What Do People Mean When They Say Something Is A Tax Write-off?
If you know someone who owns their own business or is a self-employed individual who operates like a business, then you may have heard them say "that's a tax write-off." Many people are confused by this because they think having a tax write-off means getting things for free, but that is simply not true. Today we are going to examine tax write offs so that you can understand the basics of how they work and what it means to have a tax write-off.
The first thing anyone who is running their own business should know is that they need to have a good record keeping of the business expenses and their personal expenses. This is very important because the IRS does not take too kindly to those who lump personal expenses into their business in order to gain an unfair tax advantage. Depending on the level of sophistication this can be done in many ways. Some do it through apps, some keep a shoe box of receipts, others might track it themselves using Excel. In any circumstance, it is important to know exactly how much money was spent on the business for business purposes.
Once you understand the concept of business expenses, it is time to examine how that works with business income. Every year businesses get taxed on the net amount of money they bring in (with certain expenses and activities having special tax treatments). This means a business is taxed on its income (money in) minus its expenses (money out). This is slightly different than the way individuals are taxed, which focuses more on gross income and certain deductions.
What this means for the business owner is that the money they spend related to the business will reduce their taxable income, making the money spent a "tax write-off." While this concept can seem completely broken at first, there are two important things to keep in mind:
The person does not get the full benefit of the money spent because the actual benefit is calculated after taxes. As an example, if I own a small business (that passes income through to my personal return) and find myself in the 25% tax bracket, spending an extra $100 would potentially save me $25, not the entire $100.
In order to capture that benefit, the business has to have taxable income to offset the expenses. What this means in practice is that you cannot start your own business just to spend money and then get money back from the government.
Is There More to It?
When dealing with taxes, the answer to this question is always "yes." The information listed above provides an excellent framework on how to understand how business deductions work for that tax write-off. However, it is also important to understand how businesses can do so well and not end up paying taxes because of these write-offs. Without going too far into it, businesses can take advantage of any of the following to reduce their net income for a given year:
Depreciation for tax purposes (Can be different than standard accounting)
Reinvesting into the business through research and development. This means the company spending its earnings on itself and has nothing left over at the end of the year
Net operating loss carryforwards. Business units can use their previous net losses to offset future net incomes. Disallowed startup companies to build up some benefits when they are not making any money and not pay taxes in their first couple of years of profitability.
And many more! Other examples involving tricks to reduce net income or shift the income to a more favorable line on the tax return can arise in specific situations with specific circumstances.
Well there you have it! A brief explanation of tax write-offs help you better understand how they work in practice at a high level. The key takeaway here is that if you or someone you know is running a small business, understanding how these tax write-offs work is essential to efficient spending. As always please let us know if you have any questions by sending us an email at scalefinancialeducation@gmail.com.