6
COMMON DEDUCTIONS
Time is worth more than money. You can always earn more money.
Can you replace lost time?
—TAXMAMA
The best part about being in business for yourself is all those luscious deductions. You can’t go to a cocktail party, networking meeting, or anyplace people gather without hearing how someone deducted a cruise, a party, a luxurious car, a home—in fact, most kinds of living expenses. Owning your own business is great, they say, because most of your living expenses are deductible.
Listening to what other people say, you might as well get the best of everything— the most expensive briefcase, watch, PDA, computer, and cell phones for everyone! After all, it’s practically free. It’s all tax deductible.
Please curb your euphoria for just a moment.
Even if all those things are acceptable as deductible business expenses in your particular business, your tax savings is only a percentage of the amount you spend. It’s not more than 50 percent of the price. You’re still spending $100 for every $50 you save.
No, you can’t make it up in volume.
How do you know what you can deduct and what you can’t? This chapter explains it all for you.
Rule of Thumb
Actually, you’re really rather right to rejoice in your expenses. Let’s face it; if you must spend the money, you might as well enjoy what you’ve bought. In most cases, the IRS doesn’t really have the right to dictate how much you spend on any given item. Would you like to have your business carry you around first class? If you can afford it, go for it—as long as it makes sense in the context of your business, your business budget, or your target client or marketplace. After all, traveling first class, you get to meet people who can afford to pay top rates for your products or services. You won’t meet them in steerage.
Looking at the cost of something I want to use for business, this is my rule of thumb: How many hours will it take me to pay for this thing or this experience? Do I want to devote that many hours after I’ve consumed this trip or bought this device? Or . . . will this expense or extravagance pay for itself—and soon?
Think about it. Once you develop a solid business, the money will come. On the other hand, time is not a renewable resource. Think about that when you pull out that credit card to pay for a needless extravagance or excessive expense.
Universally Deductible
As long as we’re in a spending frame of mind, what shall we spend money on that we know the IRS is used to seeing on business tax returns? The following are some of the items you can deduct.
Mixed-Use Assets
Car, computers, cameras, cell phones, and even other things that don’t start with a c are mixed-use assets—things you use both personally and for business. We’ll talk more about them later in this chapter.
Office Expenses
Especially when working at home—out of your back pocket, so to speak—you overlook a substantial part of your office costs. You may pick up supplies while you’re out running around, shopping for the family, but you often forget to split the receipts you’ve collected. Some of those family supplies were used in the business office. This category is often used as a catchall for all general business expenses. Don’t dump everything in here—or in office supplies. Look at each purchase and put it in the category where it belongs. Stamps and postal supplies belong in postage or in postage and shipping. Software, if it’s renewed annually, should be considered computer supplies. Software that has a long-term life is capitalized. It’s an asset that gets depreciated. Auto expenses, including gasoline and parking, don’t belong in office expenses. They belong in auto expenses and parking, respectively. The $1,000 down payment on the copy machine doesn’t belong here either. That’s an asset. Here’s how you enter the copier purchase on your books.
When you take out a loan to buy an asset, such as a copier, you must put the full cost of the copier on the books, as well as the loan. Here are the entries you’ll be making when you purchase the copier (journal entry #1) and when you make payments (journal entry #2):
Cost of Goods Sold (COGS)
This deduction is generally for merchandise or inventory. When you’re selling a product, wholesale or retail, your merchandise is considered your cost of goods sold.1 That cost gets reported on the second page of the Schedule C for proprietorships and on a separate form, Form 1125-A, when you file a 1065 or 1120 for other entities. Other costs of goods sold include the product’s packaging and the labor to make it, to get it ready for sale, or to install it. Freight to ship it to your facility is also a cost of goods sold. The freight to ship it to customers, however, is part of the sales costs.
For personal injury attorneys, your cost of goods sold would be the clients’ costs on a specific case, such as the filing fees for the case, the doctors’ bills, investigators’ costs, witness fees, and things like that. For someone putting on seminars, the cost of goods sold would include the fees paid to instructors or speakers, the cost of the facility and the refreshments, and the costs of the handouts or books.
When you’re involved in manufacturing, there is a raft of direct and indirect costs that may end up in this part of the tax return. It’s much more complicated. Be sure to have your tax professional set up your accounting system so you get it right. Better yet, ensure that you get the highest possible deductions and tax credits available in your industry.
Advertising, Marketing, and Publicity
The IRS clearly has no trouble with these obvious expenses. For some reason, though, people don’t deduct these correctly. When I see a business growing that doesn’t show anything on the advertising line, I wonder where the business misposted those costs. On the “Advertising” line, you may include trade shows where you exhibit your company’s products or services. Include print, radio, television, or Internet advertisements; open houses, if you’re a real estate agent; and mailers, brochures, and flyers. Other things that might find their way into this category include business cards, magnetic signs for your business’s window or your vehicle, or T-shirts with the company logo that staff must wear at work and give to clients to wear so your company gets more visibility. Certainly all the social media expenditures and freelancers who help build your company’s brand or image would fall in this category too.
Commissions and Fees
Be sure to issue 1099-MISC forms to everyone you pay $600 or more in a year. Chapter 9 tells you how to make the experience painless. I have seen people lose these deductions because the 1099-MISC forms were not issued. Be careful in this category. If your professional code of ethics doesn’t permit commissions to be paid to anyone who isn’t licensed in your field, you may not want to report illegal commissions. (Those are also known as bribes.) On the other hand, even during an audit, I haven’t seen examiners question the legality of commission paid by real estate agents to unlicensed individuals.
Interest Expense
Most businesses borrow money. In fact, it’s a good idea to establish a business line of credit now, when you don’t need it. Your bank will give you a better rate of interest now—when you’re flush with cash—than when you’re broke and begging.
Do you understand how lines of credit work? The money is available for your use whenever you need it. You pay no interest unless you use the money. And if you’re really sweet, your banker will waive the annual fees.
So what interest expenses are deductible?
• If it’s a business loan, deduct the interest.
• If it’s a personal loan, the interest deduction does not belong on your business books. Period.
• If it was a personal loan, but you used all the money for the business, put the proof into a file with each year’s tax return. (You don’t need to mail or transmit the proof when you send in your tax return.) Your business may deduct the interest.
• Credit card interest is easy to deduct if you use a separate card for all your business purchases. Personal interest expenses are not deductible. So if your funds are limited and you have to choose between paying off the balance on a personal credit card and paying off the business one—pay off the personal card first. Let the business card earn the interest fees. Those are deductible. When using the same card for both personal and business use, you’ll have to do some computations, each month, to see what percentage of the interest on that card can be treated as a business deduction. For the future, set aside one card just for business use. It will make your life much easier, and your record keeping, too.
• For vehicle loans, if you use the car for personal purposes, be sure to deduct only the business percentage of the auto interest. For example, if you use the car personally 15 percent of the time, deduct only 85 percent of the vehicle loan interest. Note: When you use the car as an employee (even as an employee of your own corporation), you may not deduct any of the interest.
• Be careful with loans from owners. Write up a loan contract for each loan, with an interest rate. Even if you don’t pay the interest, compute it for the year and accrue it. [Journal entry: Debit to interest expense. Credit to interest payable (or to loan from officer).] For corporations, be sure to put the decision to borrow this money from the officer or shareholder into your minutes. Have all the officers or members of the board of directors sign the minutes to approve them.
Rent and Utilities
The IRS expects going concerns to rent office or manufacturing or storage space. That won’t attract any attention. But if you’re trying to deduct your home office expenses, please read Chapter 7 for instructions.
Insurance
Business insurance premiums, including workers’ compensation, business liability, malpractice, and facility and equipment coverage, are all deductible. When it comes to health insurance or life insurance, Chapters 9 and 10 explain what you may and may not deduct. Health insurance issues are complicated for planning purposes. Take the time to learn the tricks. Health credits and deductions are available to those who make the effort to invest the time.
Taxes and Licenses
One of the things I always find in this account is estimated payments on the owner’s personal income tax. Sorry, my friend, those are not an expense of your business. Deductible taxes include the employer’s share of the payroll taxes, personal property taxes, excise taxes, fees paid to your secretary of state, the fee for your city business license, the cost of your professional license, sales taxes you collect from your customers (if the sales tax was included in your gross income), and if you’re a corporation, the state taxes your business pays. Note: The state income taxes or franchise taxes are generally not deductible on your state corporation tax returns. Some people advise you to pay them in December of the year before they are due so you can take the deduction early. That’s great for one year. The next year, if you don’t also do that, you won’t have a state tax deduction at all. See how that works?
Education
It doesn’t matter what industry you’re in—whether you’re a professional or a tradesperson or a truck driver, you must keep up with the latest news, information, and technology relating to your business. Classes, seminars, workshops, books, and magazines—all these are acceptable—and expected. You’re entitled to deduct travel costs. So why not look for courses in places you’d like to visit? Combine your personal and business interests. Who knows; if you’re having fun, you may even attract other people who are apt to become future clients or customers.
You may not deduct courses taken toward your degree if having that degree is a minimum requirement of the job. Nor may you deduct the cost of education to learn a new career. These sound like foolish rules, but that’s the law. You would think our legislators would do everything in their power to encourage Americans to have the best education and skills in the world. We have all seen major shifts in the workforce several times over the years. You’ve seen times when entire professions or trades were put out of work. (Engineers in the 1970s, teachers in the 1980s, engineers in the 1990s, data entry folks in the 1990s, telephone customer service folks’ jobs have been outsourced for at least 20 years, . . . just to name a few.) It’s important that people and businesses look toward the future and learn skills to fall back on if things go poorly in their present industry. That can cut social welfare costs way down. Even if no deduction is available, have the good sense to keep learning new ways to support yourself. It may also provide new, lucrative directions for your business. Besides, learning can be very satisfying!
Incidentally, some taxpayers get really aggressive about their education deductions—and stubbornly take their case all the way to Tax Court on their own. Lori Singleton-Clarke2 beat the IRS and got to deduct the full amount of her Masters of Business Administration degree. She’s not the only one. There are more cases hitting the courts where taxpayers are winning on these higher education deductions. It’s not an accident. The taxpayers who win, did their due diligence and kept excellent records about their activities and how their education related to their jobs or careers.
Gifts
Gifts are limited to no more than $25 for business gifts given directly or indirectly to any one person during the tax year. (Yes, this is archaic!) A gift to a company that is intended for the eventual personal use or benefit of a particular person or a limited class of people will be considered an indirect gift to that particular person or to the individuals within that class of people who receive the gift. (Note: That awkward wording is from the IRS.) Promotional items (pens, keychains, etc.) imprinted with a name or logo are fully deductible if the item costs less than $4. Separately track costs of wrapping, shipping, engraving, and anything else that will make it possible to deduct the full cost of a gift that exceeds $25.
Travel and Transportation
General business travel is deductible, and so is travel to attend trade shows and courses. However, if your spouse or family members come along just for fun, you don’t get to deduct their expenses. You may only deduct their travel expenses if they are an integral part of the business.
You have a choice of keeping careful receipts and deducting the actual cost of your lodging or using rates set by the IRS. If you’re frugal, the IRS’s standards, called per diem rates, may be higher. Look up current, or prior, per diem rates for travel in the continental United States (CONUS) at the General Services Administration website, available at http://iTaxMama.com/PerDiem. When you’re traveling off the continental United States (OCONUS), to places like Alaska, Hawaii, Guam, and U.S. territories, use the Department of Defense per diem rates at http://iTaxMama.com/PerDiem_OCONUS. And when you travel internationally, you can find the rates on the secretary of state’s website at http://iTaxMama.com/PerDiem_Foreign.
Before you use per diem rates at all, please do your research or consult with a tax professional on how to use per diems correctly. It’s a complicated subject. In fact, if I were to do a webinar on this topic, I could probably fill at least four hours—or a whole separate book. (And heck, I might just do that soon, so stay tuned.) In the meantime, please read some of the discussions we’ve had about the issues in the TaxMama.com forums at http://iTaxMama.com/TM_PerDiem.
Meals and Entertainment
Except for places in the business of serving food (like restaurants and daycare centers), you generally only get to deduct 50 percent of this expense. That’s why it’s so important that you post your travel expenses properly. You don’t want to find yourself in shock right before an audit, when you pull out those credit card receipts and see that a hefty part of your travel deduction was really meals. When you travel, you may use the per diem rates for meals instead of your actual expenses. They are often higher than what you normally spend. Look up current, or prior, meal per diem rates at the websites we listed for the lodging per diems. (Note: When clients come to tax professionals and have not split out their travel meals, we will generally reduce the cost of travel by 25 to 40 percent and move those costs to meals expenses. The percentage will depend on the spending habits of the client. If you separate your own meals and travel costs, you might get to keep a higher travel deduction.)
Uniforms
Aside from the tax deduction, there are other advantages to having uniforms. You know exactly what you’re going to wear each day, and your wardrobe costs drop. Uniforms create brand awareness, spreading your company name wherever you go. They also can give you and your staff a sense of pride. And they’re deductible. You can turn anything into a uniform. Simply sew your logo onto your jackets, shirts, or other garments. Establish a particular look to enhance your image and to be remembered. (Don’t look; there’s a guy wearing a brown shirt and shorts, with heavy shoes. Who is he? We all know it’s the UPS guy.) Create your own look so that people seeing you will instantly associate you with your business.
As far as the IRS is concerned, uniforms are something you only wear for work. If you can wear those clothes in places not related to work, I have seen the IRS disallow them as a uniform cost. In fact, one taxpayer went to his audit in his uniform to prove that he wore uniforms. The auditor took one look at him and said, clearly, this is street wear. No deduction! Nasty!
Special TaxMama Tip
How do you overcome this? Treat these costs as advertising costs, not uniforms. You are proudly wearing your logo to create brand awareness. In fact, those clothes are a conversation starter—and they do attract clients or customers.
Now that you know different specific items you can deduct, let’s look at expenses specific to some industries.
It’s All About You
Each industry has certain characteristic deductions to consider. These deductions won’t apply to all members of the industry, but they apply to enough to make them worth knowing. To find out the deductions unique to your industry, the best place to start is with your industry association. Often, national trade and professional associations hear from their members when they face audits relating to the industry. The better associations track the information about what was handled incorrectly by members. Either they will educate members to avoid that accounting practice, or they will lobby to change the law so that it coincides with industry practices.
While there’s no room to cover all industries, here are some tips on a few industries. Use a search engine on the Internet, such as http://www.google.com, and look for your own trade or profession to find tax issues relative to your business. That’s how I find my best resources.
Beauty Salons, Barbershops, and Other Salons
For beauty salons, barbershops, massage salons, and so on, your biggest issue is determining whether the people working at your shop are employees or independent contractors. Chapter 9 describes the results of a barber’s audit. To avoid paying employment taxes on your tenants (or people renting out chairs in your shop), get rental contracts signed with your operators. They must be responsible for rents, even on weeks they are not using their stations. When renting out space in your salon, don’t deduct the money from customers’ payments. Have the operators write you monthly or weekly checks.
If you are processing customers’ credit card payments, the contracts should include a provision allowing you to do that, spelling out the fees or percentage you will charge the operators for this service.
Remember to include laundry costs for the towels and robes you clean at home each day. The following are some sites you will find useful:
• The Cosmetology Fairness and Compliance Act of 2001. http://www.govtrack.us/congress/bill.xpd?bill=s107-879. This is the salon industry’s reply to provisions affecting it in the 2001 Tax Act. This law did not pass, but it gives you an idea of some of the issues involved.
• Beauty Salon Defined. http://iTaxMama.com/IRS_Barber_Beauty. This beauty salon guide provides information about many aspects of the cosmetology industry, including business structure, tips, estimated taxes, and more. You will also find links to videos. This guide is intended to provide an overview of the industry.
• IRS’s Salon Industry Audit Procedures, Including Allowable Expenses. http://iTaxMama.com/ATG_Beauty. This is the IRS’s guide for its auditors to use when they audit salons and shops.
Childcare Providers
Many childcare businesses are operated in the owner’s home. IRS Form 8829 has a special computation for your office in home. Rather than basing your business use on square footage, it is based on the percentage of hours your facility is in operation. It’s imperative that you keep daily logs. Often, you have parents coming very late to pick up their children—that’s still business time. The IRS has standard per diem–per student rates for the food you provide. The amounts appear to be low, to my eyes, so track your actual food costs. At the end of the year, see which is higher—your actual costs or the IRS’s rates. When buying groceries and class supplies, get separate receipts for your school purchases and household purchases. If you don’t, keep the receipt in your business and circle the business purchases.
The IRS regularly audits such businesses, since so much cash changes hands. You can read the audit guide that IRS auditors use—the IRS’s Child-Care Providers Industry Audit Procedures and Allowable Expenses—available at http://iTaxMama.com/ATG_ChildCare.
Construction Industry
Many states have rules requiring construction businesses to pay their workers as employees if they are not licensed contractors. While you may not have specific uniforms, for many trades, you can only wear your jeans or shirts once. After that, they are too caked with cement or other dirt to be washed. Since those items of clothing are disposable and definitely cannot be used on the street in that condition, pick up the costs. Keep receipts for all your tools, gloves, boots, safety equipment, and the toolbox on the back of your truck. Your office in home (see Chapter 7) probably includes the whole garage and additional storage units you’ve built. Taking that into consideration, your ratios of business use may change. On some projects, using percentage of completion costing will let you delay paying taxes on some of the money you’ve received. Sometimes, the completed contract method will work better for you. Check with your tax professional for some tricks of the trade.
An excellent resource for the construction industry is the website http://www.construction.com. During the years I spent working in this field, the Dodge Reports were an excellent source of bidding opportunities for larger projects we would never have known about on our own.
Protect yourself from audits by understanding the IRS’s Construction Industry Audit Procedures, Including Allowable Expenses. This guide, which the IRS auditors use, is available at http://iTaxMama.com/ATG_Construction.
Multilevel Marketing Industry (MLM)
Surprisingly, the IRS does not list an audit guide for MLM companies, yet the IRS has instituted an aggressive push to shut down abusive MLM schemes, such as the Tax People prosecution in Kansas.3 (Note: Not all MLM companies or activities are abusive.) Think carefully before treating this as a business. If you’re only buying the products or services for personal use, then all your expenses are personal. If you get a 1099 for your sales to yourself, report the income, and on page 2 of Schedule C, on the “Other expenses” line, enter “Not income—personal use discount only,” and deduct the same amount. If you’re getting a discount on merchandise you purchase for use in your business, your commissions are income. Add the commissions to your business income. However, if you are actively and aggressively building your downlines,4 selling products, and generating revenues, then you should take all the deductions you’re entitled to use. In case your income never builds up enough to show a profit, keep a log of all your marketing activities and marketing expenses. You’ll need them to fight the IRS in the event of a hobby loss or fraud audit.
Truckers
If you’re a trucker, you’re subject to a variety of gasoline, road, and vehicle taxes; tolls; and weight charges. Keep all the receipts for those fees in a safe place for each year. Even as an owner-operator, you’ve contracted with one or two companies that give you the majority of your runs. Have you ever looked at the pay stubs they give you? They have deducted for at least two kinds of insurance and several fees they share with you. Usually, the 1099-MISC they issue to you is for the gross amount of your income or the contracted fee. Yet the check you actually get might be at least 10 percent less. Ask the accounting department if this is the case. Or hold on to every single check from that company and add them all up. Odds are, you haven’t been taking a deduction for this 10 percent or so worth of fees. There’s also an annual heavy vehicle use tax due, $550 minimum (Form 2290). It is due on the anniversary date of your vehicle purchase plus one month. The IRS includes a chart in the instructions to Form 2290, in case the due date confuses you—see https://www.irs.gov/pub/irs-pdf/f2290.pdf.
The IRS’s per diem rates allow truckers to get a standard daily meal allowance, just like other business travelers. There’s a special rate for transportation workers, like truckers, railroad personnel, etc.—see http://iTaxMama.com/Trucker_Per_Diem. The rate changes every year. In 2015 and 2016 it was $63 per day ($68 OCONUS). Please note, if you are subject to “hours of service limits” by the Department of Transportation, you may only use 80 percent of the per diem amount. Keep an eye on this at http://iTaxMama.com/Hours_Service. It may rise to 100 percent someday.
Since you’re usually on the road, your administrative time is limited. Here are some resources to cut your time and costs of tax administration.
• Truckers Helper Online. http://www.truckershelper.com/. Trucking business software and tools
• Drivers’ Daily Log. http://www.driversdailylog.com. A software tool to help you maintain daily logs and hours of service. It’s not fancy, but certainly seems functional.
• IRS’s Trucking Industry Audit Procedures, Including Allowable Expenses. It would be wise to get familiar with the IRS’s perspective on what is and isn’t deductible by truckers. (Here is an old, 114-page audit guide from 1995: http://www.unclefed.com/SurviveIRS/MSSP/truck.pdf.)
• Form 2290, Heavy Highway Vehicle Use Tax Return. https://www.irs.gov/pub/irs-pdf/f2290.pdf. You must file Form 2290 within the first month that you put any heavy highway vehicle, with a taxable gross weight of 55,000 pounds or more, into use.
Cash-Intensive Businesses
One of the wonderful things about a business that collects cash from its customers is that there is little or no accounts receivable. The big drawbacks are that you are a frequent target for thieves—and for IRS audits. After all, since all the revenue is cash, it’s easy to skim off some money each day without paying taxes. The IRS has a special audit guide (available at http://iTaxMama.com/ATG_Cash) to help close that insidious tax gap. Read it carefully if you own a restaurant or a grocery or convenience store—in other words, an establishment that handles a high volume of small-dollar transactions. The IRS also uses the audit guide for industries that engage in services, such as construction or trucking, where independent contract workers are generally paid in cash.
These days, there is another growing industry that is quite a target for federal scrutiny—on many levels. The state-legal marijuana industry has rapidly grown to a multibillion-dollar level. The federal government has made it a semiofficial policy to leave the medical marijuana businesses alone. But the feds are still raiding and auditing recreational marijuana businesses. For more in-depth information about the special tax and business issues involved, watch the video of my annual course— Marijuana’s Tax Paradox (or the Uncanny Cannabis Controversy)—http://iTaxMama.com/CPE_Pot.
Mixed-Use Assets
Mixed-use assets were introduced earlier. Now is the time to look at them in depth. Cars, computers, cell phones, cameras, and other property used for entertainment, recreation, or amusement are called “listed property”5 and have the honor of occupying their own special place, taking up most of the second page of Form 4562.
Computers, video equipment, cameras, monitors, and beepers—you can’t run a business today without them. They’re no longer a luxury. In fact, they’re so reasonably priced that many children have their own electronics. Parents and their businesses no longer share the home computer. Since the initial public offerings (IPOs) of the 1990s, everyone is trying so hard to re-create the phenomenon, who has time for a personal life anymore? Besides, with digital cameras and reality television, everyone’s family and home is going online.
Let’s talk about how you can make the most of your deductions with each of these mixed-use assets.
Cars, aside from real estate or a complete manufacturing plant, are likely to be the biggest one-shot expense to a small business. In the American economy, your car is the key to your image. Chapter 8 tells you all of the most effective ways to squeeze deductions out of it—whether you lease or buy.
Would you like to get even more money out of your car dollars and be able to get something better than you thought you could afford? Go to the dealer selling the model of your dreams—and buy a used model. New luxury cars lose value instantly when taken off the lot. That’s not just a myth. So let someone else pay for that quick devaluation. Instead, you can buy the completely refurbished one- or two-year-old dream machine with most of the warranty left, and have the dealer detail it for you before you pick it up. If you don’t squeal, people will think you bought the car new.
The listed property rules with respect to just about everything except cars, televisions, and stereos are obsolete. They should be removed from the tax code. Even the IRS isn’t paying attention. The IRS used to target the split usages of listed property. Aside from personal use of cars, I haven’t seen an auditor ask about personal use of property (except for television or cable) since the early 1990s. Congress removed cell phones from “listed property” permanently in the Small Business Jobs Act of 2010.
What Do the Listed Property Rules Mean to You?
For all listed property you want to deduct, you must track the business and personal usage so you know what percentage of that usage is for business. If you want to treat your camera, stereo, DVD player, and television as business property, you have to keep logs of all the usage with a separate column for business. That’s right. Can you just see yourself sitting down to watch television and making a notation in your log with the date, starting time, and list of the programs you’re watching? Be sure to include a few lines about how you’re using the time or the programming for business purposes. If other family members use the TV, they have to make log entries, too. After all, your family’s time counts toward total use of the asset. At the end of the year, you’ll be able to deduct about 20 percent of the expenses, based on the few business hours you actually logged. Yes, it’s a pain. That’s the point. Congress wants to discourage you from deducting personal assets. Many entertainment industry folks set up their equipment in a separate screening room, even if it’s just a separate bedroom, to use for business viewing.
The main thing you need to know is that when business use of the asset falls to less than 50 percent, you can’t take a depreciation deduction for the asset. If you’ve been depreciating over several years and business use falls below 50 percent, you may have to recapture, or pay back, some of the depreciation. This is what you have a tax professional for—to help you in times like that.
As for the special rules for cars—and there are many—we’ve devoted an entire chapter (Chapter 8) to this subject. But we didn’t explain what depreciation is all about—that comes next.
Depreciation
Back in the good old days, a depreciation deduction was provided so companies could write off a portion of the cost of their large capital expenses (buildings, equipment, fixtures, and so on) over the item’s useful life. This was to provide them with the incentive to put that money aside, into a reserve fund, so they could afford to replace items as they wore out. Back then, depreciation life was related to how long a piece of equipment or building would last without substantial repairs or improvements.
Depreciation was also easy to figure out back then. Using a simple mathematical formula or two, you could determine depreciation without a scientific calculator or slide rule6—just a pencil and paper . . . and perhaps an extra finger or toe. We used nifty worksheets, which you can use too. (See Table 6.1.) Really, depreciation was logical: you could use straight line, declining balance (DB), or sum-of-the-years digits.
TABLE 6.1 Form 4562, Depreciation Worksheet
Straight line was the easiest type of depreciation. For this, you just had to divide the cost of the asset by the number of months in its useful life. Then all you had to do was multiply that result by the number of months the asset would be in use during the year:
Cost ÷ useful life in months × months used this year
Straight Line
Trixie bought a computer for $1,200 on September 5. It had a five-year useful life: 5 years × 12 = 60 months. Dividing $1,200 by 60 = $20 per month. She used the computer for four months this year. The deduction is 4 × $20 = $80.
Next year, Trixie will depreciate it for a whole year: $20 × 12 = $240, or 20 percent per year.
In a double-declining balance (DDB) or a 1.5 declining balance (1.5 DB), you simply took the first formula and multiplied it by 2 or 1.5:
(Cost ÷ useful life × months used this year) × 2
or
(Cost ÷ useful life × months used this year) × 1.5
The only difference in the declining balance method is that you multiply your resulting percentage against the undepreciated balance of the asset. Let’s go back to Trixie, shall we?
Double-Declining Balance
Divide the number of months the asset was in business use this year by the total life. Trixie had 4 months of use, divided by 60 months’ life. Her straight-line depreciation rate would be 6.67 percent. Using DDB, she would multiply that rate by 2 = 13.33 percent. Trixie’s first-year depreciation would be $160 (13.33 percent × $1,200).
The following year, Trixie deducts the $160 already written off from the full purchase price of $1,200 to equal $1,040. She would multiply this reduced asset cost by the second year’s depreciation. In Trixie’s second year, she used it 12 months out of a total of 60. That’s 20 percent. Remember, we multiply that number by 2 to equal 40 percent. So the second year, Trixie’s depreciation is $416 ($1,040 × 40 percent). From then on, Trixie’s rate would be 40 percent, but the balance will keep decreasing. In the third year, the asset cost is $624 ($1,040 − $416). Multiplying $624 by 40 percent gives Trixie a smaller deduction than last year, equal to $250. And so forth.
The formula is:
(Cost ÷ useful life × months used this year) × 2 × (cost − previous depreciation)
or
(Cost ÷ useful life × months used this year) × 1.5 × (cost − previous depreciation)
Halfway through the useful life, you’d switch back over to straight line.
Depreciation in Today’s World
Aside from mere historical value, there’s a reason for explaining the old way of determining depreciation to you. The present depreciation system still has a little resemblance to these two computation methods.
The IRS changed its depreciation rules in 1986. It introduced concepts such as the accelerated cost recovery system (ACRS) and modified accelerated cost recovery system (MACRS). For the present, you’ll be using MACRS, which is based on the two systems described above. (See Table 6.2.)
TABLE 6.2 MACRS Percentage Table Guide
Depreciable assets are categorized in groups called classes. You can look them up in IRS Publication 946, How to Depreciate Property (available at https://www.irs.gov/publications/p946/index.html) or read IRC §168. Most businesses only need to know about these four classes. The life is called a recovery period.
• Three-year property. This property includes manufacturing equipment, certain racehorses, tractor units, and rent-to-own property.
• Five-year property. This category includes autos, taxis, small aircraft, trailers, computers and peripherals, office equipment, apparel manufacturing equipment, certain construction equipment, and fixtures and appliances used in rental properties.
• Seven-year property. Office furniture; manufacturing equipment (not already included in the first two classes); oil, gas, and mining equipment; agricultural buildings or structures; and anything that isn’t classified anywhere else fit here.
• Real estate (buildings only, not land). Commercial real estate is depreciated over 39 years using a straight-line method. Residential real estate is depreciated over 27.5 years, straight line.
Don’t worry; you won’t have to do the calculations. You’ll be able to look up depreciation in the tables. Table 6.3 gives you the most commonly used depreciation table for small businesses. Table 6.4 covers residential real estate (apartments and homes rented out) and commercial and business property. This also includes your home office. Although you’re living in the house, the office part makes it subject to the 39-year rules.
TABLE 6.3 MACRS Depreciation: 3-, 5-, 7-, 10-, 15-, and 20-Year Property; Half-Year Convention
TABLE 6.4 Residential Rental Property Mid-Month Convention Straight Line—27.5 Years
In addition to recovery periods, you have “conventions” that dictate adjustments in the MACRS tables. Did you notice that “half-year” designation in the title of Table 6.3? It refers to the date you bought your assets.
• The half-year convention treats all your property as if you bought it in the middle of the year.
• The mid-month convention applies to real estate. It treats all buildings as if they had been bought in the middle of the month.
• The mid-quarter convention comes into play if more than 40 percent of your assets (based on cost) were bought in the last three months of your tax year.
I’m sorry; despite the title of this book, there is no way to make depreciation easy. All this, and we haven’t even talked about the part you’re most excited about—bonus depreciation.
Bonus Depreciation
This is like a yo-yo. Some years, we have bonus depreciation. Others we don’t. Lawmakers use this provision as a political toy. You will have to read the “What’s New” section of IRS Publication 946 each year to see if you are entitled to any bonus depreciation. Typically, if there is bonus depreciation, it will only apply to the purchase of new, not used, assets. The idea is to boost sales of new products to increase manufacturing activity. Sometimes, the bonus depreciation will only be available in designated disaster areas. Sometimes, it will be universally available.
Section 179 Depreciation
It is called Section 179 depreciation because that is the Internal Revenue Code section that covers this. Section 179 depreciation may be used for new or used property. This limit changes constantly with the political wind. The Protecting Americans from Tax Hikes (PATH) Act of 20157 finally locked in some permanent amounts for Section 179 depreciation. You may now deduct up to $500,000 in business assets purchases each year.
There are strings attached to the Section 179 deduction.
• If more than $2 million worth of property is placed in service during the year, the allowable Section 179 expense must be reduced by the amount in excess of the limit.
• The Section 179 election can’t cause income from all trades or businesses to be reduced below zero.
• Any amounts expensed under this provision reduce the depreciable basis of the assets placed in service during the year. In other words, you can’t expense part or all of the cost of an asset and also depreciate the same costs.
• If the property is disposed of prior to the end of its useful life, you will be required to recapture some of the Section 179 deduction previously taken. Recapture means that a portion of your Section 179 deduction must be included as taxable income on your tax return.
• You can use Section 179 on vehicles over 6,000 pounds. But the deduction is limited to $25,000. (See Chapter 8.)
Large corporations have entire departments devoted to tracking assets and recording their disposal. Take the cost of administration into account when you discuss the value of depreciation deductions.
If the Section 179 deduction will take your business income to zero, cut back on how much of it you use. As previously mentioned, you cannot use Section 179 to take your business profit below zero. However, regular depreciation may be used to generate a loss. A good tax professional will play with the numbers to give you the highest deduction you can get without throwing you into alternative minimum taxes, or having you waste the deduction. When the Section 179 depreciation you take is too high, the rest of it gets carried forward to the next year; while regular depreciation might have given you a deduction. I’ve seen people totally waste this deduction, year after year. Remember, you may have to pay back the deduction if you stop using the asset for business, trade it in, or sell it. So do a careful analysis before using Section 179.
Affecting Pass-Through Entities
When using bonus depreciation and Section 179 depreciation for partnerships, LLCs, S corps, or other pass-through entities, talk to the partners, members, or shareholders first. If you use the Section 179 deduction on the business return, but they can’t use it, they’ll be forced to carry it forward. It might be wasted.
Depreciation is one of the most complex tax computations. So many forms, schedules, and limits are affected that it’s like playing multidimensional chess. Even the best tax software doesn’t always get this right. If you talk to your tax advisors, they’ll admit they check their software’s depreciation calculations to make sure all affected forms and limits are taken into account on your tax returns.
More Deductions Than You Can Imagine
We’ve just scratched the surface of how to use expenses, and we haven’t delved deeply into the expenses you can’t use. Some businesses are subject to passive loss limitations or alternative minimum taxes and the intricacies of net operating losses. These are things you’ll need to have your tax professional explain if they pertain to you. After all, you need to have something to call your tax person about now that you’ve learned all you need to know to run your business.
And if you can’t get an answer there . . . just ask TaxMama. Really. All you have to do is visit www.TaxMama.com and click on Ask a Free Question. You will get an answer, usually within 24 hours, on a business day.
Incidentally, a word to the wise—don’t spend all your time learning to run the business. At some point, you have to take action—and start working.
Deduction Resources
IRS Forms, Publications, and Resources
• Form 1125-A, Cost of Goods Sold. https://www.irs.gov/pub/irs-pdf/f1125a.pdf.
• Form 4562, Depreciation. https://www.irs.gov/pub/irs-pdf/f4562.pdf.
• IRS Publication 946, How to Depreciate. https://www.irs.gov/publications/p946/ch01.html.
Per Diem Rates
CONUS—Continental United States. http://iTaxMama.com/PerDiem.
OCONUS—Outside the Continental United States. http://iTaxMama.com/PerDiem_OCONUS.
International. http://iTaxMama.com/PerDiem_Foreign.
Meal per Diems for Transportation Workers subject to Department of Transportation (DOT) rules. http://iTaxMama.com/Trucker_Per_Diem.
Questions and Answers About Per Diems in the TaxMama forums. http://iTaxMama.com/TM_PerDiem.
IRS Audit Guides for Specific Industries. http://iTaxMama.com/IRS_ATG.
Mileage Tracking Resources
• Tax MiniMiser. http://iTaxMama.com/EnUSA. Tax MiniMiser allows you to log the usage of vehicles or mixed-use assets. You can use it to track income and expense as a complete, stand-alone, accounting system—on paper.
• TaxPal. http://www.taxpal.net/. A software tool to use with the Tax MiniMiser, or stand alone. It lets you enter mileage and expense data by hand or import it from various apps. It’s still growing and developing and welcoming input from users. The unique thing about this is, it’s built around the questions IRS asks about each meal or entertainment, trip or deduction. It’s designed to protect you in audits.
º Magical Miles. https://itunes.apple.com/us/app/id817598888. An iOS mileage app that can be imported into TaxPal.
º MileIQ. https://www.mileiq.com/howitworks. The Android app you can use with TaxPal.
Other Resources
• Construction Industry Resources. http://www.construction.com.
• Small Business Taxes and Management. http://www.smbiz.com. Tax updates, summaries, and news for small businesses.
• Marijuana’s Tax Paradox (or the Uncanny Cannabis Controversy). http://iTaxMama.com/CPE_Pot. TaxMama’s recorded webinar about the tax issues of the marijuana industry.
• Open, by American Express. http://open.americanexpress.com. For discounts on business supplies and services.
• TaxMama’s Quick Look-Ups. http://iTaxMama.com/TM_QuickLookUp. You will find all kinds of useful reference materials, webinars you can replay, e-books, and more.
• Your Business Bible. http://www.yourbusinessbible.com. Look for worksheets, printable checklists, and other goodies and resources.
1 Cost of goods sold is the hard costs involved with producing your product or delivering your service.
2 Lori A. Singleton-Clarke v. Commissioner of Internal Revenue, http://www.ustaxcourt.gov/InOpHistoric/singleton-clarke.sum.WPD.pdf.
3 Analysis by attorney Jeffrey A. Babener of the 2001 prosecution of Kansas-based company Renaissance, The Tax People, available at http://www.mlmlegal.com/taxpeople.html.
4 In multilevel marketing terminology, downlines are the members that you have recruited to the company. These are the people whose sales (or purchases) earn you a commission.
5 Internal Revenue Code §280F(b) applies to less than 50 percent business use of listed assets.
6 Slide rule—a geek tool. Instructions on how to use them from the Museum of HP Calculators can be found at http://www.hpmuseum.org/srinst.htm.
7 See Section 123 and Section 124 of the PATH Act—http://waysandmeans.house.gov/wp-content/uploads/2015/12/SECTION-BY-SECTION-SUMMARY-OF-THE-PROPOSED-PATH-ACT.pdf.