Can I deduct my business?
That’s a question I get a lot from sole proprietors. The trick is that most information about small business taxes reads like it aimed more at slightly larger businesses, specifically, those that have employees. However, the same IRS tax rules that apply to those small businesses apply to entrepreneurs running their own single person business.
It’s an important question because enough small business expense deductions can lower your overall tax rates and move you down a bracket on the tax tables.
When Can You Deduct a Business?
There is really only one simple test that a business must pass to be tax deductible: Is there a profit motive?
For the IRS, the sole determination of whether something is a hobby, or a legitimate, tax-deductible business, is whether or not you are doing it for profit, or for fun. Of course, it wouldn’t be the IRS without hundreds of pages of documentation and dozens of publications helping sort out just what is a deductible profit motive (as well as legions of would-be tax cheats looking for a loophole).
There is a somewhat legendary tax law case where a man claimed all of his golf expenses as business deductions. Unlike other situations where a separate business might have a way to deduct some golf expenses, this person claimed that the golf itself was his business. His profit motive was that professional golf pays players and his current golfing efforts were dedicated toward that end.
There can be no doubt that some people do make money playing golf. Big names make millions of dollars, but hundreds of other players make thousands of dollars each year, and you can bet that the IRS taxes every bit of it as income. Those players can, and do, deduct any and all expenses relating to their golf play without drawing any additional IRS scrutiny. However, the person in this case was not on the PGA tour, or any professional golf tour, nor had he made any income from playing golf. The IRS denied that this was a business, and ruled it was a hobby and therefore not deductible.
This story has a happy ending for the taxpayer. IRS rulings and decisions on matters relating to the tax code can be appealed to the Tax Court. A judge there ruled that the taxpayer’s efforts were a legitimate, if unprofitable, business and that he was entitled to normal business deductions. The ruling was made, in part, because the golfer ran his efforts like a business. He kept meticulous records, he had business plans, and, perhaps most importantly, he routinely competed in the qualifying tournaments that can lead to a spot in a professional golf tournament. Just because he didn’t qualify, didn’t mean he wasn’t trying. After all, an advertising business won’t land every client it pitches either.
For most small business owners, it isn’t quite that complicated, or interesting. If you really think of it as a business, and you really think that you can make money doing it, it probably counts as a business. However, if you’re going to be making business tax deductions on your Schedule D, you want to make sure that your deductions are allowed, without going to Tax Court to prove it.
How to Qualify for Business Tax Deductions
Earn a Profit
The easiest way to prove you have a profit motive, is to actually make a profit. Even the most leisurely, hobby-like, endeavors become unquestionable businesses when you make money doing it. In fact, there is an IRS rule stating that an effort is automatically considered a business and not a hobby if it makes a profit in any three of the five proceeding years. So, if during the last five years you were profitable in at least three of them, the IRS will not dispute whether or not your business has a profit motive.
Beware of misinterpretations of this rule. Many people get confused and think that your business MUST make money in three of five years to qualify. That is not true. The 3 of 5 rule is just on of many ways to establish a profit motive that makes your small business deductible.
The IRS prefers that your business efforts are profitable. Profits mean income, and income means taxes. However, the reality is that not all businesses are profitable. Still, most businesses do have some income. Otherwise, they probably aren’t very good businesses. That income, whether it adds up to a profit or not, can go a long way in showing a profit motive. The best income is income reported on a 1099 form. That means that another, presumably legitimate business, is paying your business for goods or services. That means that they think you are a business, and therefore, maybe the government should too.
If you sell actual goods, then the reports you file with the State for sales tax purposes can fulfill the same role as a set of Form 1099 s.
The trick to income is that it needs to be both regular and substantial if you want to use it as proof of a profit motive. If you only earn $500 in January and then deduct thousands of dollars throughout the year, that won’t look as good. You’ll need to find another way to prove your profit motive.
File the Paperwork
Legitimate businesses have forms and paperwork they have to file. Most small businesses have an EIN from the IRS. Many others also have to file some paperwork with their State. The forms to create your business entity, such as an LLC or S Corporation, are further evidence that you have created a legitimate business.
If you plan to sell physical goods, a sales tax license is a virtual requirement. Otherwise if you get audited you can expect a question along the lines of, “How can you say you expect to sell stuff and make a profit if you don’t even have the sales tax license that allows you to legally sell the goods?” — Not fun.
As the example of the golfer shows, sometimes just keeping all the paperwork, emails, and other documentation is all it takes to establish a business profit motive. If you have no income, your documentation of how you go about trying to get income will go a long way. A freelance writer, for example, who can produce emails, proposals, rejections, and other documentation showing an ongoing effort to land clients will have little trouble establishing the profit motive.
Be Boring and Do Nothing Else
Although not officially criteria in any way, it can help to have a boring business. Certain sole proprietorships likely gather more scrutiny. The aspiring pro golfer, for instance, seems to be having a lot of fun in his business. The more an activity tends to be thought of as a fun hobby, the more eyebrows it may raise when trying to claim it as a business.
Finally, when you have a steady, full-time, well paying job, claiming a small, unprofitable, fun, side business can be a tougher sell. A freelance web developer with income, but whose deductions leave him with no profit at the bottom of Schedule D will make a much better case for thousands of computer related deductions than one with no business income, but another job that looks like the “real” income for the taxpayer.
Take Reasonable Deductions
Certain businesses have high start-up costs that might leave even the most savvy, profit-minded, entrepreneur with years of losses to deduct. Otherwise, most sole proprietorships start out with expenses in some proportion to their income. Deducting a new laptop makes perfect sense. Deducting a new laptop, an iPad, a new printer, phones, business trips, and much much more for a small, recreational type business, when you have no records, no profits, and another job that provides a sizable income, looks like a way to just avoid paying taxes.
Take Your Small Business Deductions
In the end, the best sole proprietor business tax strategy is to take every single deduction you can find. Along the way, run your business like a professional, and you shouldn’t have any trouble. That means keeping records and filing the right paperwork. Don’t think you can’t, or shouldn’t, take legitimate tax deductions because you aren’t earning a profit.
Deduct every dollar you can, because the IRS will tax every dollar it can when you do start making a profit.