For some reason, people tend to get very excited about tax deductions. Admittedly, claiming deductions does reduce the tax burden on a small business (for now), but they require time and effort to prepare, and may increase the risk of an IRS audit. About 10% of the money claimed on tax deductible expenses may be “saved” each year. In other words, spending $1,000 on the business will result in a $100 decrease in Federal income tax at the end of the year.
Particularly for new small business owners, the notion of maximizing deductions quickly becomes an intoxicating contest that may lure proprietors to the brink of sensible practice. Resisting the urge to spend money on training or supplies, just because they’re tax deductible, will be a real struggle on some days.
Another strategy is to find indirect expenses that don’t require out of pocket spending. The primary way to do this legitimately is through a mileage deduction.
The Mighty Mileage Deduction
When using a personal vehicle for business commuting, taxable income may be reduced by an amount that is proportional to the number of business miles driven each year. Pet sitters making all those 2-mile trips each day drive up to around 8,000 miles annually. When multiplied by the Department of Treasury’s current rate of $0.585 per mile, that’s a $4,680 deduction. This is a significant amount, and really something to be excited about. At first.
To do this for more than one year, one must establish their home as a business location. This is great because now you can pro-rate utility bills used in the newly assigned home office area as a deductible business expense. This becomes a little less exciting after an irksome receipt search and tiresome tally yields a utility deduction that is barely $100 per year.
Establishing a home office does not affect a mortgage interest deduction, although it may now need to be provided on two tax form lines instead of one.
A home office does change things with regards to capital gains tax. Generally, the sale of a home will be exempt from paying capital gains tax, unless the home was used to run a business. The way you set up your home office and claimed operation and occupancy expenses will affect how much capital gains tax will need to be paid when the home is finally sold.
A mileage log will need to be developed to demonstrate how many miles were traveled for business each year. This requires a bit of work. Even with phone apps that “automatically” track mileage, trip details must be documented, and that daily information adds up over time.
IMPORTANT: A mileage deduction supersedes cost deductions for operating a vehicle (gas receipts, car payments, depreciation). Most business owners complete the mileage deduction instead of costs because it is easier than collecting and pro-rating business receipts throughout the year. Besides, there are cantankerous computations required to determine depreciation, and deciphering IRS depreciation calculation instructions leaves most business owners more confused than a termite in a yo-yo.
Risk of Audit
Another thing about deductions is that taxpayers don’t HAVE to be an “official” business entity to submit deductible expenses. Even so, consulting an accountant is highly recommended to consistently follow the tax codes and reduce the risk of an IRS audit.
Pet sitters that make less than $30k a year, don’t have employees, and deduct a few thousand dollars annually are not considered high risk for an IRS audit. The Treasury Department IS watching however, and they will notice if deductions exceed 50% of revenue, or if an LLC is donating things like cars, boats, and small aircraft.
Another common challenge for good pet sitters is when they hire people to meet additional demand. Labor and tax laws associated with defining whether a hire is an independent contractor, or an employee, are tricky. The temptation is to say, “Oh I’ll just hire Herbert to walk my extra dogs.” Well, if employee benefits are not extended to Herbert, or the business entity isn’t set up to have employees, you are increasing the risk of an audit.
Sitters that do this may want to label Herbert as an independent contractor, but if Herbert isn’t set up as a business entity, you may BOTH enjoy a tax audit in the near future.
Of course, six months down the road when Herbert steals his share of your clients, his status as an independent contractor or an employee will seem like the least of your worries.
Forgetting to log mileage one month is not the end of the world. Auditors are looking for tax fraud, such as the folks that “borrowed” their neighbors $6,000 receipt for a new fence. Taking accountant’s advice, documenting expenses, and following tax regulations are excellent ways to reduce the risk of an IRS audit.
Summary of Deductions
Since Eric’s Pet Sitting is set up as an LLC, taxes are submitted with a personal tax form each year (Form 1040), and deductions are included with a Schedule C attachment. This is called “pass through taxation,” since income passes through to the owner’s individual tax return. The following is a list of tax deductions for Eric’s Pet Sitting, LLC each year.
Mileage $4,000
Phone $960
Internet $480
Business Insurance $400
NC Secretary of State $200
Pet Sitter Membership $165
Dog Park Memberships $100
Website $100
County Tax (desk, cpu) $20
Total: $6,425
Even though most phone and internet use is personal, owners won’t have to painstakingly pro-rate its use because the conventional wisdom is that entities cannot do business without phone and internet, therefore it is considered a deductible expense.
Pet sitter membership refers to a pet sitting group (like NAPPS) so owners may obtain group insurance for pet sitting. Some years, there will be line items for supplies like bowls, leashes, or business cards.
Other expenses for a home office deduction MAY include trash removal services, cleaning services, homeowner’s insurance, HOA fees, or the cost to install and maintain a security system.
North American Industry Classification System (NAICS) codes may be required on tax forms and it’s not a bad idea to include this number on receipts prepared for clients. Code 81291 is used for “Pet Care (not veterinary services).”
Closing Thoughts
Tax deductions will save a few hundred dollars each year, and they feel like a clever way to beat the system through hard work and entrepreneurship. Just remember that Uncle Sam has already thought this through and is way ahead of us.
Tax breaks help to start and maintain a small business, but the government scoops their chunk eventually. Often, they accrue a larger lump from fees or interest penalties, since folks may get greedy or miscalculate because they didn’t understand the deliberately enigmatic and perpetually changing tax codes along the way.
Additional Notes
The Federal Insurance Compensation Act (FICA) tax is 7.65 percent of gross taxable income for both the employee and the employer (6.2% for Social Security and 1.45% for Medicare). These rates are the same regardless of the amount of income earned, and employers pay a matching FICA tax.
Self-employed individuals are considered both the employee and the employer, and are responsible for paying the full 15.3%. However, the IRS allows self-employed individuals to deduct the employer portion of self-employment taxes from their taxable income, but they are still required to pay both the employee and employer tax for Medicare.
The actual tax reduction from claiming deductible expenses varies from year to year and is primarily dependent on reported taxable income and the advanced premium tax credit (for health care). Even so, 10% is a sound budget number to use when considering tax burden reduction from most deductible expenses.
Single Member LLCs do not pay unemployment insurance, unless employees become involved. Workers compensation doesn’t enter the picture unless 3+ employees work for the pet sitting owner.
Charging sales tax for pet sitting services varies by state, the type of service, and other factors.
Featured photo – Remy, my accountant, is too legit to quit.
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