Photo By Images_of_Money

As a CPA in one of my previous lives, in this article I want to discuss a few income tax specific matters as it may pertain to you and your business operation.

Whether you own an offline brick and mortar business, or run an online ecommerce store like Steve’s wife, or are contemplating starting either, it is around this time of the year that you have to start compiling receipts from the previous year’s activity to prepare your income tax returns.

First off, tax planning and effective compliance is a year long process. Many treat income taxes as a chore that must be done from the time tax related statements start hitting your mail (i.e. W2 forms) through the deadline. This approach, while it works for many, particularly those with simple lives and just a W2 to report, is not necessarily the most effective or efficient for someone with a more complex tax situation.

Year Long Record Keeping Discipline

To ensure a smooth tax compliance process, clean record keeping is essential. So my first tip right off the bat is to get your business its own credit card. You don’t have to get a “business card” per se. A credit card can be in your name, but ensure you only use it for business. I understand not everyone can do this, but to the extent you can I strongly recommend you do (not to mention the credit card rewards).

This does a couple things. First, credit card providers have sophisticated websites that allow you to download your card usage activity and slice it and dice it any which way you want. In less than 3 minutes, you can download an entire year’s activity and slice it into a pie showing how much you spent on what category. Pretty nifty stuff.

Second, you ensure close to 100% capture of business activity. Gone are the days when cash was needed in wallets. When was the last time you paid for something in cash that cost over $50? Even if you do, chances are there won’t be many instances. Even if you were to aggregate the instances, at whatever your tax rate is, you won’t be missing out much in terms of deductions if you lost the receipts and weren’t able to take the deduction. Remember, $100 in deductions doesn’t mean $100 in saved taxes. Your savings depend on your tax rate. Bottom line – keep a credit card just for business usage.

Advantages of Business Formation / Incorporation

I can write a book on this sub section alone. But in the interest of quickly conveying my message, I want to keep things simple by focusing on a Limited Liability Company (LLC), which is the most preferred method of business incorporation by working individuals who own side businesses online.

Because most of Steve’s readership fits this profile, discussing the advantages of an LLC would be most appropriate in my opinion. But that said, the underlying concepts work for other types of legal entities as well. The point is to take advantage of what you are allowed as a business to effective conduct tax planning throughout the year and save on taxes as much as possible come compliance time.

As LLC is mostly a pass through entity from a tax perspective, which means that profits and losses from your business (Schedule C) are to be netted with your wage income from employment. Now if you are conducting business, there are obviously going to be a certain number and type of expenses that come with the territory.

Fortunately, many of these expenses are expenses you would’ve incurred anyway if you didn’t own a business. For example, chances are you always had a phone, a house, a car and internet. There are many other expense types that one typically incurs anyway, but because of a business, one can deduct a certain portion of those expenses that previously were not deductible to them as just individuals filing a 1040 income tax return.

I am not saying these expenses are the main reason one should get into business. But given the fact that you are allowed deductions for many expenses that you used to, are and would incur anyway, why not? When your business becomes your only source of income, you can start deducting 100% of these expenses (with the exception of housing and housing related as the IRS would argue your house is not a full time office).

An LLC is also a limited liability entity, which separates you legally as a business from you as an individual. In the unfortunate and unforeseen event that you are sued, authorities cannot comingle your assets so as you don’t either. You must be able to show separation, thus the initial tip about keeping business activities such as expenses completely separate. Whatever you do, do not ever conduct business as a sole proprietor. This leaves you exposed from every angle and you don’t want that!

Editor’s Note: If you want to learn more about how to decide on a corporate structure, please check out my small business startup guide.

Tax Planning is Your Right

Saving on taxes is your right. Don’t believe me? Ask the IRS who states you should pay as little tax as you legally owe. Many business owners take this to hear and aggressively deduct anything they can so as long as they can reasonably justify it. Personally, if I can legitimately justify the expense as business, I claim it. I understand that the IRS may challenge, and I / you may lose, but we can try. That said, don’t go gangbusters and start deducting everything like your Colgate toothpaste either. Be reasonable, be prudent.

Editor’s Note: If you want to learn more about what you can and can not deduct for your business, please visit my guide to the most common business tax deductions

Many don’t understand what an effective tax rate is. Do you truly understand how much you are paying in taxes? You may think so, but do you realize what the overall rate is? Many don’t. Business tax deductions can significantly lower your effective tax rate and thus the overall gross dollars that you pay in tax to Sam.

There are some significant advantages of owning your own business. In my opinion, it is the single best tax planning tool and how you can truly get ahead financially relative to your peer group. I have stuck to the same answer now for years, especially when friends and family ask me how they can save on their taxes at dinner conversations and casual gatherings.

Readers: Are you taking advantage of all the tax deductions you are allowed? If you don’t have a side business yet, do I make a strong enough argument to contemplate starting one? Of course I recommend you do what you enjoy.

Service

Are you only looking for your accountant to prepare your 1040 (personal tax return in the U.S.) and to report your side business activity on your Schedule C? Or perhaps you run several businesses that are all distinct entities and require their own returns and operate across state lines? Furthermore, get this, accountants do much more than just prepare tax returns! Audits, reviews and compilations, tax planning, business valuation, payroll, and just plain providing you the information that you need to manage and grow your business are some of the many services accountants can provide.

Experience/credentials

In the United States any schmo can prepare your tax return but only lawyers, Certified Public Accountants, and Enrolled Agents can legally sign your return and represent you before the IRS should the need arise. In other English speaking countries the appropriate designation is a chartered accountant. By signing your return, your accountant is actually taking some limited responsibility for your return; that is, they aren’t taking responsibility for the information that you gave them but they are assuming some responsibility for the proper treatment of that information.

Price

Usually, the more complex your return is, the more likely it is that you will be charged by the hour. This can make it extremely difficult to price-shop accounting services but most will give you a ballpark figure and, if you’re an obnoxious pain in the ass, count on paying much more than that.

Compatibility

Is your accountant familiar with and able to work with your accounting system? Are you the type that expects your accountant to work with you online, possibly giving them access to your Quickbooks accounts, or are you more like that person that sends in the shoebox of receipts and a check register and asks them to work their magic? Does you accountant have the ability to work with the software that you use? If not, can you download everything into Excel? Expectations for technological and systems compatibility need to be addressed before engaging an accountant.

Personality

You don’t have to want to take your accountant on your honeymoon with you, but you ought to at least feel comfortable calling them up and asking them about the tax implications of any major purchases or big business deals you plan on making (before you make them, please!). Accountants have the reputation of being stodgy, conservative, and not the best communicators in the world. However, after years of working in the industry and meeting tons of accountants through work, school, and professional associations I can honestly say that, yeah man, it’s mostly true.

Geography

More and more people are wired in and used to doing business by phone and Internet, so much so that geography is no longer the factor that it once was. However, if you’re a last minute type of girl and you know that you will need to drive to your accountant’s office on the 15th of April to sign some documents then it’s probably best that your accountant isn’t located in, say, Bangalore or Manila.

My Two Cents

Since you are reading My Wife Quit Her Job and since it is an awesome resource for Internet entrepreneurship I am going to assume that you own your own business or are a freelancer. If all you think you’ll ever need is tax preparation, an Enrolled Agent or even, if your return is simple enough, H&R Block are perfectly adequate. However, for those of you with larger aspirations and who want to use their accounting records for tax and business planning as well as for filing your tax return, my advice is to look for an accountant at a small or mid-sized firm that specializes in working with business owners. Wait until summer and then call up some accountants who fit the bill or who have been referred to you and talk to them. In my opinion, these are some of the questions your accountant should ask:

• What your business is and how it makes you money,

• To see your prior year’s tax returns, including those of your business if you file a separate return for it, and to discuss some of the items on it and ask you about some of the tax strategies used,

• What level of service you are looking for,

• What your immediate plans for your business are.

Look for an accountant that is interested in your business and seems familiar with what you do. Also, look for an accountant that informs you about the full range of services that they could offer you, even if you’re only in the market for a tax preparer right now. No, I’m not just saying this to drum up business for my colleagues. Look, you’re a busy person and even if you know how to do everything you can’t possibly do it all. So a little interest from your accountant and information on the services they offer might end up saving you time and making you money.

By the same token, you should be asking them:

• How they bill for their services,

• Whether they have any expertise in your industry,

• Who will actually prepare your tax return. It is not a joke that some of the big firms will farm your return out to India. This is not necessarily a bad thing because even in my smaller firm at least two people look at every return and it is the person who signs it that you are most concerned with. Still, it is worth knowing who you should call when you have questions.

• What their golf handicap is. Alright, I know that there are at least 5 accountants who don’t golf (I’m one) but you at least want to know if they are someone that you feel comfortable talking to. Your accountant can be a great reference and also a great source of referrals if you take the time to get to know them and they take the time to understand your business and its needs.

Integrity

As you establish your relationship with your accountant you should begin to get a feel for her integrity. If you value your integrity and want to get your return right then don’t just make sure your accountant complies with your wishes, make sure that uncompromising integrity is a basis of their practice. There are few things quite so nasty and having an IRS agent combing through your business records because they have uncovered other shady dealings by your accountant with different clients. Sure, if you’re on the up and up everything will come out fine in the end but what an incredible waste of time and effort and immense source of stress. On the other hand, if your accountant has done her job and you have faith in them then there’s no reason to lose any sleep over it. Two names go on the return, make sure that both of them are on the same page.

Well, there’s my two cents, have you anything to add? Do you have a horror story of an accountant gone bad or even a story about how your accountant helped your business become more profitable? Let us know!

Editor’s Note: This past year, my wife and I decided to perform an experiment with respect to filing our taxes. Instead of just using Turbo Tax like we normally do, we had an accountant file our taxes for us and compared the accountant’s results with Turbo Tax. In case you missed it, I reported my results in my article entitled the outcome of hiring an accountant to do our taxes vs Turbo Tax. Unfortunately, the accountant didn’t do so well. But in the back of mind, I couldn’t help but think that it was partially my fault for not choosing the right accountant. I wish Tyler had written this article earlier…

Photo Youssef Abdelaal

So the results are in! The good news is that our accountant fulfilled his promise and delivered our tax return way ahead of the April 15th deadline. The bad news is that our experiences with our accountant weren’t exactly positive.

Before I continue, I just want to emphasize that the conclusions I’m making in this article should be taken with a grain of salt and are not indicative of accountants in general. There are thousands of CPAs out there and our experiences represent just a single data point.

To provide some background information, my wife and I have worked with this accountant for a little over a year now to discuss tax strategies for our small business. But this is the first time that we have used him to actually file our taxes and it will probably be our last. Here’s why.

We Got Off On The Wrong Foot

Because our accountant works about 40 minutes away by car, it’s not very convenient for us to talk face to face or to drop things off at his office. During the weekdays, my wife is with the kids and I’m at work. On the weekends, our accountant is not in the office. Pretty much the only convenient way to send our accountant information is through email or snail mail.

For those of you wondering why we chose an accountant that works so far away, it’s because he came highly recommended by a coworker of mine. In any case, since we didn’t want to make the drive up to his office, we decided to scan all of our 1099′s and other tax forms into pdf format and emailed encrypted versions to him for review. That’s when the trouble started.

Because we emailed him an archive of about a dozen password protected pdf’s, his assistant got fed up because she didn’t feel like opening each pdf up and printing them out. So she called and asked us to mail a physical copy of our tax forms to their office instead.

Personally, I thought this was ridiculous. We wasted more time on the phone than she would have spent printing out the forms. Even though I offered to condense all of the forms into a single pdf, she said that she would have to charge us $200 an hour for her to take the time and print out our pdfs.

Needless to say, this left a bad taste in my mouth from the start. But what could we do? We ended up sending her copies via certified mail, but I was pretty annoyed (mainly by the $200/hr threat).

He Was Difficult To Get Ahold Of

Once our accountant received our tax information, things proceeded much more smoothly but what annoyed me was that it was difficult to reach him to ask even the most basic of questions. Since it’s tax season, I completely understand that he’s probably swamped working on many other tax returns outside of ours but it would have been nice to receive quicker responses.

Perhaps it’s because I’m impatient and am used to doing everything on my own, but I like knowing what is going on and I need reassurance that everything is proceeding smoothly. With our accountant, after dropping off our tax forms, we basically didn’t hear from him again until he was done with our return. Outside of a brief questionnaire in the beginning, there was no feedback loop and no additional questions asked.

He Made Errors

Not providing us with feedback during the process was all fine and good as long as he did a good job. But as soon as we received our tax return, we immediately noticed some errors.

For one thing, there was a typo and the cost basis for one of our stock transactions was completely off. Granted, it wasn’t a straightforward transaction, but it should have been entered correctly. To provide some background, the discrepancy was with a stock that I had purchased in several lots which had undergone a reverse split and then finally was acquired by an overseas company. With Turbo Tax, I simply imported everything in directly from Schwab. But my accountant completely missed one of our buy transactions which resulted in a lower cost basis. In short, even though we took a loss on the stock, his return showed that we had a gain.

The second thing he missed was an energy tax credit provided by the government. Because we recently added insulation and drywall to portions of our house, Turbo Tax said that we were eligible for a 1K tax credit. However on the return filed by our accountant, this credit was nowhere to be found. The status of this discrepancy still remains unresolved and we are trying to get ahold of our accountant to discuss whether this credit truly applies. But based on what Turbo Tax is telling us, we should be able to take it as a tax credit.

The final discrepancy that we noticed was that information from one of our 1099′s was not entered at all. We currently leave some of our money in Paypal’s money market fund and there was a minuscule dividend(around 20 bucks) that we were paid during the year. However, we could not find this amount anywhere in the return. Once again, this is something we are in the process of clearing up.

Most Of The Work Is In The Prep

My wife and I went into all of this thinking that using an accountant was going to save us time in filing our taxes. But instead, we discovered that we had to do most of the prep work. In fact, we ended up spending several hours collating our business numbers and gathering all of the tax data for the accountant.

One of the reasons we spent extra time was because our accountant wanted our business numbers in a different format than we had them in. In the end, all of our numbers tied out the same way but massaging them into his format took a good chunk of my wife’s time.

In any case, once all of the data was ready to go, entering all of the numbers into Turbo Tax took hardly any time at all. And this prep work was required whether we used an accountant or not. Arguably, using our accountant took more time because after finding the initial error, we went through his return line by line to check for additional discrepancies.

Benefits Of Using Our Accountant

I don’t want to come across as completely negative towards our accountant because we actually really like working with him and will continue to use him as a tax advisor. It’s just that my wife and I were very disappointed with the results.

That being said, one of the benefits of using our accountant to file our taxes is that we now know the right way to file our LLC paperwork. One of our motivations for using an accountant this year was that we converted our business to an LLC midway through last year and it was unclear how to indicate this properly in our tax return. Because we used an accountant, we now know how to do this ourselves from now on.

The other benefit is that our accountant is currently working with us to avoid having such lopsided tax returns in the future. A lopsided return is when you either have to pay a large amount or receive an abnormally large refund during tax time. To provide you with some context, I’ve done a bad job in the past in regards to estimating our income and our accountant is helping us do a better job. This year, we are getting a 10k tax return whereas last year we had to pay 30k in taxes. Clearly, I need some help in this department.

Conclusion

Once again, please take these conclusions with a grain of salt because they reflect only my experiences with a single accountant. But here’s what I have to say about using an accountant to do your taxes versus using Turbo Tax or Tax Cut.

• An accountant can’t change the past. Therefore, using an accountant is probably not going to save you much money versus Turbo Tax for just filing a tax return. In our case, Turbo Tax did a better job of finding extra deductions.
• It’s good to use an accountant if something has changed with your tax situation and you are not sure how to proceed. We recently switched to an LLC and needed guidance.
• An accountant can help you improve your future tax situation by suggesting things to look out for in future returns.

Even though we had a bad experience with this tax return and shelled out $550 in the process, we will continue to use our accountant as an advisor to plan for next year. For those of you with a relatively simple tax return like ours, I doubt that an accountant will make much of a difference. In addition, if you are anal like I am, you’ll end up checking up on all the numbers anyways which means you probably won’t save that much time either. The true value of having an accountant on board is to provide future guidance and answer your tax questions going forward.

Photo by Nick See

I’m especially nervous because by having someone else file our taxes for us, we are essentially turning over all of our sensitive financial data to a stranger and paying him to file a crucial document that could have a big effect on our finances. So yes, my wife and I are making this decision with a few reservations.

Since I’m a bit apprehensive about the whole thing, I thought I’d document some of my thought processes about our decision to use an accountant over Turbo Tax. I’m also going to conduct an experiment to see whether having an accountant really makes a difference in terms of tax savings. BTW, I’m sure some of my readers have their own accountants do their taxes for them with no issues. For those of you who do, please feel free to chime in at anytime.

Why Do We Need An Accountant?

With the birth of our second child, our business, this blog and the book that I’m working on, my wife and I have very little time to spare. Every free moment that we have, we would prefer to be hanging out and relaxing as a family rather than crunching numbers. It typically takes us a good solid weekend to put our taxes together so ideally, we’d rather not be devoting our brain power towards something we hate doing. Plus, we aren’t experts on taxation by any means.

Filing our taxes in the past has been relatively straightforward. We use Turbo Tax, and in theory Turbo Tax should calculate the numbers the same way that any accountant would. But deep down, I wonder whether a human accountant could find us more deductions than a computer program. For those of you with accountants, does your accountant find deductions that Turbo Tax can’t? I’m curious to find out.

What Does An Accountant Buy You Exactly?

Our accountant charges $200 an hour. This year, filing our taxes will cost us approximately $500 which includes our LLC. Compare that to the $75 that we usually spend on Turbo Tax and we’re blowing an extra $425. So what does this extra $425 buy us?

The accountant will prepare and file all of our taxes for us. All we have to do is provide him with all of the necessary data. Everything sounds pretty straightforward except for one thing. The accountant typically does not audit the data we provide and we are the ones responsible for any writeoffs we make with our business. While he will alert us of any red flags, by default he will not challenge or check up on our business deductions and will only do so if we ask. Needless to say, at $200/hr his time can really add up if we just hand him a bunch of receipts. That being said, it is nice to be able to ask an actual human questions regarding any borderline deductions that we might be taking which could trigger an audit.

I was also under the impression that our accountant was responsible for filing our taxes correctly. In other words, our accountant would be on the hook if we ever got audited. While this is true to a certain extent, it turns out that we are ultimately responsible for providing the correct numbers for the tax calculations.

In the event of an audit, the accountant is responsible for only the calculations and not the actual baseline data. For example, even if our accountant advises us to take a borderline tax deduction, we are still responsible for proving that the deduction is legit despite his advice. In addition, in the event of an audit, it costs extra money for the accountant to respond if he is not at fault.

The good thing about having an accountant is that in theory, he is supposed to file your taxes optimally based on your numbers and your current tax situation. He may be aware of obscure tax rules that could save you money and you don’t have to lift a finger. If you trust your accountant, everything should be taken care of correctly with no worrying on your part.

What About Turbo Tax?

Good ole Turbo Tax is super cheap. It costs us $75 only because we buy the home business deluxe version. The base version I believe is free for the federal filing. In theory, Turbo Tax should be aware of all of the latest deductions and ask you the right questions so you can take advantage of all of the tax breaks much like an actual accountant would.

While Turbo Tax is supposed to act like a virtual accountant, I personally find myself always erring on the side of extreme conservativism when it comes to taking deductions with Turbo Tax. Sometimes the descriptions are obscure and not well explained so I’d rather not take the risk. The thing I hate about Turbo Tax is that I’m always afraid that I’m leaving money on the table by not taking deductions that I’m entitled to because I don’t understand the deduction thoroughly.

That being said, one of the things that I like about Turbo Tax is that they offer this program called Audit Defense. For an extra $40, an accountant or an account representative will take care of dealing with the IRS for you in the event of an audit. One of my friends was audited last year and “Audit Defense” took care of everything. In the end, they discovered that he made a typo on his filing that was easily correctable and he didn’t have to pay anything extra. There was no hassle at all because Audit Defense took care of everything.

The other thing that I like about Turbo Tax is that you get to keep an electronic version of all of the worksheets that can easily be imported into Turbo Tax the following year. You can also try different scenarios to see what effects certain deductions and filing options have on your bottom line. In other words, you have complete visibility over your taxes and it’s dirt cheap. Ultimately, Turbo Tax is great for control freaks like myself who like to do everything themselves.

The Experiment

Since I’m a skeptic, I’m going to be conducting an experiment with our accountant. Even though we are going to pay him $500 to file our taxes, I’m going to go ahead and prepare my tax return with Turbo Tax and compare the two to see if there’s a difference.

If the accountant can save me more than $425, then it’s a no brainer to use him again. For my wife and I, it’s less about the money as it is about time savings so if he is on par or a little better than Turbo Tax, we’ll be satisfied. In any case, I’ll post the results of my accountant vs Turbo Tax results come tax time once I’ve completed the filing.

How many of you use an accountant vs filing taxes yourself? Has your accountant saved you money that you otherwise wouldn’t have been able to save?

Click Here To Find Out Whether Hiring Our Accountant Was Worth The Money

Photo by Chasing Fun

That’s right! Most people don’t consider the tax savings involved in running a business. Most people don’t realize that having a day job is one of the worst ways to save on taxes because Uncle Sam takes a huge chunk out of your paycheck BEFORE you pay for anything. On the other hand with a business, you can effectively pay for everything using pre-tax dollars which can save you up to 35%. So while on paper your business may not be making any money, in reality you could be saving big bucks by purchasing goods with money that is not taxed at all.

But talk is cheap! I thought that it would be interesting to throw some numbers into the mix by calculating how much the average American could save by starting their own business.

The Average American

First off, the average American makes roughly $63,091 before taxes. If we assume that they fall under the 25% tax bracket, the average American is also getting reamed up the wazoo by Uncle Sam to the tune of about $11960 before they can even use this money leaving themselves with only $51131. Even worse, the average American spends roughly $49638 a year which doesn’t leave much savings. It’s no wonder that the average American household is just barely scraping by!

In order to calculate the tax savings associated with running a business, we must break down each and every expense of the average American to see what can possibly be written off with a business and assume a certain percentage of savings. Below is my analysis.

Transportation – Gasoline And Oil Costs

The average American spends roughly $2384 on gasoline and oil related products. If we assume that gas is $3 a gallon and that the average car gets 20 miles per gallon, the average American drives roughly 15893 miles per year. We’ll round this number to 16000 for simplicity.

Currently with my business, I’m able to expense roughly 22% of the miles I drive on my car for business purposes. How do I do this? Whenever I need to drive some place or run some errands, I make sure that I try to take care of something business related along the way. For example, if I need to go to the grocery store, I also make a trip to the office store or other related establishment where I need to pick up something for the business. It takes a bit of planning and excellent documentation but you’d be surprised by how easily you can find ways to use your car for business.

For the average American, 22% of 16000 miles is roughly 3520 miles. For 2009, the IRS mileage tax deduction is 55 cents. 3520 * $.55 equals a tax writeoff of $1936.

Housing And Shelter

The average American spends $10,023 on housing or shelter every year. Currently, my wife and I expense 20% of our rent for business related purposes. In actuality, we use more than 20% of dedicated business space in our home but we keep things at 20% to prevent the likelihood of an audit. In any case, 20% of $10023 equals $2004.60 of tax writeoffs for the average American.

Food – Eating Out

The average American spends roughly $2668 a year eating out. For my wife and I, we love discussing business over dinner. In fact, we make many of our key business decisions at restaurants because it’s a more relaxed environment and easier for us to concentrate.

As a result, we are able to expense some of our meals every month. For this analysis, let’s assume that the average American can expense 10% of their meals. Because meals and entertainment can only be deducted at 50%, this effectively equals a 5% writeoff. $2668 * .05 equals $133.40.

Travel

The average American spends roughly $1600 on summer vacations every year. While travel expenses purely for pleasure can not be expensed, any vacation can be made to be business related with the proper planning. So what my wife and I usually do every year is plan our vacations around our business travel.

For example, a few years ago my wife and I had to meet with linen and textile vendors in Japan so we made a vacation out of it. We purposely planned our meetings every other day and used our free days to relax and pamper ourselves. If you do things right, you can pretty much expense almost the entire vacation!

Because I’m not sure how the $1600 a year is broken down in terms of airfare vs food/entertainment costs, I’m going to assume that 75% of this cost is deductible for the average American. Total tax deduction $1200.

Utilities

Since we use 20% of our house for business, it’s only fair that we deduct the same percentage for utilities. In addition to water, gas and electricity, we also have a dedicated phone line for the business which can all be expensed.

The average American spends $3477 on utilities every year. Once again, the exact breakdown of this number is unclear so we need to make some assumptions. For example, a business probably wouldn’t be able to expense the cable tv bill. However, most other items are fair game. To be conservative, I’m going to assume that at least 10% of this amount is deductible which puts the deduction at $347.70.

Computer Equipment And Household Furnishings

Unfortunately, this category is extremely vague. Computer equipment and household furnishings covers everything from furniture all the way to decorative items and computers but excludes major appliances. Because this category is so broad, I’m going to be conservative here and assume only 15% of this amount is deductible.

Thanks to section 179, computer equipment and other furnishings can be expensed 100% up to a six figure dollar amount every year. Chances are, if you have a business and purchase a computer, it can be written off in its entirety in the same tax year. The average American spends $1797 in this category. 15% of $1797 is $269.55.

Adding It All Up

Obviously, I have not included every possible business expense in my analysis, only the common items. If you really want to get nit picky, in reality you could probably expense far more than what I’ve mentioned in this article.

In any case, if we total all of the categories mentioned above, this comes out to $1936 + $2004.60 + $133.40 + $1200 + $347.70 + $269.55 = $5891.25.

Based on an income of $63091, this represents almost a 10% writeoff on the average American’s taxes! Putting all of the numbers together at a 25% tax bracket, this is a savings of $1472.81 every year. Keep in mind that most of the deductions I calculated above were on the conservative side. In practice, my wife and I actually deduct a good amount more especially under the computer and equipment category.

If you are worried about getting audited, the best thing to do is to arm yourself with an accountant and document every expense carefully. Your accountant should be able to tell you with high confidence whether or not an expense is actually deductible. This is free money folks, but only available if you have a business. Stop giving your money away to the government now!

Further Reading

• How To Save Money On Taxes

Disclaimer: As one reader pointed out, this article is not meant to encourage people to haphazardly make tax deductions for their business. In fact, I discuss the flip side in depth in my article on Is Your Business Just A Hobby In The Eyes Of The IRS. However that being said, the deductions mentioned in this article are not exaggerated. In fact, I believe that the majority of people don’t take tax deductions that are rightfully theirs because they are afraid of the IRS. Talk to your accountant! They will know how to help you figure out how to make the most out of your deductions.

Hey Steve! You know how I love to paint right? And just the other day I sold a painting to someone on Ebay… Why don’t I just call this a business and declare business losses off my tax return? May as well right?

At first glance, my friend’s logic sounds reasonable. After all, he does create paintings that are sold for profit as a side business. So shouldn’t he be able to take business deductions and losses for all expenses incurred while painting?

Unfortunately, the answer to this question is a bit complicated. While my friend is technically allowed to deduct business related expenses for his painting business, the extent of these deductions depends on whether the IRS considers his business a legit business or not.

If my friend were to ever get audited and the IRS ruled that his business was not a true business, then he would not be able to deduct any business losses on his tax return. Instead, he would only be allowed to deduct expenses up to the amount of income that his hobby has generated and nothing more.

Obviously, these rules are in place so people don’t abuse the tax system. If you declare business losses on your tax return year after year, you can face stiff penalties and fines if the IRS determines that you are just spending money on just a hobby. The tax benefits of running a business only exist if you are actually trying to turn a profit.

What Does The IRS Consider A Business Vs A Hobby?

The business vs hobby rule is somewhat of a gray area when it comes to the IRS. According to the tax code, a business must actively be “engaged in trying to make a profit” in order to be considered a business. So how do you demonstrate your profit intentions to the IRS in the event of an audit?

Be Profitable 3 Out Of 5 Years

The easiest way to show your profit motive is to actually turn a profit. If you are profitable, then no one can dispute whether you are actually trying to make money because you really are. In general, your business is safe from being considered just a hobby if you turn a profit for at least 3 out of every 5 years of operation. The profit amount doesn’t have to be large, even a couple of bucks profit is good enough for the IRS.

That is why in general, it’s okay to declare business losses on your tax return for up to 2 years without increasing your risk of an audit. However, if you declare business losses on your tax return for longer than 2 consecutive years, the chances of an audit increase dramatically.

What If I Fail The 3 Out Of 5 Test?

Just because you aren’t turning a profit for 3 out of the 5 years doesn’t necessarily mean the IRS is going to declare your business a hobby. It just means that you are more likely to be audited. If you find that your business is not profitable for over 2 consecutive years, you basically have 4 choices.

• You can close up shop. This option makes sense if you don’t think that you’re ever going to be profitable. Sometimes, it makes sense to cut your losses on a dead end idea.
• You can continue declaring losses on your tax return and risk getting audited. This option is a good choice if you are confident that you can convince the IRS that your business is for real
• You can start a new venture altogether and declare losses on behalf of the new business. Of course, this can come across as a bit sketchy to the IRS especially if you happen to start a new business every two years.
• You can stop declaring losses on your tax return. Usually if you stop cold turkey and lie low for a while, you can stay below the radar of an audit

My Business Is Real And I Want To Risk It

Like I mentioned in the previous section, just because you aren’t turning a profit doesn’t mean you aren’t running a real business in the eyes of the IRS. Some business ideas just take a little longer to materialize gains. If you have confidence in your business plan, then there’s no reason to fear the IRS. Just in case of an audit though, you should do the following things to make sure your case for being a real business is air tight.

• Keep Good Records – Track each expense with as much detail as possible. If you are spending money on dining or entertainment, make sure you jot down who you are entertaining, why you are wining and dining them and the precise date and cost. Keep your business accounts completely separate from your personal ones and maintain an accurate spreadsheet of all expenditures.
• Keep Your Advertising Collateral – Most real businesses advertise in some shape or form. Make sure you keep copies of all of your advertising collateral so you can show it to the IRS. This includes business cards, flyers, newspaper ads etc…
• Keep A Business Calendar - By marking down important dates and milestones for your business on a calendar or scheduler, this shows the IRS that your business is happily progressing on a path towards profitability.
• Run A Legit Business – Make sure you register for all the necessary permits to run your business legitimately. If you do everything strictly by the book, you are showing the IRS that you are putting forth your best efforts in maintaining a real business.

Don’t Take Losses For The Hell Of It

Believe it or not, it’s pretty easy for the IRS or any third party to tell if you are just pretending to run a real business. So don’t start declaring losses on your tax return for the sake of saving money on taxes. The IRS will find out eventually.

Even if you are sandbagging it and taking deductions on just a hobby, the amount of work required to fake being a real business is simply not worth it. If you are taking business deductions, then be a real business with real profit intentions. Getting caught with an audit is not worth the time or the money.

The Homeowner’s Deduction Has Changed For The Worse

After all of the bad loans and speculative buying that led to the real estate debacle, Congress has decided to crack down on the tax deductions for homeowners. In the past, you could exclude up to 250K(or 500K for married couples) of real estate gains off your tax return as long as you used your house as your primary residence for 2 out of the last 5 years. For example, if I purchased a home, lived in it for 2 years and rented it for the next 3, I would be fully tax exempt on any profits resulting from the sale of the property up to 250k.

Starting in January 1, 2009 however, you will only be allowed to take the exemption for the pro-rated amount of time you used your house as your primary residence. For example, let’s say your home was your primary residence for 2 of the last 5 years. Whereas you could take the full exemption before, you can now only take two-fifths of the exemption on your taxes. Also, don’t forget to take advantage of any energy tax credits as well.

What this means is that if you have rental property that you are planning on selling in the coming years, you should move back in as your primary residence before 2009.

Property Tax Laws Have Changed In Some States

In the past in California, you had to pay your property taxes only twice a year in equal increments. Starting in 2009, all homeowners with under 20% equity in their home must have their property taxes impounded as part of their monthly payments. This can have a direct hit on your immediate cash flow since you now have to essentially pay your property taxes each month as opposed to bi-annually. As long as you have 20% or more equity in your home, you shouldn’t have to worry about this. You’ll have to check to see if this tax changes applies to your particular state.

New Vehicle Tax Deductions

You’ve probably noticed that sales of large trucks and SUVs have been extremely slow due to rising gas prices. Because the automakers lobbied heavily for help from Congress, Congress passed a new law which allows you to deduct up to 25k off of the purchase price of any vehicle over 6000 pounds used for business purposes. Of course the percentage deduction fully depends on what percentage you use the vehicle for business, but this is still a large sum of money. This deduction only applies for large vehicles purchased before the end of 2008. If you were planning on purchasing a business vehicle anyways, you might want to do so by the end of the year to take advantage of this tax break.

The other major tax change related to your vehicle is that the new mileage deduction is now 58.5 cents as opposed to 50.5 cents. The depreciation limits have been increased as well. The new laws now specify that you can depreciate in the first year up to 11k for new passenger autos or vans and trucks that weigh less than 6000 pounds.

New Section 179 Rules

This is probably the tax change that will have the largest effect on small businesses. Starting in 2008, the IRS has increased the section 179 deduction to 250k. This is huge! Now you can afford to purchase more capital equipment tax free to start up your business. With the economy in its current doldrums, Congress is clearly doing whatever they can to foster business activity and growth. Now is the best time to be starting your own business if you haven’t done so already.

If you wish to learn more about tax deductions, please read my articles on how to save on your taxes.

Disclaimer: I am not a tax professional so please consult your accountant or do your own research before making any tax related decisions.

1. Your home must be your principal place of business. This means is that you conduct all of your business related activities in your home and you have no other set locations where you do business
2. You must have a special area sectioned off for your business. This might be a separate room or the garage. Anywhere that you store inventory or products counts as well.
3. You must actually conduct business at home and use the dedicated space solely for business. This one sounds like a no brainer, but this is to prevent people from setting up a fake office and taking it as a deduction. What this also means is that you should remove the bed and dressers from the room as well.

If you meet the above rules, the way you handle the deduction depends on whether you own or rent your home.

Deducting a Rental

Deducting a home office for renters is the simplest case to deal with. Simply calculate the percentage of space that your business occupies and multiply this by the amount of rent that you pay each year. Also, don’t forget to include your utilities and insurance policies as well.

Deducting a Home That You Own

When you actually own your own home, things start to get a bit more complicated and the tax rules aren’t nearly as advantageous as when you rent. Below are steps you must follow to claim your home office deduction.

1. Calculate the percentage of space that your business occupies.
2. Calculate the cost of your house itself. You’ll need to separate out the cost of the house versus the cost of the land. Unfortunately, in many cases, the value of your land greatly trumps the value of your house
3. Calculate all of the expenses relating to utilities, repairs, taxes and insurance.
4. Add up items 2 and 3 above and multiply this by the percentage calculated in item 1.
5. Add the depreciation amount applicable to your house. Check the IRS and figure out what the depreciation rules are for your house. This isn’t that complicated, but you should check with your accountant just to make sure how to do it properly since it changes from year to year.
6. Add in any expenses that we done directly to your home office and not to the rest of the house. This includes decorations and furnishings.

The main disadvantage of running your business out of a home that you own is that you’ll have to pay taxes on the amount you’ve depreciated on your house when it comes time to sell your home. For example, if your house is worth 100k and you depreciated it 10k. When you sell your house, you’ll need to pay taxes on the gain from what you sold it for minus 90k.

Audit Risk

In general, your chances of getting audited when taking the home business deduction are much much higher if your business doesn’t show a profit. If your business isn’t profitable, I wouldn’t advise taking the home office deduction but I always err on the more conservative side. If you do take the deduction anyways, make sure that you can prove that your business is actually legit and not just a hobby of yours that you are taking advantage of. Also keep in mind that your chances of an audit go up for every year that you don’t show a profit.

Learn other ways on how to save on your tax return

Purchases must be used mostly for business

The official rule is that the asset that you are deducting must be used for at 50% or more for business. Let’s say for example that you are trying to write off a computer in its entirety for a given tax year. You should make sure that you are using this computer more for business more than pleasure and be able to demonstrate this if you ever get audited. For the most part, as long as you don’t abuse this rule, you should be fine.

Asset must be used for a certain period of time

This rule is kind of vague but basically it states that any equipment you are writing off must be used over a period of time that corresponds to how long you would have depreciated its value to 0. For example, office furniture must be depreciated for at least 7 years. Therefore, if you were to use section 179 for your furniture, you would have to keep this in use for at least 7 years.

Certain Purchases are excluded

Some common things that you can’t use section 179 are listed below. I might be missing some items so you should definitely check for yourself but these are some of the more common exclusions.

1. Inventory – Basically you can’t write off stuff that you are planning on selling
2. Gifts – Anything that you’ve obtained or inherited as a gift can be deducted
3. Real Estate
4. Items that you already own or did not purchase for the tax year

Most small businesses will choose to take the Section 179 deduction for most of their assets. There are some cases where you wouldn’t want to however. For example, if you business profits are low and you’re at the lowest tax bracket already, you might want to defer some of those write offs for when your business is more profitable to keep yourself at a lower tax bracket later. In any case, you should always do the math both ways to see what makes sense for you.

Learn other ways on how to save on your tax return

Officially though, anything you expense must obey the following rules.

1. The entertainment expense must be reasonable and accepted in your field of business – For example, if I’m selling vegetarian food over the internet, it most likely wouldn’t fly if I took the employees out for a steak dinner. In any case, you get the point.
2. The purpose of the entertainment expense must be to bring in revenue – For example, if you are hosting an event to promote your company, this is perfectly acceptable. Even if you and your business partner go out to eat to discuss the business, your meal can be deducted as well.
3. The expense can’t be extravagant – Basically, this means don’t abuse this deduction!

Anyways, entertainment is defined as any activity or recreation that directly for customers, clients or employees. Only 50% of entertainment and meals is deductible but these expenses can add up over the course of the year. For our store, my wife and I go out at least once every few weeks to discuss new ways to expand the business.

Learn other ways on how to save on your tax return