Where do I deduct all my business expenses?
In your dreams, buddy!
Now, please, before you write me a nasty email, let me explain. I’m not being rude with you, and I’m not trying to rob you. My opening words simply reflect the attitude of the IRS. Part of this attitude comes from the tax law as written by Congress. The other part is, well, just the IRS attitude.
I guess, you can counter their attitude with one of your own, as in “I don’t care.” In fact, a lot of people don’t care to follow the rules. Even more people simply don’t know the rules. As long as the IRS is not paying attention – anything flies. But, should they ever come knocking on your door, guess whose attitude is the bigger one?
This situation with the tax law is very similar to speeding. Yes, everybody around you is speeding too. Still, it will not help you persuade the cop who pulls you. At least, I failed to persuade mine. Ironically, he pulled me as I was returning from an IRS seminar.
In this article, we will look at the most important tax rules that apply to people like you and me who run their small businesses and want to minimize taxes. If you decide to not comply – well, at least you will know what you’re breaking.
Why I cannot simply deduct everything?
I cannot answer why, this is better be asked in Washington, D.C. I can only explain the crazy rules, as they are. If the world was simple, we could use a process like this:
- add up all business income
- subtract all business expenses
- pay tax on the difference.
As great as this concept is, it is DOA – dead on arrival. First, what is and what is not income? If I did a small job for someone and did not make any money on it – is it still income? If I sold something – is it income? All of it or part? If my investment real estate went up in price – is it income? What if I refinanced it? What if it did not come to me in cash but was redirected towards something else, like my health insurance or my retirement plan – is it still income? What if I sold something and immediately reinvested the money?
More than one person suggested what seems to be a simple solution: let’s count as income everything that came into your bank account. Not in your bank account = not income.
Well, great idea but not solving the problem. We still have countless what ifs: what if the deposit is a transfer from my other account? What if it’s a loan from my parents? What if it’s a refund for something I bought before? What if it’s a tenant security deposit? What if it’s insurance proceeds on a claim? Not that simple any more, is it?
Now, to expenses. Once again, it’s tempting to suggest a simple approach: if it’s taken out of your bank account, it’s an expense. Ha! Such simple solution is anything but simple. What if it’s charged on my credit card? What if it’s paid from my partner’s account? What if it’s paid from loan proceeds or from a line of credit? What if I return it to the store or get a rebate? What if my insurance paid for it?
And to make things even more confusing, let’s ponder what is actually business? Is my day job a business? How about a part-time job? What if I’m paid by hour? What if I have partners? Any difference if I create an LLC or a corporation? If I took a bunch of classes and bought bundles of CDs and manuals – this is business expense, right? And I bought a new truck to go to work – this must be business deduction?
No, I cannot answer all these questions in one article. I’m just trying to point out that there is no such thing as a “simple” solution for calculating taxes. Even if the Congress and the IRS tried to create one (which clearly is NOT their intention) – they would not be able to.
Now, let’s look at 4 critical areas where common sense and IRS rules do not meet.
- What is business?
- What is business income?
- What is business expenses?
- Can business expenses be deducted?
What is business?
For most people, business means making money. Our casual “How’s business?” can refer to anything from career growth at work to stock investments to running a restaurant to exploring some future opportunities. The IRS, however, has a rather narrow view.
A. Business means making money from selling products, providing services, or from leasing property. This excludes such potentially money-making ventures as investing in securities, lending money to other people (for instance, owner- financing in real estate), or gambling (which includes owner-financing, if you ask me).
B. Business means that you’re calling the shots, as opposed to working for a boss. Holding a salaried or commission job is absolutely not business, for tax purposes. It does not matter how high you’re in the company - if you’re an employee, you are not in business.
C. Working on contract is a confusing topic. When you say that you’re working on contract, it usually means that you are paid by hour, by job, or on commissions. By itself, it does not answer whether or not the IRS considers you to be in business. The key issue is: whoever pays you, do they deduct taxes from your pay? If they do, you’re an employee. If they don’t, you’re legally running a business, which is the same as saying that you’re self-employed or is an independent contractor.
D. Business means having a realistic expectation of making money. Losing money in business, even for several years in a row, is not technically against the IRS rules. However, you will have to prove that you honestly expected to make money and acted wisely and diligently. If your business plan involves promoting ice hockey in Africa or selling yoga textbooks to inmates – you may have tough time convincing the IRS.
E. Business means actually doing the work, as opposed to getting ready. Reading about business, taking seminars about business, daydreaming about business – none of that counts, even if you spend thousands of dollars and get divorced in the process. This rule is much trickier than it seems at first. You’re not in the restaurant business until your restaurant is open for customers. You’re not in the consulting business until you start marketing your services and bidding on projects. And here comes bad news for many real estate investors: you’re not in the rental business until you have a property ready for rent. Translation: not only you must buy the property, but you must finish the initial rehab – until then, you’re not legally in business, sorry.
Assuming that you passed the “in business” test, let’s move to the definition of income.
What is business income?
This question is obviously quite important. If something is not income – you don’t have to pay taxes on it.
As we discussed, in the land of simplicity you could go thru your bank statements and treat every deposit as income. In the IRS world, things are predictably much more complicated. The good news is that some items that are deposited into your account are not taxable income. The bad news is that some other items are taxable income, even if they were not physically in your bank account. Hey, I’m just the messenger; I hate it as much as you do.
Fortunately, we already have the starting point. Remember the first part of the definition of business? It’s making money from selling products, providing services, or from leasing property. Guess what? Income is when you are paid for one of these same three things: selling products, providing services, or leasing property.
Let’s practice. All of these would be income:
- commissions from sales
- payments by customers
- referral fees
- profits from flipping houses
Now, let’s list some examples of monies that are not business income:
- mortgages and loans you took
- repayment of loans that you extended to others
- most insurance proceeds
- cash from refinancing a rental house
- refundable tenant deposits
Are we done with the definition of business income? No, not yet. The next issue is what it means to be paid? You only think you know the answer, sorry. Cash, check, or credit cards are not the only ways you can receive income. Some other taxable variations are payments to third parties, payments “in kind” (property or services), forgiveness of debt, and benefits. To illustrate these hidden forms of income, let’s consider couple examples.
- A management company, instead of paying cash to one of their managers, Anna, pays Anna’s rent to her landlord. The IRS says that Anna received income equal to her rent.
- I prepare a tax return for Jim, a professional painter, and Jim offers to paint my office instead of paying me. If I accept his offer, we both have taxable income, known as barter income.
- Roger falls behind on a personal loan that he received from his business partner, Helen. Helen agrees to call it even if Rogers forfeits his half-interest in the property they own together. Per the IRS, it is a sale in which Roger received income equal to the balance of the loan.
Finally, for a real bummer, I have to tell you that sometimes the IRS loads you with “paper” income: the money you have not actually received but are still taxable to you. The most notorious example concerns real estate dealers who sell with owner financing. They are forced to pay taxes on future payments right away, even though they have not yet received the money and may never receive it if the buyer defaults. Tough deal.
Now, if the IRS made the definition of business income so confusing, maybe they can at least give us a clear definition of business expense? Well, let’s see.
What is business expenses?
Yes, there is an official definition. No, it’s not making any sense for us, mere mortals. Instead, I offer you an unofficial but practical definition. My website has an entire article Can I deduct this on my tax return? devoted to this definition. Here, I will only do a quick summary. Business expense is something that:
- you actually paid
- had a specific business purpose
- nobody reimbursed you for it
- not specifically excluded by the IRS.
As always, it only looks simple, as evidenced by a few examples.
- The cost of your own labor is not a business expense – because you did not pay anyone for it.
- Despite your need to look professional, the IRS will not treat your haircuts as a business expense.
- The hotel bill is not a business expenses either – if your out-of-town client reimbursed you for it.
- If the city fined you for not pulling a construction permit – it is not a business expense either. Why? Because the IRS says so.
At this moment you may be wondering if the Congress and the IRS can make these tax rules any more obnoxious than this? And the answer is a resounding YES! Never underestimate the creativity of politicians who are well paid with our tax money to make this mess. For proof, let’s look at deductibility of expenses.
Can I deduct business expenses?
Well… Some of them – yes. Others – no. Yet others – yes, you can, but in small portions over many years. This involves funny words like capitalization, depreciation, amortization, and, in extreme cases, institutionalization. Sounds like fun? Not to me, either.
In a sense, we returned to where we started. If we had a simple tax system, all business expenses could be deducted at once. Unfortunately, the IRS created different types of business expenses, each with its own set of rules. Hint: those are not the simple, reasonable kind of rules.
Start-up expenses. These are all expenses incurred before your “in business” date. Here we include all research, training, marketing and other pre-opening expenses. You can usually deduct the first $5,000 ($10,000 in 2010) of start-up expenses once the business starts, but the rest of it will take 15 years of small deductions. And before your business officially starts – nothing at all. Ouch.
Asset acquisition expenses. The “big ticket” items that serve your business for more than 1 year are called assets. For example, machinery, computers, furniture, cars, real estate. What you pay for such things is called acquisition expenses or basis. Instead of letting us deduct the entire cost, the Congress wants us to deduct small portions over a number of years. Being the wonderful people they are, the IRS folks supply us with many pages of bizarre tables – presumably, to help us. This horribly complicated process is lovingly called depreciation. Trying to do it without computer software is suicide.
Fortunately, in many cases, depreciation can be substituted with an immediate deduction via another confusing concept, so-called Section 179 expensing. Unfortunately, section 179 is not available for real estate or assets used in rental business, such as appliances and carpets. Landlords have no choice but learn about depreciation.
As if not confusing enough already, asset acquisition calculations are further complicated by financing. If you financed your new copier and paid zero down, basis and depreciation are still figured out as if you paid 100% cash. When you buy real estate, both the check that you brought to closing and your mortgage terms are meaningless for tax calculation.
What matters is the sale price – the number at the top of your HUD-1 statement. If you notice a pattern, you should ignore financing altogether and do your calculations as if everything was paid in cash. And if you think this was torture – try calculating basis of a new car purchased with dealer financing and a trade-in and used partially for business. Good luck.
Capital expenses. Money spent on fixing an asset is usually added to the cost (basis) of the asset. After that, it goes thru depreciation mill, just like the asset itself. New real estate investors are usually in shock when I tell them that the initial rehab of a property is not a deductible expense. If you bought a $70,000 house and put another $20,000 into fixing it, you end up with a $90,000 depreciable asset and no immediate deduction. I know what you’re thinking, but this is the law.
In real estate business, one of the most controversial issues is the difference between repairs (such as painting) and improvements (such as new roof). Unlike immediately deductible repairs, improvements are capital expenses subject to depreciation. Please check out a special article on my website.
Operating expenses. These are the “good” expenses, deductible right away (as long as they are incurred after the business started). In this large group we have advertising, supplies, professional fees, business travel, salaries and contract labor, insurance, office expenses, repairs, interest on business loans, and all other expenses necessary for keeping your business running.
Home office expenses. If you run your business from a qualified home office, the IRS allows you to deduct a portion of all expenses related to your home: mortgage interest, taxes, insurance, utilities, maintenance, and so on. All these expenses need to be tracked, similar to operating expenses.
Automobile expenses. Contrary to what many business owners think, you do not simply deduct gas and repairs. You deduct a portion of those expenses, using a business to personal ratio, based on your mileage log. To maximize your tax benefits, two items are required: mileage log and detailed log of all automobile expenses, including gas. Let your software or your accountant handle the calculations. As far as deducting the cost of your car or truck – they are assets, subject to depreciation like all assets.
Enough complexity? Then let’s move to the most important question of all…
What should I do to navigate this mess and pay as little as possible?
If you are new to these tax rules, you could relate to Linda who came to me recently for a second opinion. She needed to know where to put the rest of the stuff. Linda prepared her tax return online, off of several hand-written pages listing all her “business expenses.” Per Linda’s thinking, pretty much everything except groceries and clothes was “business.” Well, my job is my business, isn’t it?
By now, you know better than that. I doubt it’s news to you that there’re only three ways to go.
- The first and the easiest one is to take your chances. Don’t fret over whether or not you’re considered to be in business, what does and does not qualify as a business expense, and surely none of that depreciation nonsense. And do not pay any attention to the IRS man behind the curtain. In fact, in the IRS case, it’s more likely a woman.
- Your second approach is to learn how this crazy system works. An admirable undertaking, albeit very time-consuming and hardly fun.
- Short of that, there is a 3rd option: hire a good accountant. By the way, accountant’s fees are usually deductible – provided that you are, in the eyes of the IRS, in business.