In a blog post last week, I talked about how it’s poor tax planning to spend money on something just to get a tax deduction.
In that post, I briefly mentioned a client who owed $1,500 to the IRS and who wanted to “start a side business” to “get deductions” to wipe out the $1,500. I want to write more about this today.
There are two reasons why this is a bad idea. Here’s what I told the client:
- Is it a business or is it a hobby? Even though the client had a legitimate business idea, if you operate for the express purpose of just getting tax deductions, your business lacks a profit motive. If you aren’t operating to make a profit, then you become subject to the “hobby rules”, and your deductions become severely restricted.
- Economically, it’s a horrible idea. Deductions don’t result in a dollar-for-dollar tax savings. The client was in the 25% tax bracket, so each dollar of tax deduction saved 25 cents. Even if they could have proven a profit motive, they would have had to generate business losses of $6,000 to eliminate a $1,500 tax liability. Spending $6,000 to save $1,500 makes no sense when you can just pay $1,500 and be done with it.
After hearing this, the client dropped the idea of starting a business and agreed with me — spending money specifically to get a tax deduction is always a bad idea.