There are four levels of knowledge:
- Know: I know how old I am.
- Know about: I know about how old you are.
- Know you don’t Know: I know I don’t know how to fix an electrical issue at my house.
- Don’t know you don’t know: I think I know something I really do not know.
Where do you fit in?
Sorry to say, when it comes to taxes, most small business owners fall into the fourth level. Some think they “know about” taxes. But the truth is they likely do not. Lack of knowledge is not your fault. The Tax code is incredibly complex and subject to frequent revisions. Consider, for example, that lobbyists receive $3.4 billion each year. As a result, lobbying often leads to tax changes and special rules. These rules apply just as much to the corporations that funded the change as they do to the small business owner, or in our case, you.
With lobbyists, a rotating Congress every two years, and the tax code currently sitting at a whopping 73,608 pages long (give or take a couple thousand pages), it’s understandable why many people have little tax knowledge. (At the very least, hopefully we can raise your knowledge level to “Know you don’t know.”)
Let’s begin with the most common business owner tax question: “Can I write this off?”IRS rules state that, in order to write off a business expense, it needs to be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade and business. A necessary expense is one that is helpful and appropriate for your trade and business.
Here are some tax benefits that you may be missing out on:
There are two types of income:
- ordinary income
- passive income
Most business owners earn income that is considered “ordinary”. Ordinary income is subject to self-employment tax. If you receive ordinary income, you pay 15.3% in self-employment tax,in addition to whatever you are paying in income tax. Passive income, which is typically rental income and investment income, is not subject to self-employment tax; however, if you have a loss in “passive” activities, the loss is limited.
If you earn “ordinary” income, you will want to form either an Sub-chapter S Corporation (more commonly known as S-corp), or a multi-member LLC (Limited Liability Company) taxed as a partnership. This tax structure will significantly reduce the self-employment tax hit on your “ordinary” income. As an S Corporation, you are required to pay an officer wage, and the officer wage must be “reasonable.” It is not difficult nor expensive to set up an S-Corp or LLC, but, my recommendation is to hire a professional to set this up for you. Just as you wouldn’t want an auto mechanic teaching you how to power clean, you don’t want an amateur (you) to take on your tax structure. You are saving much more in taxes than the additional price of taking this responsibility off your plate, including having a professional handle the “reasonable” wage compliance.
Most business owners know they can claim their mileage, but few actually track their mileage on a consistent basis in a mileage log. We guarantee that if you are not tracking your mileage, you are not claiming the full amount on your mileage deduction. You are cheating yourself out of a proper deduction. Also, a mileage log is a primary area IRS auditors review because they know few people maintain their logs the right way. If you are audited, you will have peace of mind knowing your records are up to date and accurate. Some of our clients like to use phone apps to track mileage. If that is your cup of tea then by all means do so. Anything is better than not tracking. Our preference is to have a piece of paper in the car. Each day reset the odometer so that when you get in the car the next morning you know how many miles you drove the day before. Write the date and miles driven on your piece of paper. It takes 10 seconds. It may take two months to develop the habit, but it will become routine, just like buckling your seat beat or swearing at idiot drivers. It helps to print off your calendar each quarter so you can show the business purposes connected to all those miles.
If you’ve made it this far, we are going to reward you with a phenomenal tax strategy. We call it corporate rent. We all know that large corporations often rent out hotels or convention centers to hold company meetings. Why can’t the small business owner do something similar? He or she can.
Rent expense is an ordinary and necessary business expense. This, in combination with the “14-day rule” makes for a powerful tax deduction. The 14-day rule basically says that if you have a personal asset, and you rent it out for more than 14-days during the year, the personal asset is now a rental asset and you need to claim rental income on it. What this also means is if you rent a personal asset for less than 14-days per year, you do not have to claim any rental income. So, the small business as an entity contracts with the business owner (aka you) to utilize his or her living space one day per month to hold its board and/or other company meetings. The company pays rent to the owner for the one-day use. The owner does not claim rental income on that amount received.
There are now some tax things that you “know about”. And now there are some areas that you “know you don’t know”, but hopefully you will never be in the “don’t know that you don’t know” category.