5 Small Business Tax Myths

November 24, 2014 : Mike Slack

Ed note: There are a few pervasive myths around taxes if you work for yourself or have a side business. Namely, supposed deductions that can’t actually be deducted. Don’t get caught making one of these mistakes next year!

1. Personal Care and Clothing Expenses as Deductions

No matter how polished and well dressed your business requires that you to look, expenditures on personal grooming are not deductible business expenses. This rule is very strict; so even if the expenses are actually required by the business, no deduction will be allowed if the expenses are inherently personal. For example, the IRS disallowed the owner of a high fashion clothing store deductions for clothing she had purchased to wear while at work, even though she never wore the clothing outside of work.

2. Using a Car as a Rolling Advertisement

Many individuals attach signs and decals to their personal cars to advertise their businesses. While the cost of the signs itself is a deductible advertising expense, the use of that car for non-business related travel is not. The IRS is clear that placing advertising material on one’s personal car does not convert normally nondeductible personal travel into deductible business travel. To claim deductions for the use of that vehicle, it cannot be for expenses used to commute and there must be an actual business purpose, in addition to meeting other rules.

3. All Mileage Is Deductible

When you’re in fact using your car business purposes, it does not automatically mean you get a deduction for that travel. The rules that disallow commuting expenses for employees also apply to self-employed individuals. Those rules generally state that travel between your home and your office or first business-related stop of the day, and travel between your last business-related stop of the day and your home, are not deductible. However, travel between your first business stop of the day and a second are deductible as business expenses.

One exception to this rule applies when small business owners use their homes as a place of business, and their home office is considered their principal place of business. In that situation the commuting rules generally do not apply, and the business owner is allowed to deduct mileage from their home to their business-related stops.

IRS Publication 463 includes a handy diagram that illustrates what types of travel expenses are deductible by individuals performing business in a particular area.

4. Employees with Side Businesses Don’t Need to Pay Self-Employment Tax

It is not uncommon anymore for a full time employee to also have a side business. The fact that their employer withholds Social Security and Medicare taxes from their wages does not mean that the income from their side business is exempt from paying those same taxes via the self-employment tax. Employees with income from self-employment are subject to the self-employment tax on their side businesses in the same manner as those whose income is solely from their self-employment. However, once these individual’s combined income reaches certain levels each year, the rate at which they pay self-employment tax can be reduced.

5. There are No Tax Consequences for Having Multiple Business Losses Over the Years

If your business isn’t doing well, there is one potential benefit. Any business losses can be used to offset the business owner’s income from other sources, and thus reduce their overall tax bill. But, multiple years of losses from a business, where the deductions exceed income, can have adverse tax consequences.

If a business consistently generates losses, the IRS may step in and say it’s a hobby —an activity not engaged in for profit—rather than a business. Under the hobby loss rules, most business expenses are only deductible if the taxpayer itemizes. In addition, the expenses are subject to a threshold based on 2% of your adjusted gross income while income from the activity is reported on page 1 of Form 1040. This means that it is quite possible that any benefit of the expenses can be potentially lost, leaving all the income subject to tax.

There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to turn it into a profit-maker, rather than operate it as a mere hobby.

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Mike Slack

Mike Slack

The Tax Institute, H&R Block

Mike Slack, JD, EA, is a senior tax research analyst at The Tax Institute. Mike leads research teams focused on business and investment tax issues.