Avoid An Audit
Are you in business? Hell yes, you say. You’ve practiced five days a week, 52 weeks a year for the last seven years, took lessons from some heavy hitters, played in more bands than you care to remember, taught yourself how to read music, even bought yourself a truck just so you can haul your drums around. Guess what? It doesn’t mean squat to the IRS. The only thing the IRS cares about is whether you made a profit this year from drumming.
What does that mean? Unfortunately your interpretation of whether or not you are truly in business is probably more relaxed than the IRS’s. There are a number of criteria that the IRS follows in order to establish whether someone is in business or not. Here’s what they are:
- You must have a clear intention to make a profit.
- There must be a reasonable expectation of a profit.
- You must spend a significant amount of time conducting the business.
- You must have good record keeping.
- You must be able to prove that you have expertise in the field.
- If the business is unsuccessful after several years, you must change the way in which you operate in order to increase your chances of being profitable. For example, you might try teaching, playing in a cover band, songwriting or cutting your expenses.
Is starting a business important to you? Absolutely, without question. Being self-employed brings you many opportunities and benefits. First of all, you don’t have a boss. You can work when you want, where you want and for whomever you want. You can control how much money you spend, when you spend it and where you invest your profits. You can contribute up to $30,000.00 per year into a pension plan and write it off. You don’t have to wear a suit and tie (well, some of you might), you don’t have to get up at the crack of dawn to fight the commuter traffic and you can take a vacation whenever you want.
But there’s a downside to this pretty picture. The amount of money you make depends solely upon yourself. You have to make it happen. No one else is going to hand you a paycheck, no one else is going to get you the gigs and there’s no one else to blame when things go wrong. You’ve got to get the work, keep track of your expenses and pay your taxes. Just like any other business.
It’s a hip thing to save a few bucks by writing off your expenses as a musician. It’s even better if your business is profitable and you had to pay a few dollars in taxes. What a concept. Maybe it would be so profitable that you could quit the day gig and play drums for a living. That’s the general idea, isn’t it? In the bigger picture, over the course of your career you want to pay taxes. That would mean you were very successful. Of course, you should still take advantage of all the deductions allowed to reduce your tax liability, but hopefully there will come a time when your income will rise above all of your business expenses, pension contributions and mortgage payments.
Saving Money On Taxes
Now to the specifics of reducing your tax liability while avoiding trouble with the tax man. Saving money on a tax return is simple. Turn your expenses into tax deductions. This is the basic concept that all taxpayers should follow, whether you’re a drummer, computer programmer or circus clown. For example, if you pay rent where you live, it’s not deductible. If you instead buy the house and make mortgage payments and pay property taxes, the portion of the mortgage payment representing the interest is deductible, as are the property taxes. If you save part of your earnings and put it in a savings account, those earnings are still taxable. If you put the money in a pension plan you can write it off and save anywhere from 15 to 50.6 cents on the dollar, depending on your tax bracket. If you start your own business as a musician, then the money you spend on sticks, drum equipment, recording studio time, rehearsal space, CDs, tapes, driving and going to concerts is all deductible. No business, no deductions. In order to turn your music expenses into deductions you must turn your hobby into a business. Easier said than done, especially these days.
The IRS has turned up the heat over the last few years on sole proprietorships. They are now the number one target for audit, especially if it shows a net loss. This is not hard to understand, given the state of the current tax code. Sole proprietorships are one of the only tax shelters left available to an individual. Whether you’re already in business or just starting, the key to reducing your income tax liability starts with good record keeping. Since the basis for saving money on your tax return is by turning your expenses into deductions, then the starting point is to examine what you actually spend your money on. That’s where good record keeping comes in. This approach is recommendable because of the larger financial picture. If you want to create financial independence for yourself, you must know where your money goes. Then you can set goals for how much you can save, how much you can invest in your business and where you can cut overhead.