Whether starting up or branching out, make taxes work for you
With the goal of stimulating fresh revenue sources and services, it’s not unusual for an established chiropractor to branch out and start a new operation in the same or a related field. Few chiropractors realize, however, that Uncle Sam stands ready to become a partner—though not always an advantageous one.
But if you play your cards right, Uncle Sam in the form of tax laws will not only pick up part of the cost of starting that new venture, but will often allow the losses from a secondary activity to reduce the income tax bills generated by self-employment, wages, investments, or the primary business.
Write me off
In most cases, the necessary expenses of carrying on a trade or business are tax deductible. But if there is no business entity, business tax deductions don’t apply. Fortunately, special rules exist for the expenses incurred in starting a business as well.
Anyone who pays or incurs startup costs and subsequently enters into a trade can expense and immediately write off up to $5,000 of those costs. But the $5,000 deduction amount is reduced dollar-for-dollar when the startup expenses exceed $50,000.
Organizational costs are in a separate class from startup expenses but are subject to similar rules. An incorporated practice can, for instance, choose to deduct up to $5,000 of organizational expenses incurred in the tax year in which it begins business.
The balance of startup or organizational expenses, if any, is amortized over a period of no fewer than 180 months, beginning with the first month of business.
Extending an office branch
Many chiropractors have multiple business activities. In almost every situation, you must determine whether the new activity is a subsidiary of the existing practice or if the IRS will view it as a separate operation. If it can be argued that the addition is really an extension of the original practice, a significant write-off is available.
To illustrate, suppose you operate a profitable practice and decide to build a warehouse at the same location for online sales of health supplements. Your startup expenses amount to $70,000 and include the cost of hiring staff, setting up bookkeeping and an operations manual, as well as advertising and promotional efforts. If this were an integrated operation, you could immediately deduct the startup costs. If not, the rules require they be capitalized and amortized.
Find a hobby
Income from any source is usually taxable. Fortunately, the losses from a money-losing activity (existing or new) can be used to offset the income from other sources. With hobbies, or activities that are not engaged in for profit, the expenses are generally deductible only to the extent of income produced by the hobby.
Some expenses are tax deductible regardless of whether they are incurred in connection with a hobby (such as taxes, interest, and casualty losses). If, however, the activity is engaged in for profit—meaning that it operated with the intent of making a profit—many activity-related expenses are deductible even if they exceed the income from that activity. Any losses can offset income from other sources.
The general rule is that an activity is presumed not to be a hobby if profits result in any three of five consecutive tax years. Without profitable years, anyone operating a secondary activity or hobby can, if asked, prove there is intent to earn a profit using IRS guidelines.
Whether starting a new venture or expanding an existing one, consider formalizing the operation by incorporating or forming a limited liability company (LLC) to obtain personal liability protection and earn advantages in fees, sales, financing, and taxes. Incorporated startups or expanding enterprises won’t escape IRS scrutiny under the hobby rules.
Corporations (both S and C), LLCs, and limited partnerships do offer protection to owners for the debts of the corporation. Sometimes it’s enough that the principals are majority shareholders, exercise substantial control over the incorporated operation, or regularly use corporate funds to finance personal expenses.
Good times or bad, often the most difficult decision during startup or expansion is where to seek funding.
Generally, there are two ways to fund a business: debt financing or equity financing. With the debt route, financing capital is received in the form of a loan that must be paid back. With equity, capital is received in exchange for part ownership.
Putting money into a practice, or taking money away, is not something to be tackled by amateurs. Money invested in a practice can be withdrawn with a tax bill on any profits from the sale of that capital investment. On the other hand, a loan can be repaid tax-free if it is a bona fide, arm’s-length transaction.
By the accounting books
No single accounting method is best for all businesses. Both the cash and accrual accounting methods have their pros and cons. The basic difference between the two lies in the timing of revenue and expenses.
The cash-basis method realizes revenues when money comes in and expenses when money is paid out. Cash-basis accounting doesn’t recognize accounts receivable or payable. Only when a bill is paid does an operation recognize an expense.
Your practice must use the same accounting method to calculate taxable income in your bookkeeping records as it does to operate the venture you’re branching out from. Your accounting method must clearly show income.
The passive trap
Material participation rules limit the deduction of losses from passive activities in which the taxpayer does not “materially participate” in the activity. Generally, losses from passive activities may not be deducted from nonpassive income (such as wages, interest, or dividends).
An individual materially participates in an activity if he or she is involved on a regular, continual, and substantial basis during the year (the facts and circumstance test), or if the individual participates in the activity for more than 500 hours during the year (the 500-hour test).
Can I pick your brain?
Access to legal, accounting, and other expertise is essential for rapid growth when expanding a practice. In addition to legal advice, seek accounting services to set up the new operation’s books, auditing, taxes, and retirement planning.
The first step to finding the right professionals requires an inventory of resources and, most importantly, your budget for that counseling. Determine beforehand how much of the work will be done by outside assistance and what tasks will be internally.
The IRS can both tax and underwrite practice expansion costs. On the one hand, it stands ready to tax all income. On the other, many of the expenses incurred by an expanding or new venture can be used to offset income.
Will the IRS view your new or expanding practice as a tax business?
MARK E. BATTERSBY is a tax and financial adviser, freelance writer, lecturer, and author located in suburban Philadelphia. He can be reached at 610-789-2480.
DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional adviser about issues related to your practice.