Keeping Taxes Low
Since writers have to pay taxes like everyone else, it is in their best interest to understand how to minimize their tax liabilities. The main way to do this is to understand what expenses can be taken as business deductions and how to keep track of these expenses.
Although many of the incentives offered to businesses to encourage investment do not apply to writers, writers can benefit in some cases from certain provisions of the Internal Revenue Code to reduce their tax liability. However, writers should also be aware that many taxpayers have abused the opportunities to take deductions for legitimate business expenses by claiming that expenses for vacations, entertainment, and hobbies were incurred as part of their writing businesses. The abusive use of sham deductions has long caused the IRS to view such deductions with a fair degree of skepticism. While writers are encouraged to claim the deductions to which they are lawfully entitled, they should also be careful to understand what can be properly claimed and know how to document their expenses.
QUALIFYING FOR BUSINESS DEDUCTIONS
Professional writers may deduct their business expenses and thereby significantly reduce their taxable income. To deduct them, the writer must have incurred the expenses with the motive to make a profit. They also must be ordinary and necessary expenses to carry on a business. An ordinary expense is one that is common and accepted in a particular field of trade, business, or profession. A necessary expense is one that is helpful and appropriate for that business. An expense does not have to be required to be considered necessary. Deductions are not allowed for personal, living, and family expenses, such as the cost of the first telephone line in a residence.
People who write as hobbyists are not entitled to trade or business deductions, except against income earned specifically from a given project. For example, if an avid hunter spends $2,500 on an elk hunting trip in eastern Oregon, and later gets paid $250 by a hunting magazine for an article on the trip, he will be able to deduct $250 of the expenses if he is a hobbyist. However, if a professional writer incurs the same expenses to develop an article or book on which he intends to earn more than $2,500, the expenses would likely be deductible even though the IRS might take a hard look at it. Even if the specific trip did not result in a profit, the professional writer is still allowed to deduct the expenses of the trip from the gross income derived from other writing projects, whereas the hobbyist would not be.
The tax laws presume that a writer is engaged in a business as opposed to a hobby if a net profit results during three out of the five consecutive tax years. In other words, if the writer meets this standard, the IRS will not question that the writer is engaged in a business (though they may still question individual deductions). Writers who do not meet this standard will have to prove the expenses were incurred with a profit motive in order to claim them as business expenses. To prove this, the writer is not required to show that a profit was actually made, but only that he or she intended to make a profit. In determining whether a profit motive existed, the IRS and courts will look to the following nine factors when evaluating an activity:
1. the manner in which the taxpayer carries on the activity (i.e., effective business routines and bookkeeping procedures);
2. the expertise of the taxpayer or the taxpayer’s advisors (i.e., study in an area, awards, prior publication, critical recognition, membership in professional organizations);
3. the time and effort expended in carrying on the activity (i.e., at least several hours a day devoted to writing, preferably on a regular basis);
4. expectations that business assets will increase in value (a factor that is of little relevance to the writer);
5. the success of the taxpayer in similar or related activities (i.e., past literary successes, either financial or critical, even if prior to the relevant five-year period);
6. history of income or losses with respect to the activity (i.e., increases in receipts from year to year unless losses vastly exceed receipts over a long period of time);
7. the amount of profits earned, if any;
8. financial status of the taxpayer (wealth derived from other sources sufficient to support a hobby would weigh against the profit motive); and
9. elements of personal pleasure or recreation (i.e., if significant traveling is involved and little writing produced, the IRS and tax court may be suspicious of profit motive).
No single factor will determine the results. However, claims that writing was done as a business will be subject to close scrutiny by the IRS if the expenses appear to have been motivated by personal enjoyment instead of profit. Examples of the kinds of expenses that suggest an insincere profit motive are research trips to see concerts or experience a cruise, and the purchase of household entertainment equipment, such as televisions and video equipment, for review. This does not mean that such expenses cannot be considered legitimate business expenses or that writers cannot incur business expenses for items they enjoy personally. However, one cannot convert a personal trip into a business trip merely by writing about it and trying to sell the work.
Nonetheless, many expenses that superficially appear to be personal in nature may be deductible—if the writer can prove they were incurred with an actual and honest intent to make a profit. This is illustrated in a tax court opinion involving several deductions taken by a writer, including payments to prostitutes and the travel expenses incurred to visit brothels in another state. The writer was a retired federal employee whose career had entailed writing budget justifications and procedures for an agency. He began writing fiction about two years before his retirement in the hopes of making writing a second career. In order to authenticate the story and develop characters for his manuscript, the writer traveled several times from Virginia to Nevada, where he visited legal brothels and acted as a customer for prostitutes. He kept a journal that recorded extensive information about the brothels and prostitutes.
After completing the manuscript, the writer paid a subsidy publisher $4,375 to publish the novel Searchlight, Nevada. He continued his research at Nevada brothels and prepared another manuscript, which apparently was never published. The subsidy publisher filed for bankruptcy without paying the writer. However, the writer did submit a proof of claim for about $18,000 to the bankruptcy court. Although the writer earned no income from writing during 1994 and 1995, he deducted $37,800 as business expenses. When the IRS objected, the writer petitioned the tax court to allow the deductions.
The court noted that the writer’s record-keeping, level of effort, promotional activities, and extensive search to find a new publisher after the rights to Searchlight, Nevada were returned to him indicated that he had an actual and honest intent to make a profit. It allowed the writer to deduct his home office expenses, the payment to the subsidy publisher, and much of his travel expenses. However, the court disallowed the $9,100 in expenses he incurred in visiting the prostitutes, on the grounds that the expenses were too inherently personal to qualify as business expenses.
There are some strategies available to help writers show the IRS that they are a legitimate business. The following are some ideas that can help you.
• Keep a good set of accounting records, including the use of a separate business bank account.
• If there are any assets that are used for both personal and business use (such as an automobile, computer, photo equipment), keep a log of the personal and business use of each.
• Have a business credit card that is never used for personal expenses.
• Get business insurance.
• Properly register your business with any applicable state or local agencies.
• Secure your business name (if any) with the applicable state authorities.
• If you have a home office, consider setting up a separate telephone line just for business use.
• Keep records that show that you have periodically reviewed the profitability of the business and what ideas were implemented to improve the financial performance of the enterprise.
THE HOME OFFICE DEDUCTION
Tax law changes have made taking a home office deduction much more attractive than it has been in the recent past. Each writer should consider the benefits of taking a home office deduction carefully, even if they have been told in the past that they would be better served not to take the deduction. The home office deduction allows various home expenses to be deducted against the net business income. Expenses that fall into this category include, but are not limited to
• mortgage interest(up to a limit after the changes in the new tax law passed during the Trump administration);
• real estate taxes; (also up to a limit under the new tax law);
• home repairs/maintenance;
• rent;
• utilities;
• insurance;
• security system; and
• depreciation.
The expenses for a home office are broken down into two categories—indirect expenses and direct expenses. Indirect expenses are those that benefit both the business and the personal use portions of the home. The business portion of the expense is taken as a percentage of the total spent. The business use percentage is determined by dividing the square footage of business use of the home by the total square footage. Direct expenses are those that were made to improve only the business use portion of the home. These amounts are allowed in full.
In order for an area of your home to be considered for business use, it must be used regularly and exclusively. Regularly means that the space is consistently used for business purposes only—occasional use does not qualify. Exclusively means that the area is used only for the business purpose (there is an exception for the storage of inventory). Generally, an area is used for business if it meets the above tests and is
• the principal place of business (this includes administrative use);
• a place to meet clients; and
• used for business purposes.
A separate structure from the taxpayer’s personal residence (such as a detached garage converted into a writing room) that is used for business purposes qualifies as well.
IN PLAIN ENGLISH
A home office will generally qualify as a business use for administrative work if the area is used exclusively and regularly and there is no other location available for the taxpayer to conduct these activities.
If the writer is an employee writer as opposed to a freelance writer, the question of whether he or she can take a home office deduction will depend largely on whether the use of a home office is for the convenience of the employer. If the employer provides the writer with an office and does not require him or her to work at home, the convenience-of-the-employer test is not met and a deduction cannot be claimed for the business use of the home. On the other hand, if the employer does not provide office space, and the employee meets the exclusive and regular use requirements, the deduction may be taken.
Meeting the convenience-of-the-employer test will depend on how necessary it is for the employee to work at home as opposed to how convenient it is for the writer. If the employer provides an adequate office that meets the writer’s needs, a home office deduction will likely not be allowed.
Determining the Deduction
There are now (beginning in tax year 2013) two ways to calculate the deduction for business use of a home: the regular method and a simplified method. The simplified method makes the calculation and record-keeping requirements easier. The taxpayer can choose either method for any taxable year. Once you have chosen one method for a particular year you cannot change to the other method for that year. If you use the simplified method one year and change to the regular method in a subsequent year, there are rules about how you must calculate the depreciation deduction. The depreciation rules for the regular method of calculation are beyond the scope of this book. It is wise to consult a good accountant to be sure that you do this properly. For both methods you can deduct a portion of the residence for home office use only if that portion is used exclusively and on a regular basis for business purposes. Under the simplified method of calculation:
• determine the square footage of the home that is used for business (not to exceed 300 feet)
• apply the standard $5 per square foot to determine the deduction
• home-related itemized deductions are to be claimed in full on Schedule A
• there is no depreciation deduction
• there is no recapture of depreciation on the sale of the home
• the deduction cannot exceed the gross income from the business use of the home less the business expenses
• any amount in excess of the gross income limitation may not be carried over to subsequent years
• any loss carryover from the use of the regular method of computation in prior years may not be claimed
Under the regular method of calculation:
• determine the percentage of the home used for business
• the actual expenses must be determined and good records maintained
• home-related itemized deductions must be apportioned between Schedule A and business Schedule—Schedule C or Schedule F
• a depreciation deduction for the portion of the home used for business may be taken
• the depreciation is recaptured on any gain from the sale of the home
• the deduction cannot exceed the gross income from the business use of the home less the business expense
• any amount in excess of the gross income limitation may be carried over in subsequent years
• any loss carryover from using the regular method in prior years may be claimed if the gross income test is met in the current year
An allocable portion of mortgage interest and property taxes can be deducted against the business income. These would be deductible as personal itemized deductions anyway. The advantage of deducting them against the business, in the regular method, is that the business profit subject to self-employment taxes is reduced. A taxpayer who lives in a rented house and otherwise qualifies for the home office deduction may deduct a portion of the rent that would not otherwise be tax deductible. The primary tax advantage for both renters and owners comes from a deduction for an allocable portion of repairs and utility bills and, for owners using the regular method of computation, depreciation. Otherwise, these would not be deductible at all.
As mentioned earlier, deductible business expenses for a writer include all the ordinary and necessary expenditures involved in writing as a business. Most of the expenses that writers incur are classified as current expenses, which are items with a useful life of less than one year. Examples include office supplies, postage, the cost of research books used for specific works, and telephone bills. These expenses are fully deductible in the year incurred.
Some business expenses, however, cannot be fully deducted in the year they were purchased, but must instead be depreciated. These kinds of costs are called capital expenditures. Examples include equipment and furniture. Instead, the taxpayer must depreciate, or allocate, the cost of the item over the estimated useful life of the item. This is sometimes referred to as capitalizing the cost. Although the actual useful life of office equipment varies, fixed periods have been established in the Internal Revenue Code over which depreciation may be deducted. In addition, Section 179 of the Internal Revenue Code allows businesses to deduct all the expense of tangible personal property in the year it is placed in service, up to a certain limit (e.g., $500,000 in 2016). This means that a writer can claim a deduction for all the equipment and furniture purchased during a tax year if the expenditures do not exceed the limit.
There is also what is called a “safe harbor” that would permit certain taxpayers, without audited financial statements, to avoid capitalization of items. The criteria for this safe harbor is technical and beyond the scope of this book. You should discuss this issue with your accountant or tax preparer.
In some cases, it may be difficult to decide whether an expense is a capital expenditure or a current expense. Repairs to machinery are one example. If you spend $200 to repair a computer, this expense may or may not constitute a capital expenditure. The general test is whether the amount spent restoring the machine adds to the value or substantially prolongs the useful life of the machine. Since the cost of replacing short-lived parts of a machine to keep it in efficient working condition does not substantially add to the useful life of a machine, such a cost would be a current cost and would be deductible. A major upgrade that significantly extended the useful life of the computer, on the other hand, would be a capital expenditure that must be depreciated.
Expenditures for professional services, such as commissions paid to agents and fees paid to accountants and attorneys, are generally deductible as current expenses as long as the writer is not treated as an employee for a particular project. The same is true of salaries paid to typists, researchers, and others whose services are necessary for the writing business. If you need to hire help, it is a good idea to hire people on an individual project basis as independent contractors rather than as regular employees. This avoids liability for Social Security, disability, and withholding tax payments. When hiring, you should specify the job-by-job basis of the assignments, detail when each project is to be completed, and if possible, allow the person you are hiring to choose where to work (since this might emphasize the person’s independence). Further, the IRS is getting stricter in requiring W-9 forms and 1099 forms to be filed. There are penalties for failure to properly file them. The IRS applies a twenty-factor test, which focuses on who has control over the work being done, to determine whether a worker is an employee or an independent contractor. It is recommended that a writer, as an employer of either an employee or an independent contractor, consult with a qualified accounting professional at the outset to be certain that the employment relationship is properly structured to result in the proper tax consequences.
Travel
Writers can also deduct expenses for travel provided they can show that the travel expenses were incurred for a business purpose. On a business trip, whether within the United States or abroad, ordinary and necessary expenses may be deductible if the travel is solely for business purposes. Transportation and lodging costs are fully deductible, except when traveling by ocean liner, cruise ship, or other form of luxury water transportation, for which the deductions are subject to a daily limit. Only 50 percent of the costs of meals consumed while on a business trip are deductible, unless they are fully reimbursed by the employer or client and are adequately documented.
In situations where the trip was primarily for business but was extended for personal activities, the business-related travel expenses can be deducted. These expenses include the travel costs of getting to and from the business destination and any business-related expenses at that destination. If the trip is primarily for personal reasons, such as a vacation, the transportation cost is a nondeductible personal expense, even if some incidental business is done on the trip. However, expenses incurred at the destination that are directly related to your business may be deducted. For example, if you travel to attend a friend’s wedding and take a client to lunch while in town, the trip would be a personal expense, except the costs directly associated with the client lunch would be deductible as a business entertainment expense.
When any part of your business travel is outside the United States, some of the deductions for the cost of getting to and from your destination may be limited. For tax purposes, the United States includes the fifty states and the District of Columbia. If the trip is entirely for business, then all expenses may be deducted. If someone travels outside the United States primarily for business, but spends some of their time on other activities, he or she generally can only deduct the business portion of the cost of getting to and from the destination. However, in certain cases, the trip will be considered entirely for business even if some personal aspects are involved.
One situation applies to employees who are reimbursed or paid a travel expense allowance, are not related to their employer, and are not managing executives. Another applies to trips in which the time spent outside of the United States is for a week or less. In such cases, the entire cost of transportation getting to and from the business destination is deductible, as are the other costs associated with days on which business was done. Related to this situation are trips in which the taxpayer is outside the United States for more than a week and spends less than 25 percent of the total time on nonbusiness activities. Finally, there is a catch-all exception, where the trip is considered entirely for business if the taxpayer can establish that a personal vacation was not a major consideration, even if they had substantial control over arranging the trip.
If you are claiming one of these exceptions, you should be careful to have supporting documentation. If you cannot take advantage of one of the exceptions, then you must allocate expenses for the trip abroad according to the percentage of the trip devoted to business versus vacation. This is a very technical area of tax law and mischaracterization can result in serious problems. It is, therefore, important for you to consult with your accountant regarding the proper characterization of travel expenses.
Business Day
Whether inside or outside of the United States, the definition of what constitutes a business day can be very helpful to the taxpayer in determining a trip’s deductibility. Travel days, including the day of departure and the day of return, count as business days if business activities occurred on such days. If travel is outside the United States, the same rules apply if the foreign trip is for more than seven days. Any day that the taxpayer spends on business counts as a business day, even if only a part of the day is spent on business. A day in which business is canceled through no fault of the taxpayer counts as a business day. Saturdays, Sundays, and holidays count as business days, even though no business is conducted, provided that business is conducted on the Friday before and the Monday after the weekend, or on one day on either side of the holiday.
Entertainment
Entertainment expenses incurred for the purpose of developing an existing business are also deductible in the amount of 50 percent of the actual cost. However, starting in 2018, only meals are allowed as entertainment expenses. You must be especially careful about recording entertainment expenses. You should record the amount, date, place, business purpose, substance of the discussion, the participants in the discussion, and the business relationship of the parties who are being fed. Keep receipts for any expenses. You should also keep in mind that the tax code disallows deductibility for expenses that are lavish or extravagant. The IRS has not precisely defined what constitutes lavish and extravagant, but advises taxpayers that an expense is not considered lavish or extravagant if it is reasonable considering the facts and circumstances of it. The IRS also has stated that expenses will not be disallowed just because they exceed a certain dollar amount or take place at deluxe restaurants, hotels, nightclubs, or resorts.
Conventions and Seminars
The IRS tends to review very carefully any deductions for attendance at conventions and business seminars that may serve as a pretext for a vacation, whether inside the United States or abroad. In order to deduct the business expense, the taxpayer must be able to show, with documentation, that the reason for attending the meeting was to promote production of income. Normally, for a spouse’s expenses to be deductible, the spouse’s presence must be required by the writer’s employer or the spouse must be attending as a bona fide employee of the writer’s business.
You cannot deduct expenses for attending a convention, seminar, or similar meeting held outside of the North American area unless the meeting is directly related to your business. Furthermore, to qualify, you must be able to show that it was as reasonable to hold the meeting outside the North American area as within it. If the meeting meets these requirements, you must also satisfy the rules for deducting expenses for business trips in general.
Deductions for conventions and seminars on cruise ships are even more restricted. No more than $2,000 may be deducted per year and the ship must be a US flag ship (registered in the United States). In addition, all ports of call must be within the United States or its possessions. You must provide documentation with your tax return that provides the total days of the trip, the number of hours each day that you devoted to scheduled business activities, and a program of the scheduled business activities of the meeting. You must also attach a written statement signed by an officer of the organization sponsoring the meeting that includes the schedule of the business activities and the number of hours you attended those activities.
Documentation
Maintaining documentation and an expense diary is probably the best means of ensuring that your deductions will withstand scrutiny from the IRS. When you are traveling, keep the following in mind.
With respect to travel expenses:
• keep proof of the costs;
• record the time of departure;
• record the number of days spent on business; and
• list the places visited and the business purposes of your activities.
With respect to the transportation costs:
• keep copies of all receipts;
• if traveling by car, keep track of mileage; and
• log all other expenses in your diary.
Similarly, keep receipts for all items and make sure to record all less expensive items in a logbook for meals, tips, and lodging.
CHARITABLE DEDUCTIONS
The law regarding charitable deductions by creative people of their own work is not very advantageous. Individuals who donate items they have created may only deduct the cost of materials used to create those works. This provision has had unfortunate effects on libraries and museums, which, since the law’s passage in 1969, have experienced enormous decreases in charitable contributions from authors, artists, and craftspeople. The Museum of Modern Art, for example, received fifty-two paintings and sculptures from artists from 1967 to 1969, but between 1972 and 1975 only one work was donated.
Although several modifications of the law have been proposed, Congress continues to resist change in the area of tax treatment regarding individuals’ donations of their own work. However, some states have been more responsive. For example, Oregon and Kansas allow creators to deduct the fair market value of their creations donated to qualified charities, and California treats creative property as a capital asset.
GRANTS, PRIZES, AND AWARDS
Scholarships and fellowships granted may be excluded from taxable income if the recipient is a degree candidate, and are limited to the amounts used for tuition, fees, books, supplies, and equipment. Amounts designated for room, board, and other incidental expenses are considered to be income. Fellowships under which the recipient provides teaching or research services are taxable. No exclusions from income are allowed for recipients who are not degree candidates.
At one time, prizes or awards for recognition of past accomplishments in the scientific, artistic, and literary fields were not taxable income. Now such awards, including the Pulitzer Prize and the Nobel Prize, are included as income to the recipient, unless the prize is assigned to charity.
DEFERRING AND SPREADING INCOME
Another way to reduce tax liability is to defer the income to future tax years or to spread it to more than one person. One way the writer can spread income is to receive payments in installments. Care must be taken with the mechanics of these kinds of arrangements. If a writer arranges to accept compensation in the form of a negotiable note due in full at some future date, the IRS will consider that the compensation is essentially equivalent to cash. Therefore, it is required that proceeds be reported as income realized when the note is received and not when the note is paid off. However, if the agreement provides for payments to be made in installments received in successive tax years, the income is taxed only as the payments are received.
For example, suppose a writer sells a magazine article for $3,000. Ordinarily, the entire $3,000 would be taxable income in the year it was received. However, if it is paid with four payments of $750, received annually over four years, the income will be taxed as the installments are received. In either case, the amount of income is $3,000, but under the installment method, the amount is spread out over four years, and the writer may be able to take advantage of being taxed in a lower tax bracket than if the full $3,000 is received in the year the article was sold.
IN PLAIN ENGLISH
Writers can agree in a book contract that royalty payments for a book will not exceed a certain amount in any one year, with excess royalties to be carried over and paid to the writer in the future.
Negative factors associated with tax deferral include the uncertain effects of inflation, the risk that the publisher may go broke before you are fully paid, and the possibility that income tax rates will rise. The writer should consider these risks carefully before entering into a contract for deferred payments, because it might be quite difficult to change the arrangement if the need arises later.
Shifting Income
Another strategy for writers in high tax brackets is to divert some of their income directly to members of their immediate family who are in lower tax brackets by hiring them as employees. Putting dependent children on the payroll can result in tax savings for professional writers, because their salaries can be deducted as a business expense. The child can earn up to the amount of the standard deduction and the personal exemption without incurring tax liability, unless they are claimed as dependents on the writer’s tax return. If they are claimed on the return, the child may not claim the personal exemption. In addition, the following must be true:
• The salary must be reasonable in relation to the child’s age and the work performed.
• The work performed must be a necessary service to the business.
• The work must actually be performed by the child.
Family Partnerships
A second method of transferring income to members of your family is the creation of a family partnership. Each partner is entitled to receive an equal share of the overall income, unless the partnership agreement provides otherwise. The income is taxed once as individual income to each partner. Thus, the writer with a family partnership can break up and divert income to the family members, where it will be taxed to them according to their respective tax brackets. The income received by children may be taxed at a significantly lower rate, resulting in more net income reaching the family than if it had all been received by the writer, who is presumably in a higher tax bracket than the children. But a writer must be vigilant to avoid the kiddie tax that applies to a child’s unearned income, such as income received from income-producing or investment types of property. This affects children under the age of nineteen, or between nineteen and twenty-three who are full-time students and whose earned income does not exceed half of the annual expenses for their support. You should work with an experienced accountant regarding the kiddie tax since the laws have been revised under the Trump administration.
Although the IRS allows family partnerships, it may subject them to close scrutiny to ensure that the partnership is not a sham. Unless the partnership capital is a substantial income-producing factor, and unless partners are reasonably compensated for services performed on the partnership’s behalf, the IRS may deny the shift in income. The IRS would be relying on the section of the code that deals with distribution of partners’ shares and family partnerships. This section provides that a person owning a capital interest in a family partnership will be considered a partner for tax purposes, even if he or she receives the capital interest as a gift. However, the gift must be genuine and it cannot be revocable.
Incorporating
In the past, some families had incorporated in order to take advantage of the then more favorable corporate tax rates. If the IRS questioned the motivation for such an incorporation, the courts examined the intent of the family members, and if the sole purpose of incorporating was tax avoidance, the scheme was disallowed. There is rarely a substantial tax benefit to be derived by incorporating a business, but there may be other reasons for incorporating, such as limiting personal liability. If the writer employs a spouse and children, salaries paid to them will be considered business deductions, thus reducing the writer’s taxable income. When the spouse and children are made owners of the corporation by being provided with shares of stock in it, then all of the benefits discussed in the previous section on partnership will be available. The unearned income received from the corporation by a child to which the kiddie tax applies follows the same rule as unearned income from a family partnership.
NOTE
The scope of this chapter and the information contained in it is not intended to offer tax advice specific to your circumstances. Its purpose is to point out issues and areas of concern or opportunity to enable you to obtain further information. It is highly recommended that you locate, and retain, a good tax accountant to give you advice pertinent to your particular situation. The principal benefit of this chapter is to provide you with the ability to identify tax issues that you should discuss with your accountant or tax advisor. Be aware that regulations for the tax changes inherent in the Trump administration’s Tax Cuts and Jobs Act have not been written as of the date this book was written, so consultation with a knowledgeable tax expert is particularly important.