If you have a business, you pay taxes on your profit. In the simplest possible terms, if you have $100,000 in sales and $70,000 in expenses, you'd have $30,000 in profits and owe taxes on it. However, taxes are rarely simple, and it's entirely possible that you could lose money for tax purposes when you have a profit, or have to pay taxes when you actually lost money. These rules apply whether you have a small part-time business like selling crafts online or a full-time operation with employees.
Expenses That Don't Count
When you calculate your business's expenses for tax purposes, some of your expenses either aren't tax-deductible or are only partially tax-deductible. For instance, if you spend money on meals or entertainment, only half the cost is deductible. The Internal Revenue Service also caps the amount you can deduct for gifts at $25, so if you give a client a $300 golf club, $275 of the cost wouldn't be counted when calculating your business expenses for tax purposes. If you have enough non-deductible expenses, you could end up with a profit on your tax return and have to pay taxes.
When you make major purchases of items that last more than one year for your business, such as buildings, equipment or furniture, the IRS usually doesn't let you claim the entire cost as an expense. For instance, if you have a small baking business that usually earns $75,000 per year and you decide to put $100,000 down on a $500,000 building, the down payment and the purchase price wouldn't count as an expense. The cost of designing and building a new website, which could last your company for years, also is not always considered an expense. Instead, you have to spread capital purchases like these out over time through a process called depreciation or amortization. The IRS makes an exception for some purchases of "tangible personal property" like computers, machines and furniture, and will let you write them off as an expense under Section 179 of the tax code.
If you have a small business that could be viewed as a hobby, you also run a risk of having to pay taxes. The IRS lets you write off business expenses, but generally won't let you deduct a hobby if they think you just call a business to save money on your taxes. If you can't establish that you're actually running a business, the IRS could audit you and disallow your deductions. In that instance, you'd have to pay taxes on your sales without counting some or all of your expenses against them. There aren't absolute hard and fast rules to tell whether you have a business or a hobby. One test is whether you show profits in three out of five years. The IRS can also make a judgment call to see if what you're doing really looks like a business.
The Bigger Picture
Your business is just one of the many components of your income. The 2013 version of the 1040 tax return has more than 15 different lines for you to enter income or losses. If you lose money on your business and you make money elsewhere that more than cancels out the loss, you could end up still having to pay taxes.
- IRS: Topic 512 -- Business Entertainment Expenses
- IRS: Gifts
- Nolo: Section 179 -- What Every Business Owner Needs to Know About This Depreciation Deduction
- Nolo: How to Prove Your Hobby Is a Business
- IRS: Form 1040 -- U.S. Individual Income Tax Return
- Duane Morris: Tax Implications of Incurring Website Development Costs
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.