Creative Cogitation

My day job is a  tax accoun­tant.  I spe­cial­ize in small busi­nesses.  Time and again I am told things like “I am not that orga­nized,” asked “Why can’t I take the deduc­tion?”, and “Why do I need receipts, all my receipts?” etc.

Rule num­ber 1. In gen­eral, for tax pur­poses, there is no deduc­tion with­out doc­u­men­ta­tion.  Doc­u­men­ta­tion con­sists of receipts, invoices, state­ments, can­celed checks, logs for listed prop­erty (auto­mo­biles, cell phones, com­put­ers and enter­tain­ment equip­ment) etc.  From these lit­tle bits a book­keeper or accoun­tant can gen­er­ate a set of books and cre­ate finan­cial state­ments for you, but I real­ize many of you out there read­ing this do not have a book­keeper or accoun­tant.  So you will have to DIY, or you will have to bring the shoe­box of your stuff to your tax per­son at year’s end.

Your tax pre­parer should ask you if you have receipts.  We don’t usu­ally need to see them, unless we have rea­son to believe you are being dis­hon­est with us, (“Yeah, that that boat I bought is only for busi­ness pur­poses.”) or unless we are deal­ing with your shoe box because you have not cre­ated a real­is­tic profit and loss state­ment from those records.  If you hand over the shoe box, I gotta tell you, if it ain’t in there you are not get­ting the deduction.

“How bad can it be? I didn’t make that much”. As a self-employed artist, even if you did not make enough money to pay income taxes on, you will still owe self-employment taxes.  That’s right-you still owe money.  If you made $5000 total from sell­ing your art in a given year then your Uncle Sugar wants 15.3% of it or $706–not includ­ing income tax; you may owe another $500 in income tax or more depend­ing on your mar­ginal tax rate.  If you didn’t keep your receipts then you will not be able to deduct any of your expenses for cre­at­ing that income from that income. So get that shoe box out and start fill­ing it up.

Lets get back to the hypo­thet­i­cal $5,000 in sales.  For the sake of argu­ment lets your work is very detailed an you spent a lot of time cre­at­ing it, in addi­tion to time spent mar­ket­ing for shows, con­tact­ing col­lec­tors, work­ing with your gallery etc.  Lets say had the fol­low­ing expenses: $1000 in mate­ri­als, $100 in brushes & other small tools and equip­ment, $62 for a sales tax license, accoun­tant you paid $200 last year to do your sched­ule C, 1065 or 1120S, cell phone $50 per month, a web­site that costs $500 per year,$500 for the art-show fees, drove 100 miles each way to the fair where you sold that art,  rented a motel room for $80 per night for 2 nights and ate mod­estly at $40 a day for a three day show, that you drove an addi­tional 500 miles for busi­ness meet­ings with col­lec­tors, gallery own­ers, buy­ing sup­plies etc. Lets say that your car had 8000 miles total for the entire year.

• Mate­r­ial par­tic­i­pa­tion: You do work at your art busi­ness don’t you?  If you don’t then cer­tain lim­i­ta­tions apply, which are beyond the scope of this discussion.
• You expect to turn a profit don’t you?  Deduct­ing expenses directly from income is for folks who have the profit motive.  If you are a hob­by­ist and not really try­ing to turn a profit then you can only take expenses up to the income from your hobby sub­ject to the 2% lim­i­ta­tion of income if you item­ize deduc­tions on your per­sonal tax return; if you do not item­ize there is no deduc­tion at all.  Busi­ness own­ers get to deduct busi­ness expenses directly from income on their sched­ule C or other busi­ness return, but you have to have the profit motive.
• Art is a funny busi­ness for tax pur­poses as we get to expense the mate­ri­als we used in mak­ing our art.  A lot of other busi­nesses don’t get to do that, they can only take the expense for mate­ri­als in their prod­ucts after they sell it–in the mean time it is nond­e­ductible inven­tory.  Lucky us.  We get to take the whole $1000 in mate­ri­als expenses this year.
• Small tools and equip­ment:  In real­ity they usu­ally last more than a year — if they don’t they are deductible as sup­plies, but if they do last longer (just how long have you had your favorite paint brush?), you are sup­posed to depre­ci­ate them over time.  The IRS will tell you the time it takes and how to do it.  Things not oth­er­wise spec­i­fied have 7-year recov­ery peri­ods.   BUT if you have net income you may be able to take the entire expense in the year of pur­chase via some­thing called sec­tion 179.  This exam­ple does have net income, so your tax pre­parer could com­plete a form that would allow you to deduct your small tools as an expense in the year of pur­chase, instead of depre­ci­at­ing this pal­try $100 amount for a over time.
• $500 in art show fees, $500 the web­site, $62 sales tax, $200 to your accoun­tant is account­ing fees are all rea­son­able and nec­es­sary expenses for your busi­ness & are nor­mal deduc­tions for tax purposes.
• The cell phone — does your bill break out the calls you made?  If it does you should fig­ure out the per­cent­age of calls that are busi­ness verses per­sonal.  The busi­ness per­cent­age is deductible (assum­ing it is not your only phone) and the per­sonal usage is not.  Don’t want to mess with it? Don’t expect to be able to take the deduc­tion at all.  Con­sider, if you use your cell phone 50% for busi­ness then that rep­re­sents $300 in expense you could use to off­set your income, that is rep­re­sents about $46 in self-employment tax and maybe another $30 in income tax or more depend­ing on your mar­ginal tax rate.  If your bill doesn’t break out the phone num­bers called then you need to keep a writ­ten log; its prob­a­bly worth it to call your cell phone provider and see if they can give you access to a detailed log so you can fig­ure it out instead of try­ing to keep a log of your calls.
• The travel expenses: $160 in accom­mo­da­tion and $120 in meals.  If you have a tax home, that is to say you are not one of those peo­ple who only lives in a town for a few weeks before mov­ing on, you maybe able to deduct cer­tain travel expenses if the travel is for busi­ness, overnight and more than 50 miles from your tax home.  If you have a tax home then this trip may be deductible as busi­ness travel.  There are a lot more rules but that is the short form of it.  So the $160 in hotel fees is com­pletely deductible, but the meals are only 50% deductible — this case is usu­ally the case for any meals or enter­tain­ment deduc­tion; if you keep your receipts you get another $60 deduc­tion for your meals on the road for busi­ness travel.
• The auto­mo­bile mileage:  You had 700 busi­ness miles and 8000 miles total.  Your busi­ness usage is not even 10% so tak­ing auto­mo­bile depre­ci­a­tion is out, but if you keep a writ­ten log which includes the year’s start­ing and end­ing mileage, the start­ing and end­ing mileage of each busi­ness trip, the date of each trip, the busi­ness pur­pose of each trip, and you use fewer than 5 vehi­cles for busi­ness pur­poses you may qual­ify for the mileage deduc­tion.  Sim­ply put instead of track­ing gas, oil, insur­ance etc, you just keep track of your mileage, which you have to do any­way if you are going to take any deductible expenses for the busi­ness use of your per­sonal vehi­cle.  In 2009 that rate is 55 cents per mile or $385 in mileage expenses.  Don’t want to keep a log? Then don’t expect to be able to deduct those expenses.  That is another $59 in self employ­ment tax and maybe another $38 in income tax or more depend­ing on your mar­ginal tax rate.

So you can reduce your income by $2582 by sav­ing receipts and another $685 by keep­ing a mileage log and fig­ur­ing out busi­ness self phone use.  That’s about $500 in self-employment tax and and maybe another $327 in income tax or more depend­ing on your mar­ginal tax rate.  Lets com­pare: $1206 tax verses $379 tax.  You have to ask your­self, come tax time is it worth it to keep your receipts, mileage log and fig­ure your busi­ness per­cent­age of cell phone use? Only you can answer that ques­tion, but many peo­ple I know have enough trou­ble cough­ing up $379, let alone $1206.  Also if you didn’t pay esti­mated taxes on that $5000 in income you may also owe a penalty and inter­est on that $1206. Why? Our tax sys­tem is pay as you go; safe har­bor is under $1000 (OR 90% of all of your taxes owed for the cur­rent year OR 100% of the tax you owed last year unless you earned more than $150,000 then its 110%).    In this par­tic­u­lar exam­ple keep­ing receipts and logs not only reduced the tax lia­bil­ity but also kept it low enough to stay within esti­mated tax pay­ment safe harbor.

Where to start?

1. Get a file, a box an enve­lope or some­thing and start keep­ing all of your busi­ness receipts, state­ments, invoices etc. NOW.
2. Poor man’s busi­ness account­ing sys­tem:  There are sev­eral banks out there with free check­ing accounts-you may be able to open one with as lit­tle as $100 and run it down to noth­ing reg­u­larly with­out incur­ring fees (just don’t over­draft it-then they really ham­mer you).  Get one for your busi­ness.  In real­ity it should be a busi­ness account, but that may involve addi­tional paper­work and expense; for the pur­poses of this dis­cus­sion if you’re a Sched­ule C filer with­out an Employer Iden­ti­fi­ca­tion Num­ber, an indi­vid­ual account may work just as well as long as you use it only for busi­ness expenses and income.  Get this account at a dif­fer­ent finan­cial insti­tu­tion from the one you cur­rently bank with if at all pos­si­ble.  Once you have that account, deposit all money you receive for your goods and ser­vices as the result of your busi­ness into that account and use those funds to pay for your busi­ness expenses out of that same account.  Do not pay for your mort­gage, elec­tric bill, car pay­ment, lunch with Lucy or any other per­sonal expenses from this account; if you need money write your­self a draw, or pay­check, deposit it into your per­sonal account and pay your per­sonal expenses out of your per­sonal bank account.  If you need to loan your busi­ness money, loan the money for­mally: Pre­pare a promis­sory note, with pay­ment terms and inter­est, and only then write a check to the busi­ness and deposit it in your busi­ness account.  If you need to buy some­thing small for the busi­ness out of your own pocket, sub­mit the receipt to your busi­ness (file it in your shoe box) with a request for reim­burse­ment (post-it note — “pay myself back for this”), but do not make a habit of pay­ing for busi­ness expenses with per­sonal funds; it is best to pay for busi­ness expenses out of busi­ness funds.  If you keep all of your receipts, and use the busi­ness account only for busi­ness pur­poses, you will have at least a min­i­mum amount of infor­ma­tion to fig­ure out profit and loss from busi­ness and pay your taxes.
3. Start keep­ing logs for listed prop­erty: I hear, “I am not that orga­nized, I don’t want to keep a log.”  My response is, “That is your choice, but you will not be able to take deduc­tions against your income for the busi­ness use of your car, your cell phone, your com­puter or your cam­era.”  The log could just be a flip book you write the infor­ma­tion in, but many office sup­ply stores carry inex­pen­sive mileage log books you can use as well. Just make sure the log and a pen is with the listed prop­erty at all times so you will remem­ber to use it.

One final note:  Keep your receipts, invoices, bills, check stubs, state­ments etc.  with your tax forms.  Just because you have used them to fig­ure out your taxes doesn’t mean you are done with them.  You may have to pro­duce these items if you are audited so don’t throw them away.

The usual dis­claimers: Although Art & Busi­ness Con­sult­ing LLC has made every effort to insure the accu­racy of this infor­ma­tion, mis­in­for­ma­tion, dis­in­for­ma­tion, changes, mis­takes, typos and hack­ers hap­pen, there­fore Art & Busi­ness Con­sult­ing LLC takes no respon­si­bil­ity for any action taken or results based on the infor­ma­tion sup­plied here in.   Inter­nal Rev­enue Ser­vice Cir­cu­lar 230 Dis­clo­sure:  As pro­vided for in Trea­sury reg­u­la­tions, advice (if any) relat­ing to fed­eral taxes that is con­tained in this com­mu­ni­ca­tion (includ­ing attach­ments) is not intended or writ­ten to be used, and can­not be used for the pur­pose of (1) avoid­ing penal­ties under the Inter­nal Rev­enue Code or (2) pro­mot­ing, mar­ket­ing or rec­om­mend­ing to another party any plan or arrange­ment address herein.  Art & Busi­ness Con­sult­ing LLC cur­rently does not have a cer­ti­fied pub­lic accoun­tant or an attor­ney on staff; this infor­ma­tion is purely for edu­ca­tional pur­poses and not to be con­strued as legal or finan­cial advice. Art & Busi­ness Con­sult­ing LLC and its employ­ees, mem­bers and asso­ciates are not engage to prac­tice law; you always should dis­cuss legal mat­ters with your attor­ney before talk­ing to any­one else.