Some of my clients are self-employed or own small businesses. Most of them know that businesses are entitled to “write-off” some of their expenses, even if they don’t fully understand how it works.
But did you know you don’t even need to be a legal business in order to take advantage of those write-offs, thanks to a little-known tax provision dealing with what the IRS calls “hobby income?”
Here is a little primer in business basics to help you understand whether these write-offs can be part of your tax picture.
Hobby income is defined as “income from an activity not engaged in for profit.” In other words, you aren’t officially a “business,” but what you do for pleasure on the side happens to generate a certain amount of income. The IRS wants their share of that, of course, but they also allow you to claim any expenses that helped produce that income.
Once we understand that, we have brought business income and hobby income to more or less equal footing. Now we need to understand how the IRS allows us to deduct our business or hobby expenses. It would be terrific if we could subtract them from what we owe in taxes, and if our taxes were already zero, even receive them back as a refund. File that under “too good to be true.”
Instead, it works like this, at the simplest level: We add up all the dollars we earned and call it Gross Sales or Gross Income (and I’ve owned a few businesses where my sales and income were pretty gross!). We are then allowed to subtract what accountants call Direct Costs, producing Gross Profit (I’ll dispense with the “gross profit” joke). Direct Costs are for things that we actually turn around and sell, or that go into what we sell. I have a client named Jeff who sells training videos for magicians. When Jeff produces a DVD and sells it on his website, the blank discs, the labels, and the cases are all Direct Costs, as is the cost of duplicating the DVDs.
We further subtract any Indirect Costs or Expenses, by which we mean anything that was necessary to operate our business or hobby, but which didn’t really become part of the product or service we provided our customers. Here, the sky is just about the limit. The monthly fee Jeff pays for his website, the annual fee he pays for his domain name, the subscriptions to magic magazines, even his business cards, banking fees, and business-related lunches with his accountant are all deductible.
I was with Jeff once when he saw a great deal on decks of cards in bulk at Costco. Because card tricks are a major feature at Jeff’s shows, those cards are a legitimate, tax deductible Expense. Subtracting Expenses from Gross Profit results in what is termed Net Profit, also known as the Bottom Line. Expressed as a math equation, it would all look like this:
Gross Sales – Costs = Gross Profit
Gross Profit – Expenses = Net Profit
Net Profit is the part the IRS charges taxes on. If you have Sales of $80,000, but after Costs and Expenses you are left with a Net $34,000, you can see how that reduces your tax liability. So everything you can possibly claim as an Expense reduces what the IRS calls Taxable Income, which reduces the taxes you pay. That’s your goal.
Now, to do this optimally requires you to know ahead of time what kinds of things you can claim, and to keep records and receipts, because the IRS doesn’t allow you to claim deductions you can’t prove—and canceled checks aren’t enough.
Did you know you can deduct mileage to and from your customers or vendors? Do you have a room in your house you use exclusively for storing your supplies, or from where you operate your business? Do you have a dedicated phone number you use for your career, separate from your home or other personal numbers? All tax deductible!
But you have to have the records to get the write-off. It does you no good to hear from your accountant in March about deductions you should have been planning for last year. The receipts you threw away won’t help you get that deduction now. That is what I mean when I say, “The difference between tax planning and tax preparation is December 31st.” If you didn’t plan for those write-offs during the tax year, all that’s left afterwards is to prepare your taxes and take your lumps.
One last thing. A business can actually take a loss—spending more in a given year than it generates in profit—and not only owe zero taxes, but actually deduct the losses against other income, or carry them forward or backward to other tax years. A hobby cannot. If you run your career as a hobby, you can only deduct expenses to the amount of gross income you produce.
Hope that helps!