It's everyone's favorite time of year: tax season! 😒
Watch the video 🎥 here 👆
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Read the post 📚 below 👇
Do you want to overpay your taxes to the IRS? I'm hoping the answer is no. Let's make sure you get every tax deduction you're entitled to. Today, I'll walk you through the seven tax tips all private practice therapists should know before filing their taxes.
What are tax deductions and why should I care?
Remember that you only pay tax on your taxable income. Your taxable income is the income remaining after you deduct all business expenses from your revenue. That's why eligible business expenses are often called tax deductions.
If this is sounding confusing - be sure and check out my post on understanding your practice P&L where I walk you through how business expenses reduce your taxable income.
Let's be sure and get the details right - and not overpay taxes!
It's really easy to get confused by deductions. My tip is to think about business expenses and tax deductions as one in the same - because they are. Virtually all expenses you incur for your business are deductible to reduce your taxable income. Assume all expenses are deductible until proven otherwise. But there are some exceptions and nuances - but don't fret, that's what we'll cover today.
If you want a general overview of how tax deductions work, this IRS page actually provides a pretty clear overview. And for a general walk-through of basic deductible business expenses you should think through, check out this post on Tax Deductions for Therapists from Mind Money Balance.
But there are some deductions that many people overlook! And some deductions are tricky and easy to get wrong. These nuanced deductions are what we're going to cover today.
I don't want you to overlook any deductions, because that means you'll overpay your taxes! Equally, I don't want you to make a mistake on the more complex deductions - that might cause the IRS to give you some grief. 👎
Before we dive in, I want to remind you that this post doesn't contain specific recommendations or tax advice for you to implement. These are general guidelines and ideas to think through on your own or - even better - in concert with your tax preparer and financial planner.
I don't know the nuances of your particular situation and there's no way I could cover every important aspect of tax law in this short post. Consult with your tax preparer or carefully follow the instructions in the tax filing software you use. If you suspect you require some professional advice, be sure and seek that out!
The top seven tax tips for therapists in private practice
1. Consider shared personal expenses 👯♀️
What the heck is a shared personal expense? That's simply my term for expenses you incur in your personal life that partially benefit your business.
Shared personal expenses might include your mobile phone and home internet. Fees paid to professionals for financial planning and filing your taxes also might be included - even tax prep software. Any out-of-pocket fees you’ve paid for your own personal therapy also could be included.
You probably shouldn't deduct 100% of these expenses as a business expense, but if you're using these personal items to support your practice, considering deducting an appropriate percentage - up to 80% is a general rule of thumb.
Think through what an accurate percentage is for how you use those personal items in your business. Consider jotting down a quick note summarizing how you arrived at that percentage and save it with your other tax documents. You don't need to overthink this, but having a small piece of documentation will really help you if the IRS ever comes knocking. Oh, and of course be sure and save those receipts!
These shared personal expenses are so often overlooked by private practice owners - which means you're overpaying on your taxes! Be sure and take this deduction if it applies to how you run your business!
2. Education expenses... not all deductible 🙈
Most continuing education expenses are fully deductible. But the education expenses you incur to first become licensed (e.g. your masters or doctorate program and test prep services for your licensure exam) are sadly off limits.
You may not deduct education expenses "that will qualify you for a new trade or business or that you need to meet the minimal educational requirements of your present trade or business." Test prep expenses and even the expense of sitting for the licensure exam itself are usually included in this non-deductible category. You can read about the specifics on this IRS page, or consult with your tax professional if you have further questions.
I know it's a bummer to not be able to deduct these expenses and reduce your tax bill - especially when you're just getting started in private practice. But better to follow the rules and not create a big headache (or tax penalties!) for yourself down the road.
3. Big expenses are subject to depreciation - or are they?! 🤔
Any single item costing $2,500 or more may be flagged to be capitalized and depreciated. Capitalizing and depreciating sounds complicated, but the idea is actually pretty simple. For big purchases, the IRS wants you to divide the deduction over several years instead of taking the entire deduction in one single year. Capitalizing and depreciating are the technical accounting methods to make that happen. The idea is that big purchases will probably benefit your practice for several years, and hence the expense should be likewise spread over several years.
But there are some ways around this! These rules are too nuanced to review in detail in this post, but if your tax preparer flags an expense to be capitalized be sure and ask whether you qualify for either Section 179 deduction or special first-year 100% bonus depreciation. These two provisions usually allow you to fully deduct the purchase price in the year you make the purchase. And we like taking those tax deductions as soon as possible because it means more money in your pocket today.
Looking for more great resources to help you navigate your financial life? Check out my free Guide to Financial Planning for Therapists. Click here to access!
4. Food & entertainment expenses 🎟
It used to be that you could deduct some entertainment expenses, but that is sadly no longer the case. Any expenses considered entertainment, amusement, or recreation are off-limits. Golfing, movies, concert tickets - none of these expenses will reduce your taxable income. (You probably didn't do much of that anyway in 2020, so perhaps a bit of a silver lining there.)
Food and meal expenses you incur are generally only 50% deductible. If you incurred $1,000 of annual expenses for in-office snacks, occasional overtime meals and the like, you may only reduce your taxable income by $500 (0.5 x $1,000). This rule will change for tax years 2021 and 2022. Recent legislation will allow meals purchased from restaurants to be 100% deductible, but only for those two years.
Be sure and keep your receipts to substantiate meal expenses. The substantiation (e.g. documentation) requirements for meal expenses are a bit stricter than normal business expenses. Simply write on the receipt the names of the meal attendees, their business relationship to you and the business purpose of the meal. Snap a quick photo of that receipt, save it in your tax directory and you should be good to go.
5. S-Corps must use an accountable plan! 💼
If your practice operates through an LLC or Corporation which has made the S-Corp election, be sure and have an accountable plan established. What the heck is an accountable plan? It's a plan that governs how your S-Corp reimburses you for business expenses you paid for with your personal accounts. An accountable plan is also necessary for claiming the home office deduction (see below) through your S-Corp.
Thankfully accountable plans aren't some big, complicated thing you need an army of attorneys to establish. It's really just a simple policy and procedure document - and it doesn't even have to be written down (although a written plan is a good best practice). For more information, check out this great post on Accountable Plans from TL;DR: Accounting. Or contact me and I'll be happy to walk you through the simple process of establishing an accountable plan.
6. Beware the home office deduction! 🏡
The home office deduction is one of the trickiest and most confusing deductions out there. Many people think claiming the home office deduction increases the risk of being audited by the IRS. Although the ways of the IRS are mysterious, I don't think that's necessarily true. But the IRS likely does find plenty of errors in applying the home office deduction because the rules are confusing - let's make sure you take the deduction the right way!
Eligibility rules for the home office deduction
There are two rules that determine whether you can take the home office deduction. You need to meet BOTH of them.
The first rule is that you must have a space in your home which you dedicate to (i) regular and (ii) exclusive use for your business. Finding a place where you regularly do business is easy but the exclusive part is tricky. And exclusive does mean exclusive. Don't store personal belongings there, don't host game night there, pretty much don't do anything but your work. There are some small exceptions for if you have to walk through the space to access another part of your house - that's fine. But other than that the space should be off limits for anything but work. You can even set aside just a small portion of a room as your office, which is useful if you live in a small home like a studio apartment. Just be sure that area is used exclusively for business.
The second rule is that your home office must be the principal place of your business. Many of you probably have a dedicated office outside of your home, but don't despair - all is not lost! You can establish a home administrative office.
This home administrative office should be the primary place you conduct administrative operations (e.g. pretty much everything other than seeing clients). If you dedicate your out-of-home office to seeing clients and dedicate your in-home office to handling administrative work, you have met this second "principal place" test. Just make sure that outside of your home office, "there is no other fixed location... where the taxpayer conducts substantial administrative or management activities."
2020 was, of course, a special year - most of us spent almost ten months of the year at home. Although I'm not aware of any formal guidance from the IRS, if you've been working from home for the majority of 2020 the 'principal place' test should be easily satisfied.
Calculating the amount of the home office deduction
There are two different ways to calculate the amount of the home office deduction: the simplified method and the regular method.
The simplified method allows you to deduct $5 per square foot of home office space each year. The square footage is capped at 300 square feet, making the maximum deduction $1,500. This is a great option if you don't want to keep records of all your home expenses.
The regular method is a better option if your home is relatively expensive. Under the regular method, you calculate the percentage of your home's overall square footage dedicated to the home office. You then multiply that percent by the total expenses of maintaining your home during the year. The total home ownership expenses which you can (partially) deduct include mortgage interest (or rent), insurance, utilities, repairs and depreciation. Note that you may not deduct the entire mortgage payment - only the portion related to interest.
I know - this is all a lot of numbers. You can use my simple worksheet to come up with a rough estimate of what this deduction might be worth to you. But always get professional tax advice (or use tax software) to calculate your actual taxes.
Should I bother with home depreciation?
You might have noticed that the regular method allows you to deduct a portion of depreciation for your home. And you might wonder what that even means. Depreciation used in this manner is complicated, and I suggest you use a tax professional to execute it. But I'll help you make an estimate of whether investigating further is worth it.
You can make a rough estimate of the potential maximum annual depreciation deduction by taking the purchase price of your home, multiplying that by 80%, dividing by 27.5 and then multiplying by the home office square footage percentage. (I know, that's a lot of steps, you can use my simple spreadsheet here.) If that number feels like a big enough tax deduction to do more work, go find a qualified CPA to execute on it. If that number doesn't seem like that big of a deal to you, forget about it and move on.
Special rules for S-Corps!
Finally, if you are using an S-Corp, what you'll want to do is charge your business entity rent and reimburse yourself for that rent through the accountable plan we talked about earlier. This process isn't actually taking the home office deduction, although you're getting the same result through a different accounting mechanism. Using the home office deduction methodology is a good way to calculate the rent amount for this method.
If you'd like more detail from a CPA on the home office deduction, check out this piece from Mark J. Kohler, CPA.
7. Beware the personal vehicle deduction! 🚗
The home office deduction is probably the trickiest, but deducting the use of your personal vehicle for business has got to be a close second. But don't let that discourage you - you should take this deduction if you meet the requirements!
Just like the home office deduction, there are two different ways you can calculate the amount of the personal vehicle deduction: the standard mileage rate and the actual expense method. Under either method, you need to track how many miles you drive your vehicle for business so let's talk about that first.
What miles count as business miles?
Your business mileage consists of any miles that you drive your personal vehicle for work-related purposes. That includes trips driven to meet a client, to run work-related errands such as purchasing supplies, visiting the bank or even meeting with your accountant, attorney or financial planner.
Some miles don’t count as business miles. Commuting from your home to your office for example does not count. However, if you establish an administrative home office and then travel to your other primary office, those are business miles. Why? Because you’re not traveling from home to office - you’re traveling between two different office locations. Similarly, if you make a personal stop during a business drive, the miles driven after that personal stop generally are not business miles.
Keeping track of this mileage can be a pain, but there are several free apps to help you automatically track miles. You can also use your phone to snap a quick photo of your odometer at the beginning and end of business journeys.
Standard Mileage Rate Method
The standard mileage rate is fairly straightforward. You simply multiply your total business miles driven by the standard mileage rate. The product of that multiplication is the amount of the personal vehicle deduction you can use in your business for the year. You can find the current rate on the IRS website. The rate for 2020 is 57.5 cents per mile and for 2021 it's 56 cents per mile.
In addition to the standard mileage rate, you can additionally deduct a few out-of-pocket expenses, provided you can document they relate to business use of the vehicle. These expenses include interest on an auto loan, registration and property tax fees as well as parking and tolls.
Actual Expense Method
The actual expense method is more work, but will typically yield a higher deduction if you own or lease a more expensive vehicle. Under this method, you’ll need to keep track of both the business mileage driven in the year, as well as the total mileage driven in the year.
You then use those two mileage numbers to calculate the percent of total miles driven for business. Simply divide the business miles by the total miles to get that percentage. Then multiply that percentage by the total actual expenses related to your vehicle in that tax year. The product of that multiplication is the amount of the personal vehicle deduction you can use in your business for the year.
What expenses are eligible to be included in the total actual expenses? Really any expense you incur to maintain and operate your vehicle. You can typically include the full amount of the lease payment, but only the interest portion of your auto loan payment. Much like the home office deduction, if you own your vehicle you can also include the expense of depreciation. Calculating the amount of that depreciation is painfully complex and best left to tax professionals. If you have an expensive vehicle and your business miles are a high percentage of your total driving, figuring out that depreciation can yield a meaningful deduction. If that’s not the case, you might consider just leaving it alone (unless you tax preparer is already looking into it.)
Nuances of the Standard Mileage Rate
If you own your vehicle, you must use the standard mileage rate in the first year you own the vehicle, otherwise that vehicle is never eligible for the standard mileage rate method (you would always have to use the actual expense method). After the initial year, you can choose either method - generally, whichever yields the higher deduction.
If you lease your vehicle, you have less flexibility. You have to choose either the standard mileage rate or the actual expense method and use that method for the entire term of the lease. You don’t have the ability to switch back on forth. Why? I have no idea. Those are just the rules. 😬
That's a Wrap 🎬
Alright, I hope you found this post helpful! This was a LOT of information. So, let me know if that avalanche of information was helpful! What made sense, and what points are still confusing? What else would you like to hear about that would be helpful? Give me a shout and lemme know!
And if this all feels a bit much, give me a shout. I work one-on-one with therapists from all over the country helping them address issues just like the ones we talked about today! There are a bunch of different ways to work with me which I describe on my services page.
Turning Point is a registered investment advisor in the state of California. Please visit turningpointhq.com for important information and additional disclosures. This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes financial, legal or tax advice; a recommendation for purchase or sale of any security; or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Read the full Disclaimer here.