GreenPal CEO Bryan Clayton spent years deducting every possible business expense on his tax returns. When he sold his former company, Peach Tree Inc., in 2013, he discovered that probably wasn't the greatest idea.
"I was penalized for taking all of those not-quite-necessary deductions," he said. "Had I taken a better approach, I would've made a lot more money in the long run when my business was acquired."
That's because the commercial landscaping company's value, which was grossing more than $8 million annually, was determined on earnings after interest, taxes and expenses. Smaller taxable income meant a lower sales price.
Self-employed professionals and business owners (there are over 15 million, according to the Bureau of Labor Statistics) may be tempted to spend freely and take as many deductions as possible in any given year, yet there are circumstances where it makes more sense to be more frugal or defer deductions, tax and financial experts say.
It's important for the self-employed to know the rules. Businesses must report all earned income and expenses. There are cases where businesses claim items that aren't actually legitimately deductible.
"They think that their personal cellphone that they may use for a few business calls, their home internet, their only car which they claim 100 percent for business, and other personal expenses can be business deductions," said Abby Eisenkraft, an enrolled agent and CEO of Choice Tax Solutions Inc. in New York.
Not only does that cause a problem if they're audited by the IRS, it could also hurt their cause when it comes to a sale, qualifying for a loan or making a retirement contribution based on taxable income, she said.
However, there are times where it makes sense to defer making purchases, and be a spendthrift in any given year.
Consider the following circumstances:
Self-employed Texas designers Pablo and Beverly Solomon tried for years to limit their taxable income by spending on their businesses, which held down how much self-employment tax they had to pay for Social Security contributions.
"We took deductions over the years thinking that by investing the savings, we could do better than the Social Security checks," Pablo Solomon said. "With so many years of low interest rates, several stock market crashes and a wild real estate market, things did not fall into place as perfectly as planned."
Their Social Security checks are now too small to live on, but the couple luckily has other sources of retirement income.
Retirement plan contributions for the self-employed — up to $54,000 annually in a SEP-IRA or solo 401(k) — are based on the amount of profit or income in the business, said Richard M. Prinzi Jr., CPA and co-founder of F-Sharp Tax Management Services. The less taxable income you have, the less you can take advantage of the plans.
You may choose to be frugal in your business or defer deductions if in the next three years you plan to either sell, as GreenPal's Clayton did, or obtain long-term financing, said Jeff White, a financial and legal analyst with FitSmallBusiness.com.
"When you sell your business, you'll likely be asked to give the buyer at least three years of tax returns," he said. "Many buyers rely on these net income numbers more than your accounting books, because so many expenses can be claimed in a sole proprietor business when you're doing your end-of-year accounting."
Loan officers also will look to your tax returns to gauge your ability to repay a loan, White said. Less income may translate to a smaller loan.
Lower taxable income could also hurt a business owner's personal goals.
"Small-business owners should be wary of their personal finances. Deductions lower business income, but that also hurts a business owner's ability to qualify for family needs like a mortgage or loan for a new minivan," said Jason J. Howell, a certified financial planner and president of Jason Howell Company in Vienna, Virginia.
Timing — and matching expenses with income — is perhaps the most important reason to defer deductions, said Paul T. Joseph, CPA and principal at Joseph & Hedrington in Williamston, Michigan.
"You may want defer expenses to the next reporting period because you are anticipating a large income item which will come in," Joseph said.
Joseph cited the example of owning a pineapple farm: There would be the expense of planting the pineapple trees in year one, maintenance in year two and income from selling your pineapples in year three. If you can defer the making the expense to the year you receive the income, you can take the losses against the gains to limit taxes.
The important thing when it comes to all tax decisions and opportunities is keeping good records.
"I meet many small-business owners, and they like to say 'I deduct everything,'" Eisenkraft said. "The problem with that line of thinking is that they will never survive an IRS audit. For those who are smarter, they will learn that lesson [early]."