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In case you couldn’t tell by the dancing Statue of Liberty’s, the hip-hop H&R Block commercials promising to give away millions of dollars, or the plethora of signage you see in random places assuring you that they can get you your biggest tax refund… it’s tax season. I know, I know. You might have been actively avoiding this fact for the last few weeks, and I’m truly sorry for being the one to bring it to your attention, but it’s the truth.

This is the time of year when people are tenderly approaching their tax professionals (or DIY software, if that’s your thing) and anxiously handing over their tax paperwork, dreading the two words that they know are coming once the return is done: “You owe.”

This is also the time of year when people try to figure out the best tax strategy to determine what they can do to avoid owing taxes in the future. One of the “strategies” that comes up time and time again is “start a business or buy some investment property so you can get some deductions and lower your income”. While this strategy may work in the short term for some people, the truth is this: Starting a business is probably NOT going to be a legitimate long term money saving solution for you.

Now, that’s not to say that starting a business never works as a long term tax strategy, but since the point of starting a business is to make money, you will (hopefully) eventually be adding income to your tax return and therefore paying more tax. And the circle starts over again.

Here are just three reasons why starting a business is not the best long term tax saving solution.

CASH OUTFLOW 

Usually, for a business to be a benefit on your tax return, you need to be reporting a loss from operations. For the most part, most taxpayers report income and expenses on their tax returns on the cash basis of accounting. This means that we report income in the year we receive the cash (or the money becomes available for our use), and we report expenses in the year we actually pay them. Because of this, in order to take a loss on your tax return, you generally have to have a real life cash loss. There are some concepts that allow you to take a deduction for a noncash expense that will cause you to have a tax loss even if you have an economic profit (depreciation, amortization, and carryforwards), but mostly if you are reporting a tax loss you’ve spent more money than you made.

Let’s take an example. Suppose you were invited to watch a video about an MLM or network marketing organization and you especially pay close attention to the promise that your start up costs and monthly fees are tax deductible. It sounds great, so you sign up for the $100/month plan in January. During the year, you don’t earn any revenue so at the end of the year you’ve spent $1,200 in fees so you show a $1,200 loss on your tax return. If you’re already well into the 39.6% tax bracket, a $1,200 loss will save you $475 in taxes. So, even with the tax savings, you will be incurring an actual loss of $725.  Note: Keep in mind these numbers do not take into account the possible tax savings on your state return.

This concept is the same with investment properties, but there are also other things to consider. You might have been advised to purchase an investment property with a mortgage, charge rent equal to your monthly mortgage payment, and deduct the property’s depreciation and possibly utilities on your tax return. Sounds good, but consider this: you cannot deduct your entire mortgage payment against your rental income. You can only deduct your mortgage interest, insurance, and real estate taxes. You cannot deduct the portion of your mortgage payment that is principal, so taking depreciation into account you may end up breaking even or have a profit. If you pay property management fees, lawn care, utilities, repairs, etc. all out of your own pocket you may end up with a loss on your tax return, but at that point you will have actually sustained a real live loss (negative cash flow) in order to save a portion of that loss on your tax return. Another thing to consider is the possible risk of not being able to rent the property for the entire year and incurring the carrying costs (interest, taxes, insurance, utilities, management, etc) for the months there is no revenue.

COST OF COMPLIANCE

When you start a business there are costs that you have to incur, other than your normal operating expenses, to stay in business. Depending on how your business is organized, you may have to register with the secretary of state and pay a registration fee. In order to operate your business in a certain area you may need to pay for a business license. You may need certain licenses from a regulating body in order to offer your product or service.

In addition to costs paid to governments and other regulatory agencies, compliance costs can be a big deal during tax season. Even if you have a tax loss on your business and will pay no tax for your business, you still have to complete a business tax return. Business tax returns are separate from personal returns and cost more to complete due to the more complex nature. If you are operating as a sole proprietor, you would complete a Schedule C that would be attached to and filed along with your Form 1040. Depending on the kinds of expenses you have for your business, there may be additional forms and schedules that have to be attached to that Schedule C. If you are operating as an LLC (that is not disregarded), partnership, S-Corporation, or C-Corporation you will need to complete a separate form altogether that is filed apart from your individual tax return.

Going back to the MLM example form above, if you are saving $475 in taxes by reporting your loss, but your tax return preparation fees increase by, say, $300 because you now have to file a Schedule C and all related forms and schedules, your actual tax savings have now decreased to $175. Forms 1065, 1120, and 1120-S could cost much more than the $300 and cause the $475 tax savings to disappear.

PROFIT MOTIVE

Every income producing activity is not considered a business for tax purposes, sometimes it is reclassified as a hobby. Hobby income is different from business income in that you must include all of your hobby income on your tax return and, starting in 2018, you cannot take a deduction for your hobby related expenses. The main factor of whether your activity is a hobby or business is whether or not you are engaging in this activity with the intent to make a profit. There are many factors that the IRS uses to gauge this, but the bottom line is that if you are not in business to make money, the IRS will deem your activity to be a hobby and disallow any losses.

Starting a business so that you can take a loss on your tax return absolutely violates the profit motive principal. The driving motivation behind starting a business to save money on taxes is that you want to be able to reduce your taxable income. In order to do that, you must not anticipate generating any profit. If you start a business and happen to have losses but are actively trying to generate revenue and make a profit, you may be able to argue that you have a profit motive. Signing up for an MLM and just paying the fees each month with no effort or intent to sell your product/service or recruit others to generate revenue for yourself, however, is not a profit motive. If the IRS reclassifies your MLM business from above to a hobby, you would not be able to take a deduction for any of your monthly fees since you would have not generated and reported any revenue.

Starting a business can be rewarding and filled with a sense of accomplishment. However, starting a business with the sole purpose of saving taxes can get you in over your head and cause you to spend more money than you save. The best tax saving advice I can give someone is to consult a tax professional to get an idea of what to expect at tax time.

What is the best tax saving advice you’ve ever heard? Let me know in the comments!

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Why Starting a Business May Not Save You Money on Taxes