How do Tax deductions work?

There is a lot of misconceptions about how tax deductions work, and we want to help demystify this a little bit.

We at Wilson Lake don’t recommend purchases solely for the purpose of obtaining a tax benefit. There are times where it can be beneficial to make a purchase because there are tax benefits, but there needs to be a business case. A rule of thumb is to ask the question:

Would we make this purchase without the tax benefit?

If the answer is yes, or even maybe, then the purchase decision should be moved forward. But if your answer is a flat “no,” then don’t make the purchase.

How does a deduction work?

We think of the tax code as a complex version of the financial reporting standards for normal operations. The IRS recognizes that there is some wiggle room inside of the financial reporting standards, so they have created their own rules to decide what is and is not deductible. In the end businesses and people are left with what is called their Adjusted Gross Income (AGI).

Are we oversimplifying this? Yes.

For a sole proprietor, here is an example:

Taxable revenue of: $100,000

Tax Deductions of :    $30,000

AGI of $70,000

Tax bracket of 25% would make their tax liability approx:

13,238.75 = 5,226.25 + (8,012.5 = 25% x (70,000-37,950))

I picked up the tax brackets from the Tax Foundation here.

For the purposes of consideration, lets consider the above individual owns a small construction company and decides that they want a big shiny new truck, which will be a great tax deduction. So, they decide to buy a $20,000 truck. (We recognize that is cheap for a big shiny new truck)

So, our owner deducts their $20,000 for their truck to arrive at their new AGI. (Note that it isn’t a straight deduction, there is depreciation and other considerations, but this is a simplified example)

New AGI: $50,000

Same tax bracket, but new liability:

8,238.75 = 5,226.25 + (3,012.5 = 25% x (50,000-37,950))

There was a total of $5,000 savings.

We want to highlight that this illustration shows it isn’t a one for one swap on these purchases. But there was a tax savings.

Now, the net for this business owner for the purchase of the truck is $15,000, which is the purchase price less the tax savings.

It is still $15,000 cash outflow.

If there had been a business need for the truck, perhaps the old one was having maintenance issues, and was not presenting a professional appearance to customers than it would be worth it. But if it was a purchase for the sake of deductions and vanity it would be a poor decision.

As you are making decisions throughout the year, consult with your accountant. They can be invaluable for advise on large purchases.
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Disclaimer: The information contained in this document is provided for informational purposes only and should not be construed as financial or tax advice. It is not intended to be a substitute for obtaining legal, accounting, or other financial advice from an appropriate legal professional, financial adviser or for the purpose of avoiding U.S. Federal, state or local tax payments and penalties.

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