BOOKS AND TAXES FOR ARTISTS (Updated for the 2017 Tax Cut and Jobs Act)
By Christy Nicholas, aka Green Dragon
I have been a practicing Certified Public Accountant licensed in the state of Florida since 1997, and specialize in small business taxes. As a result of this, I have discovered that many people with the talent and drive to start their own business seldom have the education and tools required to satisfy the bookkeeping requirements for their venture. Therefore, I have compiled this article to help those who may be confused on some of the issues.
I have my own small businesses, including a growing art business and an ongoing tax preparation business. If you should have any questions regarding the information I’ve included here, please feel free to contact me at firstname.lastname@example.org for more information or clarification.
This essay was originally written for art businesses, as artists seldom come with business backgrounds. However, it can be adapted to many other small business structures quite easily.
WHAT STRUCTURE SHOULD I USE?
The first question to ask in setting up your art business is how you should set it up – i.e., what structure it should have. This may seem like a silly question, but it is a very important one, as it determines how you report your income and expenses. And report them you must!
There are several types of organization to choose from, and the determining factor is risk. How much risk are you willing to take? Are you willing to pay more for less risk? I will demonstrate what this means:
The most risky organization is the sole proprietorship. This is because if someone sues you as a sole proprietorship, they can, theoretically, take your home, your car, and all your worldly possessions in a lawsuit. There is no separation between the business and you, so any lawsuit can take everything. However, most art businesses have little lawsuit risk attached to them. I am unlikely to get sued for damages unless I steal someone else’s art. (don’t do that!) If I was installing stairs, on the other hand, I would definitely want to limit my risk. The term for this characteristic is ‘unlimited liability.’
Now, there are advantages to being a sole proprietorship. There is little to no cost in setting it up, no legal forms to fill out, no paperwork to file with the state. When you report your income and expenses, it goes on the Schedule C of your own personal tax return (1040), and isn’t taxed separately.
There are also disadvantages, such as the aforementioned unlimited liability. There is also the fact that the company has a limited life – when you pass away, so does the business. (Ask Disney if this is important!). It is also more difficult to get financing from banks and therefore difficult to expand.
If you are willing to pay a little more money on a regular basis, you can get the advantage of limited liability with a corporate setup. A corporation is a separate entity from you as a person, therefore if it is sued, only those assets owned by the company can be taken, not your personal home and possessions. This is the main advantage of having a separate corporation. It is also easier to expand, as banks are usually more willing to offer financing for this. It can have a life beyond the life of the founder, as many corporations have (i.e., Sears, Disney).
Now to the disadvantages; The main one is the cost and complication of setting up and upkeep. There are fees to setting up the corporation with the state (none for the federal government), and annual fees to keep the license in good standing every year. In my home state of Florida, it is about $75 to set up the corporation, and $150 a year to keep it going. There is also additional paperwork, as you need to file a separate tax form every year (1120 or 1120S) with the federal government. You may also need to file one for your state. And, you may have to pay taxes at a corporate rate, which is usually higher than your personal rate.
I would like to go into the differences between a C corporation and an S corporation. C is the corporations we are most familiar with – corporate monsters like Microsoft, IBM, Disney, Sears, etc. These get taxed at a corporate rate, which changed as of the 2017 tax reform (see bold below). An S Corporation (S stands for Small) has to have less than 100 stockholders (among other requirements) but does NOT get taxed at the corporate level. Let me repeat that – no tax is paid on the corporation itself. Instead, the income gets reported on each shareholder’s tax return, and is paid at their personal rate. This is usually the better deal for small companies, as personal returns are not taxed at all for the first chunk of income.
TAX CUT AND JOBS ACT 2017:
On Dec 15, 2017, Congress passed a huge Tax Bill that changed a lot of long-standing truths about taxation. Trump signed it into law on Friday, Dec 22, 2017. Here are the ways it affects small business:
All pass-through businesses (Sole proprietorships, S corporations, partnerships, LLCs, LLPs) have a 20% deduction.
There is an exception: Individuals who own service-based businesses (law firms/accounting firms) only get that 20% deduction if their annual income is $157,500 (Single filer) or $315,000 (MFJ filer).
The corporate tax rate (C corporations) drops from 35% to 21%
The AMT (Alternative Minimum Corporate Tax Rate) is eliminated.
What does this all mean? First, this is ONLY for 2018 taxes and beyond – it doesn’t affect 2017 tax returns.
The most broadly applicable of these changes is the 20% deduction. Here’s how it works.
Say you have a sole proprietorship with $70,000 in gross sales and $25,000 in net income, after all your deductions. Previously, you would be taxed on that $25,000 net income at your personal income tax rate, whatever that may be.
Under the new law, that 20% deduction means you only get taxed on $20,000 ($25,000 X 20% = $5000), and it’s still at your personal income tax rate.
For those of you that have C corporations, the tax rate on your federal net income is reduced to 21% rather than 35%.
Overall, this is actually good news for the small business owner.
LLCs and LLPs
Many people ask me about Limited Liability Corporations and Limited Liability Partnerships. These are both fairly new entities, and as such, don’t have (as of yet) their own share of rules and laws by the IRS. The advantages is that some entities must be in a type of partnership (such as lawyers and accountants) so this offers some limited liability for them.
I personally don’t recommend them, as they have little advantage over the S corporation, and are usually more expensive to set up. A savvy person can set up an S corporation fairly easily. A lawyer is required for LLLCs, LLCs and LLPs, and they like charging a good deal of money to do so – which may be why they recommend them so much. However, I’m NOT a lawyer. You may want to consult one in case there is some advantage I haven’t yet found. They don’t have their own tax forms yet, they use the Corporate forms (1120 and 1120S). Until they’ve ‘settled’ in as accepted entities, I cannot recommend them as corporate structures. Unless, of course, you would like to line some lawyer’s pockets with money. If you are that interested in gifting money, my paypal account is always open J
In my personal opinion, most artist would do best as a sole proprietorship, unless there is a significant possibility of liability (i.e., you do 3D installations that someone could trip and fall on). In that case, I would recommend S corporations as the best alternative.
Since sole proprietorship is usually the most beneficial to artists, I will continue the essay under the assumption that this is the structure chosen.
WHAT IS INCOME?
In the common usage, Income means (literally) any money coming in – whether it be a loan from the bank, a paycheck from your job, a gift from Grandma, or a sale of a painting. However, in the accounting world, many words take on different meanings. This is one of them.
Income, for someone running a business, derives from operating the business. If it’s an art business, then sales from your art business is your main form of income.
That income can have several categories, though; You can have sales of existing art and art products, such as bookmarks, you can have commissioned sales of art, and you can have sales of excess supplies, or shipping, or display equipment. The majority of your income should come from the first two categories, though.
What about selling old stuff on ebay, at a garage sale, or on craiglist? Maybe to a friend or a co-worker? The IRS basically ignores these casual sales of used items, until they reach a certain amount or number of transactions. If you are scouring local garage sales and selling stuff en masse on ebay, the IRS is going to consider it as a business. If you have two garage sales a year, they will ignore you.
For those that are unfamiliar with commissions, it is when someone contracts with you to produce a piece of art to their own needs and desires, rather than purchasing art you created before you met them. Sometimes you collect money up front as a down payment – this isn’t income until the item is produced. Instead, it’s ‘unearned revenue’, or money that you will have to pay back if you never produce the item.
Another form of sales is consignment sales, which involves placing your artwork in someone else’s store, and only receiving money when it is sold. Sometimes this is a gallery, sometimes a gift shop, sometimes online – but the portion of income you receive is the only income you declare, not the total price. For instance, if I have a print on sale at the local gift shop for $30, and I get $20 from it when it sales (the other $10 goes to the gift shop) then I declare $20 income from the sale.
SELLING OTHER STUFF
Sometimes an artist has too much of a particular supply, and decides to sell off the excess on ebay, or doesn’t need a table anymore, or a particular display piece. This is called incidental income – not something you do on a regular basis in your business. It’s not the sale of art, but it is slightly related. These sales are income, but not always sales income – sometimes it’s called ‘gain’ rather than profit. It’s reported differently only if you are selling fixed assets, i.e., your computer, your desk, your display equipment. If it’s just paint or brushes, it’s regular income. Sometimes size DOES matter!
If you also charge shipping on your sales, this too is considered income. The cost of your shipping shows up in expenses, and usually these two cancel out. However, with the advent of so many businesses on Ebay making their profits from outrageous shipping fees, this could come back to bite you in no return customers if gets out of hand!
Many people ask how Sales Tax comes into play with income. In reality, we never ‘earn’ sales tax – we merely collect it and hold it for the state government. Whenever we make a sale that is taxable, we collect the sales tax. Once a month, or once a quarter, or sometimes once a year, we tally up all the sales tax we SHOULD have collected and pay it to the state. That SHOULD is a very important word! If you did not collect sales tax, but should have, you are STILL liable to pay it to the state, out of your own pocket.
Since Sales Tax is not income, when we collect it we do not include that as income (thus we don’t get charged income tax on that money). It’s not an expense that we can deduct, either… it doesn’t go on the federal income tax return at all.
All in all, income is any money coming in that is a result of a business transaction in your business. That sounds complex, but it helps differentiate between things that aren’t income – like a gift from your dad, an inheritance, or a loan from the bank. Those aren’t income, and you don’t pay taxes on it.
We wouldn’t want to be paying Uncle Sam MORE than he is asking for, now, do we?
HOW DO I VALUE INVENTORY?
Inventory is one of those mysteries of the accounting world, an esoteric subject fit to backroom discussions by candlelight and adding machines, right? WRONG! Inventory is a very simple concept – the cost of the stuff you have that you can sell.
Inventory can include any number of things, but they should be things that can be traced to a particular piece. That means that you can include the canvas, paper, frame, matboard, and hanging hardware that you bought for that painting – but not the paint itself. The reason is that this tube of Titanium White has been used to paint on 12 other paintings, and is still only halfway used. There is no easy way to attach the cost of the paint to a particular piece, so it is instead deducted as ‘supplies expense’, along with the paintbrushes, turpentine, disposable pallet pages, etc.
If, however, you use 4 buckets of gesso for one installation, that can be traced to one piece, so you can use that as an inventory cost.
So, the cost of one of my digital prints would NOT include the computer, or the program, but would include the cost of printing, the matboard, and the bag. It wouldn’t include the ink from the pen to sign it. Be reasonable, and you’ll be ok.
This inventory cost is usually counted at the end of the year. The amount you have in inventory is the cost of each item you have that is ready for sale (‘finished goods’ inventory), plus unfinished pieces, which are considered ‘work-in-process’ inventory. Also include items that will be used for such pieces, like blank canvasses and uncut matboard, etc. – this would be considered ‘raw materials’ inventory.
On your tax return, you list a beginning inventory amount (the amount of these items you had at the beginning of the year). You add the cost of purchases during the year, and you subtract the amount of these items you sold (at cost, not at sale price!). The ending figure should match how much you have on hand at the end of the year. If not, you make an adjustment so it does – this is breakage, spillage, spoilage, loss, etc., and can be deducted as an expense.
By structuring it this way, the expenses for inventory are only deducted when the item is sold, as opposed to when the items were purchased. This is an important difference to the IRS, even if not to most sane people.
Here’s an example to illustrate:
At the beginning of the year, I had $120 in inventory, mostly matted and bagged prints. I bought $800 in new prints, $200 in mats and bags, and have assembled most of those into salable pieces. I have sold $500 worth of these items (that is the cost, NOT the sale price). Based on this, my ending inventory should be $120 + $800 + $200 – $500 = $620
I have on hand at the end of the year $500 worth of salable items, and an additional $100 in unused mats. That means I have on hand $600 worth of inventory.
The difference between $620 and $600 is represented by 10 prints that were damaged in shipping, and I can write those off as Spoilage Expense. My cost of goods sold is $500 (this goes on the tax return, as well as the beginning inventory, ending inventory, and purchases).
As I mentioned earlier, items that are used for many pieces are supplies, not inventory. They are deducted when they are purchased, rather than when they are used.
Supplies typically include items used up over the course of time, such as paints, inks, regular paper (office supply rather than photographic paper), pencils, pens, erasers, tape, etc. You get the idea. Also, these are typically low cost items, where it would take more time to keep track of the cost than the deduction is worth – this is known as the cost-benefit principle.
One of the quirks of a sole proprietorship is that you, as the owner, cannot deduct wages for yourself. You can pay someone else and deduct those, but you simply take extra cash out of the company funds as a withdrawal – this is not deductible. If you are paying someone wages and they are directly responsible for creating inventory, you CAN include that portion of their wages in inventory cost. For example, you create painted vases – you have three apprentices doing the base work for you, prepping the vases for your master’s touch. Their wages can be added to the inventory cost for the vases they prepare.
TIMING AND CASH BASIS
Timing is an important concept in the creation of inventory, and the sale thereof. The IRS likes to see an expense taken in the same month that the sale it is associated with is made (thus inventory). If you sell an item in December of 2014, and the payment is collected in January 2015, then you should record the sale in 2015 – and the associated inventory cost of goods sold. This is called ‘cash basis’ as opposed to ‘accrual basis’. Most sole proprietors and S corporations are on cash basis accounting.
Accrual basis accounting is when you made that sale in December 2014, reported it in 2014, and listed it as a receivable – a sale that is made but not paid for yet. When the payment is made in 2015, it is not a sale, but a payment of the receivable.
Cash basis is much simpler, and therefore much more common in sole proprietorships.
When you have inventory, you are on ‘modified cash basis’, and that is the preferred method for sole proprietorships, and the one I have found works best with artists.
WHAT CAN I DEDUCT AS EXPENSES?
There are several things that people get confused about when considering what can be deducted on a tax return for your business. I will attempt to cover those items that cause the most questions.
One of the most confusing areas is equipment. According to the IRS, if a piece of equipment is a substantial cost (i.e., more than $100) and will last more than one year, you should ‘capitalize’ it. By capitalize, they mean list it as an asset, and take the expense as a deduction over several years, rather than all in the year you purchase it. This is called depreciation, and has several rules to follow.
Equipment can include computers, mat cutters, display booths, desks, software, any number of things. The main point is that it should last longer than one year. Do not include consumables such as pens, paint, paper, brushes, even if they last longer than one year – the cost of these are minimal and it is a waste of time and paperwork to keep track of them.
For example, I purchased a booth to display my art at art shows. The booth cost $700. I plan on getting several years worth of use out of it, and the IRS says it’s furniture (ok, sort of!) and therefore, according to a list they maintain, it should be used up in 7 years. Therefore I take the total cost ($700) and divide it by 7, getting $100. This is the amount I deduct every year for ‘depreciation expense’ on that item.
Many of you have heard of Sec 179 depreciation. That is a special rule by the IRS that says you can take the whole cost of such an item in the year you purchased it. That is ONLY allowed if you are making a profit, and if you bought it new (not used). For the example given, the entire $700 would be taken the year it was purchased. The 2017 tax plan renews this, and allows used equipment purchases.
Under the 2017 Tax Cut and Job Act, there is bonus depreciation in which you can take 100% of the purchase price of a new fixed asset, but that gets phased out after 2022.
Furniture and fixtures are considered 7 year property, while cars, computers and other electronics are 5 year property. For other items, you can check out www.irs.gov for the list.
As mentioned previously, you can deduct wages paid to someone else, but not to yourself. Wages you take yourself are not deductible, and are considered a repayment on the loan you gave the company to start up.
If you have set up as a Corporation, however (C or S), you CAN deduct your wages – and you must declare them as income on your personal return. This is usually a wash, but you will be paying payroll taxes on the wages as well. This will reduce your taxable income, but also increase your actual out-of-pocket expenses. On the other hand it will build up your social security taxes… if you think you will ever see that money when you retire.
TRAVEL AND MEALS
This is one of the more controversial aspects of IRS law and business deductions. The rules are fairly simple – it’s the interpretation that’s a bear!
You can deduct the costs of travel if you are primarily there on business. If there is some business and some pleasure, you should prorate the costs. For instance, I go to Dragoncon every year. If I didn’t have my art in the art show, I would still go, so there is some pleasure factor. However, most of my time is spent in or around the art show, either setting up, tearing down, attending panels, helping the art crawl, schmoozing with other artists, etc. In my interpretation, I spend 80% of my time on business – so I feel justified in deducting 80% of my costs (not my husband’s costs) of the trip.
The 2017 Tax Cut and Jobs Act disallows a deduction for (1) an activity generally considered to be entertainment, amusement, or recreation; (2) membership dues for any club organized for business, pleasure, recreation, or other social purposes; or (3) a facility or portion thereof used in connection with any of the above items.
That would include transportation there (we drive, so it’s actual gas expense or mileage at 57.5 cents a mile for 2015, and 54 cents a mile for 2016), the hotel room, the fee for renting the panel, the fee for attending Dragoncon, and 50% of MY meals there (again, not husband’s).
This is always a sticky area, as it’s hard to prove I’ve spent my time in art-related activities. However, the fact that I keep my receipts, record my mileage, have art at the show, and keep my records in a business-like manner will prove to the IRS (should I ever get audited) that I approached the show as a business expense. It is still up to them to say yea or nay, but I’ve got a great case, so to speak.
Other expenses you can take in this area are fees for art shows and galleries, networking club dues, travel to such club meetings, client meetings, and installations. You can even deduct the mileage on trips to the craft store! If you are staying overnight on business travel you can deduct REASONABLE expenses for hotel and meals.
Any deductible meals are only allowable at 50%, and should be directly related to the business, i.e., entertaining potential or existing clients, or traveling on business.
This is another area filled with confusion, but the IRS has gotten more and more lenient in this area over time, due to the increased popularity of telecommuting in today’s work environment.
However, you still need to have an area of your home devoted to art production to deduct the expenses related to it. It helps if it is a separate entrance, or better yet, a stand-alone structure on your property, like a garage transformed into a studio.
For instance, I have a room in my house that has my computer, my art supplies, my inventory, and my business records. I conduct most, if not all, of my art business at home in this area. Let’s say it is a 15X15 room (225 square feet), and I have a 2250 square foot house. That means I have 225/2250 = 10% of my house dedicated to the business – we use that percentage to prorate the indirect expenses.
Indirect expenses are those that are paid on the whole house, including mortgage interest, real estate taxes, utilities, homeowner’s insurance, rent, house repairs, etc. All of these get added up, and 10% of them is deductible.
Direct expenses would include a dedicated business phone line, repairs or utilities that are for the dedicated work area alone, etc. These are deducted at 100%. (i.e., the window in your studio was repaired).
If you have a net loss on your business, the deductions for home office expense can’t be taken that year, but can be carried over to next year’s tax return to be deducted when you DO have a profit.
A small percentage of depreciation on your house is also deductible, based on the value of the house and the land.
There are several other expenses that can be deducted that many people don’t think about. Here are some of them:
Health insurance for the artist can be deducted, and it is usually better deducted for the business (self-employed health insurance deduction) than on the Schedule A, where it is limited by your income level. This is one of those deductions you can only take if you’ve got a net profit.
Advertising – including mailings to your mailing list, business cards, etc.
Business insurance – something very important. This is separate from health insurance! It protects your stock and tools from damage, and your business from liability.
Legal or professional services – including the costs of setting up the corporation and doing the taxes each year.
Office supplies or rentals – do you have a water cooler? Postage machine? How about a credit card machine?
Rent of space or equipment – definitely deduct rental trucks or space fees. The booths at the art shows, if they are rented, and the space itself, certainly!
Repairs or maintenance of equipment – yes, this includes your computer if you use it for business! If it is also used for personal things, you should again prorate it. If I use my computer for 90% business, I can deduct 90% of the repairs. You get the picture!
Taxes and licenses – property taxes, business licenses, those can all be deducted. Sales tax, however, is NOT a business expense – nor is it income when you collect it. Technically, it is something you collect and hold in order to pass it on to the state government. Same thing with federal withholding for any payroll taxes. The employer portion of payroll taxes, however, is an expense to be deducted.
Taking responsibility for running your own business is a big step, but it can be done with a little organization and education. When you are out of your depth, contact a professional and let them help you. Most artists are afraid of the business side of art, and that is understandable. However, the more you know the better you can understand how the business works, and the more you can devote your time, energy and creativity to forming the art you love.
IRS site for Businesses: http://www.irs.gov/businesses/index.html
Links for state Dept. of Revenue sites: http://www.smbiz.com/sbrl041.html
My website (where a copy of this article is, as well as several others) www.GreenDragonArtist.com