Chapter 1

Tax Deduction Basics

The tax code is full of deductions for professionals—from auto­mobile expenses to wages for employees. Before you can start taking advantage of these deductions, however, you need a basic understanding of how businesses pay taxes and how tax deductions work. This chapter gives you all the information you need to get started. It covers:

   how tax deductions work

   how to calculate the value of a tax deduction, and

   what professionals can deduct.

How Tax Deductions Work

A tax deduction (also called a tax write-off) is an amount of money you are entitled to subtract from your gross income (all the money you make) to determine your taxable income (the amount on which you must pay tax). The more deductions you have, the lower your taxable income will be and the less tax you will have to pay.

Types of Tax Deductions

There are three basic types of tax deductions: personal deductions, investment deductions, and business deductions. This book covers only business deductions—the large array of write-offs available to business owners, including professionals.

Personal Deductions

For the most part, your personal, living, and family expenses are not tax deductible. For example, you can’t deduct the food that you buy for yourself and your family. There are, however, special categories of personal expenses that may be deducted, subject to strict limitations. These include items such as home mortgage interest, state and local taxes, charitable contributions, medical expenses above a threshold amount, interest on education loans, and alimony. This book does not cover these personal deductions.

Investment Deductions

Many professionals try to make money by investing money. For example, they might invest in real estate or play the stock market. They incur all kinds of expenses, such as fees paid to money managers or financial planners, legal and accounting fees, and interest on money borrowed to buy investment property. These and other investment expenses (also called expenses for the production of income) are tax deductible, subject to strict limitations. Investment deductions are not covered in this book.

Business Deductions

Because a professional practice is a profit-making enterprise, it is a business for tax purposes. People in business usually must spend money on their businesses—for example, for office space, supplies, and equipment. Most business expenses are deductible, sooner or later, one way or another. And that’s what this book is about: How professionals may deduct their business expenses.

You Pay Taxes Only on Your Profits

The federal income tax law recognizes that you must spend money to make money. Virtually every professional, however small his or her practice, incurs some expenses. Even a professional with a low overhead practice (such as a psychologist) must pay for office space and insurance. Of course, many professionals incur substantial expenses, even exceeding their income.

If you are a sole proprietor (or owner of a one-person LLC taxed as a sole proprietorship), you are not legally required to pay tax on every dollar your practice takes in (your gross business income). Instead, you owe tax only on the amount left over after your practice’s deductible ­expenses are subtracted from your gross income (this remaining amount is called your net profit). Although some tax deduction calculations can get a bit complicated, the basic math is simple: the more ­deductions you take, the lower your net profit will be, and the less tax you will have to pay.

Example: Karen, a sole proprietor, earned $100,000 this year from her child psychology practice. Fortunately, she doesn’t have to pay income tax on the entire $100,000—her gross business income. Instead, she can deduct from her gross income various business expenses, including a $10,000 office rental deduction (see Chapter 3) and a $5,000 deduction for insurance (see Chapter 13). These and her other expenses amount to $20,000. She can deduct the $20,000 from her $100,000 gross income to arrive at her net profit: $80,000. She pays income tax only on this net profit amount.

The principle is the same if your practice is a partnership, or an LLC, LLP, or S corporation: Business expenses are deducted from an entity’s profits to determine the entity’s net profit for the year, which is passed through the entity to the owners’ individual tax returns.

Example: Assume that Karen is a member of a three-owner LLC, and is entitled to one-third of the LLC’s income. She doesn’t pay tax on the gross income the LLC receives, only on her portion of its net income after expenses are deducted. This year, the LLC earned $400,000 and had $100,000 in expenses. She pays tax on one-third of the LLC’s $300,000 net profit.

If your practice is organized as a C corporation, it too pays tax only on its net profits.

You Must Have a Legal Basis for Your Deductions

All tax deductions are a matter of legislative grace, which means that you can take a deduction only if it is specifically allowed by one or more provisions of the tax law. You usually do not have to indicate on your tax return which tax law provision gives you the right to take a particular deduction. If you are audited by the IRS, however, you’ll have to provide a legal basis for every deduction the IRS questions. If the IRS concludes that your deduction wasn’t justified, it will deny the deduction and charge you back taxes, interest, and, in some cases, penalties.

The Value of a Tax Deduction

Most taxpayers, even sophisticated professionals, don’t fully appreciate just how much money they can save with tax deductions. A deduction represents income on which you don’t have to pay tax. So the value of any deduction is the amount of tax you would have had to pay on that income had you not deducted it. A deduction of $1,000 won’t save you $1,000—it will save you whatever you would otherwise have had to pay as tax on that $1,000 of income.

Federal and State Income Taxes

To determine how much income tax a deduction will save you, you must first figure out your marginal income tax bracket. The United States has a progressive income tax system for individual taxpayers, with six different tax rates (often called tax brackets) ranging from 10% of taxable income to 39.6% (see the chart below). The higher your income, the higher your tax rate.

You move from one bracket to the next only when your taxable income exceeds the bracket amount. For example, if you are a single taxpayer in 2016, you pay 10% income tax on all your taxable income up to $9,275. If your taxable income exceeds that amount, the next tax rate (15%) applies to all your income over $9,275—but the 10% rate still applies to the first $9,275. If your income exceeds the 15% bracket amount, the next tax rate (25%) applies to the excess amount, and so on until the top bracket of 39.6% is reached.

The tax bracket in which the last dollar you earn for the year falls is called your marginal tax bracket. For example, if you have $160,000 in taxable income, your marginal tax bracket is 28%. To determine how much federal income tax a deduction will save you, multiply the amount of the deduction by your marginal tax bracket. For example, if your marginal tax bracket is 28%, you will save 28¢ in federal income taxes for every dollar you are able to claim as a deductible business expense (28% × $1 = 28¢).

The following table lists the federal income tax brackets for single and married individual taxpayers.

Income tax brackets are adjusted each year for inflation. For current brackets, see IRS Publication 505, Tax Withholding and Estimated Tax.

You can also deduct your business expenses from any state income tax you must pay. The average state income tax rate is about 6%, although seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) don’t have an income tax, and New Hampshire taxes only gambling winnings and dividends and interest. You can find a list of all state income tax rates at the Federation of Tax Administrators website at www.taxadmin.org.

Social Security and Medicare Taxes

Everyone who works—whether a business owner or an employee—is required to pay Social Security and Medicare taxes. The total tax paid is the same, but the tax is paid differently depending on whether you are an employee of an incorporated practice or a self-employed owner of a partnership, an LLC, or an LLP. Employees pay one-half of these taxes through payroll deductions; employers must pony up the other half and send the entire payment to the IRS. Self-employed professionals must pay all of these taxes themselves. These differences don’t mean much when you’re an employee of a business you own, since the money is coming out of your pocket whether it is paid by the employee or employer.

These taxes are levied on the employment income of employees, and on the self-employment income of business owners. Self-employment taxes consist of two separate taxes: the Social Security tax and the Medicare tax.

Social Security tax. The Social Security tax is a flat 12.4% tax on net self-employment income up to an annual ceiling, which is adjusted for inflation each year. In 2017, the ceiling was $127,200 in net self-employment income. Thus, a self-employed person who had at least that much in net self-employment income would pay $15,773 in Social Security taxes.

Medicare tax. There are two Medicare tax rates: a 2.9% tax up to an annual ceiling—$200,000 for single taxpayers and $250,000 for married couples filing jointly. All income above the ceiling is taxed at a 3.8% rate. Thus, for example, a single taxpayer with $300,000 in net self-employment income would pay a 2.9% Medicare tax on the first $200,000 of income and a 3.8% tax on the remaining $100,000. This 0.9% Medicare tax increase applies to high-income employees as well as to the self-employed. Employees have to pay a 2.35% Medicare tax on the portion of their wages over the $200,000/$250,000 thresholds (their one-half of 2.9% (1.45%) plus the 0.9%). In addition, Medicare taxes must be paid by high-income taxpayers on investment income. (See “The Medicare Net Investment Income Tax” in Chapter 2.)

For both the self-employed and employees, the combined Social Security and Medicare tax is 15.3%, up to the Social Security tax ceiling.

However, the effective self-employment tax rate is somewhat lower than 15.3% because (1) you are allowed to deduct half of your self-employment taxes from your net income for income tax purposes, and (2) you pay self-employment tax on only 92.35% of your net self-employment income. But taxpayers who earn more than the $200,000/$250,000 thresholds, can’t deduct the 0.9% increase in Medicare tax from their income.

Like income taxes, self-employment taxes are paid on the net profit you earn from a business. Thus, deductible business expenses reduce the amount of self-employment tax you have to pay by lowering your net profit.

Total Tax Savings

When you add up your savings in federal, state, and self-employment taxes, you can see the true value of a business tax deduction. For example, if you’re single and your taxable business income (whether as an employee of an incorporated real estate business or a self-employed owner of a partnership or an LLC) is $100,000, a business deduction would be worth 28% (in federal income tax) + 15.3% (in self-employment taxes) + approximately 6% (in state taxes)—depending on what state you live in. That adds up to a whopping 49.3% savings. (If you itemize your personal deductions, your actual tax savings from a business deduction is a bit less because it reduces your state income tax and therefore reduces the federal income tax savings from this itemized deduction.) If you buy a $1,000 computer for your business and you deduct the expense, you save about $493 in taxes. In effect, the government is paying for almost half of your business expenses.

This is why it’s so important to know all the business deductions you are entitled to take and to take advantage of every one.

 CAUTION

Don’t buy things just to get a tax deduction. Although tax deductions can be worth a lot, it doesn’t make sense to buy something you don’t need just to get a deduction. After all, you still have to pay for the item, and the tax deduction you get in return will only cover a portion of the cost. For example, if you buy a $3,000 computer you don’t really need, you’ll probably be able to deduct less than half the cost. That means you’re still out over $1,500—money you’ve spent for something you don’t need. On the other hand, if you really do need a computer, the deduction you’re entitled to is like found money—and it may help you buy a better computer than you could otherwise afford.

What Professionals Can Deduct

Professionals are business owners, and as such they can deduct four broad categories of business expenses:

start-up expenses

operating expenses

capital expenses, and

inventory costs.

This section provides an introduction to each of these categories (that are covered in greater detail in later chapters).

 CAUTION

You must keep track of your expenses. You can deduct only those expenses that you actually incur. You need to keep records of these expenses to (1) know for sure how much you actually spent; and (2) prove to the IRS that you really spent the money you deducted on your tax return, in case you are audited. Accounting and bookkeeping are discussed in detail in Chapter 19.

Start-Up Expenses

The first money you will have to shell out will be for your practice’s start-up expenses. These include most of the costs of getting your practice up and running, like license fees, advertising costs, attorney and accounting fees, travel expenses, market research, and office supplies expenses. Start-up costs are not currently deductible—that is, you cannot deduct them all in the year in which you incur them. However, you can deduct up to $5,000 in start-up costs in the first year you are in business. You must deduct amounts that exceed the first-year threshold amount over the next 15 years. (See Chapter 10 for a detailed discussion of deducting start-up expenses.)

Example: Cary, an optometrist who recently graduated from optometry school, decides to open his own practice. Before Cary’s optometry office opens for business in August, he has to rent space, hire and train employees, and obtain all necessary optometric equipment. These start-up expenses cost Cary $50,000. Cary may deduct $5,000 of this amount the first year he’s in business. The remainder may be deducted over the first 180 months that he’s in business—$2,500 per year for 15 years.

Operating Expenses

Operating expenses are the ongoing day-to-day costs a business incurs to stay in business. They include such things as rent, utilities, salaries, supplies, travel expenses, car expenses, and repairs and maintenance. These expenses (unlike start-up expenses) are currently deductible—that is, you can deduct them all in the same year in which you pay them. (See Chapter 3.)

Example: After Cary’s optometry office opens, he begins paying $5,000 a month for rent and utilities. This is an operating expense that is currently deductible. When Cary does his taxes, he can deduct from his income the entire amount he paid for rent and utilities for the year.

Capital Expenses

Capital assets are things you buy for your practice that have a useful life of more than one year, such as land, buildings, equipment, vehicles, books, furniture, and patents you buy from others. These costs, called capital expenses, are considered to be part of your investment in your business, not day-to-day operating expenses.

Large businesses—those that buy at least several hundred thousand dollars of capital assets in a year—must deduct these costs by using depreciation. To depreciate an item, you deduct a portion of the cost in each year of the item’s useful life. Depending on the asset, this could be anywhere from three to 39 years (the IRS decides the asset’s useful life).

Small businesses can also use depreciation, but they have another option available for deducting many capital expenses. They can currently deduct a substantial amount of long-term asset purchases in a single year using bonus depreciation or a provision of the tax code called Section 179. Section 179 and bonus depreciation are discussed in detail in Chapter 9.

Example: Cary spent $1,000 on a new office chair for his office and $10,000 on new optometry equipment. Because the chair and equipment have a useful life of more than one year, they are capital assets. He can deduct the chair in a single year using the de minimis safe harbor. He can deduct the cost of the equipment in one year using Section 179 or depreciate it over several years using bonus and regular depreciation.

Certain capital assets, such as land and corporate stock, never wear out. Capital expenses related to these costs are not deductible; the owner must wait until the asset is sold to recover the cost. (See Chapter 9 for more on this topic.)

Inventory

Inventory is merchandise that a business makes or buys to resell to customers. It doesn’t matter whether you manufacture the merchandise yourself or buy finished merchandise from someone else and resell the items to customers. Inventory doesn’t include tools, equipment, or other items that you use in your practice; it refers only to items that you buy or make to sell.

Whether professionals sell inventory for tax purposes can be a tricky question. Materials that are an indispensable and inseparable part of the rendering of a service are not inventory—for example, gold that a dentist places in patients’ teeth is not inventory.

You must deduct inventory costs separately from all other business expenses—you deduct inventory costs as you sell the inventory. Inventory that remains unsold at the end of the year is a business asset, not a deductible expense. (See Chapter 13 for more on deducting inventory.)

Example: In addition to providing optometric services, Cary stocks and sells eyeglasses to his patients. In his first year in practice, Cary spent $15,000 on his inventory of eyeglasses, but sold only $10,000 worth of them. He can deduct only $10,000 of the inventory costs for the year.