Online Extra: Don't Write Off That Tax Write-Off (extended)
For many self-employed people, the line between work and personal life isn't always clear. Tax and financial consultant June Walker, author of Self-Employed Tax Solutions (Globe Pequot, $17.95), argues the confusion often causes people to cheat themselves out of legitimate deductions.
BusinessWeek personal finance writer Suzanne Woolley quizzed Walker, who has 25 years of experience and works out of her home in Santa Fe, N.M., about ways to make self-employment less taxing. Edited excerpts of their conversation follow. (Note: This is an extended, online-only version of the interview that appears in the Feb. 14, 2005 issue of BusinessWeek.)
Q: Why do the self-employed write off too little? A:
Q: Why do the self-employed write off too little?
A:They often cheat themselves by considering an expense personal when it's really a business expense. In the corporate world, it's clear who is a business associate, and who isn't. For the self-employed, that line is very wiggly. Just because someone is a friend or a family member doesn't mean he or she isn't a business associate.
Q: In that vein, you say that a gift for mom can be a legitimate deduction. How so? A:
Q: In that vein, you say that a gift for mom can be a legitimate deduction. How so?
A:Say your mother watched the kids because the babysitter didn't show, and you had to do this interview. You thank her by sending flowers. You can write that off. [The limit is $25 per gift.] You note on the receipt that it was a gift for mom because she watched the kids while you did an interview.
Or say an information-technology consultant is going out on her own, and her husband is in the ad business. They have three kids. She wants him to look at her brochure and help lay out a business plan, so they go out to dinner. She can write it off even though it's with her husband. She couldn't have had that dinner at home with the kids running around. You can't write off every dinner, but if there's a business motive, you can.
Another example where you don't want to discount an expense because there's a personal connection would be if you make something like gift baskets at home and deliver them while dropping the kids off at school. That counts as business miles. If you go from your home office to the school, and from the school to the client, then just the miles from the school to the office count as business miles. But if the client is on the way to the school, and you drop the baskets off, the whole trip counts.
Q: What's the mindset self-employed taxpayers need to adopt? A:
Q: What's the mindset self-employed taxpayers need to adopt?
A:Look at everything that you do as a possible business connection and define your business as broadly as you can. You might define what you do as tech consulting rather than computer repair. If you're a writer who's a generalist, you can write off a lot more than if you wrote only about sports.
Q: The IRS says an expense must be "ordinary and necessary." What does that really mean? A:
Q: The IRS says an expense must be "ordinary and necessary." What does that really mean?
A:The IRS defines necessary as "appropriate and helpful." What counts as ordinary? If a computer-game developer buys other people's games, that's an ordinary expense to him. It's not an ordinary expense for me unless I'm writing and have the potential to write about computers or what effect computer games have on the brain.
Q: What record-keeping advice do you give to the self-employed? A:
Q: What record-keeping advice do you give to the self-employed?
A:I tell people to get a backup for every dollar they spend, whether it's a canceled check, credit-card slip, or a receipt for cash. Just buy something, keep the slips in an allotted space, and then you can go over it later. I don't want people to be thinking about whether their spending is personal or for business all the time.
Using one credit card can make your record-keeping easier. The more papers and more statements that come in, the less organized someone is going to be. I always say if a piece of paper comes in, and your name isn't on it, throw it out.
Q: Should you set up a separate business checking account? A:
Q: Should you set up a separate business checking account?
A:I advise clients not to have a business checking account. It costs money to set up, and it doesn't work. Let's say you're starting a cookie business, and you have clients coming over for a tasting. You go to the store and buy a week's worth of groceries. You're also buying supplies for the people coming over. Are you supposed to split that up and pay with two checks? It doesn't happen.
Self-employed people are very busy, and the easiest thing is one checking account. The IRS likes to see a clean audit trail, so if everything goes into one account, it's all there. If mom gives you $100 for your birthday, and it goes into the checking account, then you write down that it's a gift from mom. If you get paid $100 for writing a press release, it's $100 income, and you deposit it in checking and write that it was income for writing a press release.
Q: Why do you advise people not to incorporate? A:
Q: Why do you advise people not to incorporate?
A:It's expensive, it complicates your self-employed life, and in most cases, it's not necessary. People, especially those not well-versed in the business world, think that if they're a corporation they don't have to worry because no one can sue them. That's not so. Often the money spent on incorporating would be better spent on insurance, such as liability insurance.
Q: What are audit red flags on tax returns of self-employed people? A:
Q: What are audit red flags on tax returns of self-employed people?
A:My belief is this: Don't worry about them. The IRS puts up red flags to scare you. If you're a legitimate self-employed person, take every deduction you can, and don't let the big boys push you around.
If you make a profit in three consecutive years out of five, the IRS will tend not to look at you. If you write a book, and it takes 10 years, you're going to have a loss for 10 years, and that's fine as long as you can prove that you're in it to make money -- that your goal is a profit.
The first thing the IRS says is that you should have a business card. Someone like an info-tech consultant who isn't getting jobs should save the proposals that show that he or she is out there looking for work.
Q: The conventional wisdom is that claiming a home-office deduction triggers an audit. Is that true? A:
Q: The conventional wisdom is that claiming a home-office deduction triggers an audit. Is that true?
A:It's a scare tactic. And so what if they audit you? If you have good record-keeping, an audit is nothing. Also, office-in-the-home regulations have been liberalized.
Say an info-tech consultant shares an office in town with another consultant and has computers there because she lives in a small apartment. Of course, she can deduct rent for the office. But as long as she has a place at home used exclusively for work -- suppose she bills from there -- she can write off that area, though it will be a small write-off.
More significant is the deduction she'll be allowed to take for travel between the two offices. If she didn't have the home office, she couldn't take that deduction.
Q: What big mistakes do the self-employed make regarding their taxes? A:
Q: What big mistakes do the self-employed make regarding their taxes?
A:Many people don't keep track of their income. They may not realize if the client makes a mistake in reporting to them and, more important, to the IRS. You need to keep your own records, too.