Don’t Let Tax Deductions Run Your Business

Based on some articles I see popping up around the web, tax deductions are a magic wand that sets your business right. If you get the right ones, they’re the rainbow farting unicorns of running your own business.

Well, unfortunately, I’m here to burst that bubble.

I talked about this a bit in the Meals deduction post, but let me ratchet up the drama with another example. You see a new sound board. You don’t NEED it for your recording business, but it would be nice. When you mention it to your friend Chad, he says, “come on, just buy it! Treat it as one of those tax deductions! It’ll be like the government is buying it for you!”

At this point, if your life were a scare tactic documentary, a deep, dramatic voice over would proclaim, “Or is it?”

Putting Tax Deduction in Context

Yes, tax deductions are important. But if you’re doing something just to get the deduction, you’re doing it wrong.

The intention of a tax deduction is to allow you to run you business more or less normally. Then, at the end of the day, you get taxed on the NET income. There’s certainly weird rules that keep tax accountants (such as me) employed, but in general, the IRS wants your income to reflect what your business is actually doing.

Let me put this in an example. Amy wants to buy a computer for her graphic design work. After quite a bit of research, she decides that she’d be really productive with an expensive decked out Surface Studio. We’ll say it cost $10k just to make this example easy to follow

Yes, it’s expensive. But Chad shows up again to give her the GREAT NEWS! It’s deductible!

If Amy is bringing in enough money to put her marginal tax rate at 50%, her tax deduction would save her $5k on her tax bill.

$5k for a $10k computer. “See,” Chad gloats, “it’s like the government is paying you!”

Amy is so excited that she buys a second Surface Studio. Which she doesn’t really need. And she won’t really use. But it’s such a good deal!

Except now it’s not a good deal. She just spent $10k to save $5k in taxes. Since she doesn’t need the second machine, this purchase was really only to save on taxes. Put in that context, she wasted $5k.

Business purpose first. If it’s not needed for her business, it doesn’t matter what she’ll save in taxes.

Tax Deductions Depend on Tax Rate

I used big numbers for Amy to make things obvious. But let’s put that in context.

For Amy to have a 50% tax rate, she needs to be living in California (or another VERY high tax state) and making close to $600,000 a year.

If she’s single and making a more most $50k a year, her tax rate will be closer to 25%. That gets you down to the fantastic deal of paying $10k to save $2,500, or wasting $7,500.

And depending on a host of factors–being married, business type, personal deductions, etc.–her tax rate could be even lower. And if she owes no taxes at all, she gets zero benefit.

Business Purpose First

To emphasize what I mentioned before, business tax deductions are intended to reflect what your business is actually doing.

So repeat after me: business purpose first!

Even, as happens with entertainment, it’s not deductible

If everything you do is with an eye on how much you can deduct, you’ll end up making a stupid business decision at some point in your business life.

Figure out first what you intend your business to do. Taxes can absolutely be a factor in that! It can certainly change your return on any investment. But if you’re making business decisions based on the best Internal Revenue Code deductions, you’re going to be making bad business decisions.

If your only intent is to pay less in taxes, the easiest way to do that is to make no money. And I’m guessing that’s not what you want.