“It’s ok, it’s a tax write-off!”
Sometimes business owners don’t fully understand what it means when something is tax deductible, and think that by writing something off on their tax return that somehow justifies the purchase. So, in this blog post, we’re going to talk about what exactly tax deductions are, and what they aren’t!
This is best explained with an example:
You have revenue of $10,000, and no expenses.
If your tax rate is 25%, you’ll owe $2,500 in taxes
Tax = $10,000 * 25% = $2,500
You have revenue of $10,000, and $4,000 of business tax deductions.
If your tax rate is 25%, you’ll owe $1,500 in taxes
Tax = ($10,000-$4,000) * 25% = $1,500
Which scenario would you prefer? You may see that you’ll save $1,000 in taxes under Scenario B, but you had to spend $4,000 in business expenses to save in taxes.
Income after tax
Scenario A: $10,000 – $2,500 = $7,500
Scenario B: $10,000 – $4,000 – $1,500 = $4,500
As you can see, even though your taxes were higher under Scenario A, you’re still coming out ahead!
What a tax deduction isn’t
Free money. “It’s a write-off” doesn’t mean it’s free! In Scenario B, you had to spend $4,000 to save $1,000 in taxes, so you’re still out $3,000.
Tax credits, on the other hand, can result in a dollar-for-dollar reduction in taxes, but that’s beyond the scope of this post.
An excuse to buy something you wouldn’t otherwise need. The ultimate goal of any business should be to make money! I know that we all like to save in taxes, but don’t buy stuff you don’t really need just to lower your tax bill, and don’t use tax savings to justify your purchases.
I’m not saying you should ignore your taxes – of course, you need to consider tax implications of running your business. I just don’t believe that taxes are the only thing that matters!
What are tax deductions?
Tax deductions are expenses that you subtract from your income to calculate your taxable income.
You’re allowed to deduct business expenses if they are 1) ordinary and 2) necessary. One of the more frequent questions I get is “If I buy a new car, is it tax deductible?” If you’re driving your car around to client sites, then that usage is deductible. On the other hand, if you aren’t using your car to do business, then the answer is no. Automobile expenses might be ordinary, but if you don’t have to drive around to run your business, then they aren’t necessary.
Some of the more common business deductions include product costs, marketing, website, legal and accounting, contractors and employees, rent, and computer equipment. You might also be able to deduct the business usage of your home office, automobile, and cell phone.
The bottom line. Remember, you have to spend money to save on taxes. Focus on increasing your revenue and being as efficient as possible with your spending, and the rest will follow.