Tax benefits can provide a nice break for many, allowing them to pay on less income than they would have without them. Self employed professionals taking in revenues of $100,000 operating under an overhead of $40,000 covering his or her vehicle, office and travel expenses would only have to pay taxes on $60,000.
This income after expenses drops the business owner "John" from the 28% tax bracket down to 25%, saving the company and individual approximately $13,000 (28% of 40k and 3% of 60k) that would have gone to the government. After taxes John has earned a respectable $45,000.
But Americans eligible for tax breaks should be wary not to seek them out simply for the purpose of the break itself, because searching for tax breaks on unnecessary expenses is a waste of money.
A Tax Break can be Like Trading a Dollar for Thirty-five Cents
Dave Ramsey, radio show host and author of The Total Money Makeover, is always telling his listeners not to fall into the trap of searching for tax breaks when they can simply be without debt. For those not familiar, Ramsey believes in a life without debt above all else with the exception of spiritual faith.
Ramsey's website, DaveRamsey.com, has an archive of commonly asked questions. In one, "Susan" explains that she and her husband earn $120,000 a year, but do not own a home. She then asks if she and her husband should purchase a home to get a break on their taxes.
Ramsey explains that buying a home is great, but buying one simply for a tax break may not be a good idea. He explains by stating that if she took on a $200,000 loan at 5% interest she would pay a deductible $10,000 to the bank resulting in she and her husband paying taxes on $110,000 of income instead of $120,000.
The tax break would be $3,500- but at the expense of nearly three times that.
To clarify: Susan and her husband gave $10,000 to the bank in interest to avoid paying $3,500 in taxes, essentially receiving $.35 in benefits for every dollar they spent. The alternative would be to retain $.65 of every dollar taxed.
Debt for the Sake of Tax Breaks
One caller to the Dave Ramsey show last year called because she and her husband own a farm with no mortgage and her family thought that that was a terrible idea, "because of the tax breaks she was losing."
The truth of the matter is that although there is debt that can be leveraged in one's favor, debt on personal items such as a home or unnecessary business expenses are harmful and not worth the fraction of the money that comes back in the form of breaks or returns at the end of the year.
What are Unnecessary Business Expenses?
Running a business can be expensive. Some of the worst expense comes in the form of waste.
Here is an example using John from the beginning of the article, who is taking in $100,000 with a profit of $60,000 and post tax income of $45,000. As business begins to grow John finds that he is going to be in a higher tax bracket. Not thinking that more money is better he increases expenses, trading in his paid off aging Ford Escort for a brand new Mustang. With a five-year loan and the increase in insurance John may be paying $8,000 a year in car expenses versus perhaps $2,000 on his Escort, or $5,000 on a less expensive new vehicle.
In the 25% tax bracket he'd be trading in dollars for quarters.
Running up Expenses for the Right Reasons
Expenses do not need much encouragement to go up. A growing company will naturally grow in expense by way of more employees, added workspace, and business travel.
Long Island band As Tall as Lions (ATAL) knows all about this as they are set to promote their new album "You Can't Take it With You" on a 20 city tour this July following their headlining show at The Bowery in New York City at the end of this month.
In a phone interview with ATAL's lead singer, Dan Nigro, the band has grown to reach many great fans, and with reaching new people, expenses increased as well. According to Nigro the band's humble beginnings of high school students busing tables to put together a four song demo album brought them to a self-funded tour in 2001.
ATAL traveled from Long Island to Georgia on roughly $400 for which they operated at a loss. Nigro and his band mates made hard work work for them, and their last tour in 2007 cost them nearly $80,000. This July necessary expenses are expected to go up again.
The important thing to remember is that tax write-offs work best when they are within the realm of necessary expenses. If a business owner really does need a new vehicle that he can enjoy as much as depend on, or a musician needs expensive carrying cases to protect every piece of equipment from damage, then the expenses are not unnecessary.
In conclusion, if tax right offs are a part of the justification of a purchase, it is probably a purchase that can wait to be made.
This article was written with the guidance of Edward Duras, a Certified Public Accountant from Long Island, New York
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