Tax Tips for Musicians
Everybody complains about taxes, but how many of us do anything about them? Well, you can improve your tax situation by doing several things. Even though it's too late for the 2002 tax year, you can save a bundle, legitimately, with your music business for this year'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 most tax 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 Business Administration, there are 25 million small businesses in the United States today, and a large percentage of them are sole proprietorships, or one-person shops. As a sole proprietor, you report your music business income as part of your personal income using the IRS Schedule C and a few other forms. (Tax forms and Schedules can be downloaded from the IRS Web site, www.irs.gov.)
It all comes down to income and expenses — the money you make and the money you spend. The more you make, the more you pay in taxes. Even the most convoluted of IRS instructions make that point painfully clear. That means the converse is also true. Because the IRS taxes only your business profits, cut back on the profit and pay less in taxes.
You might be thinking, “But, dude, I gotta eat.” I'm not saying that you should earn less. Instead, look for all the possible ways to convert your everyday expenses into legitimate business deductions. Even some personal expenses may be deductible against the business. The more expenses you have, the more you reduce your taxable income. And because you were going to spend the money anyway, you might as well realize some tax benefits from those expenses.
Basically, all the expenses you incur to run your small music business are deductible. To be fully deductible, however, business expenses must be “ordinary and necessary” according to the IRS. That's just fuzzy enough to be dangerous. Ordinary means the expenses must be typical for the business. Buying a new guitar could apply; buying a dishwasher wouldn't. Necessary means the expense 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 items are definitely necessary for the success of the typical music business (see the sidebar “Deductible Reasoning” for a list of typical 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 15.3 percent self-employment tax, and send an additional 3 percent to your state. Furthermore, these percentages are given only for the purpose of discussion. The Tax Code changes from time to time, so you should verify your federal and state income tax brackets.) Of course, that also implies that for every legitimate $100 business expense you incur, 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 to succeed. It lets you invest money in your business as incentive for you to earn more. And the more money you make, the more you'll pay in taxes. You see, it has an ulterior motive.
Here's the caveat: your business must turn a profit three out of every five years or it will be classified a hobby, and you forfeit the expense deductions. The bottom line here is a very high tax bill.
The burden of proof falls solely on you, so it is vital that you record all your music business income and expenses diligently. A shoebox full of receipts does not a bookkeeping system make. Get help setting up your books or look for a software solution to help document your business financial transactions.
Here's another important gotcha: If you're just launching your music business, startup expenses can't be deducted all at once. You must amortize them over five years by taking 20 percent portions of the total 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 a sweet tax deduction? Under section 179 of the Tax Code you can deduct or “expense” up to $25,000 of tangible property this year and write it all off when you prepare your taxes next year. For tangible property, think expensive, long-lasting items, such as a new computer. This amount is above and beyond many other normal business expenses you might incur.
If you've had a particularly strong earnings year, you can offset some of that gain by deducting all the cost of large purchases in one year (up to the $25,000 limit). Alternatively, you can depreciate what you buy and deduct a portion of those costs over the next several years.
HOME SWEET HOME
If you do the majority of your music work in your home office, you can deduct a portion of the same expenses that currently do little or nothing to lessen your tax burden. You can write off rent or mortgage interest, property taxes, utilities (gas, electricity, water/sewer), insurance, repairs, and depreciation. First, dedicate a portion of your home entirely to your music business. Keep it free of personal items and make it your primary business location. Beware that if you do most of your work elsewhere (gigging, for instance) and use this home office only occasionally, your deduction may be limited or entirely verboten.
Here's how to figure your deductions. Total up the square footage of your exclusive place of business and compare it to the total square footage of your residence. Say your math works out to 10 percent. You can then deduct 10 percent of the aforementioned expenses using Form 8829 — Expenses for Business Use of Your Home. The total deduction then flows through to your Schedule C, reducing your income and therefore your taxes.
There is a recapture clause for homeowners to consider. If you sell your home and make a profit, those profit dollars become taxable business income at the same percentage rate as your deduction. Score a $50,000 gain from the sale of your home and, following the above example, $5,000 of it belongs to the business (subject to self-employment tax and regular income tax, of course). It's important to note that the personal income you make from a house sale is generally not taxed, though. If you stop taking the home-office deduction for two tax years prior to the home sale, this recapture clause doesn't apply.
Yes, we self-employed people have a special tax just for us. Actually every worker pays the same tax — funding for Social Security and Medicare — it's just a little different when you're on your own. You must contribute both the employee and employer contributions, which total up to a whopping 15.3 percent. Yep, just over 15 pennies on every buck you earn goes right into the Social Security kitty. This is, of course, before you start paying any regular income 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 send in 25 percent of that money on April 15, June 15, September 15, and January 15 of the next year. These estimated tax payments are important, because if you don't pay enough, there's a penalty due the next April 15.
EAT, DRINK, AND BE MERRY
When you entertain your clients, the money you spend is another write-off. However, meals and entertainment are subject to a 50 percent limitation, so if you spend a $100 on a pizza party, you can take $50 off on Schedule C. Give clients gifts, up to $25 per client, and you can take that as a full deduction, though.
When you travel as part of your music business, those expenses are deductible including airfare, lodging, and meals. You must support your travel and lodging deductions with receipts. However, instead of keeping track of your meals, you can take the government's standard per diem allowance of $30 for “meals and incidentals.” A few cities (such as New York City) may have a higher rate than the $30 standard; check the official Web site (www.policyworks.gov/perdiem) to be sure. Meals on the road are, of course, still subject to the 50 percent limit.
Yes, that old beater is worth money! Keep track of actual vehicle expenses (gas, repairs, and so on) or take the standard mileage rate (which changes every year; check with the IRS). In either case, you must document the miles you drive for business, the date and purpose of trips, and the expenses incurred. A dedicated notebook/diary earns a gold star from the IRS.
Even if you use your ride for business and personal use, the business portion of your expenses is still deductible. Determine your business percentage by dividing your business miles by the total miles driven (2,500 business/10,000 total = 25 percent). If you just use the standard mileage rate, multiply your business miles driven by that rate (2,500 × $/mile = deduction) to arrive at your deductible expense amount. You can also deduct the full cost of tolls and parking fees incurred while on business. Furthermore, the loan interest on the car is deductible (subject to the business-use percentage).
YOUR HEALTH AND FUTURE
Your health-insurance premiums are deductible. That doesn't come off the Schedule C but is a front-page deduction on your personal 1040. In 2003, self-employed individuals can finally deduct 100 percent of the premiums they pay. Other typical medical costs are deductible on Schedule 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 it rewards you with a nice, fat deduction each year. This is another 1040 deduction, not Schedule C. IRAs are the first method that pop up. However, they're limited to $2,250 this year. With a SEP (Simplified Employee Pension), you can deduct as much as 15 percent of your business income topping out at $30,000 total per year. The more you put away, the more you save. And since you're really helping yourself down the 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 no up-front deduction, but the earnings are tax-free. You should talk to a financial planner to figure which approaches will benefit you the most.
EOY TAX TIPS
At the end of each year, you have another opportunity to reduce your tax burden: accelerate expenses and decelerate income. First, spend some cash on business expenses. Don't just blow the wad; make sensible purchases this year that will reduce your taxable income. Ideal last-minute purchases include postage, equipment, general office supplies, and promotions. You can also pay your mortgage and health insurance premium before the year-end to realize some other tax savings on the personal side. Second, this December, put off collecting money until January by billing your clients a little later. Though you'll have to pay taxes on the money eventually, you defer that payment for a whole year.
Even though we all have to pay taxes, we are only required to pay our 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-related businesses.
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 personal deduction)
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 download the free guides that explain the specific tax benefits for small-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 your music success fortune. See it and other resources atwww.jeffreypfisher.com.