Tax Write Offs - Not As Frivolous As Many Think
If it hasn’t already happened, I’m certain that at some point in everyone’s life, they are going to hear someone brag about or pitch them on the idea of using a business to write off expenses. It is often talked about in the tone that writing off an expense means you don’t have to pay for the purchase. Need a new car? Write it off. Want a new swimming pool? Write it off. New dirt bikes for the family? Use the magic write-off. The list is never-ending. While at first glance it seems like a foolproof plan, using your business to write off expenses is not everything it’s cracked up to be.
To start at the very basics let’s first discuss what people mean when they say “I’ll just write it off.” When you write something off, you are claiming it as a business expense. Each year businesses will net their expenses out with their business income. A very basic calculation that every business will run at the end of the year is income minus expenses. This results in their profit for the year (yes this is an extreme simplification, but for the sake of this article we will keep it simple). As a business owner, you will pay taxes on the profit portion of that equation. So by taking additional expenses, you can in theory lower your profit, which in turn will lower your tax bill. This is where a lot of people get confused. Lowering your profit doesn’t save you money dollar for dollar. Let’s illustrate with an example and a couple of different scenarios below:
Joey Strong is a single tax filer who owns and operates a gym as a sole proprietor. In 2023 Joey had a gross income of $200,000.
Example 1: Joey somehow had a magical year and had $0 of expenses for 2023. Joey would be required to pay taxes on the $200,000 of income.
Example 2: Joey had $200,000 in expenses in 2023. Using the same calculation as above, Joey would have $0 of net income resulting in taxable income of $0. Theoretically, Joey would owe $0 in taxes.
Let’s dig into these examples and show the difference between each of them. Each of the below explanations will use the 2023 single tax rates with the standard deduction they will not include any other deductions or credits.
Example 1: If Joey were to make $200,000 this would put him in the 32% tax bracket. Making his federal tax bill, not including other deductions, credits roughly $38,400.
Example 2: If Joey’s income was $0 he would owe $0 in taxes he may even get a refund.
Now let’s compare examples 1 and 2. In example 2 Joey racked up $200,000 of expenses on things that his business didn’t really need because he was just going to write it off. While he certainly saved money he did not get to spend $200,000 for free. His savings can be calculated by comparing the tax amounts. In this example, Joey spent $200,000 to save $38,400. Savings of 19.2%. Now you may be thinking that’s a lot of savings, but oftentimes people are using these write-offs to buy things that are truly out of their means, or unnecessary purchases. Assuming the expenses were unnecessary Joey lost $161,600 ($200,000 - $38,400) for a benefit of $38,400. I don’t know about you but I would much rather just pay the taxes.
There are a myriad of other rules and factors that should be considered before jumping in feet first and starting a business to start writing off expenses. I will only list a few in this article. The first, which seems like a no-brainer, in order to have business expenses you need to be running a business. You can’t start a business in the interest of writing off expenses. You have to have an intention to make a profit. There are also many expenses that don’t allow for the full expense to be deducted. A great example is meals. Per the Internal Revenue Code, you are only allowed to deduct 50% of expenses spent on business meals. That is not considering that you generally have to have a customer with you and will need to keep the receipts to prove the costs are legitimate if you’re ever audited. So while you thought that burrito you wrote off was free, it wasn’t. You got at most a discount of approximately 19%. Meals are not the only expenses that are subject to limitations, there are many other things that you are not able to deduct in full.
Now putting numbers aside one of the most important things in claiming business expenses is the legitimacy of the expense. Business expenses are required to be ordinary and necessary for your business. If you run a business on the side helping people build websites, I think you are going to have a very difficult time justifying the new Ford F-350 and wake surfing boat you bought as ordinary and necessary for your business. Now, I’m not an IRS auditor but I don’t think many of them are going to be fooled by that one. However, if you have an expense for some basic web design software that is a legitimate expense for a business of that kind.
While there are savings to be had by writing off expenses, these expenses are not intended to create a loophole in the tax code so that you can get a discount on a new toy. If you are wondering whether or not certain purchases are going to qualify as an expense I suggest you consult with a tax advisor or visit this IRS website to ensure that you are complying with the tax code. If you would like to schedule a review or plan around any business expenses feel free to contact us.