Filed under: Earned Income Credit, Self Employed, Small Business
Now some people may be wondering, “Why would I want to prove I have more income than I have to?” But for many small business owners, that’s exactly the problem—you have income, you want to report it to the IRS, and you’re having a hard time proving it. This post is for you.
The number two reason for reporting your non-1099 income (number one of course being basic honesty) is qualifying for the Earned Income Tax Credit. 2011 sort of hit small business owners who normally qualify for EIC with a one-two punch. We had the new 1099 reporting requirements that upped the ante for so many businesses, and we had the new EIC tax preparer due diligence rules with one of the questions being “Do you have forms 1099-MISC to support the income?” With the next question being, “If not, is it reasonable that the business type would not receive Form 1099-MISC?” Here’s a clue: if you answered NO to the first one, you have to answer YES to the second.
So what types of businesses wouldn’t normally receive a 1099? Bunches of them! Face it, if you’re reading this—I’m guessing that your business doesn’t receive 1099s. Generally, it’s reasonable to expect that anybody who works for other people, as opposed to other businesses, would not receive a 1099. House cleaners, dog walkers, handymen, lawn mowing services, daycare providers, interior decorators, and even income tax preparers are all types of business that could easily never see a 1099. (Yeah, me too! Although I’m now getting 1099k forms because I take credit cards, I don’t get 1099-MISC for preparing personal tax returns. Maybe I’ll see some 1099-MISC forms from some of my business clients this year, but I never used to get them in the past.)
So, how does a small time personal service provider prove his or her income to the IRS? There are a couple of things you can do. I’m going to start with my favorite: the business bank account. This is what I do and several of my clients do it too. (Okay, because I’m their accountant and this is what I tell them to do.) Get an Employer Identification Number (EIN) for your business and set up a separate bank account for your business in your business name. Only business income goes in, only business expenses go out. You may have to put some of your own money in for a start up, and once you’re making money you’ll take out a draw, but you’ll label those as such. Other than those two items, your business checking account is pretty much your profit and loss statement as well. Now for a bigger company that would be over simplifying things, but for us little folks–I’m spot on. See this post for more information about getting an EIN number: Free EIN
Why does this make good proof? Because you’ve got a monthly record of your income and expenses. I also have deposit slips to back it up: Mary Jones paid me $200, Fred Smith paid $250. It’s a good solid audit trail. Here’s another post about bookkeeping and your business bank account: Banking and Bookkeeping
But what if you don’t have a separate account? Maybe your business is just too small to bother with the expense of an extra account. What if you’ve just got something really simple like watching the little neighbor kid for a couple of hours after school every day. There’s no contract, no business cards, no advertising. You get $100 a week from your neighbor friend. She pays you in cash—it never sees the inside of a bank because that’s your grocery money. It’s not much but it supplements your child support. How do you prove that kind of income?
The easiest way to prove your income if you provided child care is to have the person you provided it for claim your services on their tax return. You make them a daycare receipt, just like the ones regular day cares do showing the name of the child, how much they paid you and your EIN number. (You can use your social security number but I never recommend that. You can get an EIN number for free. Protect yourself.) This is doubly good because the IRS will get confirmation of your income from an outside source. You prove income, your customer gets a tax deduction, it’s a win/win situation.
But what if your business isn’t day care? What if you did something like mow lawns around the neighborhood and shoveled snow in the winter? Nobody’s going to be claiming you on their tax return, what can you do? In your case, I like receipt books. You can find different kinds at Office Max or any office supply store. I like the ones with a carbon copy—one for you, one for your customer.
Now if you have just one customer and you’re always going to the same place—you can just use the little one that just has a couple of lines and the amount on it. You might write, “Mowing, Mr. Jones, $30, 5/15/2012” on it. You know what you did, who you did it for, how much you got paid, and when. If you have multiple customers you’ll want the larger receipt books that include the address and phone number of the customer. If you do different types of jobs for different people, you might need the bigger ones so you can write down the type of work that you did for them as well.
You don’t have to have a 1099-MISC to prove your income to the IRS. You just need to have a system in place to document your income and you’ll be fine.
First things first, let’s tackle the big “problem” many daycare providers have – licensing. The IRS demands that you report all of your daycare income, but if you’re not licensed, you don’t qualify to claim any of the deductions. Now the whole licensing thing varies by state. Here in Missouri, you do not have to have a daycare license if you care for four or fewer children who are not related to you. If you’re exempt from licensing requirements for your state, then you’re qualified to claim all of the federal tax deductions relating to your daycare business. Different states have different rules. Just across the river in Illinois, the licensing requirements are much stricter. Be sure to look up the rules for your state before you claim daycare deductions.
Your daycare income will go on a form called Schedule C which will be part of your regular 1040 tax return. You are required to pay self-employment tax on your daycare income; that will be 13.3% for 2011, generally it’s 15.3%. Self employment tax is in addition to your regular income tax, so you can see why claiming your expense deductions can come in kind of handy.
The first, and probably the biggest, daycare deduction is for the business use of your home. That’s going to go on a Form 8829 and it’s going to be linked to your Schedule C. You won’t be able to deduct all of your rent, utilities, and expenses, but you’ll be able to deduct a portion of them as a percentage of how much of the home the kids have access to and how long you’re open. Kids put a lot of wear and tear on your home so definitely take advantage of this deduction.
Another big expense for many daycares is food. You can deduct as a business expense 100% of the cost of the actual food the kids you care for eat. If you’re doing your taxes yourself when you’re looking at the actual Schedule C form, there’s a section for “meals and entertainment” –you don’t want to use that line. That only gets counted as a 50% expense – that’s for sales people taking clients out to lunch and stuff like that. You’re going to want to put the food for kids on a separate line in the “other” expenses category. Call it “food for kids”. (Okay, that seems pretty “duh” but I didn’t have a better way to say it.)
If you get reimbursements under the Child and Adult Food Care Program of the Department of Agriculture, that’s not taxable unless you get more money than you actually pay out for food for the kids. Usually, you’ll get a 1099 showing you received a payment. If that’s the case, you must report it as income on your Schedule C, but then you’ll deduct the cost of food in the expense category. (If you get a 1099 and don’t show it as income, you’ll get a nasty IRS letter—that’s why you want to show it on the Schedule C even though it’s not supposed to be taxable.)
If you’re deducting food, keep separate receipts for your daycare food from your family food. (Right, I know, that’s not easy.) But remember, you can’t take a deduction for the food you feed to your own family. Now let’s get real: you just shop and buy groceries for your daycare kids and your family in one fell swoop don’t you? (Okay, that’s what I’d do, and I’m one of those anal retentive accountant types!)
Here’s how you solve that problem. The IRS has official “snack and meal rates”. Granted, they haven’t been updated since June of 2010 but I’ll work with what the IRS gives me. The rates are as follows:
- Breakfast: $1.19
- Lunch: $2.21
- Dinner: $2.21
- Snack: $0.66
Alaska and Hawaii have different rates:
- Alaska: $1.89, $3.59, $3.59, $1.07
- Hawaii: $1.38, $2.59, $2.59, $0.77
So let’s say you take care of Oliver 5 days a week. His parents take care of breakfast and dinner, but you do provide lunch and a snack every day. Oliver stayed home two weeks over Christmas and one week over Easter, other than that you’ve had him all the other days. You take $2.21 for lunch and add $0.66 for lunch and that makes $2.87. That’s what you spend on Oliver’s food on a daily basis. You multiply that by 5 days a week and get $14.35. You multiply that by 49 weeks (there’s 52 weeks in a year and you didn’t have him for 3 weeks) and you get $703 spent on Oliver’s food that you can deduct from your income.
Granted, you probably spend more than that on your daycare kids, but at least this gives you something to work with, especially if you haven’t been keeping good records.
Don’t forget the other deductible things either: money you spend on toys and games, and extra costs of laundry and cleaning supplies. If you take the kids on field trips, be sure to keep track of your mileage and the cost of admission to events. And remember that if you’re reading magazines to help you with taking care of the kids, those can be a business expense too: things like Family Fun Magazine that give you tips on things to do with kids, that’s work reading.
Taking care of other people’s children is hard work. You deserve every penny you earn. My job is to help you keep it.
Filed under: Self Employed, Small Business, Tax Deductions, Tax Preparation
If you’ve started a new business and you filed the Articles of Organization in your state to become an LLC, then here are some things you need to know about filing taxes for your new company.
First, there is no such thing as an LLC tax return. I know that sounds crazy, but it’s true. Every year, thousands of people walk into their accountants’ offices and say, “I want to file an LLC tax return!” This is what accountants joke about at their conventions and at the water cooler. We even post silly You Tube videos about it. This post is to help you not be the butt of some dumb accounting joke.
An LLC is a Limited Liability Company. One of the most common mistakes people make is that they think LLC means “Corporation”, it doesn’t. If you have an LLC, you probably are not going to file a corporation return (although you might, I’ll discuss that later).
The IRS considers an LLC to be something they call a “disregarded entity.” That means that it doesn’t have a specific tax document that goes with it. If your LLC only has one “member” (member is LLC-speak for owner) then the default tax return for your LLC is a Schedule C which is part of your 1040 income tax return. It’s due on April 15th just like any other individual tax return.
If your LLC has two or more members, then by default you are considered to be a partnership and you must file a partnership return, form 1065. Form 1065 is due on April 15th also, but it’s a good idea to get it done sooner because the information on the 1065 needs to go onto your personal tax return before you file it. When your accountant prepares the 1065, she’ll also prepare a K-1 form that will be used to prepare your personal income tax return.
So, if you have an LLC, the default tax return you might file would be a Schedule C as part of your individual income tax return, or a 1065 partnership return (and you’d receive a K1 form so you could put your partnership income on your personal tax return).
Instead of using the default filing options, you can choose to have your LLC treated as an S corporation or a C corporation for income tax purposes. It’s very rare to choose to have your LLC treated as a C corporation. Usually, if a person wanted to pay corporation tax rates, she would file articles of incorporation to begin with. But one advantage to filing as an LLC and then electing to be taxed as a C corporation would be to avoid some of the stringent reporting and meeting requirements that C corporations have. Usually, it’s not advantageous tax-wise to be treated as a C-Corporation, but there are always some exceptions. If you do go this route, you will need to file an election to be taxed as a corporation: form 8832. The tax return for a C-Corporation is called an 1120. You must file the 1120 or the extension by March 15th or you will be assessed a late filing penalty even if you owe no tax. A C-Corporation pays taxes on its income and pays wages and/or dividends to the owner.
The more common corporate tax treatment for LLCs is to be taxed as an S Corporation. A Sub-chapter S corporation passes its profits through to the owner. If you elect to be a Sub S Corporation, you must pay yourself a wage. For most businesses, the purpose behind a Sub-chapter S corporation is to avoid paying self-employment taxes. There are two things you must know:
1. A Sub S Corporation isn’t always the best way to avoid paying self-employment taxes and,
2. You’re not allowed to say that you’re trying to avoid paying self-employment taxes, even though that’s pretty much the reason anybody ever makes the Sub S election.
To make the election to be taxed as a Sub S Corporation, you will need to file form 2553. A Sub S Corporation tax return is called an 1120S form and it is due by March 15th. The S corp does not pay income tax; the income from the S corp will be reported on a K1 and will flow through to your personal tax return.
If you make an election to be taxed as a C or an S Corp, you will have to keep that designation for at least five years unless you get special permission from the IRS to change. You want to make sure you really want to make the election for corporate tax treatment before filing those forms.
Here’s my really important tax advice: Assume that you’re filing your LLC return either as a Schedule C (sole proprietor) if you’re a solo owner, or a 1065 partnership return if you have more than one owner, at least for the first year. But then, sit down with your preparer and run the numbers all three ways, (Schedule C, S-Corp, C-Corp) to see what makes the most sense for your business. Make some projections about your future income and expenses and take into account the deductions that you may have missed last year but won’t miss again. Smart planning can save you thousands of dollars in taxes over the years to come. Saving on taxes helps your business grow and puts money in your pocket.
It’s audit season and I just got back from meeting with the IRS. So far this season, I’ve worked with two different artists and they both were contacted about the same thing: Cost of Goods Sold.
If you go to the IRS website and research what they’re looking for, you’re not going to find much information. I did find an old IRS audit guideline for artists from back in the 90’s, but that didn’t address Cost of Goods Sold for artists either.
In a normal business, Cost of Goods Sold would be what you pay for the stuff you sell. For example: say you own a teddy bear store. You pay $5 for each bear and then you turn around and sell the bear for $10. You start the year with 100 bears in your inventory, you buy 500 more bears to sell, and you end the year with 50 bears in your inventory. Let’s do the math:
Beginning inventory: $500 (100 bears times $5 each)
Purchases: $2,500 (500 bears times $5 that you paid for each new bear)
Ending inventory: $ 250 (because you have 50 bears left times the $5)
Cost of Goods sold: $2,250 (this is the confusing one: you take the 500 and add the 2500—that’s all the bears that you’ve purchased to sell, right? That equals $3000. Then you subtract the ending inventory 250 (because you didn’t sell those) and you’re left with $2,250—that’s your Cost of Goods Sold.)
But if you’re an artist, you don’t have a bunch of identical $5 bears. How do you even begin to value your artwork? Here’s the thing—most artists should not be doing a Cost of Goods Sold report on their taxes. Let me repeat that: Most artists should NOT be doing a Cost of Goods Sold report on their taxes.
Think about your art. If each piece is a unique work, where the value of the piece is mostly due to your labor as opposed to the materials that you put into the work, then generally you’re fine just writing off your expenses as “expenses” rather than listing your materials as a Cost of Goods Sold.
So at what point do you “cross over” from just recording your expenses to actually keeping inventory? I asked that at the IRS the other day. “It’s really hard to say,” was the answer I got. Even for an IRS agent with years of experience, this was a tough question. If you’re mass producing works-for example you’ve produced a limited edition of numbered prints, well then that’s a case where you should be taking inventory. Still—your purchases are only the products that you sell. For example: you pay $2,000 to have 100 prints produced which you then hand number and sign. You sell 70 of the prints for $100 each.
Your Beginning inventory: $0 (up until now, all of your art was unique. You never did COGS before)
Purchases: $2000 (because that’s what you paid for them)
Ending inventory: $600 (You have 30 prints left and they cost you $20 each because 2000 divided by 100 equals 20.)
Cost of Goods Sold: $1400 (You started with $0, you added $2000 in purchases. To get the Cost of Goods Sold you subtract the ending inventory of $600 and you get $1400.)
Is this making sense? Art and Accounting don’t go together well, but you need to know this stuff. (And I’ve worked with enough artists by now to know that you’re way better at math than you let on.)
But what about the 70 prints I sold for $100 each? That goes in the front of your schedule C, $7000 under gross receipts on line 1.
Cost of Goods Sold will go on line 4.
You’ll take your Gross Receipts minus your Cost of Goods Sold to get your Gross Income. In this example, you’d take the $7,000 – $1,400 to get $5,600.
But once again, let me make this clear—as a professional artist, you shouldn’t be using Cost of Goods Sold unless you are producing a significant amount of work and you have a way of determining the cost and a way of counting the work. For example: A painter could count canvasses, but it would be almost impossible to count paint. Canvas could be a COGS but paint would be a regular expense. A potter might be able to count pounds of clay, but the tools and glazes might need to be a regular expense.
If you choose to count your inventory, it’s important to value items at what they cost and not what you are selling them for. Let’s go back to our example about the prints. You paid $20 apiece for them so your ending inventory of 30 prints is worth $600. If you value your inventory at what you want to sell the prints for ($100 apiece) then your ending inventory will be $3000—that’s more than you spent on the prints to begin with. If you did that on your tax return, your COGS would come out as negative $1000 and your income would go up to $8,000 instead of the $7000 that you actually made. Valuing your inventory at the “retail” price will really mess you up, so don’t do that.
Remember, as an artist your business situation is as unique as your art. Don’t let your packaged software intimidate you into using Cost of Goods Sold when you shouldn’t. If you’re thinking that you produce enough that you should be taking inventory, spend the money to get help from a professional so that you get started on the right track. It’s much cheaper than an audit.
If you’re an artist, you may have been asked to donate a piece of your artwork for a good cause. You might have also been told that it’s good PR for you, because people at the event will get a chance to see your work and bid on it. And of course you’ve been told that your donation is tax deductible.
While it’s true that your donation is deductible, it’s not nearly as deductible for you as it is for me. Come again? You heard me right—your art donation is not as deductible for you as it is for me. Let me give you an example: Let’s say you donate a painting that would normally sell for $500. If I bought that painting and donated it to a charity, I’d get to write off the full $500 on my tax return as a charitable deduction. If you donate that painting instead, you can only write off the cost of the materials that you used to create that painting—depending upon what materials you’re using, that’s maybe $50 to $100.
Additionally most artists are sole proprietors, their art income goes on a Schedule C on their regular 1040 tax return. Your charitable donation can’t be counted as a business expense, it must go on your Schedule A with your other personal itemized deductions. If you don’t already itemize your deductions on a Schedule A, that donated painting gives you no tax benefit whatsoever.
I’m not saying that you can never donate to charity, I like charities and I think they deserve donations. It’s just that when you donate your art, you’re not getting much bang for your buck. So what are your alternatives?
One thing is to pay to “advertise.” For example: I support a small, local ballet company. I used to just donate money to them, but now instead I purchase an ad in their performance program. They get the money they need and I get a business deduction for advertising. This is especially good for me. Before, being in the 25% tax bracket, my $100 donation was worth $25 off my taxes. Now, as a business expense, my $100 advertisement reduces my taxes by $40 ($25 from my regular tax plus an additional 15% for my self-employment taxes.) The advertising option gives you the best tax value on your donation because you can use it to offset your self-employment taxes.
Do be careful about the charity advertising though. I once did an ad thinking I was supporting a local organization, when really the money was going to an advertising agency. The organization got some money, but most of it went to the promotional company. I won’t make that mistake again.
Another option for you is to donate the profits from one of your art pieces. For example, let’s take that $500 painting; assume you paid $100 for your materials,that’s a $400 donation to the charity. Most likely, that’s a better donation than what the charity would gain if they auctioned one of your pieces off. If you’re in the 25% tax bracket, you still get a $100 reduction in your taxes. It won’t help with your self-employment tax, but you do get the good feeling of making a donation and your art work sells for its actual retail value instead of some discounted auction price (another disadvantage of donating your art for charity.)
There are many worthwhile causes out there that need and deserve your help. If providing a piece of your art work is how you want to help, by all means do it. Just remember, it’s not your best tax strategy.
Rule Number 1: If you learn nothing else from this post, learn this: don’t believe everything you read on the internet. Even if you read it in this article, you should always get some sort of definite confirmation of what I am telling you. There’s a lot of misinformation out there and some of the stuff can get you into big trouble with the IRS.
There’s a lot of hype these days about incorporating or setting up your LLC in Delaware or Nevada because these states have favorable business climates. But, unless your business is located in Delaware of Nevada, it doesn’t make sense to file your organization documents in these states. For one thing, tax law and business law don’t always go hand in hand. Here in Missouri, as with most states, if you’re earning the money here, you’re paying the taxes here—no matter where you incorporated.
Bottom line, if you own a small business, your business organization documents should be filed in the state that you live in, your employees live in, your customers live in, your shareholders live in, and where your offices are located.
Hiding or disguising your identity is another thing that doesn’t make sense for the legitimate small business owner. When you own a small business, you want people to know who you are and what kind of business you’re in. By the way, let me introduce myself. I’m Jan Roberg, I do taxes. I also write these blog posts myself. I want you to know who I am because I want you to remember me when you need tax help. That’s my picture up in the corner.
This is supposed to be tax blog, not a marketing blog, but seriously, if you own a small business—you want your clients and customers to know who you are, what you do, and how to find you. (By the way, my office is in Westport Plaza and my phone number is (314) 275-9160—just sayin’.) See what I mean? The more people know you, the more likely they are to use your products or services or refer a friend who needs you.
But let’s talk about the tax implications with hiding your identity. You might even be thinking, gosh, how would a person even do that in the first place? This is where you hire a third party in another state to file your EIN for you– this keeps your personal identification off of your federal corporate registration. It doesn’t really sound like such a bad thing, really. You might even be thinking that sounds like a good idea, but it’s not if you’re running a legitimate business!
If you try to hide your identity, the IRS sees it as a red flag for things like: underreporting, not filing returns, money laundering, financial crimes, and my personal favorite: financing terrorists. How’d you like to be delayed at the airport because you wound up on a terrorist watch list because you incorporated in another state? Okay, I’m pretty sure that you’d have to do more than just incorporate in Nevada to wind up on a terrorist watch list. But the point is, why flag your business that way?
I know I post a lot of ideas on saving money on taxes. I preach the “don’t pay more than you have to” sermon all the time. But you should never do something as a tax strategy that isn’t also good for your business too. You remember the old acronym KISS? (Keep it Simple, Stupid!) If you have a small, one owner (or husband and wife) business working in a local market, you really have no need to be filing tax documents out of state.
Let’s be real, how often do you get to hear the words “surprise” “IRS” and “nice” in the same sentence? I know it’s rare, but a nice surprise is exactly what senior citizen small business owners are getting this year from the IRS. For 2010, your Medicare payment counts towards the self-employed health insurance deduction.
This is brand new. So new in fact, that people don’t seem to know where this new rule came from. In the past, Medicare payments were never allowed to be used for the self-employed health insurance deduction. The rule is not in the Small Business bill that was passed earlier this year, and it doesn’t seem to be hidden in the numerous pages of the health care bill either.
So where can you find this new mystery tax ruling? It’s right in the 2010 instruction book for the 1040 tax form. It says: Medicare Part B premiums can be used to figure the deduction. …For more details, see Pub. 535
Now if you go to Publication 535, you’ll find it says: Medicare Part B premiums are not considered medical insurance premiums for purposes of the self-employed health insurance deduction.
Oopsies! But according to the IRS, a new Publication 535 is being produced and it will say that you can make the deduction.
So what’s it worth to you? Depending upon your tax bracket – a few hundred dollars! The average Medicare Part B premium is about $1200. For 2010 only, you can use that $1200 to reduce your self-employment tax which would save you about $180. Additionally, you’d reduce your regular taxable income by $1200 so you’d save even more.
Should you be worried about the conflicting rules? No. According to the IRS, the 1040 instructions are the rule to use. I don’t expect this rule to stick around for next year, but enjoy the gift while you’ve got it.
Filed under: Self Employed, Tax Deductions, Uncategorized
I’ve done a lot of posts about unusual small business deductions, but I haven’t done anything about the basics. If you’re new to the small business world, that’s what you really need to know. These are some of the basic, core facts that you need to know to prepare your small business taxes.
First, if you’re just starting out, and you haven’t filed any papers like articles of incorporation, and you don’t have any partners, then you’re considered to be a sole proprietor. Your business tax return goes on a form called a Schedule C, and that’s part of your regular 1040 form. Don’t file your personal taxes and then try to file your business return later, they’re one and the same thing.
What if I’m an LLC? An LLC is a limited liability company, it’s not a corporation. Most LLC’s will file as sole proprietors unless they have filed documents to be treated as an S corporation. Then they file tax form 1120S. LLCs that have partners will file partnership returns, form 1065. This post is about sole proprietors who file Schedule C with their 1040 return.
A popular question I hear is, “How much money do I have to make to file a return?” According to the IRS, if you make over $400 of self employment income, you are required to file a federal tax return. This is very different from the minimum filing requirements of regular returns. Once you’ve made over $400, that income is subject to self employment tax and the IRS is very keen on collecting your self employment tax.
Another common question is, “How will the IRS know that I’ve made over $400?” The easiest way for the IRS to find out your income, assuming that you haven’t reported it yourself, is from forms 1099MISC. Many companies hire people as contract labor and don’t withhold payroll taxes. If you make over $600 from them, they are required by law to give you a form 1099MISC, showing how much they paid you. A copy of that form also goes to the IRS. That’s the most common way small businesses can get in trouble for underreporting their income.
Another way the IRS can find out that you’re not reporting your income is through your bank records. Let’s say for example that all of your business transactions are for cash and you never receive a 1099MISC. Although you wouldn’t get caught as quickly, let’s say you had an annual income of $20,000 from your all cash business. Your spending would be out of line with your income and could trigger an audit. A quick look at your bank statements would prove you weren’t reporting your income. If you’re serious about starting a real business, do it right and have a plan for handling your taxes. It will save you a lot of trouble in the future.
Small business income, unlike wage income, has one big disadvantage–it get’s taxed twice. First, it’s taxed at your normal tax rate (10, 15, 25 or 28%) and then again at the self employment tax rate (15.3%.) Let’s say you’re already in the 25% tax bracket for another job you have, your self employment income would then be taxed at 40% (the 25% plus the 15%.)
Small business income also has one big advantage–you can reduce your self employment income by any expenses you had acquiring that income. You may even have more business expenses than you have income, in that case, you can use your business losses to reduce your regular income, that lowers your overall income tax bill. Now you don’t want your business to be losing money every year (that’s not really good business practice.) But when you’re starting up, being able to deduct your losses is very helpful.
So what kinds of expenses can you deduct? The key phrase that the IRS uses is anything that is “regular and necessary” for the business. A good guideline is right on the Schedule C form. Here’s a link to it right here: Schedule C. Advertising, legal and professional fees, auto expenses, insurance, rent, repairs and maintenance, supplies, and office expenses. Meals and entertainment are deducted at 50% of what you spend (since the idea is that you’d have to eat anyway.)
If this is your first time filing taxes for your small business. I recommend getting a professional to help you. Even if you have a knack for the paperwork, it really helps to have someone else go over the possibilities of what you can deduct and make sure that the big things like depreciation (if you have that) are handled correctly. If you get started on the right track, it’s easier to stay that way.
Filed under: Self Employed, Tax Deductions, Uncategorized
Batman stopped by my office the other day. He usually doesn’t visit me in his Bat costume, but he had just done a charity fundraiser as Batman and had promised the ladies in my office to visit us in costume. (I’d just like to point out that not all of my friends and clients are super heroes. I do know plenty of normal people.)
I recently did a post about a fellow who made a business out of appearing as Superman. On a good day, Superman can take in some decent money. After Batman’s successful fundraiser, he kind of wondered aloud about following in Superman’s footsteps and making occasional appearances for pay also. While I recently made the case for Superman being a legitimate business, Batman’s income I believe would be a hobby.
How do you tell if something is a business or a hobby? Sometimes it’s kind of hard to tell. Everybody recognizes that if you open up an Ace Hardware store selling tools and duct tape you’ve got yourself a real business. But what if you make purses and wallets out of duct tape and sell them at craft fairs? Where does that fit in? What if you breed your champion Cocker Spaniel and sell the puppies? Dog breeding is a real business, but how many litters makes you a breeder? It’s not all black and white. Here are some guidelines to help you.
First, I want to point out the most important key ingredient that the IRS uses to determine if you are a real business: a 1099MISC showing an amount under “non-employee compensation.” There are numerous guidelines as to what constitutes a business versus a hobby and this one is never mentioned. Yet it’s the most important factor as far as the IRS is concerned! If you receive a 1099MISC, the IRS counts that as self-employment and they will tax you not just income tax, but an additional 15% self employment tax. As a professional preparer, if I see one of those, even if I truly believe that your business should be classified as a hobby, I’m preparing a Schedule C showing you as a business. That’s how the IRS is treating that income.
What’s the difference in how your income is classified and why is it important? Business income is taxed at your regular income tax rate plus the self employment tax rate. Let’s say your regular tax rate is 25%, then your business income is taxed at 40% (25% + 15% = 40%.) The advantage of being treated as a business is that you can write off your direct business expenses against the income and you can even have a loss that will offset your other income. Hobby income is taxed at your regular tax rate, there is no self employment tax so you pay less tax on hobby income. The disadvantage is that although you can write off expenses against your hobby income, you can never take a loss. Also, for many people, the hobby expense write off is a worthless deduction. (It goes on the Schedule A under miscellaneous deductions subject to the 2% limitation rules.)
You cannot switch your business back and forth from hobby to business depending upon whether or not you have a profit or loss. It’s okay to grow your hobby into a business. It’s even okay to downgrade your business into a hobby. But flip flopping for the sake of lowering your taxes is just going to land you in trouble with the IRS. You need to put a little thought into it before you start claiming business losses.
If you’re not receiving 1099 MISC forms, what other tests can you use to prove your business is real and not a hobby? One is the three year test–if you’ve shown a profit in three out of the past five years, then you’re considered a business. This is a good rule, but it’s not completely hard and fast. There are court cases proving businesses to be valid even though they’ve shown losses for more than three years. Even though its a good rule of thumb, I don’t like to see people get too hung up on it, there are other tests.
Is the business carried out with the intention to make a profit? Does the taxpayer (or the taxpayer’s advisors) have the knowledge to make the business a success? Does the taxpayer spend enough time on the business to indicate a profit motive? Has the taxpayer made a profit on similar activities in the past? The answers to these questions is why I put Superman in the business category and not the hobby category. Superman had previous paid experience as a costumed character and model, and he also had a website devoted to his business and posted blogs about how to be a superhero. He clearly devotes a great deal of time to his business. Batman,on the other hand, wouldn’t really pass these tests, that’s why I consider his income to be hobby income.
One final point. Batman takes offense at Batman labeled as a hobby. “Batman isn’t a hobby, it’s a calling.” Like I said in the beginning, some of my friends are normal.
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Filed under: Jobs, People, Self Employed, Tax Deductions, Uncategorized
What do you do for a living? Are you in advertising, construction, real estate? When you tell people what your job is do they seem to have a grasp of what that means? Some people’s jobs aren’t so easily defined, like Superman for example.
Actually, his name is Charlee Chartrand and he dresses as Superman for his job. This is not your every day occupation. Now I don’t know Mr. Chartrand and I don’t do his taxes, if I did, my confidentiality rules wouldn’t allow me to talk about him. I read about him in Sunday’s Post Dispatch. I did contact him and ask for his permission to use him as an example though.
The main part of Mr. Chartrand’s job is that he dresses as Superman, hangs around at Cardinals games and collects tips for posing in pictures with fans and tourists. He’s also been performing at birthday parties. If you think there’s no money in this, think again, he can earn as much as $400 in tips in a day. And that’s why he’s going to need to figure out his deductions before he files his tax return.
So what can Superman deduct? Let’s hit the obvious thing first: the costume–all of it. Cleaning, repairing, replacing, clearly this is one clothing expense that will count as a business expense. I would also include his undergarmets. You can’t dress as Superman and wear any old boxer shorts.
The hair: most of the time hair cuts and styling products, etc are not considered legitimate expenses for business, even if you are a professional actor or television personality. In Superman’s case here, I would claim his hair expenses. He has to dye his hair black to be Superman, and he uses four different products to get just the right effect–including the “S” shaped curl on his forehead. I think that goes far beyond what would be normal for Mr. Chartrand during his off duty hours.
I can’t tell from the photo if Superman is wearing make-up or not. He doesn’t look like it, but if he was, I’d allow it. (He might need to darken his eyebrows to match his hair.) A note about make-up: generally, make up is frowned upon by the IRS as a business expense. A clown wearing clown make-up would qualify for a deduction, but most women in any business would not. I once helped a dancer with her return and as we went through her expenses she claimed “a gallon of eyelash glue.” Now, I thought that was an excessive amount even for a professional dancer. “Not for eyelashes,” she said, “It’s to keep my costume on!” Evidently, during a dress rehearsal she had had a “wardrobe malfunction”. In order to keep herself looking decent, she glued her costume on to make sure she stayed covered. That clearly fit the category of “necessary” and I put it in. (Even the meanest IRS agent couldn’t argue that one.)
Let’s get back to Superman, He can probably claim either a home office deduction or rent for his work space. And, since he travels from his home office to his gigs, he can deduct his mileage as well. These are expenses that are pretty normal for many small businesses. It’s important to remember that even unusual businesses have normal types of expenses. Another normal type of expense for Superman might be advertising, if he has flyers or cards that he distributes to get new business.
Here’s another expense that I would use for Superman that might seem out of the ordinary: comic books—Mr Chartrand uses comic books to compare against his costume and maintain the authenticity of his look. I’d count it as a valid business expense.
Also, Mr. Chartrand has a goal of moving to Los Angeles. Making a permanent move to Los Angeles would count as a moving expense, as opposed to a business expense. But, if Mr. Chartrand makes a trip to Los Angeles, to test the market so to speak, he could probably write off most of that stay as a business deduction. This would give him a chance to test out the market and give himself an out to come home if he found Los Angeles wasn’t the place for him.
When claiming business deductions, the key phrase the IRS uses is “ordinary and necessary”.
To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary.
When you’ve got a one-of-a- kind type of career, it’s not always easy to figure out what ordinary means. Hopefully, Superman’s example can give you some ideas about what’s ordinary and necessary for your business.
To read more about Charlee Chartrand, aka Superman, this link will take you to the St. Louis Post-Dispatch article about him: