Thursday, December 15, 2011

Deductions Versus Tax Credits - Part I

When you hear someone say, "well, that's a deduction!" or "you can write that off!" just slap them, please.

Many folks have a lot of misapprehensions about tax deductions and tax credits, and mostly, don't understand the difference between them.  And they don't understand that even within the field of deductions, that there are deductions for expenses (say, for a business) and deductions that are more like incentives (mostly for individuals).

And in fact, most people have only vague ideas how taxes work at all, which is why they like to say stupid things like, "let's have a flat tax!" - which would actually increase their tax burden and decrease taxes on the wealthy.  Yea, it is true,  dumb people, who are almost always poor people, think that a flat tax is a swell idea - which illustrates why the poor stay poor.

Another thing you will hear them say is things like "Well, that's a deduction!" as if you can make money on tax deductions.  Or, if you lose money as a businessman, they say, "Well you can write that off!" as if a write-off was a profitable enterprise.  I don't know how many times I heard, when I was at GM, some Union lackey saying things like "Well, they can write that off!" as if GM made money on losses.

All a "deduction" means is that you don't pay taxes on the money you spent or lost.  And since our tax rates are well below 100%, you cannot make money on a deduction.  You can only ameliorate a loss or expense.

Trying to get rich by seeking out deductions (like buying a more expensive home to increase your tax deduction) is idiotic.   You are still spending money - you don't come out "ahead."  And yet, during the Real Estate meltdown, many people tried to do just this.

So what are deductions and tax credits?  Let's try to illustrate with some simple examples.  I will divide this into a number of postings, as it is a large topic.

1.  Business Deductions for Expenses

Suppose you set up a lemonade stand on the 9th green at the local golf course (as we did as kids - thirsty golfers need a drink by the 9th hole!).  You spend $5 on lemons, sugar, a bag of ice, and paper cups.  After a long day's work, you earn $20 in sales.

So, how much money did you make?  Believe it or not, a lot of Americans would say you made $20.  No, really!  They have no idea of what the definitions of "gross receipts" and "net profit" mean.  And they cry angrily when companies are taking advantages of "loopholes" to not pay taxes on huge gross receipts, when in fact they made little.

If you have half a brain, you realize that your gross receipts were $20 and your expenses were $5, and thus your net profit was $15.  And if you fill out an IRS form 1040 Schedule C, there are places where you put in these numbers.

Your $20 is your gross income (total gross receipts, line 1d), your $5 in costs (line 4) and your gross profits (the $15) is line 7.

Yes, you deduct your expenses from your gross receipts, before paying taxes on your profits.  Those are deductions, and there is nothing "loophole" about them.

But what about other deductions?  Well, it gets more complicated after that.  For example, suppose you put all your supplies in a Radio Flyer wagon to take them to the golf course.  You own the wagon, but your use of it in business, dragging it a half-mile to the course, wears on the tires and wheels.  Isn't there a real cost involved in using the wagon?

And the IRS recognizes this and allows you to deduct  this actual cost from your profits.  The problem is, how to deduct it?  You could take a certain allowance per mile, say 51 cents a mile.  This obviously is not an exact calculation of the wear and tear on your wagon, but a flat number they came up with, based on the average cost of operating wagons.  Accounting is not an exact science, and neither is tax law.  And you would enter that expense on line 9.

But, suppose instead you decide to BUY a wagon to use for your business?  Say you buy a brand new wagon for $50 and use it ONLY for your lemonade business?  Well, that is an expense, and it should be deductible.

But how?  You could subtract $50 from your income ($15) and end up with a negative $35 in profit.  So you would owe no taxes and show a loss!  You might be allowed to carry over that loss to subsequent years, thus deducting the remaining $35 from the next year's income.

But the problem with expensing items like this, in a single year, is that they do tend to wipe out all your corporate profits, so you show a zero income, even though you now have a shiny new red wagon.  (And now liberals are protesting your lemonade stand for "not paying taxes!" by using "loopholes").

Another approach is to depreciate the wagon, over a number of years.  Once again, the word depreciation does NOT mean anything is really depreciating (although in this instance, a used wagon is) but is just a term to indicate a tax concept.  IIn order to understand depreciation, get the idea out of your head that something is running down or wearing out.  Depreciation, in tax law, is just a number, not a description).

Here, we would write off the cost of the wagon over a number of years, say, five.  So instead of expensing the wagon by deducting $50 from your income in one year, you would depreciate it by writing off $10 every year, for five years.  Consult your tax accountant for actual depreciation schedules, of course.

If we depreciate the expense then your net profit is going to be $5:  $20 minus your $5 cost of materials, minus the $10 depreciation expense on the wagon.  And for the next four years, you would get a $10 depreciation expense on the wagon as well.

And there are, of course, other deductions as well - your advertising, your telephone costs, wages you pay to employees, and the like.

Say...Wages paid to employees!  Those are tax-deductible, like any other expense.  You would think that would be self-evident, but you'd be wrong.

One of the "arguments" made in these tax debates is that if we eliminate the Bush Era 2% Tax Cuts for the Rich, small businessmen would hire fewer people!  But as you can see, since wages are deductible, this is a nonsensical argument.

Increasing the personal taxes on the owner of a company would give him no incentive to not expand his business.  Not hiring an additional person would not lower his taxes or increase his income.  You hire people to make more money, and if you hire fewer people, you make less money, period.

And if you are hiring more people and they aren't making you any additional money, why would you hire them in the first place?  You wouldn't.  And what your personal tax rates are would not affect the decision.

But the people who make these "arguments" that increased personal income taxes would cut hiring seem to be under the impression that income taxes, for a businessman, are assessed on his GROSS RECEIPTS and not his net profits.

Like I said, people don't understand the most basic things about deductions!

So, business expenses are deductible.  That seems pretty simple and easy to understand.  And you can see also, that depending on whether you depreciate or expense a deduction, you can show wildly different profits, for a given year.  If you have a huge expense in one business year, and are allowed to expense it on your Schedule C, well, you can show zero profits - for that year.

But of course, next year, you won't have that deduction, so you may end up paying a lot more taxes then (but you end up with a tax holiday for a year, which is worth something!).

And from a taxpayer point of view, expensing is preferable to depreciating over time, as the bookkeeping is a lot less work, and a lot less hassle.

For example, you buy a computer.  It costs $500.  Now, in the olden days, the IRS thought computers were all IBM System 360 mainframes, and were "expensive" items that would have to be depreciated over several years.  But $500?  That is a different story, and the rules had to be changed accordingly.

And of course, one way around the expensing/depreciation problem for large-ticket items is leasing.

Yes, to a company, leasing can make sense.  To you personally, it is stupid.  If you lease something, for your business, however, whether it is a new car, a computer, or even a new boiler, you can write off - that is to say expense - the lease cost every year as a single line-item expense.   No complicated depreciation calculations to deal with, just a simple expense to write off.

But again, a deduction is not a profit center.  Just because you can deduct the cost of a lease from your income, does not mean that going out and leasing 100 new cars will make your business profitable - it will just mean you are broke and have a parking lot full of cars.  You cannot deduct your way to wealth just as you cannot eat your way to slimness.

Next:  Business Deductions gone Wild!