Below is an excerpt from my upcoming third book My Happy Assets - Taking the Last Steps to Financial Independence.
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“Small business people can deduct with proper documentation their house, their spouses, business vacations, food with colleagues.” – Sandy Botkin, Lower Your Taxes Big Time.
The first item to address is business losses and the chief question as it relates to this area: must you show a profit every year in order to qualify as a small business and take deductions? The answer:
If your business produces a loss in the first year, you can use that loss against any other income you have. It can be used against wages earned as an employee, dividends, pensions, interest income or against spouse’s earnings if filing jointly.
Example: Mike makes $50k at a regular job and has a small business loss of $10k. He thus pays taxes on $40k.
So, the answer is, typically, in order to audit proof your small business, you need to show a profit three out of five years. You can apply business loss against your ordinary income.
Meals and Entertainment
Meals and Entertainment deductions are one of the most approachable business deduction categories for small business owners. With adequate documentation and by following business protocol, described below, you will be able to turn your meals into legal, tax deductible business meals.
First, some highlights on the percentage of deductibility for meals and entertainment:
· Entertainment expenses are typically 50% deductible.
· If you report the full amount make sure to tell your accountant it is 100% of the expense.
· No receipts are needed for entertainment expenses under $75 but keep all business expense receipts regardless.
· You should pay attention to the amount you can deduct. Don’t report the full amount and think you are still following the rules. Meals are 50% deductible.
Also, there are rules of road to follow in order to categorize a meal as a business meal.
“A business meal must be prearranged for the purpose of conducting specific business. Your prospect must reasonably expect a business reason for the meal or entertainment.” – Botkin
As a result, you can’t just simply run into Joe at Red Lobster, sit down and munch on shrimp scampi with him and then count it as a business meal. You would need to call Joe up before going to lunch and tell him you want to discuss business. This action would qualify the meal as a prearranged business meal.
You must discuss business before, during or after a business meal to qualify for the business meal deductions and it must be with a legitimate prospect. For meal expense audit proofing, you should have a document that details a clear and specific business discussion. Also, the meal must take place in surroundings conducive to a business discussion e.g. a restaurant. A restaurant or a movie theater would not be conducive.
Again, although receipts are not required for purchases under $75, you must document your meal or entertainment expenses adequately. There are 5 main questions that need to be answered in your documentation in order to audit proof your meal:
1) Who was entertained and what is the business relationship?
Identify the person or persons, name, occupation, official title and other corroborative info to establish the business relationship.
2) Where did it take place?
A receipt will substantiate this requirement. The nature and place must also be described.
3) When did the entertainment take place?
Note the date and time in a tax diary or again, the receipt should detail this.
4) Why did the entertainment take place?
Note the business purpose – state the exact nature of the business discussion or activity. Example: “Talked about using my services including consulting on property investment.” Be brief but be very specific.
5) How much did it cost?
Again, a receipt will cover this.
Also, the IRS would prefer that you record these answers in a timely fashion. You can’t wait a year and then go back and backdate the documentation. Plus, it would not be an easy task.
In addition, if your spouse is not an employee of your company, his or her meal can still be tax deductible if you bring them along in order to entertain an opposing spouse of a business couple. This is called the “Dutch Treat” rule. Here’s the example: you meet with Ralph to discuss business at TGI Friday’s. Ralph brings along his wife Betty and you bring along your wife Sally. During the meal, Sally talks with Betty while you and Ralph discus pork futures. Your spouses’ meal would thus be 50% tax deductible along with yours.
Just make sure to name the other couple in your documentation. One method to log and archive the preceding pertinent information is to simply write on the back of the receipt and to keep the receipt.
Associated Entertainment/Goodwill Entertainment
Another form of tax deductible entertainment is associated entertainment. Associated entertainment takes place in a non-business setting that precedes or follows a substantial and bona fide business discussion during the same day as the entertainment. Thus, if you follow-up your TGI Friday lunch with a round of golf, the green fees would be considered associated entertainment and would therefore be 50% deductible. Furthermore, it would not be necessary to discuss business on the golf course. This is not a requirement necessary for associated entertainment deductibility. The golf must merely be preceded or followed by a business discussion.
To audit proof your golf round or other associated entertainment, you must have a link showing that you discussed business either before or after the event on the same day.
For a thorough tax diary that will aid you in documenting all of the necessary details, go to Sandy Botkin’s website at:
www.taxreductioninstitute.com.
Although keep in mind, the back of the receipt should provide enough writing room.
Other associated entertainment location examples include:
· Night Clubs
· Theaters
· Sporting Events
Yes, season tickets to a sporting event or other form of entertainment venue can be tax deductible but the percentage of deductibility is based on the ratio of how many games are used for business purposes. For example, if you take a client, Ralph, to eight out of ten hockey games, you would be able deduct 80% of your season tickets.
At this point, Ralph is a happy camper since he got to eat TGI Friday’s, play a round of golf and attend a hockey game.
Charity Events
Yes Virginia, you can deduct charitable donations.
If you buy tickets to a charity ball, the tax deduction for the event would not be limited to the face value of the ticket if three conditions apply:
1. The event is organized for the primary purpose of benefiting a tax exempt charity.
2. All net proceeds of the event are contributed to a charity.
3. The event uses volunteers for substantially all the work performed in carrying out the event.
So in essence, it truly has to be a charity event. Also, if you make a business gift, you will hit a $25 ceiling deduction but gifts made to an entire department within a business are tax deductible. This means you can send an entire fruit basket to your favorite IT department at XYZ Corporation or organization and the entire basket would be deductible. Ideally you would send it to the department that employs Ralph so you can ensure he is still living high on the hog.
If you gave a gift of entertainment such as tickets to a concert, they would be 50% deductible.
Home Entertainment
How much home entertainment can be deducted and where is the line on this category? Are we starting to cross a line here? The answer is no. Again, by following the rules, maintaining accurate, detailed documentation and by consulting a professional accountant, you should have no fear about the types of deductions you can take.
Yes, you can deduct home entertainment:
Example: Sam has a five minute discussion about referrals while entertaining friends at his home. One of the friends of course is Ralph. Sam can deduct 50% of the party but I still must emphasize that he had to discuss specific business. As a rule of thumb, the number at the party should be kept under 12. Anything above serves as a red flag to your friendly IRS auditor.
Also, never combine a personal event with a business event. This is a big no-no. Example: writing off your two year old’s birthday party by discussing specific business with the other tots’ parents. This does not count.
But, you can give a sales presentation at your home and the food served can be 100% deductible for the seminar/presentation. Just make sure you answer the five questions – who, where, when, why and how much money – and document, document, document.
Entertainment Recap
1. Discuss business when you eat and document who, where, when, why and how much. Make sure this is a premeditated business meal.
2. Deduct theater tickets, golf fees, movies, sports tickets and other associated entertainment if they are preceded or followed by a legitimate business meeting.
3. Deduct season tickets by taking clients (Ralph) to games. Only deduct the percentage of games you took him to.
4. Deduct your spouse’s food and entertainment expenses if it falls under the “Dutch Treat” provision where he or she is entertaining another couple.
5. You can also deduct entertainment at 100% if it is considered business promotion – a professional movie critic who goes to the movies to write a review or a golf pro who plays a round of golf with a client would qualify under this rule.
6. Deduct at home entertainment expenses by discussing specific business at small parties or by giving a presentation or sales seminar. And don’t try to deduct your two year old’s birthday party – Ralph would be ashamed.
Vacations
A vacation can be deducted if it is combined with the appropriate amount of business thus qualifying as a business trip. Vacations or business travel can be a great source of tax deductions (and fun). Of course, this is the area you want to make sure you cross your Ts and dot your Is documentation-wise.
As a rule of thumb, an overnight business trip is a trip that requires you to sleep overnight on the trip. To qualify a trip as a business trip, the majority of days spent on the trip must be for a business purpose. To qualify a day as a business day, your presence must be required for part of the day for a bona fide business purpose. For example, you deliver a document to a business partner. This would qualify as a business day. Or say you are in San Francisco and you attend a 30 minute meeting with an investment property realtor. This would qualify as a business day. For someone in the property investment business, you can spend the rest of the day sightseeing or traveling across the golden gate bridge while still maintaining business day status. Also, you must make sure that the majority of your days are business days in order to activate the business trip status.
Example: You go for a five day trip to Denver, Monday thru Friday, with meetings scheduled on Tuesday and Wednesday. Since Friday is considered a travel day, and Tuesday and Wednesday are business days because of the meetings, the trip would be considered a business trip since the majority of days, three out of five, are business days.
In addition, the IRS counts weekends sandwiched in between business days as working weekends thus, the sandwiched weekend days count towards the business day majority criteria even if you spend the days surfing.
Example: You go to Hawaii for seven days, leaving on a Thursday with meetings scheduled on Friday and Monday. Five out of the seven days will be considered business days and therefore the trip is a bona fide business trip. (Friday and Monday are meeting days with Saturday and Sunday sandwiched in between totaling four business days. The Thursday return is considered a travel day for a total of five. Thus, you meet the majority business day criteria.)
This is what it looks like table-wise:
Document, Document, Document
The chief tactic to make your business travel audit proof is to schedule appointments in advance and keep the documentation proving that you made and kept those appointments. For example, if you e-mail a real estate office setting up an appointment in order to discuss investment property, you need to print and keep your sent e-mail as well as the acceptance reply you receive from the realtor. Also, when you meet with the realtor, make sure to grab his or her business card along with sample property listings in order to substantiate the business meeting.
The Expenses That Can be Deducted
If it is a business trip, you get to deduct 100% of
· Hotels on business days
· Dry cleaning
· Tips
● 50% of food on business days.
Transportation Expenses
These are costs incurred traveling on the road to and from the destination; airfare and car costs. One hundred percent of transportation expenses are deductible on a business trip.
On the Road Expenses
As a rule of thumb, these are all costs necessary to sustain life on the trip and include lodging, meals, laundry, dry cleaning. You can deduct the first laundry and dry cleaning expenses when you get home as long as the clothes were soiled on the trip … so get to soiling!
· You are allowed to deduct on the road expenses for each day you are on business travel status. You may deduct 100% of on the road expenses but when it comes to meals, only 50%.
· You may not deduct the cost of entertainment not associated with a business nature or prospecting.
· To make your spouse’s business travel expenses tax deductible, hire her or him as an employee of your business. Otherwise you deduct the cost of one.
· All of your business car expenses are deductible, even with non business riders.
· Deduct a hotel at the single occupancy rate if you are the only deductible one on the business trip. Grab the rate card off of the back of the door for documentation purposes.
Business Trip Expense Recap
Again, clear business intent must be established before you leave for the trip. Make sure to hold on to copies of e-mails for appointments made at least a few days prior to departure noting the day time and place of the scheduled meeting. Also obtain documentation that proves you were there – business cards and paper work. Again, document, document, document.
Also, remember also that more than one half of the days must include either:
• Business travel
• Appointments for at least 30 minutes
• A weekend sandwiched in between
• Document delivery
So, if you are gone for 7 days, Friday thru Thursday with meetings scheduled on Friday and Monday:
Because of this status:
• 100% on the road expenses are deductible(hotel, dry cleaning, tips)
• 100% travel expenses (airfare, car rental)
• 50% on the road expenses (applies to food)
To audit proof your travel, document the following:
1.) The amount that you spend daily for such things as
transportation, meals and lodging.
2.) The dates of your departure and return home from each trip and
the days spent on business while away from home.
3.) Where you traveled. Describe the name of the city, town or similar
destination.
4.) Why you traveled, including the business reason for your travel or
the business benefit derived or expected to be gained. (as specific
as possible)
5.) The preexisting business intent: correspondence sent to
prospects, documented phone calls, appointments in advance, etc.
Home Office
According to Soliman vs. the US Supreme Court – the leading precedence on home office business deductions, anyone who truly works out of his or her home and performs his or her most important functions at home can take the home office deduction. This would include network marketers, freelance writers, musicians who do most of their practicing at home and consultants who do most of their important work out of their homes.
First and foremost, your office must be used solely for business purposes. You cannot have a guest bed, a book shelf containing books not related to your business a treadmill nor a box of the kids’ toys just to name a few examples. The IRS is pretty stringent about this and yes, it is possible that they will check and disallow your deduction if you do not meet the requirement.
There are three methods that you can use to figure out how much you can deduct.
• Method One: the amount of office square feet divided by the total usable square footage of the house.
• Method Two: the number of rooms the office occupies divided by the total rooms in the house.
• Method Three: net square footage method (similar to method one except you subtract out the common areas such as hallways, entranceways, landings and stairways.)
Run the numbers and use the approach that leads to the biggest deduction for your situation. You might want to consult your accountant on the home office business deduction since you run into home depreciation recapture complications when you go to sell your home if you take this deduction.
Also, don’t forget that you can deduct more rudimentary things such as office supplies, internet connection, the cell phone used for business. These are more of your straightforward, typical business deductions and should not be subject to intense scrutiny. Still, keep those receipts.
Audit Proofing, Recapping and of Course, Ralph
Just to restate the initial premise of why you should turn your hobby into a small business, the rich are getting richer through legal, justifiable tax breaks via their businesses and now, after reading this piece you can do the same. By aggressively shifting as many of your personal expenses into legitimate business, tax deductible expenses, you can take advantage of a plethora of tax breaks allowing you to retain more income in order to acquire cash flow generating assets that propel you to financial independence at an early age.
By taking action on the information detailed above you can deduct meals and entertainment, associated entertainment, charity events, home entertainment, vacations and your home office. If you are considering starting a small business, these tactics alone will give you an immediate initial leg up in your venture. You will already be employing a money making strategy off the bat or at least, a money saving strategy. If you are looking to increase your net worth or cash flow, this strategy of starting a small business will allow you to keep more of your income in order to build your assets.
Audit Proofing
In real estate the most overused, clichéd, expert advice is “location, location, location.” In small business tax deduction strategy, it is “documentation, documentation, documentation.” If you are going to be aggressive about your tax deductions (and you should be) then you need to ensure you can sleep well at night by having ample documentation to backup your deductions.
Documentation Requirements:
• Keep All Receipts
Although you are only required to keep receipts for expenses over $75, keep them all. I like to keep all receipts, personal and business, noting on the receipt whether it is personal or business and then what category it falls under. According to Robert Allen in “Multiple Streams of Income,” by doing this, in addition to verifying that the receipt is accurate, you can save tons of money over the years.
• Log Your Time
If you are promoting a hobby up to a business, keep a business journal denoting what date you worked on your business, how much time you spent and what activity you performed. The whole key here, along with creating a business plan and financial projections, is to prove you are running your business as a business. One of the biggest tactics of the IRS is to classify your business as a hobby thus disqualifying most, if not all of your deductions. You want to insure against this by documenting the time you spend in the business and don’t backdate a journal at the end of the year. Log it as you go along.
Also, it is better to work an average number of healthy hours per week, say 15 to 20, rather than cramming in 40 hours all at once at the end of the month. The first example communicates that you are putting steady time into growing a legitimate business. The second communicates that you might not actually be tracking time and instead, bulk loading it at the end of the month, thus a red flag. Don’t do this.
• Audit Sheet for Expenses
As I said earlier, there are five questions you need to answer for deducting business meal and entertainment expenses. Again, these are:
1) Who was entertained and what is the business relationship? Identify the person or persons, name, occupation, official title and other corroborative info to establish the business relationship.
2) Where did it take place? - get a receipt. The nature and place must also be described.
3) When did the entertainment take place? Note the date and time in a tax diary.
4) Why did the entertainment take place? Note the business purpose – state the exact nature of the business discussion or activity. “Talked about using my services – consulting on property investment.” Be brief but be very specific.
5) How much did it cost? A receipt will cover this and can be used to document the information.
Also, you should track travel details including hotels and overnight expenses. For a really great log sheet product, visit Sandy Botkin’s website at www.taxreductioninstitute.com. This site has a tax log product that will help you document the 5 questions for meals and entertainment as well as travel expenses.
• Mileage Log
Business mileage can be tracked in a standard mileage log book available at most local office supply warehouses.
• Documentation for Travel
Again, with business travel, make sure to capture supporting evidence proving business intent for the trip; business appointment e-mails, business cards from the trip, MLS listings, room rate cards, etc.
• Show a Profit Three out of Five years
You can lose money and apply the loss to your regular income but you must show a profit for three out of five years to prove profit intent. If you run it at a loss for many years it will prove to be just that, a tax write off and your deductions will be disqualified.
•Intention to Make a Profit
Documents such as a business plan and a financial plan showing growth and eventual profit, will prove your intentions to eventually make a profit. These supporting documents should serve as the proof in the pudding.
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