I often get asked by clients and prospects alike about whether they should start a side business or what to do with the side business that they have already. In my opinion, owning some type of business will be one of the most important tax strategies you can deploy over the next decade, whether it be extra consulting you do on the side, have a legitimate home based businesses, or you start a new venture as you decide to potentially transition out of corporate America. So, why is having a side business so important for your overall tax management strategy and how do you make sure you are doing it correctly?
Here’s the newsflash—if you have a JOB and work for the man (as a w-2):
- You make money
- You pay taxes (with limited potential top of the line deductions)
- You spend money
If you own a business—where you are the man (as a 1099, LLC, S-Corporation, etc.):
- You make money
- You strategically figure out how you spend money
- You pay taxes
Now, you can’t just have a business to try to get write offs. You must establish whatever business you set up with the intent to make profits. As we all know there are many companies who have gone public that ultimately failed without ever turning a profit, so your business doesn’t necessarily have to turn a profit to be considered a business. However, it is extremely important that you show a separation of church and state when it comes to the business. That means having a separate bank account, separate credit card, business cards, website, or other items that clearly show you are attempting to make a profit.
According to the IRS (www.irs.gov) taxpayers may deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business. Generally, an activity qualifies as a business if it is carried on with the reasonable expectation of earning a profit.
In order to make this determination, taxpayers should consider the following factors:
- Does the time and effort put into the activity indicate an intention to make a profit?
- Does the taxpayer depend on income from the activity?
- If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
- Has the taxpayer changed methods of operation to improve profitability?
- Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
- Has the taxpayer made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year — at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses. Obviously, the IRS is aware that it may take some time before a new business may make a profit.
There are lots of deductions that can be associated with the business including a home office deduction. These might include a percentage of utilities, phone lines, magazine subscriptions, cable tv, garbage collection, cleaning services, and much more. Think about this for a minute. If you have a home office, would it make sense to have two dedicated cabinets in your pantry specifically for things like coffee, peanut butter pretzels, etc.? The key to maximizing your deductions are to take copious notes on the receipts and ensuring you have a business purpose behind the deduction.
Often, new business owners don’t see the possibilities such as hiring their children in the business. Be sure that the work your children perform is legitimate work and necessary to help the business. Amazingly enough many 10 and 11 year olds can probably do power point presentations better than you can these days. You want to make sure you document their job role in the files and keep good records of their work. The key is to make sure you can justify the reasonableness of the wages you pay your child. If you are smart, you can pay them up to the standard deduction where they will pay no federal income tax especially if you are at the higher income tax brackets.
Seeing possibilities is working hard to figure out where you can incorporate your business into your life. If you have signed up for a MLM business or are starting an interior decorating business from home, be sure to bring your business credit card and make some sort of sales pitch at every meal you go to with your friends. Keep great track of your mileage that you drive from your house to all and any business activities. Open up a business account at Costco, Staples, or other vendors where it would make sense.
In order to make smart money moves, you need to see the landscape on where the future is headed and seeing the possibilities of owning a side business can be a big factor to saving taxes in the future. If you want my list of home office based deductions, e-mail me at firstname.lastname@example.org and begin thinking about how you can increase your bottom line!
CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®
Editor in Chief of Your Smart Money Moves
Co-CEO and Founder of oXYGen Financial, Inc – The Leaders in Gen X & Y Financial Advice and Services
Ted Jenkin is one of the foremost knowledgeable professionals in giving financial advice to the X and Y Generation.
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The information provided in this article is for informational purposes only and should not be used as the basis for making any legal or tax decisions. Always consult a licensed tax or legal professional when making important business decisions