Tax Deductions for Professionals By Attorney Stephen Fishman 3rd edition Third Edition JANUARY 2008 Editor DIANA FITZPATRICK Book Design TERRI HEARSH Cover Design SUSAN PUTNEY Proofreading ROBERT WELLS Index SONGBIRD INDEXING SERVICES Printing DELTA PRINTING SOLUTIONS, INC. Fishman, Stephen. Tax deductions for professionals / by Stephen Fishman 3rd ed. p. cm. Includes index. ISBN-13 978-1-4133-0782-5 (pbk.) ISBN-10 1-4133-0782-5 (pbk.) 1. Professions Taxation Law and legislation United States. 2. Professional corporations Taxation United States. 3. Tax deductions United States. I. Title. KF6495.P7F57 2008 343.7306'7 dc22 200702345 Copyright © 2007 and 2008 by Nolo ALL RIGHTS RESERVED. Printed in the U.S.A. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the publisher and the author. 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Table of Contents I Your Tax Deduction Companion 1 1 Tax Deduction Basics How Tax Deductions Work 6 The Value of a Tax Deduction 9 What Professionals Can Deduct 12 2 Choice of Business Entity Types of Business Entities 19 Limiting Your Liability 26 The Four Ways Business Entities Are Taxed 33 Comparing Tax Treatments 39 Should You Change Your Business Entity or Tax Treatment? 63 3 Operating Expenses Requirements for Deducting Operating Expenses 70 Operating Expenses That Are Not Deductible 75 Tax Reporting 76 4 Meal and Entertainment Expenses What Is Business Entertainment? 80 Who You Can Entertain 81 Deducting Entertainment Expenses 82 Calculating Your Deduction 86 Expenses Reimbursed by Clients 91 5 Car and Local Travel Expenses Deductible Local Transportation Expenses 94 The Standard Mileage Rate 99 The Actual Expense Method 101 Other Local Transportation Expenses 113 Reporting Transportation Expenses on Schedule C 114 When Clients Reimburse You 115 Professionals With Business Entities 115 6 Long Distance Travel Expenses What Is Business Travel? 122 What Travel Expenses Are Deductible 127 How Much You Can Deduct 129 Maximizing Your Business Travel Deductions 139 Travel Expenses Reimbursed by Clients 142 7 The Home Office Deduction Qualifying for the Home Office Deduction 146 Calculating the Home Office Deduction 158 How to Deduct Home Office Expenses 167 Audit-Proofing Your Home Office Deduction 171 8 Deductions for Outside Offices If You Rent Your Office 174 If You Own Your Office 177 If You Lease a Building to Your Practice 187 9 Deducting Long-Term Assets Long-Term Assets 191 Section 179 Deductions 194 Depreciation 204 Tax Reporting and Record Keeping for Section 179 and Depreciation 226 Leasing Long-Term Assets 228 10 Start-Up Expenses What Are Start-Up Expenses? 234 Starting a New Practice 235 Buying an Existing Practice 237 Expanding an Existing Practice 238 When Does a Professional Practice Begin? 239 How to Deduct Start-Up Expenses 241 Organizational Expenses 244 11 Medical Expenses The Personal Deduction for Medical Expenses 249 Self-Employed Health Insurance Deduction 250 Deducting Health Insurance as an Employee Fringe Benefit 253 Adopting a Medical Reimbursement Plan 258 Health Savings Accounts 264 12 Retirement Deductions Why You Need a Retirement Plan (or Plans) 280 Types of Retirement Plans 285 Individual Retirement Accounts—IRAs 286 IRAs for Businesses 291 Qualified Retirement Plans 295 Keogh Plans 298 Solo 401(k) Plans 299 Roth 401(k) Plans 300 13 Inventory What Is Inventory? 302 Do You Have to Carry an Inventory? 305 Deducting Inventory Costs 306 IRS Reporting 308 14 More Deductions Advertising 313 Business Bad Debts 315 Casualty Losses 321 Charitable Contributions 323 Clothing 325 Disabled Access Tax Credit 326 License Fees, Dues, and Subscriptions 327 Education Expenses 328 Gifts 331 Insurance for Your Practice 331 Interest on Business Loans 333 Legal and Professional Services 336 Taxes 337 Domestic Production Activities 341 15 Hiring Employees and Independent Contractors Employees Versus Independent Contractors 346 Tax Deductions for Employee Pay and Benefits 350 Reimbursing Employees 356 Employing Your Family 358 Tax Deductions When You Hire Independent Contractors 367 16 Professionals Who Incorporate Automatic Employee Status 372 Paying Yourself 374 Employee Fringe Benefits 386 Shareholder Loans 394 17 How You Pay Business Expenses Your Practice Pays 398 Using Personal Funds to Pay for Business Expenses 400 Your Client Reimburses You 407 Accountable Plans 409 18 Amending Tax Returns Reasons for Amending Your Tax Return 414 Time Limits for Filing Amended Returns 415 How to Amend Your Return 416 How the IRS Processes Refund Claims 418 19 Staying Out of Trouble With the IRS Anatomy of an Audit 420 The IRS: Clear and Present Danger or Phantom Menace? 422 How Tax Returns Are Selected for Audits 423 Tax Shelters, Scams, and Schemes 426 Ten Tips for Avoiding an Audit 430 20 Record Keeping and Accounting Recording Your Expenses 436 Documenting Your Deductions 438 Accounting Methods 457 Tax Years 463 21 Help Beyond This Book Secondary Sources of Tax Information 466 The Tax Law 472 Consulting a Tax Professional 478 Index 481 Introduction Your Tax Deduction Companion 2 TAX DEDUCTIONS FOR PROFESSIONALS I f you’re a professional, no one needs to tell you that taxes are one of your largest expenses. The best way to minimize your taxes and maximize your take-home income is to take advantage of every tax deduction available to you. The IRS will never complain if you don’t take all the deductions you’re entitled to—and it certainly doesn’t make a point of advertising ways to lower your taxes. In fact, many professionals miss out on all kinds of deductions every year simply because they aren’t aware of them—or because they neglect to keep the records necessary to back them up. That’s where this book comes in. Specially tailored for the unique needs of professionals, it shows you how you can deduct all or most of your business expenses from your federal taxes—everything from advertising to vehicle depreciation. This book, the first of its kind, is about tax deductions for all types of professionals, including: •accountants •architects •chiropractors •consultants •dentists •doctors •engineers •lawyers •marriageandfamilytherapists •optometrists •pharmacists •psychologists,and •veterinarians. It can be used by professionals who work by themselves, or by those involved in group practices. You can use this book no matter how your practice is legally organized—whether you are a sole proprietor, or are involved in a professional corporation, partnership, or LLC. This is not a tax preparation guide—we do not show you how to fill out your tax forms. (By the time you do your taxes, it may be too late to take deductions you could have taken if you had planned the prior year’s business spending wisely and kept proper records.) Instead, this book gives you all the information you need to maximize your deductible expenses—and avoid [...]... 15 6 Tax Deductions for Professionals T he tax code is full of deductions for professionals from automobile expenses to wages for employees Before you can start taking advantage of these deductions, however, you need a basic understanding of how businesses pay taxes and how tax deductions work This chapter gives you all the information you need to get started It covers: • how tax deductions work... have to pay Types of Tax Deductions There are three basic types of tax deductions: personal deductions, investment deductions, and business deductions This book covers only business deductions the large array of write-offs available to business owners, including professionals Personal Deductions For the most part, your personal, living, and family expenses are not tax deductible For example, you can’t... progressive income tax system for individual taxpayers with six different tax rates (often called tax brackets), ranging from 10% of taxable income to 35% (see the chart below) The higher your income, the higher your tax rate You move from one bracket to the next only when your taxable income exceeds the bracket amount For example, if you are a single taxpayer, you pay 10% income tax on all your taxable income... federal taxes) + 12.3% (in self-employment taxes) + 6% (in state taxes) That adds up to a whopping 43.3% savings (If you itemize your personal deductions, your actual tax saving from a business deduction is a bit less because it reduces your state income tax and therefore reduces the federal income tax savings from this itemized deduction.) If you buy a $1,000 computer 12 Tax Deductions for Professionals. .. one tax bracket to another and thus lower your marginal tax rate For example, if you’re single and your taxable income is $77,500, an additional $1,000 deduction will 10 Tax Deductions for Professionals lower your marginal tax rate from 28% to 25% The first $400 of the deduction will save you $112 in tax (28% x $400 = $112); the remaining $600 will save you $150 (25% x $600 = $150) So your total tax. .. the value of a tax deduction, and • what professionals can deduct How Tax Deductions Work A tax deduction (also called a tax write-off) is an amount of money you are entitled to subtract from your gross income (all the money you make) to determine your taxable income (the amount on which you must pay tax) The more deductions you have, the lower your taxable income will be and the less tax you will have... Basics How Tax Deductions Work 6 Types of Tax Deductions 6 You Pay Taxes Only on Your Profits 7 You Must Have a Legal Basis for Your Deductions 8 The Value of a Tax Deduction 9 Federal and State Income Taxes 9 Social Security and Medicare Taxes 10 Total Tax Savings 11 What Professionals Can Deduct 12 Start-Up Expenses... deduct half of your self-employment taxes from your net income for income tax purposes, and (2) you pay self-employment tax on only 92.35% of your net selfemployment income The following chart shows the effective selfemployment tax rates Income Tax Bracket Effective Social Security Tax Rate 15% 13.07% 25% 12.36% 28% 12.15% 33% 11.80% Like income taxes, self-employment taxes are paid on the net profit... year falls is called your marginal tax bracket For example, if you have $150,000 in taxable income, your marginal tax bracket is 28% To determine how much federal income tax a deduction will save you, multiply the amount of the deduction by your marginal tax bracket For example, if your marginal tax bracket is 28%, you will save 28¢ in federal income taxes for every dollar you are able to claim as a deductible... (See Chapter 3.) 14 Tax Deductions for Professionals Example: After Cary’s optometry office opens, he begins paying $5,000 a month for rent and utilities This is an operating expense that is currently deductible When Cary does his taxes, he can deduct from his income the entire amount he paid for rent and utilities for the year Capital Expenses Capital assets are things you buy for your practice that . 15 6 TAX DEDUCTIONS FOR PROFESSIONALS T he tax code is full of deductions for professionals from automobile expenses to wages for employees. Before you can start taking advantage of these deductions, . lawyer or tax professional. n Chapter 1 Tax Deduction Basics How Tax Deductions Work 6 Types of Tax Deductions 6 You Pay Taxes Only on Your Profits 7 You Must Have a Legal Basis for Your Deductions. 457 Tax Years 463 21 Help Beyond This Book Secondary Sources of Tax Information 466 The Tax Law 472 Consulting a Tax Professional 478 Index 481 Introduction Your Tax Deduction Companion 2 TAX DEDUCTIONS