The surest
way to reduce your taxes is to convert personal expenditures
into allowable deductions. Turn even a hobby into a businessand
you'll cut your tax bill. |
The No. 1 way to
reduce your taxes with a smile is to convert your personal
expenditures into allowable deductions. Turn yourself into a
business owner and cut your taxes.
It’s almost that simple.
This is part of what I call the ultimate tax strategy --that of
converting personal expenses into legitimate business expenses.
To win this game, you must own your own business. This is not
complicated, expensive, or difficult to do and incorporation is
not necessary. Let’s see how.
Establishing a ‘profit motive’ is the
key
To be in business, you merely declare it. And by doing so, you
can magically turn personal expenses into tax deductions. If you
want to operate in a noncorporate format, as an individual
proprietorship, but under a different name than your own, no
problem. It’s easy.
In some states, you may have to file a “DBA” (doing business as)
form with your local county clerk. Basically, you just fill out
a form with your name, address and the assumed name under which
you’re doing business. For example, I might be “Jeff A.
Schnepper DBA Super Tax Savings Associates.”
Here’s the best part: Your business doesn’t have to make a
profit for your expenses to be deductible. All you have to do is
establish a “profit motive.” Under the Internal Revenue Code, a
“profit motive” is presumed if you earn any net income in any
three out of five business years.
It’s recognized and expected that new businesses probably won’t
make a profit in the early years. In fact, in the early years,
you can insist that the IRS defer any challenge for the first
five years as to the legitimacy of your business by filing Form
5213.
Remember you don’t have to show a profit -- just a “profit
motive.” In one case, despite 20 years of losses, the court
found a profit objective and allowed the deduction of business
losses in full for one company. The case was not unusual.
The test for deductibility is whether you have an actual and
honest profit objective. You need not have a reasonable
expectation of a profit. While the Tax Court requires a primary
or dominant profit motive, the U.S. Claims Court has held that
having a reasonable chance to make a profit, apart from tax
considerations, will suffice.
The test is subjective: Was your intent to earn a profit? The
IRS looks at the following factors to decide if your intentions
are honorable:
The manner in which you carry on the
activity;
Your expertise and the expertise of your
advisers;
The time and effort you expend in carrying
out this activity;
The expectation that the assets used in your
business may appreciate in value;
Your success in carrying on similar or
dissimilar activities;
Your history of income and losses with
respect to the activity;
The amount of occasional profits, if any,
that are earned;
Your financial status;
The elements of personal pleasure and
recreation. That doesn’t mean that just because you enjoy doing
your “job” that the expenses aren’t tax-deductible. The Tax
Court has ruled that “suffering has never been made a
prerequisite for deductibility.”
Moreover, even if you’re employed full time elsewhere, that
doesn’t prevent you from having another vocation on the side. I
spent many years as a full-time college professor while running
a legal and accounting practice on the side. This technique
works whether your business is your primary source of income or
it’s a sideline.
Your hobby can be a business
That means your hobby could qualify as a business. In the
process, you’ll cut your tax bill.
For example, one of my clients raced stock cars as a hobby. When
he came to me, we converted his “hobby” into a business. He had
cards and stationery printed. He ran ads looking for a sponsor.
He gave what once was his hobby the image and appearance of a
business and he demonstrated a real profit motive. He wanted to
make money.
This client had a salary from his primary job of $40,000 a year.
When his new business expenses were deducted, not only did he
pay zero taxes but he qualified for the earned income credit, so
the IRS actually paid him.
Two years later, he was audited for that year’s return. The law
requires that you prove your business expenses, with receipts,
checks or a journal that’s regularly updated. Unfortunately, he
had none of these for the first year. His expenses, however,
were legitimate, and he had the receipts for the subsequent two
years. On the basis of the receipts for the two subsequent years
not in question, this taxpayer with $40,000 in other income and
no receipts, after an IRS audit, paid less than $100 in taxes,
including penalties and interest. Had he kept the records for
the first year, he would have paid nothing.
How to qualify as a business deduction
To qualify as business deductions, your expenses must be:
Ordinary and necessary -- defined by the
courts and the IRS as “reasonable and customary,”
Paid or incurred during the taxable year, and
Connected with the conduct of a trade or
business.
The term “reasonable and customary” depends on your specific
business and the business customs in your locale. The expenses
don’t have to necessarily be reasonable and customary to you,
but simply to your particular trade or industry. There are
innumerable cases of “hobbies” converted into “businesses” with
expenses allowed.
In one case, a husband and wife produced, exhibited and sold
their sculptured works. Their expenses were considered ordinary
and necessary business expenses. In another case, a coal miner
operated a kennel for bird dogs. For 11 consecutive years, he
lost money. But the courts allowed the deductions and the losses
because there was a profit objective.
In a more recent case, a high school teacher’s golfing activity
was declared an activity with a profit motive, so he could
legally deduct what once was his “hobby.”
Focus on your profit-making motive. Remember that it’s not what
you pay in taxes that counts, it’s what you keep.
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