Ask the Tax Expert: Can I Deduct the Cost of Equipment?
Question: I have a full-time job, but also do professional photography on the side. I mainly photograph weddings, engagements and a few other special events. I’ve finally decided to spend a bit more time on this, and need to buy some new equipment. Can I deduct equipment costs on my taxes?
-Sara in St. Paul, MN
Stephen Fishman: Yes, you can deduct the cost of the equipment you buy for your photography business. There are several different ways to take this deduction:
- You can deduct the cost a little at a time over 6 years—a process called depreciation.
- You can deduct the entire cost in a single year using a provision of the tax code called Section 179—you can use this deduction only if you use the property more than 50 percent of time for business each year. There is an annual limit on this deduction, currently it is $25,000.
- You can use a new IRS regulation called the de minimis safe harbor the permits you to deduct in a single year any equipment you use in your business that costs $500 or less. To use this deduction, you must file an annual election with your tax return—something that is easy to do. When you make this election, it applies to all expenses you incur that qualify for the de minimis safe harbor. You cannot pick and choose which items you want to include.
Most business owners want to deduct as much as possible the first year they buy equipment, instead of deducting a portion of the cost over many years. Thus, you’ll probably want to use Section 179 or the de minimis safe harbor.
If you use the photography equipment both for your business and for personal use, you may only deduct the business use percentage. For example, if you use a $500 camera 75 percent of the time for business, and 25 percent for personal use, your deduction is $375.
Photography equipment falls within a special tax category called “listed property.” The IRS fears that taxpayers might use listed property items for personal reasons but claim business deductions for them. For this reason, you’re required to document your business use of listed property. You can satisfy this requirement by keeping a logbook or similar record showing when and how the property is used.
For more information about deducting business equipment, Section 179, and the de minimis safe harbor, see IRS Publication 946, How to Depreciate Property.
Question: I’m starting a small marketing agency, which I’ve incorporated as an S-Corp. I have been saving for several years, and have enough stashed away to live on for a couple years while I build the business. Luckily, I’ve already landed a couple of clients and am bringing in some revenue.
I plan to invest most of this back into the business, but would like to pay myself a dividend each quarter. However, I also know the IRS requires me to take a salary, which I haven’t been doing since I’m living on my savings. Can you clarify the rules about this for me?
-James in San Francisco, CA
Stephen Fishman: When you incorporate your business, if you continue to work in it, you automatically become an employee of your corporation, whether full or part time. As such, you must pay Social Security and Medicare taxes on any employee salary your S corporation pays you for your services. You do not have to pay such tax on dividends from your S corporation (the net profits that pass through the corporation to you personally as a shareholder).
The larger your dividend, the less Social Security and Medicare tax you’ll pay. Theoretically, if you took no salary at all, you would not owe any Social Security and Medicare taxes. However, this is not allowed.
The IRS requires S corporation shareholder-employees to pay themselves a reasonable salary (at least what other businesses pay for similar services). If the IRS concludes that an S corporation owner has attempted to evade payroll taxes by disguising employee salary as corporate distributions, it can re-characterize the distributions as salary and require payment of employment taxes and penalties which can include payroll tax penalties of up to 100 percent plus negligence penalties.
What constitutes a reasonable salary depends on the circumstances and is subject to debate. There is no simple formula you can use or specific IRS guidelines to rely on. The general rule is that reasonable pay is the amount that like enterprises would pay for the same, or similar, services. Among the factors the IRS and courts consider are:
- the duties performed by the employee
- the volume of business handled
- the type of work and amount of responsibility
- the complexity of the business
- the time and effort devoted to the business
- the timing and manner of paying bonuses to key people
- use of a formula to determine compensation
- the cost of living in the locality
- the ability and achievements of the individual employee performing the service
- the pay compared with the gross and net income of the business, as well as with distributions to shareholders
- the company’s policy regarding pay for all employees, and the payment history for each employee.
However, as a general rule of thumb, to avoid problems with the IRS, you should usually pay yourself a salary of at least one/third to one/half of your S corp’s net profit, up to the annual Social Security limit ($118,500 in 2015). Since your business is in the start-up phase, you may have little or no net profits, thus your salary could reasonably be quite small.
Our resident small business tax expert, Stephen Fishman, answers your small business tax questions. Have a tax question for Stephen? Submit it here.