State and Federal Deductions
If you feel pressured at tax time, you may be tempted to settle for the standard tax deductions and exemptions, rather than going through all the work of itemizing your deductions. But if you don't explore itemizing, you may end up paying more taxes than you really owe. Should you itemize?
To figure out whether itemizing would be profitable for you, consider some of the factors that affect what you can deduct, such as home ownership, taxes, charitable donations, medical expenses, and miscellaneous expenses.
Compare your potential deduction with the standard deduction you're entitled to on 2006 returns:
• Standard deduction for single taxpayers - $5,150
• Standard deduction for married taxpayers filing a joint return - $10,300
• Standard deduction for head of household taxpayers - $7,550
If you're 65 or older or blind, you get to increase the standard tax deduction.
Click here to view Federal, State and Local deductions
Single or Head of Household:
1.65 or older $1,250
2.Blind $1,250
3.Both 65 or older and blind $2,500
Married or Widow(er)
1.One spouse 65 or older, or blind $1,000
2.One spouse 65 or older, and blind $2,000
3.One spouse 65 or older, and both blind $3,000
4.Both spouses 65 or older $2,000
5.Both spouses 65 or older, and one blind $3,000
6.Both spouses 65 or older, and both blind $4,000
If You Own a Home
Many taxpayers take the standard deduction rather than itemizing their tax deductions, even though some taxpayers with mortgages or home equity loans could have saved money by itemizing. If you have a mortgage or home equity loan on your home, fill out Schedule A to see if your itemized tax deductions are larger than the standard tax deduction to which you're entitled. In January, your mortgage lender should provide the amount of mortgage interest you paid during the previous year. Look for Form 1098, Mortgage Interest Statement. If you paid points as part of the financing for your home, the points will also be shown on that form. Tip: Mortgage lenders sometimes attach Form 1098 to your December or January mortgage bill. Here's a quick rule of thumb. Compare your mortgage interest (plus any points paid on the purchase of your residence) with your standard deduction. If you have refinanced your mortgage, points on the refinancing are deducted gradually over the life of the loan — 1/30th a year on a 30-year mortgage, for example. Don't forget to add each year's share to your deductions. For more information, consult IRS Publication 936, Home Mortgage Interest Deduction. If the interest you paid on your mortgage is larger than your standard tax deduction, you definitely benefit by itemizing -- and all the rest of your deductible expenses (including real estate taxes and state and local income taxes) are frosting on the cake.
• Many lenders provide a year-end tax summary that includes any real estate taxes and insurance paid through escrow accounts. The real estate taxes are deductible, but homeowner's insurance and homeowner's association fees are not.
• If your real estate taxes aren't paid through an escrow account, review your property tax bills and canceled checks and add up what you paid. You can't deduct any penalties you paid for late payment of property taxes: you can only deduct the actual taxes assessed and paid.
State and Local Taxes
Even if you don't own a home, itemizing can pay off handsomely. Look at the income taxes that you paid to your state, and to your city or county, if applicable. Income taxes you pay to these governments are deductible. Add up the state and city taxes shown in boxes 17 and 19 on your W-2s and compare the total to your standard deduction. If you made estimated tax payments to your state or local government (including any 2005 refund you had applied to your 2006 tax bill), be sure to total those amounts. And don't forget to add in any money you sent with your 2005 state and local tax returns in April of 2006.
Charitable Donations
You can deduct charitable donations only if you itemize your deductions. Add up the money you donated to organizations like the Red Cross, churches, synagogues, mosques, and other nonprofit organizations. If you donated things like clothing, furniture, or other household items, you need to determine their value. One way is to find out what your local thrift shop is charging for similar items or you could use a software program like Its Deductible that does this work for you. Make sure you use good judgment and that you don't overvalue your donations. Also, note that new rules arrived in August that demand more substantiation to back up charitable contributions. Under the old rules, taxpayers needed a receipt to back up any charitable contribution of $250 or more (a cancelled check was not sufficient). That's still the case for contributions of $250 or more. But now, you also need a receipt or a cancelled check to back up deductions for even smaller donations.
Medical Expense Deductions
Although medical expenses are deductible, very few taxpayers get to deduct them. Why not? Because you get to deduct such costs only to the extent that unreimbursed expenses exceed 7-1/2% of your adjusted gross income. So if your AGI is $50,000, for example, the first $3,750 ($50,000 x 0.075) effectively don't count. Before you go through all of your doctors' bills and prescription receipts, do a quick calculation based on your income to make sure your time will be well spent. Deductible medical expenses include doctors' and dentists' fees, chiropractors' fees, lab fees, contact lenses, glasses, prescription drugs and medical supplies.
• If you have a question about a particular medical expense, consult IRS Publication 502, Medical and Dental Expenses. You can deduct the premiums you pay for health insurance coverage, unless your employer pays for your coverage through a payroll deduction using pre-tax dollars. If so, you've already received a tax benefit for your premium payments, so don't deduct those premiums on your return. Consult your employer's benefits department if you're not sure.
Miscellaneous Tax Deductions
Most of the remaining deductions are subject to a limitation similar to the one for medical expenses.
1. Review the miscellaneous deductions listed below.
2. Add up the ones you can take.
3. Calculate 2% of your adjusted gross income.
4. Compare the two figures.
If the total of miscellaneous deductions is larger than 2% of your adjusted gross income, subtract the 2% figure from your total miscellaneous deductions. The difference is the amount you can actually deduct on your return. If the total of miscellaneous deductions is less than 2% of your adjusted gross income, you can't deduct any of these items. Examples of qualifying miscellaneous expenses that you could deduct include:
• Dues you pay to a union or a professional organization in connection with your employment
• Subscriptions to magazines and other publications that are related to your work
• Business liability insurance premiums
• The cost of protective work clothing, such as hard hats or safety shoes and glasses, and the cost of uniforms you're required to wear to work
• Tools and supplies used in your work
• Medical examinations required by an employer
• Tuition for classes that maintain or improve the skills required for your present job
• Expenses you incur while looking for a job in the same line of work you normally do (examples: resume' costs, career counseling, and employment agency fees)
• Depreciation on your computer or cellular phone, but only for the part of the time you use your equipment to keep track of your taxable investments (stocks, bonds, mutual funds) or as part of your job, if required by your employer
• The fees you're charged by your financial institution to maintain your IRA account, but only if you pay them from funds outside of your IRA account (if your financial institution just deducts the maintenance fees directly from your IRA, you can't deduct them)
• Safe deposit box rental fees, if you use the box to store stocks, bonds, or other investment-related documents (if you just store jewelry and other personal items there, the fees aren't deductible)
• What you pay to get your taxes done, whether it's by a professional or with tax preparation software. You can also deduct the cost of any books or publications that help you with preparing your return, and, if you file your return electronically, you can deduct any costs associated with that process
• Legal fees that you pay to protect your taxable income, or to produce your taxable income (This includes fees for legal assistance for helping you keep your job, for tax planning or investment counseling, or for handling an audit of your tax return. Legal fees for divorces aren't deductible, except for any portion specifically related to helping you collect alimony payments or for advice about the tax-ability of your alimony. You can only deduct legal fees that you pay in your efforts to collect income that's taxable to you.)
Miscellaneous deductions not subject to the 2% rule
There are a few miscellaneous expenses that guarantee tax savings to itemizers because they are deductible without regard to the 2% threshold. These three are most likely to be of any benefit:
• Amortizable bond premium is the amount over face value that you pay for certain bonds because they are paying higher-than-current-market interest rates.
• Gambling losses. This write-off comes with its own restriction. You can't deduct more than the amount of gambling winnings you report as taxable income.
• Federal Estate Tax on Income in Respect of a Decedent. This is becoming an increasingly important deduction as more and more taxpayers inherit money in company retirement plans or traditional IRAs. Such amounts are considered "income in respect of a decedent" because the decedent had a right to the income at the time of death, but the income is not included on the person's final tax return. Instead, the beneficiary is taxed on the amounts. You might also deserve a deduction, though, if the decedent's estate was large enough to pay federal estate taxes. Say, for example, that you inherit a $50,000 IRA which, because it was included in your mother's taxable estate, boosted the estate tax bill by $20,500. Although you have to pay tax as you pull money out of the IRA, you also get a deduction for that $20,500. If you pull the full $50,000 out at once, you'd get the full deduction. If you pull it out equally over two years, you'd deduct $10,250 each year. This miscellaneous deduction is not subject to the 2% limit but it's up to you to know the rules to take advantage of them Yes, if you make any money. The self-employment tax (officially known as the SECA tax for Self-Employment Contributions Act tax) is the self-employed person's version of the FICA (Federal Insurance Contributions Act) tax paid by employees to pay for Social Security and Medicare. It's due on your net earnings from self-employment
What is the self-employment tax?
Many newly self-employed people — sole proprietors, independent contractors and the like — are surprised at their tax bills at the end of the year because they notice they're suddenly paying a lot more in tax as a self-employed person than as an employee. That's because they're carrying the full burden of paying for Social Security and Medicare. Employees share that cost with their employers, with each paying the 7.65% FICA tax. When you're self-employed, though, you're stuck with the full 15.3% levy. The tax is divided into two parts:
• 12.4 percent for Social Security. For 2006, this part of the tax applies to the first $94,200 of earnings. If you earn more than (from your business or, if you also have a job, from the combination of your job and your business), then the 12.4% part of the tax that pays for Social Security stops. (The dollar limit will be a few thousand dollars higher in 2007.)
• 2.9 percent for Medicare. The Medicare portion of the self-employment tax is unlimited. No matter how much you earn, you'll pay the 2.9% Medicare tax. Even if you have investment losses that offset part of your self-employment income for income tax purposes, such losses will not effect the amount of self-employment tax you owe. For more information on this tax, see IRS Tax Topic 554: The Self-employment Tax.
How do I report the self-employment tax?
When you start a small business and you do not incorporate or form a partnership, you report the results of your operations on Schedule C and file that with your Form 1040. The result of netting your revenues and expenses is a net profit or loss. You calculate your self-employment tax on Schedule SE and report that amount in the "Other Taxes" section of Form 1040. In this way, the IRS differentiates the SE tax from the income tax.
Good news: When figuring self-employment tax you owe, you get to reduce self-employment income by 7.65% before applying the tax rate. Say, for example, that your net self-employment income is $50,000. That's the amount you report as taxable for income tax purposes on Form 1040. But when figuring your self-employment tax on Schedule SE, Computation of Social Security Self-Employment Tax, the taxable amount is $46,175. Not paying the 15.3% tax on $3,825 difference in this example saves you $585. (The savings evaporate at higher income levels. When 2006 self-employment income hits $102,003, for example, even after the 7.65% reduction, the 15.3% rate applies to the maximum $94,200 to which the full self-employment tax applies in 2006 Above that level, then, the reduction saves not the full 15.3% but only the 2.9% Medicare portion of the tax which applies to all self-employment income.)
More good news: You can claim 50% of what you pay in self-employment tax as an income tax deduction. A $1,000 self-employment tax payment reduces taxable income by $500, for example. And, in the 25% tax bracket, that saves you $125 in income taxes. This deduction is an adjustment to income claimed on the Form 1040 and is available whether or not you itemize deductions.
Example
You run a catering business as a sole proprietor. In 2006 your net profit as reported on Schedule C is $35,000.Your net earnings as calculated on Form SE would be $32,323 ($35,000 x 0.9235). Your self-employment tax would be $4,945 (32,323 x 0.153) and you would report that amount on Form 1040 in the "Other Taxes" section. Then you would report one half of your self-employment tax, $2,473, ($4,945 X .50) on the 1040 as an adjustment to income, which reduces your adjusted gross income and thus the amount of income tax you owe.
Should I file estimated taxes?
If you have worked as an employee, you know that the net earnings on your paycheck are much less than your gross earnings. Why? Because your employer withheld money for social security, Medicare, and income tax, and sent that money to the government. When you are self-employed, the entire burden for paying employment taxes and prepaying estimated income tax liability is left to you. That's why you need to pay estimated taxes in quarterly installments to the U.S. Treasury; otherwise, you may be subject to underpayment penalties
Summary of Business Tax Law Changes
Many of the tax breaks in recent tax-relief bills were designed to be phased in over a number of years. To help you determine how these tax laws affect your long-term plans, we'll explain the changes that come into effect through 2010.
Starting in 2005
Additional Depreciation Provisions to Help Hurricane Victims.
The areas most affected by Hurricanes Katrina, Rita and Wilma have been declared a "Gulf Opportunity Zone" (GO Zone). Certain business property placed in service in the GO Zone after the date of the hurricane and before 12/31/07 (12/31/08 for qualifying real estate) is eligible for a 50% special depreciation allowance in the first year placed in service. Certain business property placed in service in the GO Zone after the date of the hurricane and before 12/31/07 is eligible for an extra $100,000 in immediate tax write-off under Section 179. The investment limitation increases from $420,000 to $1,020,000 for these purchases. These provisions are designed to encourage rebuilding of the affected areas.
Expensing for Demotion and Cleanup Costs in GO Zone.
Building owners or lessees can expense 50% of the demolition and cleanup costs incurred prior to 01/01/2008. (In the past, such expenses were required to be capitalized as part of the cost of the land.)
Net Operating Losses for Hurricane Victims.
A net operating loss created by GO Zone casualty losses, certain moving expenses, depreciation deductions of qualified GO Zone property, and certain repair expenses is allowed a five-year carryback, rather than a two-year carryback. This provision is designed to allow taxpayers to receive an earlier refund of taxes paid in prior years.
Temporary Suspension of Limitations of Charitable Contributions.
Corporate taxpayers can elect to deduct qualified cash contributions without regard to the 10% taxable income limit, if the contributions were made after 8/27/05 and before 1/01/06 to a qualified charitable organization for Hurricane Katrina relief efforts.
Employee Retention Credit for Employers in Hurricane Zones.
Eligible employers can claim a credit of 40% of each qualified employee's wages up to $6,000 (a $2,400 tax credit per employee). The employer's principal place of operation must have been in one of the three disaster zones and been inoperable at least one day during this period. Qualified wages are wages paid beginning on the date the business became inoperable and ending on the date operations resumed. The credit is available without regard to whether the qualified employee performs any services, or performs services before operations have resumed.
Domestic Production Activities Deduction.
Starting in 2005, corporations, sole proprietors, and owners of S corporations and partnerships can deduct 3% of qualifying business net income from domestic production activities. This deduction applies to businesses engaged in construction, engineering, or architectural services; film production; or the lease, rental, or sale of equipment manufactured in the U.S.
Additional First-Year Depreciation.
The bonus depreciation allowance of 50% expires for most qualifying property purchased after 2004. Certain property with a long production period and certain aircraft remain eligible for the 50% bonus depreciation allowance if placed in service by 12/31/05. Also, certain property investments made in the GO Zone are eligible for a 50% additional first-year bonus depreciation through 12/31/07 (12/31/08 for real estate).
Increased Section 179 Expense Deduction.
The maximum amount increases from $102,000 to $105,000, and the annual investment limit increases from $410,000 to $420,000. Qualifying purchases made in the GO Zone are eligible for a $100,000 increase to $205,000, and the investment limitation increases $600,000 to $1,020,000 for these purchases.
Start-up and Organizational Expenses.
Taxpayers can now elect to deduct up to $5,000 of start-up costs and $5,000 of organizational costs, reduced by the amount the total start-up or organizational costs exceed $50,000. Expenditures that are not expensed in the year the business begins are amortized over a 15-year period.
Six-Month Automatic Extension for Partnerships.
Beginning with tax years ending on or after 12/31/05, partnerships can request a six-month automatic extension using Form 7004. This eliminates the time and expense of filing Form 8736 for an automatic four-month extension and Form 8800 for an additional two-month extension. Individual partners may also apply for an automatic six-month extension for taxable years ending on or after 12/31/2005.
Self-Employment Tax Contribution Base Increased.
The maximum amount of self-employment income subject to Social Security taxes increases from $87,900 to $90,000.
Social Security Tax Contribution Base Increased.
The maximum amount of wages subject to Social Security tax increases from $87,900 to $90,000.
Business Standard Mileage Rate Increased.
The standard business mileage rate increases from 40.5 cents per mile to 48.5 cents per mile for miles driven after 09/01/05.
Starting in 2006
Work Opportunity Tax Credit extended for Hurricane Katrina Employees.
This credit is no longer available for wages paid to an employee who begins work after 12/31/05. However, Hurricane Katrina employees are treated as members of a targeted group for purposes of the credit. Qualified Hurricane Katrina employees are individuals living in the core disaster area on 8/28/05 who are hired within two years of that date to work in the core disaster area, and individuals living in the core disaster area on 8/28/05 who were displaced and were hired by 12/31/05 without regard to the location of the employment.
Increased Section 179 Expense Deduction.
The maximum amount increases from $105,000 to $108,000. The annual investment limit increases from $420,000 to $430,000. Qualifying purchases made in the Gulf Opportunity Zone are eligible for a $100,000 increase to $208,000, and the investment limitation increases $600,000 to $1,030,000 for these purchases.
Self-Employment Tax Contribution Base Increased.
The maximum amount of self-employment income subject to Social Security taxes increases from $90,000 to $94,200.
Social Security Tax Contribution Base Increased.
The maximum amount of wages subject to Social Security tax increases from $90,000 to $94,200.
Business Standard Mileage Rate Decreased.
The standard business mileage rate decreases from 48.5 cents per mile to 44.5 cents per mile for miles driven. Starting in 2007 Domestic Production Activities Deduction.
Starting in 2007
Domestic Production Activities Deduction.
This deduction increases to 6% of qualifying business net income from domestic production activities. This deduction applies to businesses engaged in construction, engineering, or architectural services; film production; or the lease, rental, or sale of equipment manufactured in the U.S.
Starting in 2008
Decreased Section 179 Expense Deduction.
The maximum amount decreases to $25,000, and the annual investment limit drops to $100,000.
Starting in 2010
Domestic Production Activities Deduction.
Starting in 2010, this deduction increases to 9% of qualifying business net income from domestic production activities. This deduction applies to businesses engaged in construction, engineering, or architectural services; film production; or the lease, rental, or sale of equipment manufactured in the U.S.
Taking Business Tax Deductions As a business,
you are taxed on your profits, not on your gross income. Profits are calculated by subtracting various expenses from your gross receipts. These expenses are commonly called "deductions." The IRS dictates which business expenses are deductible. Most common expenses are deductible; however, some expenses are subject to limitations and other expenses are not deductible at all. Also, the timing of deductions varies depending on whether you are a cash basis or an accrual basis taxpayer. Knowing which deductions are deductible for your business is important. If you are a shareholder or partner in a 25% tax bracket, every dollar of deductions saves 25 cents of tax on your income. If you are located in a state that imposes income tax, you will receive a state benefit from each deduction as well. To determine whether a business expense is a business deduction, you should ask yourself: Is this expense both ordinary and necessary. Both elements are required by the IRS for an expense to be a valid business deduction.
1. An expense is ordinary if it is common and accepted in your industry.
2. A necessary expense is one that is helpful and appropriate for your business.
Automobile Expenses As a small business owner,
you can deduct automobile expenses for visits to clients, customers, or a business meeting away from your regular workplace. If you have a home office, a drive from your home to a supplier and back home again is a 100 percent deductible business expense tax. When figuring expenses, you may choose between the standard mileage rate (for 2005, 40.5 cents per mile through August 31, 2005, and 48.5 cents per mile after September 1, 2005, and 44.5 cents per mile for 2006), or your actual expenses, which includes items such as gas, oil changes, tires, repairs, preventative maintenance, insurance, and registration. If you choose to deduct your actual expenses in the year you start using your car for business, you are making an irrevocable election, which means that you can't switch to the standard mileage rate later. If you choose the standard mileage method first, you can switch to actual expenses in a later year. Choose the method that yields the higher deduction. The number of miles you drive each year is probably the most important factor. If you do a lot of driving each year, then the standard mileage rate method may yield a higher deduction. However, automobiles that consume more gas may be able to claim a higher deduction using the actual expense method. Calculate both methods to see which one gives you the higher deduction. If you decide to deduct expenses for your car or truck, you must keep a log of your trips noting the date, the miles driven, and the purpose of each trip. Try to log your trips as they occur, when it's easier to keep track of the details. You're also more likely to have an accurate (and usually higher) total of the miles you drove than if you try to recall trips later. Recording information at the time you make the trip is also very helpful. If you choose the actual expense method, keep a record of your gas purchases, insurance and registration payments, and repairs and maintenance costs. If the IRS ever audits you, they will require written documentation to substantiate your deduction. If you have a corporation, consider having the corporation own the car. A corporation can deduct all of the expenses of a vehicle, including depreciation and interest if the vehicle was purchased on credit. Any personal use of the vehicle is not deductible to the business entity, but is treated as a shareholder/partner distribution or compensation.
Bad Debts
If you have accounts receivable, you're likely to encounter bad debt. When someone doesn't pay you for work you performed or products you sold, you may take a bad debt deduction against your gross revenue, which reduces both your income tax and your self-employment tax. You must use the accrual method of accounting to get this deduction. If your business uses the cash basis method of accounting, you can't deduct a bad debt expense because with the cash basis method, you don't include an amount in gross revenue until you receive it. In business, bad debts aren't limited to losses when an accounts receivable owed to you falls through. You also may incur a bad debt expense if you loaned money to customers, suppliers, or employees who never paid you back. This type of bad debt must have the following characteristics:
• Debtor-creditor relationship - There must be a legal obligation for a debtor to pay a creditor a determinable sum of money. The best way to establish this relationship is with a written document stating the amount of the loan, interest rate, repayment schedule, etc. This is particularly important if you lend your corporation money. Without written documentation of the loan, the IRS may treat the advance as a contribution of capital to the business and it will not be deductible.
• Worthlessness - You must prove that the debt is un-collectible and that you took attempted to collect the debt.
• Loss - You must have sustained a loss because of the debt. If you previously booked an amount to income that you did not later receive, you suffered a loss.
Depreciation With an ordinary business expense,
you deduct the entire cost of the purchase in that tax year. But if you purchase an asset for your business that you will use beyond the current tax year, you must spread out the deduction over the asset's expected life. This concept of spreading out a deduction over the life of an asset is called depreciation. The asset must meet three requirements in order to be depreciated:
1. It must be used in the business or held to produce income.
2. It must be expected to last more than one year.
3. It must be something that wears out, gets used up, or loses its value over time. The following assets can't be depreciated: • Property that you place in service and dispose of in the same year
• Inventory
• Land
• Repairs and maintenance that do not increase the value of your asset, make it more useful, or increase its life. (These expenses are generally deductible in full in the year in which you pay them.) If you are eligible, you may deduct the entire cost of the asset in the year it is placed in service in your business instead of spreading the cost out over the life of the asset. This deduction is known by its section in the tax code, as a Section 179 deduction. The maximum amount of Section 179 deduction you can take in 2005 is $105,000; the same limit applies for 2006 and 2007. While the idea of taking a huge deduction may sound good to you, be careful, because there is a downside to using Section 179. If you dispose of an asset before the end of its useful life, you must recapture the original deduction on Schedule C. Recapture means reversing part of the effects of your original deduction (basically adding the deduction back as income), which in turn increases both self-employment tax and your income tax. Before you take the section 179 deduction, be sure that you will use the asset in the business for its entire useful life. Tip: Use tax preparation software or go to a tax professional when thinking of taking the Section 179 deduction.
Employee Expenses
The wages you pay employees for producing goods or services are deductible, including salaries, fringe benefits, employee benefits, awards, bonuses, sick pay, and vacation pay. You get a deduction regardless of whether you pay wages to employees (to whom you provide a W-2) or use contract labor (independent contractors, to whom you provide Form 1099). Deductible fringe benefits include:
• Discounts on goods or services
• Flights on airplanes
• Meals and lodging
• Memberships in country clubs
• Tickets to entertainment or sporting events
• Use of a car
Deductible employee benefit programs include:
• Accident and health plans
• Adoption assistance
• Cafeteria plans
• Dependent care assistance
• Educational assistance
• Group-term life insurance coverage
Home Office Expenses
To take the home office deduction, you must use your home office regularly and exclusively for your business, and your home office must be your principal place of business. To meet the regular and exclusive test, the area where you work should be a separate room in your home. However, if the area is a common area in your home, it can also qualify as long as you use it exclusively for business. If you have a desk located in a family room, for example, mixing your business correspondence with your personal mail could cause the deduction to be disallowed.
• Exclusive use means that your children cannot use your office computer to do research for school, or to play computer games.
• Regular use does not necessarily mean that you must use the office daily or even weekly, just that you use it on a regular basis. Occasional or incidental use does not qualify for business use, even if the office is used exclusively for business purposes. To claim that your home office is your principal place of business, you must:
• Perform the most important part of your work there, or
• Use the office for administrative or management activities of a trade or business, and not perform these administrative or management activities at any other location, such as another office off-site. Administrative and management activities include, but are not limited to billing customers, keeping books and records, setting appointments, calling in orders, ordering supplies, and writing reports.
Exceptions:
You can claim the home office deduction if you store inventory or product samples there, or if you operate a day-care facility. If you own your home and are operating your business at a loss, your home office deduction is limited to your direct expenses, which are the deductions normally taken on Schedule A. You can't deduct indirect expenses such as insurance, utilities, and depreciation at all unless your gross income is greater than the sum of your expenses. Even then, you divide your office's square footage by your home's square footage to obtain the percentage of your home that you use for business purposes. You then apply the resulting percentage to your indirect expenses to determine your deductible home office expenses. Because the home office deduction is a complex area that has been the subject of much controversy and many court cases.
Insurance
You can deduct insurance expenses as long as they're determined to be ordinary and necessary expenses. Common examples include
• Credit insurance on losses from unpaid debts
• Casualty insurance
• Professional liability or malpractice insurance
• Product liability coverage
• Accident and health insurance
• Overhead insurance
• Vehicle insurance
There are a few types of insurance premiums that you may not deduct. These include:
• Insurance for securing a loan. For example, if you take out a policy on your life in order to obtain or protect a business loan, that premium is nondeductible.
• Loss-of-earnings insurance
• Premiums on certain life insurance policies
• Self-insurance reserve funds (a savings account) You can deduct up to 100 percent of the health insurance and qualified long-term care insurance payments for yourself and your family. If your spouse works in the business with you and you provide a health insurance plan that covers your employees and their dependents as well as your spouse and family, you can deduct 100 percent of your health insurance expenses.
Interest
Generally, you can deduct all of the interest you pay during the tax year on debts related to your business. For example, if you take out a bank loan to help secure additional inventory to increase your business, that interest is deductible. If you're just starting your business and use a credit card to help with start-up costs, that interest is deductible as well. The source of the interest doesn't matter. If a relative loans you money to start a business, the interest you pay to your relative is also tax deductible. A corporation can deduct the interest it pays on loans from its shareholders. There should be a valid business purpose for such a borrowing arrangement and written documentation in place detailing the amount of the loan, interest rate, and maturity date. These types of arrangements may receive increased scrutiny from the IRS, and you want to have evidence that the borrowing is debt and not equity. Watch out for loans that are for both personal and business uses. For example, if you take out a loan for a car that you use in your business and for personal purposes, part of the loan interest won't be deductible. You can only deduct 100 percent of the loan interest if you can prove that you use the car 100 percent for your business.
Legal and Professional Fees
Fees that you pay to professionals, attorneys and accountants are considered ordinary and necessary when they relate to your on-going business. If you purchase a new business, the fees paid for professional services are added to the tax basis (or cost) of that business.
Example
You negotiate the purchase of a pool-cleaning route for $22,500. You hire an attorney to draft a non-competition agreement, and hire an accountant to perform a due diligence review of the books. You pay $2,500 in professional fees. For tax purposes, your cost basis in the pool route is $25,000 ($22,500 + $2,500). Legal fees to incorporate or organize your business may be amortized as incorporation fees for corporations or organizational costs for partnerships. For costs incurred after October 22, 2004, you can elect to deduct $5,000 in the first year and amortize any remainder over 180 months. You can also deduct accounting and tax preparation fees related to your business. If you are a sole proprietorship filing a Schedule C for tax purposes, you can deduct these fees to the extent that the cost is related to your business. For example, if all the income on your income tax return is related to your business, you may allocate nearly all of the tax preparation expenses to the Schedule C. On the other hand, if you have interest and dividend income, numerous donations to charity, a mortgage, a few rental properties, and a Schedule C business, you should allocate the tax preparation expenses throughout the return. Allocate some of the expenses to Schedule A (where it is only deductible when it exceeds 2 percent of your adjusted gross income), some to Schedule C (your small business), and some to Schedule E (where you report rental income and expenses).
Pension Plans
If you set up and maintain a Simplified Employee Pension (SEP) plan, a Savings Incentive Match Plan for Employees (SIMPLE plan), or a Qualified Plan (Keogh or H.R. 10 plan) for yourself and your employees, you can deduct contributions you make to the plan for yourself and your employees.
Rent
The IRS defines rent as any amount that you pay to use property you do not own. Most of us are familiar with the concept of paying rent for office space, land, or equipment. But you may not know that you can deduct part of your rent on your home, condo, or apartment if you use part of it as a place of business. (You must meet the requirements for a home office. See Home Office Expenses.) If you rent property from your relatives or a related company and the IRS deems the rent to be excessive, the IRS will disallow the deduction. To avoid this, make sure the rent is comparable to what you would pay a stranger. Contact a real estate agent and ask him or her prepare comps (or comparisons) of similar properties in the area to substantiate the rent you are paying to a related party. Rents are usually deductible in the year they are paid. Advance rent payments will be deductible when paid for cash basis taxpayers. An accrual basis taxpayer must capitalize the advance payments as prepaid rent and then write them off when the rent payment becomes due.
Taxes
There are many taxes that you can deduct when operating a business. For example, if your state taxes are based on the gross income of your business, you can deduct the state income tax. You can also deduct your employer's share of employment taxes such as social security, Medicare, federal unemployment taxes, and state unemployment taxes. Here are some other taxes you can deduct:
• Personal property taxes imposed by your state or local government
• Real estate taxes, which are deductible to the extent that you use the land for your business. If you qualify for the home office deduction, you can deduct a portion of your real estate tax against your gross revenue.
• Sales taxes, which are deductible when paid for business-related purchases or services. Note: you can't deduct the state and local sales taxes that you charge your customers, because they paid those taxes, and you just passed them along to the state. Also, don't include the amount of sales tax you collected in the gross receipts you report for your business.
• Excise taxes, which are also deductible to the extent that they are ordinary and necessary for the operation of your business. Fuel taxes that you pay for gasoline, diesel, or other types of motor fuels are already reflected in the cost of the fuel, and therefore aren't deductible. Note that you may be entitled to a credit or refund for federal excise tax you paid on fuels used for certain purposes, for example, in a farming operation where you don't use vehicles on maintained roads or highways.
Travel, Meals, and Entertainment Expenses
Any payments you deduct for travel, meals, and entertainment must be the ordinary and necessary expenses of carrying on your trade or business. In general, entertainment expenses must be directly related to, or associated with, the conduct of your trade or business. Travel expenses include those for ordinary and necessary travel away from your home for your business. You must meet two conditions to take the travel expense deduction.
1. Your duties must require you to be away from the general area of your tax home (your regular place of business, regardless of where you maintain your family home) substantially longer than an ordinary day's work.
2. You need sleep or rest to meet the demands of your work while you're away from home. If your trip meets these requirements, you can deduct a wide variety of travel-related expenses, including:
• Transportation expenses (using a plane, train, bus, or car) between your home and your business destination, including taxi, commuter bus, and limousine fares
• Baggage and shipping expenses for sending samples or display materials
• The costs of operating and maintaining your vehicle if you use your car or truck for business travel. You can choose between actual expenses or the standard mileage rate.
• Tolls and parking fees
• Rental car expenses for the business portion of the usage.
• Meals and overnight lodging. Meals are subject to a 50% deduction limitation.
Meal expenses include those incurred while traveling away from home or for entertainment of business customers at your place of business, a restaurant, or other location. This deduction may also apply to meals you furnish on your premises to your employees. Entertainment expenses fall into a broad category and include any activity generally considered to provide entertainment, amusement, or recreation. Some examples include: entertaining guests at social, athletic, or sporting clubs, theaters, yacht trips, hunting, fishing, vacation, and similar trips.
Other Deductible Expenses
There are numerous other business expenses you can deduct. So far, we've discussed the most common small business deductions. Other deductible expenses include:
• Advertising
• Clean-fuel vehicles
• Donations to qualified charities
• Educational expenses
• Licenses and regulatory fees
• Dues and cost of subscriptions paid to professional organizations or business publications
• Outplacement services
• Penalties and fines you pay for late performance or nonperformance of a contract
• Repayments of income
Expenses You Can't Deduct
Some business expenses are not deductible under any circumstances:
• Demolition expenses and losses. (These costs increase your tax basis in the property, reducing your eventual gain when you sell, thus lowering your capital gains tax in the future.)
• Dues to social, athletic, luncheon, sporting, airline, and hotel clubs even if membership is for business. • Federal income tax payments
• Lobbying expenses
• Penalties and fines you pay to a governmental agency or instrumentality when you break the law.
• Political contributions
To figure out whether itemizing would be profitable for you, consider some of the factors that affect what you can deduct, such as home ownership, taxes, charitable donations, medical expenses, and miscellaneous expenses.
Compare your potential deduction with the standard deduction you're entitled to on 2006 returns:
• Standard deduction for single taxpayers - $5,150
• Standard deduction for married taxpayers filing a joint return - $10,300
• Standard deduction for head of household taxpayers - $7,550
If you're 65 or older or blind, you get to increase the standard tax deduction.
Click here to view Federal, State and Local deductions
Single or Head of Household:
1.65 or older $1,250
2.Blind $1,250
3.Both 65 or older and blind $2,500
Married or Widow(er)
1.One spouse 65 or older, or blind $1,000
2.One spouse 65 or older, and blind $2,000
3.One spouse 65 or older, and both blind $3,000
4.Both spouses 65 or older $2,000
5.Both spouses 65 or older, and one blind $3,000
6.Both spouses 65 or older, and both blind $4,000
If You Own a Home
Many taxpayers take the standard deduction rather than itemizing their tax deductions, even though some taxpayers with mortgages or home equity loans could have saved money by itemizing. If you have a mortgage or home equity loan on your home, fill out Schedule A to see if your itemized tax deductions are larger than the standard tax deduction to which you're entitled. In January, your mortgage lender should provide the amount of mortgage interest you paid during the previous year. Look for Form 1098, Mortgage Interest Statement. If you paid points as part of the financing for your home, the points will also be shown on that form. Tip: Mortgage lenders sometimes attach Form 1098 to your December or January mortgage bill. Here's a quick rule of thumb. Compare your mortgage interest (plus any points paid on the purchase of your residence) with your standard deduction. If you have refinanced your mortgage, points on the refinancing are deducted gradually over the life of the loan — 1/30th a year on a 30-year mortgage, for example. Don't forget to add each year's share to your deductions. For more information, consult IRS Publication 936, Home Mortgage Interest Deduction. If the interest you paid on your mortgage is larger than your standard tax deduction, you definitely benefit by itemizing -- and all the rest of your deductible expenses (including real estate taxes and state and local income taxes) are frosting on the cake.
• Many lenders provide a year-end tax summary that includes any real estate taxes and insurance paid through escrow accounts. The real estate taxes are deductible, but homeowner's insurance and homeowner's association fees are not.
• If your real estate taxes aren't paid through an escrow account, review your property tax bills and canceled checks and add up what you paid. You can't deduct any penalties you paid for late payment of property taxes: you can only deduct the actual taxes assessed and paid.
State and Local Taxes
Even if you don't own a home, itemizing can pay off handsomely. Look at the income taxes that you paid to your state, and to your city or county, if applicable. Income taxes you pay to these governments are deductible. Add up the state and city taxes shown in boxes 17 and 19 on your W-2s and compare the total to your standard deduction. If you made estimated tax payments to your state or local government (including any 2005 refund you had applied to your 2006 tax bill), be sure to total those amounts. And don't forget to add in any money you sent with your 2005 state and local tax returns in April of 2006.
Charitable Donations
You can deduct charitable donations only if you itemize your deductions. Add up the money you donated to organizations like the Red Cross, churches, synagogues, mosques, and other nonprofit organizations. If you donated things like clothing, furniture, or other household items, you need to determine their value. One way is to find out what your local thrift shop is charging for similar items or you could use a software program like Its Deductible that does this work for you. Make sure you use good judgment and that you don't overvalue your donations. Also, note that new rules arrived in August that demand more substantiation to back up charitable contributions. Under the old rules, taxpayers needed a receipt to back up any charitable contribution of $250 or more (a cancelled check was not sufficient). That's still the case for contributions of $250 or more. But now, you also need a receipt or a cancelled check to back up deductions for even smaller donations.
Medical Expense Deductions
Although medical expenses are deductible, very few taxpayers get to deduct them. Why not? Because you get to deduct such costs only to the extent that unreimbursed expenses exceed 7-1/2% of your adjusted gross income. So if your AGI is $50,000, for example, the first $3,750 ($50,000 x 0.075) effectively don't count. Before you go through all of your doctors' bills and prescription receipts, do a quick calculation based on your income to make sure your time will be well spent. Deductible medical expenses include doctors' and dentists' fees, chiropractors' fees, lab fees, contact lenses, glasses, prescription drugs and medical supplies.
• If you have a question about a particular medical expense, consult IRS Publication 502, Medical and Dental Expenses. You can deduct the premiums you pay for health insurance coverage, unless your employer pays for your coverage through a payroll deduction using pre-tax dollars. If so, you've already received a tax benefit for your premium payments, so don't deduct those premiums on your return. Consult your employer's benefits department if you're not sure.
Miscellaneous Tax Deductions
Most of the remaining deductions are subject to a limitation similar to the one for medical expenses.
1. Review the miscellaneous deductions listed below.
2. Add up the ones you can take.
3. Calculate 2% of your adjusted gross income.
4. Compare the two figures.
If the total of miscellaneous deductions is larger than 2% of your adjusted gross income, subtract the 2% figure from your total miscellaneous deductions. The difference is the amount you can actually deduct on your return. If the total of miscellaneous deductions is less than 2% of your adjusted gross income, you can't deduct any of these items. Examples of qualifying miscellaneous expenses that you could deduct include:
• Dues you pay to a union or a professional organization in connection with your employment
• Subscriptions to magazines and other publications that are related to your work
• Business liability insurance premiums
• The cost of protective work clothing, such as hard hats or safety shoes and glasses, and the cost of uniforms you're required to wear to work
• Tools and supplies used in your work
• Medical examinations required by an employer
• Tuition for classes that maintain or improve the skills required for your present job
• Expenses you incur while looking for a job in the same line of work you normally do (examples: resume' costs, career counseling, and employment agency fees)
• Depreciation on your computer or cellular phone, but only for the part of the time you use your equipment to keep track of your taxable investments (stocks, bonds, mutual funds) or as part of your job, if required by your employer
• The fees you're charged by your financial institution to maintain your IRA account, but only if you pay them from funds outside of your IRA account (if your financial institution just deducts the maintenance fees directly from your IRA, you can't deduct them)
• Safe deposit box rental fees, if you use the box to store stocks, bonds, or other investment-related documents (if you just store jewelry and other personal items there, the fees aren't deductible)
• What you pay to get your taxes done, whether it's by a professional or with tax preparation software. You can also deduct the cost of any books or publications that help you with preparing your return, and, if you file your return electronically, you can deduct any costs associated with that process
• Legal fees that you pay to protect your taxable income, or to produce your taxable income (This includes fees for legal assistance for helping you keep your job, for tax planning or investment counseling, or for handling an audit of your tax return. Legal fees for divorces aren't deductible, except for any portion specifically related to helping you collect alimony payments or for advice about the tax-ability of your alimony. You can only deduct legal fees that you pay in your efforts to collect income that's taxable to you.)
Miscellaneous deductions not subject to the 2% rule
There are a few miscellaneous expenses that guarantee tax savings to itemizers because they are deductible without regard to the 2% threshold. These three are most likely to be of any benefit:
• Amortizable bond premium is the amount over face value that you pay for certain bonds because they are paying higher-than-current-market interest rates.
• Gambling losses. This write-off comes with its own restriction. You can't deduct more than the amount of gambling winnings you report as taxable income.
• Federal Estate Tax on Income in Respect of a Decedent. This is becoming an increasingly important deduction as more and more taxpayers inherit money in company retirement plans or traditional IRAs. Such amounts are considered "income in respect of a decedent" because the decedent had a right to the income at the time of death, but the income is not included on the person's final tax return. Instead, the beneficiary is taxed on the amounts. You might also deserve a deduction, though, if the decedent's estate was large enough to pay federal estate taxes. Say, for example, that you inherit a $50,000 IRA which, because it was included in your mother's taxable estate, boosted the estate tax bill by $20,500. Although you have to pay tax as you pull money out of the IRA, you also get a deduction for that $20,500. If you pull the full $50,000 out at once, you'd get the full deduction. If you pull it out equally over two years, you'd deduct $10,250 each year. This miscellaneous deduction is not subject to the 2% limit but it's up to you to know the rules to take advantage of them Yes, if you make any money. The self-employment tax (officially known as the SECA tax for Self-Employment Contributions Act tax) is the self-employed person's version of the FICA (Federal Insurance Contributions Act) tax paid by employees to pay for Social Security and Medicare. It's due on your net earnings from self-employment
What is the self-employment tax?
Many newly self-employed people — sole proprietors, independent contractors and the like — are surprised at their tax bills at the end of the year because they notice they're suddenly paying a lot more in tax as a self-employed person than as an employee. That's because they're carrying the full burden of paying for Social Security and Medicare. Employees share that cost with their employers, with each paying the 7.65% FICA tax. When you're self-employed, though, you're stuck with the full 15.3% levy. The tax is divided into two parts:
• 12.4 percent for Social Security. For 2006, this part of the tax applies to the first $94,200 of earnings. If you earn more than (from your business or, if you also have a job, from the combination of your job and your business), then the 12.4% part of the tax that pays for Social Security stops. (The dollar limit will be a few thousand dollars higher in 2007.)
• 2.9 percent for Medicare. The Medicare portion of the self-employment tax is unlimited. No matter how much you earn, you'll pay the 2.9% Medicare tax. Even if you have investment losses that offset part of your self-employment income for income tax purposes, such losses will not effect the amount of self-employment tax you owe. For more information on this tax, see IRS Tax Topic 554: The Self-employment Tax.
How do I report the self-employment tax?
When you start a small business and you do not incorporate or form a partnership, you report the results of your operations on Schedule C and file that with your Form 1040. The result of netting your revenues and expenses is a net profit or loss. You calculate your self-employment tax on Schedule SE and report that amount in the "Other Taxes" section of Form 1040. In this way, the IRS differentiates the SE tax from the income tax.
Good news: When figuring self-employment tax you owe, you get to reduce self-employment income by 7.65% before applying the tax rate. Say, for example, that your net self-employment income is $50,000. That's the amount you report as taxable for income tax purposes on Form 1040. But when figuring your self-employment tax on Schedule SE, Computation of Social Security Self-Employment Tax, the taxable amount is $46,175. Not paying the 15.3% tax on $3,825 difference in this example saves you $585. (The savings evaporate at higher income levels. When 2006 self-employment income hits $102,003, for example, even after the 7.65% reduction, the 15.3% rate applies to the maximum $94,200 to which the full self-employment tax applies in 2006 Above that level, then, the reduction saves not the full 15.3% but only the 2.9% Medicare portion of the tax which applies to all self-employment income.)
More good news: You can claim 50% of what you pay in self-employment tax as an income tax deduction. A $1,000 self-employment tax payment reduces taxable income by $500, for example. And, in the 25% tax bracket, that saves you $125 in income taxes. This deduction is an adjustment to income claimed on the Form 1040 and is available whether or not you itemize deductions.
Example
You run a catering business as a sole proprietor. In 2006 your net profit as reported on Schedule C is $35,000.Your net earnings as calculated on Form SE would be $32,323 ($35,000 x 0.9235). Your self-employment tax would be $4,945 (32,323 x 0.153) and you would report that amount on Form 1040 in the "Other Taxes" section. Then you would report one half of your self-employment tax, $2,473, ($4,945 X .50) on the 1040 as an adjustment to income, which reduces your adjusted gross income and thus the amount of income tax you owe.
Should I file estimated taxes?
If you have worked as an employee, you know that the net earnings on your paycheck are much less than your gross earnings. Why? Because your employer withheld money for social security, Medicare, and income tax, and sent that money to the government. When you are self-employed, the entire burden for paying employment taxes and prepaying estimated income tax liability is left to you. That's why you need to pay estimated taxes in quarterly installments to the U.S. Treasury; otherwise, you may be subject to underpayment penalties
Summary of Business Tax Law Changes
Many of the tax breaks in recent tax-relief bills were designed to be phased in over a number of years. To help you determine how these tax laws affect your long-term plans, we'll explain the changes that come into effect through 2010.
Starting in 2005
Additional Depreciation Provisions to Help Hurricane Victims.
The areas most affected by Hurricanes Katrina, Rita and Wilma have been declared a "Gulf Opportunity Zone" (GO Zone). Certain business property placed in service in the GO Zone after the date of the hurricane and before 12/31/07 (12/31/08 for qualifying real estate) is eligible for a 50% special depreciation allowance in the first year placed in service. Certain business property placed in service in the GO Zone after the date of the hurricane and before 12/31/07 is eligible for an extra $100,000 in immediate tax write-off under Section 179. The investment limitation increases from $420,000 to $1,020,000 for these purchases. These provisions are designed to encourage rebuilding of the affected areas.
Expensing for Demotion and Cleanup Costs in GO Zone.
Building owners or lessees can expense 50% of the demolition and cleanup costs incurred prior to 01/01/2008. (In the past, such expenses were required to be capitalized as part of the cost of the land.)
Net Operating Losses for Hurricane Victims.
A net operating loss created by GO Zone casualty losses, certain moving expenses, depreciation deductions of qualified GO Zone property, and certain repair expenses is allowed a five-year carryback, rather than a two-year carryback. This provision is designed to allow taxpayers to receive an earlier refund of taxes paid in prior years.
Temporary Suspension of Limitations of Charitable Contributions.
Corporate taxpayers can elect to deduct qualified cash contributions without regard to the 10% taxable income limit, if the contributions were made after 8/27/05 and before 1/01/06 to a qualified charitable organization for Hurricane Katrina relief efforts.
Employee Retention Credit for Employers in Hurricane Zones.
Eligible employers can claim a credit of 40% of each qualified employee's wages up to $6,000 (a $2,400 tax credit per employee). The employer's principal place of operation must have been in one of the three disaster zones and been inoperable at least one day during this period. Qualified wages are wages paid beginning on the date the business became inoperable and ending on the date operations resumed. The credit is available without regard to whether the qualified employee performs any services, or performs services before operations have resumed.
Domestic Production Activities Deduction.
Starting in 2005, corporations, sole proprietors, and owners of S corporations and partnerships can deduct 3% of qualifying business net income from domestic production activities. This deduction applies to businesses engaged in construction, engineering, or architectural services; film production; or the lease, rental, or sale of equipment manufactured in the U.S.
Additional First-Year Depreciation.
The bonus depreciation allowance of 50% expires for most qualifying property purchased after 2004. Certain property with a long production period and certain aircraft remain eligible for the 50% bonus depreciation allowance if placed in service by 12/31/05. Also, certain property investments made in the GO Zone are eligible for a 50% additional first-year bonus depreciation through 12/31/07 (12/31/08 for real estate).
Increased Section 179 Expense Deduction.
The maximum amount increases from $102,000 to $105,000, and the annual investment limit increases from $410,000 to $420,000. Qualifying purchases made in the GO Zone are eligible for a $100,000 increase to $205,000, and the investment limitation increases $600,000 to $1,020,000 for these purchases.
Start-up and Organizational Expenses.
Taxpayers can now elect to deduct up to $5,000 of start-up costs and $5,000 of organizational costs, reduced by the amount the total start-up or organizational costs exceed $50,000. Expenditures that are not expensed in the year the business begins are amortized over a 15-year period.
Six-Month Automatic Extension for Partnerships.
Beginning with tax years ending on or after 12/31/05, partnerships can request a six-month automatic extension using Form 7004. This eliminates the time and expense of filing Form 8736 for an automatic four-month extension and Form 8800 for an additional two-month extension. Individual partners may also apply for an automatic six-month extension for taxable years ending on or after 12/31/2005.
Self-Employment Tax Contribution Base Increased.
The maximum amount of self-employment income subject to Social Security taxes increases from $87,900 to $90,000.
Social Security Tax Contribution Base Increased.
The maximum amount of wages subject to Social Security tax increases from $87,900 to $90,000.
Business Standard Mileage Rate Increased.
The standard business mileage rate increases from 40.5 cents per mile to 48.5 cents per mile for miles driven after 09/01/05.
Starting in 2006
Work Opportunity Tax Credit extended for Hurricane Katrina Employees.
This credit is no longer available for wages paid to an employee who begins work after 12/31/05. However, Hurricane Katrina employees are treated as members of a targeted group for purposes of the credit. Qualified Hurricane Katrina employees are individuals living in the core disaster area on 8/28/05 who are hired within two years of that date to work in the core disaster area, and individuals living in the core disaster area on 8/28/05 who were displaced and were hired by 12/31/05 without regard to the location of the employment.
Increased Section 179 Expense Deduction.
The maximum amount increases from $105,000 to $108,000. The annual investment limit increases from $420,000 to $430,000. Qualifying purchases made in the Gulf Opportunity Zone are eligible for a $100,000 increase to $208,000, and the investment limitation increases $600,000 to $1,030,000 for these purchases.
Self-Employment Tax Contribution Base Increased.
The maximum amount of self-employment income subject to Social Security taxes increases from $90,000 to $94,200.
Social Security Tax Contribution Base Increased.
The maximum amount of wages subject to Social Security tax increases from $90,000 to $94,200.
Business Standard Mileage Rate Decreased.
The standard business mileage rate decreases from 48.5 cents per mile to 44.5 cents per mile for miles driven. Starting in 2007 Domestic Production Activities Deduction.
Starting in 2007
Domestic Production Activities Deduction.
This deduction increases to 6% of qualifying business net income from domestic production activities. This deduction applies to businesses engaged in construction, engineering, or architectural services; film production; or the lease, rental, or sale of equipment manufactured in the U.S.
Starting in 2008
Decreased Section 179 Expense Deduction.
The maximum amount decreases to $25,000, and the annual investment limit drops to $100,000.
Starting in 2010
Domestic Production Activities Deduction.
Starting in 2010, this deduction increases to 9% of qualifying business net income from domestic production activities. This deduction applies to businesses engaged in construction, engineering, or architectural services; film production; or the lease, rental, or sale of equipment manufactured in the U.S.
Taking Business Tax Deductions As a business,
you are taxed on your profits, not on your gross income. Profits are calculated by subtracting various expenses from your gross receipts. These expenses are commonly called "deductions." The IRS dictates which business expenses are deductible. Most common expenses are deductible; however, some expenses are subject to limitations and other expenses are not deductible at all. Also, the timing of deductions varies depending on whether you are a cash basis or an accrual basis taxpayer. Knowing which deductions are deductible for your business is important. If you are a shareholder or partner in a 25% tax bracket, every dollar of deductions saves 25 cents of tax on your income. If you are located in a state that imposes income tax, you will receive a state benefit from each deduction as well. To determine whether a business expense is a business deduction, you should ask yourself: Is this expense both ordinary and necessary. Both elements are required by the IRS for an expense to be a valid business deduction.
1. An expense is ordinary if it is common and accepted in your industry.
2. A necessary expense is one that is helpful and appropriate for your business.
Automobile Expenses As a small business owner,
you can deduct automobile expenses for visits to clients, customers, or a business meeting away from your regular workplace. If you have a home office, a drive from your home to a supplier and back home again is a 100 percent deductible business expense tax. When figuring expenses, you may choose between the standard mileage rate (for 2005, 40.5 cents per mile through August 31, 2005, and 48.5 cents per mile after September 1, 2005, and 44.5 cents per mile for 2006), or your actual expenses, which includes items such as gas, oil changes, tires, repairs, preventative maintenance, insurance, and registration. If you choose to deduct your actual expenses in the year you start using your car for business, you are making an irrevocable election, which means that you can't switch to the standard mileage rate later. If you choose the standard mileage method first, you can switch to actual expenses in a later year. Choose the method that yields the higher deduction. The number of miles you drive each year is probably the most important factor. If you do a lot of driving each year, then the standard mileage rate method may yield a higher deduction. However, automobiles that consume more gas may be able to claim a higher deduction using the actual expense method. Calculate both methods to see which one gives you the higher deduction. If you decide to deduct expenses for your car or truck, you must keep a log of your trips noting the date, the miles driven, and the purpose of each trip. Try to log your trips as they occur, when it's easier to keep track of the details. You're also more likely to have an accurate (and usually higher) total of the miles you drove than if you try to recall trips later. Recording information at the time you make the trip is also very helpful. If you choose the actual expense method, keep a record of your gas purchases, insurance and registration payments, and repairs and maintenance costs. If the IRS ever audits you, they will require written documentation to substantiate your deduction. If you have a corporation, consider having the corporation own the car. A corporation can deduct all of the expenses of a vehicle, including depreciation and interest if the vehicle was purchased on credit. Any personal use of the vehicle is not deductible to the business entity, but is treated as a shareholder/partner distribution or compensation.
Bad Debts
If you have accounts receivable, you're likely to encounter bad debt. When someone doesn't pay you for work you performed or products you sold, you may take a bad debt deduction against your gross revenue, which reduces both your income tax and your self-employment tax. You must use the accrual method of accounting to get this deduction. If your business uses the cash basis method of accounting, you can't deduct a bad debt expense because with the cash basis method, you don't include an amount in gross revenue until you receive it. In business, bad debts aren't limited to losses when an accounts receivable owed to you falls through. You also may incur a bad debt expense if you loaned money to customers, suppliers, or employees who never paid you back. This type of bad debt must have the following characteristics:
• Debtor-creditor relationship - There must be a legal obligation for a debtor to pay a creditor a determinable sum of money. The best way to establish this relationship is with a written document stating the amount of the loan, interest rate, repayment schedule, etc. This is particularly important if you lend your corporation money. Without written documentation of the loan, the IRS may treat the advance as a contribution of capital to the business and it will not be deductible.
• Worthlessness - You must prove that the debt is un-collectible and that you took attempted to collect the debt.
• Loss - You must have sustained a loss because of the debt. If you previously booked an amount to income that you did not later receive, you suffered a loss.
Depreciation With an ordinary business expense,
you deduct the entire cost of the purchase in that tax year. But if you purchase an asset for your business that you will use beyond the current tax year, you must spread out the deduction over the asset's expected life. This concept of spreading out a deduction over the life of an asset is called depreciation. The asset must meet three requirements in order to be depreciated:
1. It must be used in the business or held to produce income.
2. It must be expected to last more than one year.
3. It must be something that wears out, gets used up, or loses its value over time. The following assets can't be depreciated: • Property that you place in service and dispose of in the same year
• Inventory
• Land
• Repairs and maintenance that do not increase the value of your asset, make it more useful, or increase its life. (These expenses are generally deductible in full in the year in which you pay them.) If you are eligible, you may deduct the entire cost of the asset in the year it is placed in service in your business instead of spreading the cost out over the life of the asset. This deduction is known by its section in the tax code, as a Section 179 deduction. The maximum amount of Section 179 deduction you can take in 2005 is $105,000; the same limit applies for 2006 and 2007. While the idea of taking a huge deduction may sound good to you, be careful, because there is a downside to using Section 179. If you dispose of an asset before the end of its useful life, you must recapture the original deduction on Schedule C. Recapture means reversing part of the effects of your original deduction (basically adding the deduction back as income), which in turn increases both self-employment tax and your income tax. Before you take the section 179 deduction, be sure that you will use the asset in the business for its entire useful life. Tip: Use tax preparation software or go to a tax professional when thinking of taking the Section 179 deduction.
Employee Expenses
The wages you pay employees for producing goods or services are deductible, including salaries, fringe benefits, employee benefits, awards, bonuses, sick pay, and vacation pay. You get a deduction regardless of whether you pay wages to employees (to whom you provide a W-2) or use contract labor (independent contractors, to whom you provide Form 1099). Deductible fringe benefits include:
• Discounts on goods or services
• Flights on airplanes
• Meals and lodging
• Memberships in country clubs
• Tickets to entertainment or sporting events
• Use of a car
Deductible employee benefit programs include:
• Accident and health plans
• Adoption assistance
• Cafeteria plans
• Dependent care assistance
• Educational assistance
• Group-term life insurance coverage
Home Office Expenses
To take the home office deduction, you must use your home office regularly and exclusively for your business, and your home office must be your principal place of business. To meet the regular and exclusive test, the area where you work should be a separate room in your home. However, if the area is a common area in your home, it can also qualify as long as you use it exclusively for business. If you have a desk located in a family room, for example, mixing your business correspondence with your personal mail could cause the deduction to be disallowed.
• Exclusive use means that your children cannot use your office computer to do research for school, or to play computer games.
• Regular use does not necessarily mean that you must use the office daily or even weekly, just that you use it on a regular basis. Occasional or incidental use does not qualify for business use, even if the office is used exclusively for business purposes. To claim that your home office is your principal place of business, you must:
• Perform the most important part of your work there, or
• Use the office for administrative or management activities of a trade or business, and not perform these administrative or management activities at any other location, such as another office off-site. Administrative and management activities include, but are not limited to billing customers, keeping books and records, setting appointments, calling in orders, ordering supplies, and writing reports.
Exceptions:
You can claim the home office deduction if you store inventory or product samples there, or if you operate a day-care facility. If you own your home and are operating your business at a loss, your home office deduction is limited to your direct expenses, which are the deductions normally taken on Schedule A. You can't deduct indirect expenses such as insurance, utilities, and depreciation at all unless your gross income is greater than the sum of your expenses. Even then, you divide your office's square footage by your home's square footage to obtain the percentage of your home that you use for business purposes. You then apply the resulting percentage to your indirect expenses to determine your deductible home office expenses. Because the home office deduction is a complex area that has been the subject of much controversy and many court cases.
Insurance
You can deduct insurance expenses as long as they're determined to be ordinary and necessary expenses. Common examples include
• Credit insurance on losses from unpaid debts
• Casualty insurance
• Professional liability or malpractice insurance
• Product liability coverage
• Accident and health insurance
• Overhead insurance
• Vehicle insurance
There are a few types of insurance premiums that you may not deduct. These include:
• Insurance for securing a loan. For example, if you take out a policy on your life in order to obtain or protect a business loan, that premium is nondeductible.
• Loss-of-earnings insurance
• Premiums on certain life insurance policies
• Self-insurance reserve funds (a savings account) You can deduct up to 100 percent of the health insurance and qualified long-term care insurance payments for yourself and your family. If your spouse works in the business with you and you provide a health insurance plan that covers your employees and their dependents as well as your spouse and family, you can deduct 100 percent of your health insurance expenses.
Interest
Generally, you can deduct all of the interest you pay during the tax year on debts related to your business. For example, if you take out a bank loan to help secure additional inventory to increase your business, that interest is deductible. If you're just starting your business and use a credit card to help with start-up costs, that interest is deductible as well. The source of the interest doesn't matter. If a relative loans you money to start a business, the interest you pay to your relative is also tax deductible. A corporation can deduct the interest it pays on loans from its shareholders. There should be a valid business purpose for such a borrowing arrangement and written documentation in place detailing the amount of the loan, interest rate, and maturity date. These types of arrangements may receive increased scrutiny from the IRS, and you want to have evidence that the borrowing is debt and not equity. Watch out for loans that are for both personal and business uses. For example, if you take out a loan for a car that you use in your business and for personal purposes, part of the loan interest won't be deductible. You can only deduct 100 percent of the loan interest if you can prove that you use the car 100 percent for your business.
Legal and Professional Fees
Fees that you pay to professionals, attorneys and accountants are considered ordinary and necessary when they relate to your on-going business. If you purchase a new business, the fees paid for professional services are added to the tax basis (or cost) of that business.
Example
You negotiate the purchase of a pool-cleaning route for $22,500. You hire an attorney to draft a non-competition agreement, and hire an accountant to perform a due diligence review of the books. You pay $2,500 in professional fees. For tax purposes, your cost basis in the pool route is $25,000 ($22,500 + $2,500). Legal fees to incorporate or organize your business may be amortized as incorporation fees for corporations or organizational costs for partnerships. For costs incurred after October 22, 2004, you can elect to deduct $5,000 in the first year and amortize any remainder over 180 months. You can also deduct accounting and tax preparation fees related to your business. If you are a sole proprietorship filing a Schedule C for tax purposes, you can deduct these fees to the extent that the cost is related to your business. For example, if all the income on your income tax return is related to your business, you may allocate nearly all of the tax preparation expenses to the Schedule C. On the other hand, if you have interest and dividend income, numerous donations to charity, a mortgage, a few rental properties, and a Schedule C business, you should allocate the tax preparation expenses throughout the return. Allocate some of the expenses to Schedule A (where it is only deductible when it exceeds 2 percent of your adjusted gross income), some to Schedule C (your small business), and some to Schedule E (where you report rental income and expenses).
Pension Plans
If you set up and maintain a Simplified Employee Pension (SEP) plan, a Savings Incentive Match Plan for Employees (SIMPLE plan), or a Qualified Plan (Keogh or H.R. 10 plan) for yourself and your employees, you can deduct contributions you make to the plan for yourself and your employees.
Rent
The IRS defines rent as any amount that you pay to use property you do not own. Most of us are familiar with the concept of paying rent for office space, land, or equipment. But you may not know that you can deduct part of your rent on your home, condo, or apartment if you use part of it as a place of business. (You must meet the requirements for a home office. See Home Office Expenses.) If you rent property from your relatives or a related company and the IRS deems the rent to be excessive, the IRS will disallow the deduction. To avoid this, make sure the rent is comparable to what you would pay a stranger. Contact a real estate agent and ask him or her prepare comps (or comparisons) of similar properties in the area to substantiate the rent you are paying to a related party. Rents are usually deductible in the year they are paid. Advance rent payments will be deductible when paid for cash basis taxpayers. An accrual basis taxpayer must capitalize the advance payments as prepaid rent and then write them off when the rent payment becomes due.
Taxes
There are many taxes that you can deduct when operating a business. For example, if your state taxes are based on the gross income of your business, you can deduct the state income tax. You can also deduct your employer's share of employment taxes such as social security, Medicare, federal unemployment taxes, and state unemployment taxes. Here are some other taxes you can deduct:
• Personal property taxes imposed by your state or local government
• Real estate taxes, which are deductible to the extent that you use the land for your business. If you qualify for the home office deduction, you can deduct a portion of your real estate tax against your gross revenue.
• Sales taxes, which are deductible when paid for business-related purchases or services. Note: you can't deduct the state and local sales taxes that you charge your customers, because they paid those taxes, and you just passed them along to the state. Also, don't include the amount of sales tax you collected in the gross receipts you report for your business.
• Excise taxes, which are also deductible to the extent that they are ordinary and necessary for the operation of your business. Fuel taxes that you pay for gasoline, diesel, or other types of motor fuels are already reflected in the cost of the fuel, and therefore aren't deductible. Note that you may be entitled to a credit or refund for federal excise tax you paid on fuels used for certain purposes, for example, in a farming operation where you don't use vehicles on maintained roads or highways.
Travel, Meals, and Entertainment Expenses
Any payments you deduct for travel, meals, and entertainment must be the ordinary and necessary expenses of carrying on your trade or business. In general, entertainment expenses must be directly related to, or associated with, the conduct of your trade or business. Travel expenses include those for ordinary and necessary travel away from your home for your business. You must meet two conditions to take the travel expense deduction.
1. Your duties must require you to be away from the general area of your tax home (your regular place of business, regardless of where you maintain your family home) substantially longer than an ordinary day's work.
2. You need sleep or rest to meet the demands of your work while you're away from home. If your trip meets these requirements, you can deduct a wide variety of travel-related expenses, including:
• Transportation expenses (using a plane, train, bus, or car) between your home and your business destination, including taxi, commuter bus, and limousine fares
• Baggage and shipping expenses for sending samples or display materials
• The costs of operating and maintaining your vehicle if you use your car or truck for business travel. You can choose between actual expenses or the standard mileage rate.
• Tolls and parking fees
• Rental car expenses for the business portion of the usage.
• Meals and overnight lodging. Meals are subject to a 50% deduction limitation.
Meal expenses include those incurred while traveling away from home or for entertainment of business customers at your place of business, a restaurant, or other location. This deduction may also apply to meals you furnish on your premises to your employees. Entertainment expenses fall into a broad category and include any activity generally considered to provide entertainment, amusement, or recreation. Some examples include: entertaining guests at social, athletic, or sporting clubs, theaters, yacht trips, hunting, fishing, vacation, and similar trips.
Other Deductible Expenses
There are numerous other business expenses you can deduct. So far, we've discussed the most common small business deductions. Other deductible expenses include:
• Advertising
• Clean-fuel vehicles
• Donations to qualified charities
• Educational expenses
• Licenses and regulatory fees
• Dues and cost of subscriptions paid to professional organizations or business publications
• Outplacement services
• Penalties and fines you pay for late performance or nonperformance of a contract
• Repayments of income
Expenses You Can't Deduct
Some business expenses are not deductible under any circumstances:
• Demolition expenses and losses. (These costs increase your tax basis in the property, reducing your eventual gain when you sell, thus lowering your capital gains tax in the future.)
• Dues to social, athletic, luncheon, sporting, airline, and hotel clubs even if membership is for business. • Federal income tax payments
• Lobbying expenses
• Penalties and fines you pay to a governmental agency or instrumentality when you break the law.
• Political contributions
Copyright The Border Group© 2009 -2012 all rights reserved
O:203-400-6439 • F: 203-538-4012
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Each Keller Williams office is individually owned and operated
132 Monroe Turnpike. Trumbull, CT 06611
O:203-400-6439 • F: 203-538-4012
E-mail Direct
Each Keller Williams office is individually owned and operated
132 Monroe Turnpike. Trumbull, CT 06611
