Sunday, March 12, 2017

Can You Incorporate Your Life? No, You Can't.

If businesses can "write off" all their expenses, why can't you?  You are not a business!

A reader asks about an old canard that I have heard since I was a youth.   When I was a kid, someone would tell me, usually between bong hits, that there was a way to "incorporate" yourself and then make your personal life into a business, write-off all your personal expenses as deductions, and avoid paying taxes entirely.

It is a nice pot-fueled fantasy, but it is sadly just fantasy.  That doesn't stop con-artists on the Internet from selling you brochures or books or "kits" or holding seminars or whatever, to get you to pay cash-money to educate you about such schemes.   At best, you are out $50 for the the "Information Packet" and at worse, you spend years being audited by the IRS and end up bankrupt due to penalties and interest - and maybe even go to jail for tax fraud.

Some fun, eh?

But it begs the question, why do businesses get to deduct expenses and people do not?  After all, "corporations are people, too!" according to Citizens United.

Well, first of all, you don't need to incorporate a business to deduct expenses.   There are three basic forms of businesses - sole proprietor, partnership, and corporation.   There is nothing special about a corporation in terms of tax deductions.  

The main advantage to a corporation is to shield yourself from personal liability.  For example, someone slips on the porch of my rental property, they can only sue the corporation, not necessarily me (in some cases, anyway).  That is the entire idea behind corporation - hence the name "Limited Liability Company" - shareholders of GM are not liable for design defects in the cars.

But incorporating doesn't create special magick with the IRS that makes non-deductible expenses suddenly deductible.

So why are business expenses deductible and your personal expenses not?   Well, a business incurs expenses to make more money.   So if you run a company and receive $100,000 a year in gross income, but spend $75,000 a year in rent, wages, local taxes, and cost of materials, you should not have to pay taxes on the whole $100,000 but rather only the $25,000 "net profit" that you made.

And this concept eludes a lot of people, even the financial reporters in the press, who breathlessly report a company's increasing "revenues" but fail to mention declining profits.   Revenue is fine and all, but a trillion dollars in revenue means nothing if you have expenses of 1.1 trillion dollars.    Profits are what matters.  Profits are what is taxed - for the most part, anyway.

In your personal life, your personal expenses are not something you use to make more money, unless you run a real business - and we'll get back to what constitutes a "real" business in short order.   You can't say, "Well, in order to get a paycheck, I need somewhere to sleep and eat and clothes to wear, so those are all expenses I have to make to keep the business of Me, LLC going on a daily basis!"

Nice argument, it won't fly with the IRS.   You see, eating, sleeping and wearing clothes are all things you'd do even if you didn't work at all, and thus are not related to your "business" of working for a living.

"But what about car expenses?  I have to commute to get to to work!"  And here is where it gets tricky.   The IRS decided that commuting expenses are not tax-deductible.   But if you are a Real Estate agent, and have to drive to a property to show it to clients, those miles driven are deductible.   And in fact, if you buy a car just to drive clients around in, the entire cost of the car can be depreciated (deducted over a number of years) or if leased, the annual lease payments deducted every year (which is why business use is really the only time leases make sense).

It is a bit of a grey area, of course.   For example, let's take food.   No, you can't deduct the food you eat as a business expense, because that is something you do anyway, and not directly related to the business.   But if you take a client out to dinner at the $15 Baked-Potato Steak House, you could deduct that entire cost of the meal in years gone by.   The IRS finally decided that maybe you enjoyed that steak too much, and cut the deduction to 50% or so, as a compromise between something that is a business expense and something you'd do anyway to survive.

Like I said, it is a gray area, and often arbitrary decisions are made about what is and what isn't deductible.

If you are an independent contractor or run your own business from home or whatever, you can deduct, legitimately, a lot of things.  But what is and isn't deductible is often a factor of what the IRS thinks this year, so it pays to hire a good accountant or understand the law, the rules, and the procedures.

For example, the home office deduction allows you to deduct a certain square footage for a home office.   In the early days of this deduction, a lot of people abused it, claiming home-based businesses or claiming they needed a home office for their work job - where they already had an office.   The IRS clamped down and for several years, making the home office deduction was pretty much an automatic audit.   You learn to avoid "audit-bait" by making sketchy or outlandish deduction claims.

The IRS finally relented, recognizing that a lot of people (such as myself) are contractors and need a home office.   The deduction isn't huge, but it helps bring down your business income.   But you do need to have a legitimate business to make the deduction.  And it helps if your home office is your only office.   If you have a salary W2 job, odds are, deducting a home-office will be audit-bait.  If you have an office in an office building and also want to deduct a home-office, you may be able to deduct a certain percentage of it, but again, it might also be viewed as audit-bait (two office deductions?  Don't get greedy!).

The IRS also has internal guidelines (not published that I know of) as to what is to be expected as a "normal" range of deductions for a given business.  In my case, my deductions are far less than the range, as I err on the side of caution.   Others, including a friend of mine who was an IRS agent (and Real Estate Agent) were less cautious, understanding the system better than I did.   He deducted a car, meals, and all sorts of stuff - all legitimate business expenses of course.  But I never intentionally set out to have a meal with clients, just to get the deduction!

Again, if your deductions exceed these guidelines, you are audit-bait, and you can pretty much expect to get audited, which is a pain in the ass, and likely some of your deductions will not be allowed, and you may owe back taxes, interest, and penalties.

But in the world of tax law, making improper deductions is not as bad as failing to report income, which is the real audit-trigger of all time.   And pretty easy for them to catch, too, if the person paying you files a 1099 form with the IRS.   Unreported income can put you in jail.

Improper deductions can get you in trouble too, if it was shown that you intended to defraud the government.  Leona Helmsley famously said, "only the little people pay taxes" and joked about deducting her girdles as "uniform expenses" - and saying all this in front of a disgruntled employee.  The IRS made quite a show of her trial, which they do on occasion to scare the snot out of the rest of us.   It was sad, too, that Leona would take such a trivial deduction as a girdle, when she had much bigger tax issues to deal with.

Speaking of which, are uniforms deductible?   If your employer requires you to wear a uniform, and that uniform is not clothing you ordinarily wear for other purposes, then yes, it is tax deductible.   So your uniform jumpsuit or hospital scrubs are tax-deductible, if you are forced to pay for them.   But a suit-and-tie or Izod shirt and Khakis is not.   If you ran a company and forced everyone to wear color-coded jumpsuits (like Dr. Evil does) they could deduct the cost of these uniforms.  Or, as employer, you could provide them as a tax-deductible (to you) benefit to your employees.

But ordinary clothing?  No.  Sorry, Leona, a girdle is not a uniform!

But what is a "legitimate business" anyway?   Could you take a hobby of yours and turn it into a business and deduct all your hobby expenses?   Yes and No.  The IRS has rules about  "Hobby Businesses" which can seem a little unfair at times.

For example, my Mother ran a bookstore in town for several years.   She lost money nearly every year, and after about five years of claiming losses (which offset my Father's income) the IRS came calling, claiming she had a "hobby business" and was creating artificial losses.   It was a pain in the ass to settle the case, and she didn't know what any tax accountant would tell you, and that is you should declare a profit every so often.

It is a difficult area to be sure.   And what qualifies as a "hobby" and "business" is often hard to parse.

For example, Jim likes to race cars.  He buys an old race car and races it on the weekends, usually coming in last or late in the field.  A few times he comes in 3rd place and takes home a small trophy and check.   He thinks about declaring his hobby a business.   He invests in a better car and acquires sponsors who provide him with free or reduced prices on tires and auto parts, or pay to have their business advertised on the side of his car.

But of course, you don't win races overnight, and it costs a lot to drive to the different tracks and prep the car for racing, make repairs when it crashes, manage the books, and so forth and so on.  And all of this while he has a regular 9-to-5 job to go to.   But over time, his finishes get better and better, he comes in 2nd, and even 1st in some races.  The prize money gets bigger, but he still is losing money. 

He can't quit his job and race full-time just yet, as there isn't even a profit to be had from this.   He can deduct his expenses up to the income he is making from racing, which is the same as paying no additional tax, but he gets no loss deduction - if his business is classified as a "hobby business".   Again, this is a gray area.

But suppose he starts to win more races, gets more sponsors, and actually makes money at racing?  Isn't that a "legitimate business" and not a "hobby business"?   The same IRS that would have denied his deductions earlier, will now come calling asking for taxes on his profits.  In a way it isn't fair, but it illustrates why the Jim's of the world need a good tax accountant.

In way, your personal life is the ultimate "hobby business" which is to say it is not a business at all.  You can't deduct your life expenses as a business.  And you can't deduct personal expenses as part of even a legitimate business - although a lot of people try this (and many get away with it on a small scale - pigs get fat, hogs get slaughtered).

This is not to say that a celebrity can't deduct a lot of what could be personal expenses as business ones - the line gets blurred.  The Kardashian (sp?) sisters fly to New York on a chartered jet and stay at the Trump hotel, and then are interviewed on the Today show.  They can legitimately argue that what would be a vacation trip to New York for you and me was a "business trip" to promote their "Brand" or whatever.

But you and I are not celebrities.

Some folks suggest that you create a "business" and then use business deductions for your personal expenses.   For example, this "Financial Samurai" guy seems to suggest that you should start a business just for the hell of it, and then make deductions (scroll down to the end of the article).  Again, the problem with this model is you run into the hobby business rules, and if your "business" is all deductions and no income, then you will get audited and will likely be socked with taxes and penalties.

But his posting does illustrate the grey areas of deductions.  I buy a box of paperclips for my business and use them to clip together client papers - and deduct the expense.   If I use three of those paperclips in my personal scrap book, am I a tax cheat?   If I buy a computer for "business use" and then spend a hour playing computer solitaire on it, am I a tax cheat?   Again, there are gray areas and also de minimus infringements that the IRS isn't going to go after.   Pigs get fat, hogs get slaughtered.   People cheat a little bit around the edges and don't get caught.  But the folks who claim to owe no taxes due to deductions are sure to get beaten down in due course.

I would not take advice from "Financial Samurai" in that regard.

As I wind down my personal business, I realize I will miss some of those nice deductions I had as a sole practitioner.   From now on, if I want to buy a computer or a cell phone, it ain't a tax-deduction - nor is my internet service or cell phone service.   But then again, you can't deduct your way to wealth, as I have noted before, and the IRS code is not an investment guide.

People, for some reason, obsess about avoiding paying taxes, which of course, is important to do - legitimately.  But if you have this monocular vision that taxes are the whole enchilada when it comes to wealth creation, you will miss the larger picture.  Most of us only pay 15% or so in taxes.   Trying to make 15% more isn't going to make you spectacularly wealthy over time.   Making more money, on the other hand, will.

And yes, I "get it" with what "Financial Samurai" is saying.  When I was making the six-figure salary, I had rental properties that I depreciated that offset my income very nicely.   And I took every legitimate deduction I could think of.  But I didn't create businesses for the sake of deductions, because I took courses in tax law and understood that "audit bait" means.

Death and Taxes - both are inevitable.  People obsess about taxes, for some reason, and I think in the end, it becomes an obsession - almost a mental illness. For example, this poor bastard, who died in jail after being a "tax denier" for decades (and making a lot of money selling books about it).  Folks laud him as a "hero" but I would say he is more of a "zero."   Sacrificing your own life to avoid paying 15% to Uncle Sugar.   What's the freaking point of all of that?

Oh, right, he made money from selling book about it.  The poor bastards who followed his advice ended up in a world of woe.

Just go out and make more money - legitimately.  It's a lot easier that obsessing about taxes.