years after starting a business you can insist that the IRS can defer a challenge to your business losses until you have completed a five-year period.
The three-out-of-five year rule is not absolute; it is more of a safe haven. It is okay to lose money in more years than that as long as you can prove a true profit motive for the activity that you are undertaking. More accurately, you must prove that you have an honest profit objective—even if there is not a reasonable expectation of actually earning a profit. In determining whether you have as your motive the intent to make a profit, the following things will be considered:
· The manner in which you carry on the activity
· The time and effort you spend in the activity
· Your success in carrying on similar activities, as well as other profit-motivated activities
· Your history of income and loss related to the activity
· Your expertise in the activity, as well as the expertise of you advisors
· The expectation that the assets in your business may appreciate in value
· How high your profits are when you are profitable
· Your personal financial status
· The elements of personal pleasure and recreation involved in the activity
It does not matter if you are employed full-time in another business. Only the demonstrable profit motive will determine the deductibility of losses. If the IRS successfully shows that your “business” does not have a profit motive, however, you will be subject to the back taxes, penalties, and interest that come from the reduced taxes that you didn’t pay because of those losses.
There are many hobbies that can be successfully turned into a profit-motivated business. If you can find ways to derive income from those hobbies (or at least reasonably expect income) you can claim the expenses. If it turns out that you are continuously showing a loss and you don’t want to have a run-in with the IRS, just be sure not to claim all of your deductions in three of the five years so that you show a little income. In this way you will be able to write off a lot of your personal expenses that would otherwise bring you no tax benefit.