Business ownership offers many potential rewards: freedom, independence and financial security, to name the biggest. One benefit that is somewhat less discussed, however, are tax breaks. The fact is, business owners are capable of lowering their tax bills in ways that salary or wage employees can only dream of.
Take advantage of these opportunities, and starting a business may wind up being the best legal tax avoidance strategy you ever used.
While losses are never something to be hoped for or expected, it is true that business owners can deduct operating losses from their personal income tax returns. SmartMoney offers the following specific example as guidance on how to practically apply the net operating loss (NOL) deduction:
Say your business generated a $100,000 NOL in 2008 which you chose to carry all the way back to 2003 (the fifth year before 2008). You used up the entire NOL to offset 2003 income and got a big tax refund. Now it looks like your business will run up another $100,000 NOL for 2009.
Under the new law, you can choose to carry this year’s NOL back as far as 2004 (the fifth year before 2009). Say your 2004 taxable income was $80,000. Under the 50% limitation, you can use the NOL carryback to wipe out $40,000 of 2004 income (50% of $80,000). You can then use the remaining $60,000 of NOL to offset income from 2005-2008 (there’s no 50% limitation for carrybacks to those years.)
Additional examples are offered in the same article. The basic, underlying principle of this is that losses can be used to reduce your taxable income (and overall tax bill.)
Business owners can also reduce their tax bills by deducting any “ordinary and necessary” business expenses incurred during the year. In their overview of deducting business expenses, Entrepreneur.com categorizes the deductions businesses are entitled to into three categories:
- Current expenses
- Amortized costs of long-term investments
- Cost of inventory
Current expenses are deductible at the time that expense is paid, and include such things as office supplies and rent on buildings or equipment. Deductions of long-term investments “must be spread out over time so that the cost of using the business asset is matched better to the lifetime of the asset” – otherwise known as depreciation. Inventory, meanwhile, is deducted against the income generated when that inventory gets sold.
Unlike regular employees, business owners can deduct most of your health care costs. This includes health insurance policies, contributions to Health Savings Accounts and/or out of pocket money spent on needed medical procedures. About.com explains the self-employed health insurance deduction as follows:
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Before claiming this tax deduction, you must calculate your allowable health insurance deduction. Take your self-employment income, and subtract the 50% deduction for self-employment taxes, and subtract any retirement contributions you make to SEP-IRA, SIMPLE-IRA, or Keogh plan. The remainder is your allowable deduction for health insurance expenses.
As with any deductions, record keeping is key. Regularly document your health care expenditures and store them somewhere they can easily be accessed in the event of an audit.
Education & Training
Another excellent way that owning a business can trim your tax bill lies in education and training expenses. As a self-employed business owner, you are eligible to deduct, in full, the costs of any and all education you consume. While this does not generally include the cost of a college degree, it does include such things as:
- Instructional seminars or workshops
- Home-study courses
- Magazines related to your field
- Industry trade journals
- Personalized instruction or business-related skills training
Since smart business owners tend to consume this sort of training anyway, the fact that you can also deduct it from income taxes is icing on the cake and yet another way to minimize your overall tax burden. Note that you may not deduct education costs which, to use IRS language, are required “to meet the minimum requirements of your present trade or business.” For instance: if you need a license (but do not currently have one) you cannot deduct the costs of obtaining it.
Larger Retirement Contributions
Self-employed businesspeople can make far larger tax-deferred retirement plan contributions than employees. The most stark example of this is the Solo 401(K) plan. In an article on these incredible retirement programs, the Wall Street Journal uses, as an example, a 51 year old sole proprietor with business income of $100,000 per year. If this person used a SEP IRA, they would be limited to investing only $18,600 – which is 20% of $92,936 ($100,000 – half of this person’s self-employment taxes.)
With a Solo 401(k), however, this same person could put away $22,000 plus 20% of 92,936 – or about $40,600 in total retirement account contributions. The IRS is not eager to spread the word about these favorable plans, but they are most certainly available to the self-employed and should be considered.
About the Author: Tim Coffman is a freelance writer for Quicken. Quicken offers personal finance software that makes money management easy. Quicken’s products help people get their spending under control with helpful budgeting tips.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.