Everybody complains about taxes, but how many of us doanything about them? Well, you can improve your tax situation by doingseveral things. Even though it's too late for the 2002 tax year, youcan save a bundle, legitimately, with your music business for thisyear's taxes and for years to come.
If you're making even the tiniest amount of music-related money,there's no reason to pay more taxes than you have to. To reap the mosttax benefits, start running your music career as a legal small business(see “Working Musician: Going Legit” in the February 2002 EM).The IRS loves small businesses. According to the Small BusinessAdministration, there are 25 million small businesses in the UnitedStates today, and a large percentage of them are soleproprietorships, or one-person shops. As a sole proprietor, youreport your music business income as part of your personal income usingthe IRS Schedule C and a few other forms. (Tax forms and Schedules canbe downloaded from the IRS Web site, www.irs.gov.)
It all comes down to income and expenses — the money you makeand the money you spend. The more you make, the more you pay in taxes.Even the most convoluted of IRS instructions make that point painfullyclear. That means the converse is also true. Because the IRS taxes onlyyour business profits, cut back on the profit and pay less intaxes.
You might be thinking, “But, dude, I gotta eat.” I'm notsaying that you should earn less. Instead, look for all the possibleways to convert your everyday expenses into legitimate businessdeductions. Even some personal expenses may be deductible against thebusiness. The more expenses you have, the more you reduce your taxableincome. And because you were going to spend the money anyway, you mightas well realize some tax benefits from those expenses.
Basically, all the expenses you incur to run your small musicbusiness are deductible. To be fully deductible, however, businessexpenses must be “ordinary and necessary” according to theIRS. That's just fuzzy enough to be dangerous. Ordinary meansthe expenses must be typical for the business. Buying a new guitarcould apply; buying a dishwasher wouldn't. Necessary means theexpense is vital to the success of your business. Office equipment,postage, phone charges, graphic-design charges, recording-studio fees,duplication, dues, magazine subscriptions, and other such related itemsare definitely necessary for the success of the typical music business(see the sidebar “Deductible Reasoning” for a list oftypical deductions).
For every $100 you earn, you pay approximately $45.30 in taxes.(This is assuming you're in the 27 percent tax bracket, pay the 15.3percent self-employment tax, and send an additional 3 percent to yourstate. Furthermore, these percentages are given only for the purpose ofdiscussion. The Tax Code changes from time to time, so you shouldverify your federal and state income tax brackets.) Of course, thatalso implies that for every legitimate $100 business expense youincur, you also save $45.30 you would otherwise pay in taxes.Hey, that's like getting everything you buy at a discount.
Why does the IRS let you deduct all these expenses? It wants you tosucceed. It lets you invest money in your business as incentive for youto earn more. And the more money you make, the more you'll pay intaxes. You see, it has an ulterior motive.
Here's the caveat: your business must turn a profit three out ofevery five years or it will be classified a hobby, and you forfeit theexpense deductions. The bottom line here is a very high tax bill.
The burden of proof falls solely on you, so it is vital that yourecord all your music business income and expenses diligently. Ashoebox full of receipts does not a bookkeeping system make. Get helpsetting up your books or look for a software solution to help documentyour business financial transactions.
Here's another important gotcha: If you're just launching your musicbusiness, startup expenses can't be deducted all at once. You mustamortize them over five years by taking 20 percent portions of thetotal expenses and deducting them over five consecutive years.
GEAR LUST = TAX SAVINGS
Did you know that the gear you buy for making your music could be asweet tax deduction? Under section 179 of the Tax Code you can deductor “expense” up to $25,000 of tangible property this yearand write it all off when you prepare your taxes next year. Fortangible property, think expensive, long-lasting items, such as a newcomputer. This amount is above and beyond many other normal businessexpenses you might incur.
If you've had a particularly strong earnings year, you can offsetsome of that gain by deducting all the cost of large purchases in oneyear (up to the $25,000 limit). Alternatively, you can depreciate whatyou buy and deduct a portion of those costs over the next severalyears.
HOME SWEET HOME
If you do the majority of your music work in your home office, youcan deduct a portion of the same expenses that currently do little ornothing to lessen your tax burden. You can write off rent or mortgageinterest, property taxes, utilities (gas, electricity, water/sewer),insurance, repairs, and depreciation. First, dedicate a portion of yourhome entirely to your music business. Keep it free of personal itemsand make it your primary business location. Beware that if you do mostof your work elsewhere (gigging, for instance) and use this home officeonly occasionally, your deduction may be limited or entirelyverboten.
Here's how to figure your deductions. Total up the square footage ofyour exclusive place of business and compare it to the total squarefootage of your residence. Say your math works out to 10 percent. Youcan then deduct 10 percent of the aforementioned expenses using Form8829 — Expenses for Business Use of Your Home. The totaldeduction then flows through to your Schedule C, reducing your incomeand therefore your taxes.
There is a recapture clause for homeowners to consider. If you sellyour home and make a profit, those profit dollars become taxablebusiness income at the same percentage rate as your deduction. Score a$50,000 gain from the sale of your home and, following the aboveexample, $5,000 of it belongs to the business (subject toself-employment tax and regular income tax, of course). It's importantto note that the personal income you make from a house sale isgenerally not taxed, though. If you stop taking the home-officededuction for two tax years prior to the home sale, this recaptureclause doesn't apply.
Yes, we self-employed people have a special tax just for us.Actually every worker pays the same tax — funding for SocialSecurity and Medicare — it's just a little different when you'reon your own. You must contribute both the employee and employercontributions, which total up to a whopping 15.3 percent. Yep, justover 15 pennies on every buck you earn goes right into the SocialSecurity kitty. This is, of course, before you start paying any regularincome taxes. Ouch!
You have to pay the self-employment taxes (along with income taxes)quarterly. You need to predict what you are going to earn this year,and the taxes that would be due on that dollar amount. Then, you sendin 25 percent of that money on April 15, June 15, September 15, andJanuary 15 of the next year. These estimated tax payments areimportant, because if you don't pay enough, there's a penalty due thenext April 15.
EAT, DRINK, AND BE MERRY
When you entertain your clients, the money you spend is anotherwrite-off. However, meals and entertainment are subject to a 50 percentlimitation, so if you spend a $100 on a pizza party, you can take $50off on Schedule C. Give clients gifts, up to $25 per client, and youcan take that as a full deduction, though.
When you travel as part of your music business, those expenses aredeductible including airfare, lodging, and meals. You must support yourtravel and lodging deductions with receipts. However, instead ofkeeping track of your meals, you can take the government's standard perdiem allowance of $30 for “meals and incidentals.” A fewcities (such as New York City) may have a higher rate than the $30standard; check the official Web site (www.policyworks.gov/perdiem) to be sure. Meals onthe road are, of course, still subject to the 50 percent limit.
Yes, that old beater is worth money! Keep track of actual vehicleexpenses (gas, repairs, and so on) or take the standard mileage rate(which changes every year; check with the IRS). In either case, youmust document the miles you drive for business, the date and purpose oftrips, and the expenses incurred. A dedicated notebook/diary earns agold star from the IRS.
Even if you use your ride for business and personal use, thebusiness portion of your expenses is still deductible. Determine yourbusiness percentage by dividing your business miles by the total milesdriven (2,500 business/10,000 total = 25 percent). If you just use thestandard mileage rate, multiply your business miles driven by that rate(2,500 × $/mile = deduction) to arrive at your deductible expenseamount. You can also deduct the full cost of tolls and parking feesincurred while on business. Furthermore, the loan interest on the caris deductible (subject to the business-use percentage).
YOUR HEALTH AND FUTURE
Your health-insurance premiums are deductible. That doesn't come offthe Schedule C but is a front-page deduction on your personal 1040. In2003, self-employed individuals can finally deduct 100 percent of thepremiums they pay. Other typical medical costs are deductible onSchedule A (if you qualify).
You also save money by contributing to a qualified retirement plan.The IRS makes it easy to sock away some cash for a rainy day, and itrewards you with a nice, fat deduction each year. This is another 1040deduction, not Schedule C. IRAs are the first method that pop up.However, they're limited to $2,250 this year. With a SEP (SimplifiedEmployee Pension), you can deduct as much as 15 percent of yourbusiness income topping out at $30,000 total per year. The more you putaway, the more you save. And since you're really helping yourself downthe road, it's a smart way to manage your taxes and your retirement.For some of us, a Roth IRA may be more prudent. Roths give you noup-front deduction, but the earnings are tax-free. You should talk to afinancial planner to figure which approaches will benefit you themost.
EOY TAX TIPS
At the end of each year, you have another opportunity to reduce yourtax burden: accelerate expenses and decelerate income. First, spendsome cash on business expenses. Don't just blow the wad; make sensiblepurchases this year that will reduce your taxable income. Ideallast-minute purchases include postage, equipment, general officesupplies, and promotions. You can also pay your mortgage and healthinsurance premium before the year-end to realize some other tax savingson the personal side. Second, this December, put off collecting moneyuntil January by billing your clients a little later. Though you'llhave to pay taxes on the money eventually, you defer that payment for awhole year.
Even though we all have to pay taxes, we are only required to payour fair share. Make sure you are not throwing money out the window.Take advantage of these and all the other tax BREAKs available to you.Put more music money in your pocket, where it belongs!
Here are some common business-expense deductions for music-relatedbusinesses.
Advertising and promotion costs
Car and truck expenses
Commissions and fees you pay to other people and businesses
Depreciation and section 179 deduction
Insurance (except health insurance, which is a personaldeduction)
Interest on business loans
Legal and professional fees
Rent or lease payments
Repairs and maintenance
Taxes and licenses, such as a business license
Meals and entertainment
Wages or salaries paid
GET HELP FROM THE IRS
Surf on over to the always exciting IRS Web site (www.irs.gov) and downloadthe free guides that explain the specific tax benefits forsmall-business owners.
#334, Tax guide for small business
#463, Travel, entertainment, gift, and car expenses
#533, Self-employment tax
#535, Business expenses
#583, Starting a business and keeping records
#587, Business use of your home
Jeffrey P. Fisher's latest book, Moneymaking Music (artistpro.com,2003), is a guide to making, keeping, protecting, and growing yourmusic success fortune. See it and other resources at www.jeffreypfisher.com.