Accounting and Taxes

The Truth about Write-Offs
Retirement Savings
Business Tax Schedules
Manual Accounting vs. Software
Accountants and Tax Preparers
Insurance and Other Necessary Evils
Workers Comp
Is Cash King?
Incorporation vs. Sole Proprietorship

The Truth about Write-Offs (Book Excerpt)

Everybody who's not in business and knows somebody who is, has heard of that wonderful thing called a write-off. Maybe a friend has treated you to lunch or paid the tolls on a road, with a wink and a "It's a write-off." Maybe you've already talked to an accountant who's told you about saving all your receipts so they can be written-off. Write-offs work like this: when you file your taxes at the end of the year, you get to subtract your business expenses from your business income. INCOME. So, for starters, you need to be making money to benefit from write-offs. Many business expenses are unavoidable, but here we're applying the term "write-off" to purchases you didn't absolutely require. We're going to use some round numbers and generalizations in the following paragraphs for the sake of illustration. Income tax rates change frequently, and taxes are highly dependent on an individual's situation in life, number of children, etc. However, the principles illustrated by these examples hold; it's just the percentages that may change. The discussion gets a little complicated, but we sum it up in a table at the end.

Now, take the example used in Setting Prices of a first year in business where you do $200,000 in gross sales your first year and end up with a gross profit of $28,000. In that example, I allowed you $8,000 for non-critical expenses (which were already figured in). Keep in mind that by spending this money on allowable deductions, you no longer have it in your pocket. It's gone. So you reduced your net profits from $28,000 to $20,000, but what does that save you?

Self-employed people are subject to self-employment tax, in which you make the Social Security and Medicare payments that are deducted from all workers' paychecks (yours in this case), plus you make the employer's matching contribution. This runs 15.3%, meaning that by reducing your self-employed income by $8,000, you already saved $1,224 on your taxes. Your total self-employment tax payment is $3,060. This does come at the price that your eventual Social Security benefits will be lower, since you contributed less. You do get to deduct half of that self-employment tax from your income, and between that and the standard deductions, your taxable federal income will be down under $12,000.

Let's say you are living on the cheap and you make a $2,000 IRA contribution (also money out of your pocket), and your taxable income is down to $8,970. You pay the 15% marginal rate on that income (the minimum rate is 10% but we're using 15% to simplify math), which means your income tax bill is $1,345, and your total Federal Tax bill is around $4,405. Pay another $449 in state or city tax (5% for our example), and you have a total tax bill of $4,854 and an after tax (and voluntary IRA contribution) income of around $15,146.

Now let's say you had no business write-offs, keeping in mind that merchandise you buy and sell (inventory) is not a write-off. You would have paid 15.3% self-employment tax on $28,000, or $4,284. You would then have paid income tax (same $2,000 IRA contribution and deductions) on around $16,358 at the same 15% marginal rate for a $2,456 Federal Income tax bill, and a total Federal Tax bill of $6,738. Your state tax will have crept up a few hundred dollars to $817, and your total tax liability on the year is $7,557. Strangely enough, that leaves you with $20,443 in pocket money. So, generating $8000 in write-offs saved you over $2,500 on your tax bill, but you ended up with $5,297 less in your pocket and a decreased Social Security benefit. What happened?

That $8,000 you spent on flying to the PC show in Ve-gas, a new tilt-and-swivel leather chair, and the gaming laptop is gone. You don't have it anymore. The good side is, not having it, you don't have to pay taxes on it. The bad side is, not having it, you really don't have it. What you've essentially done is purchased those things you wrote-off at a discount. That discount, ignoring again the marginal drop in Social Security benefits, is the $2,703 you save on your tax bill divided by the $8000 you spent, or 34%. Basically, that discount remains constant until you push your income into the next tax bracket, for which you'll need to sell quite a few more computers. Again, the only way to earn that discount is to buy stuff, which means the money is gone. We give a line-by-line replay of the situation in the following table. Note that I've simplified the 2013 tax bracket as 15%, although some of the money will likely end up in the 10% bracket, but tax laws are fluctuating at publication time.

Net Profit (Schedule C) after required expenses $28,000 $28,000

Unnecessary expenses (Write-Offs) $8,000 $0

Net Income for Self Employment Tax (SE) and Income Tax (1040) $20,000 (15.3% tax = $3,060) $28,000 (15.3% tax = $4,284)

1/2 Self Employment tax $1,530 $2,142

IRA Contribution $2,000 $2,000

Standard Deductions (approx) $7,500 $7,500

Taxable Income $8,970 $16,358

Federal Income Tax (2001 year) $1,345 (15% bracket) $2,456 (15% bracket)

Income Tax + Self Employed Tax $4,405 $6,740

State Tax (Depends on State) $449 (5% for example) $817 (5%for example)

Total Taxes $4,854 $7,557

After Tax Earnings $15,146 $20,443

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