When Can I Start Deducting Invention Expenses?

Dear Rich: I've been working on a "green" invention for a few years but I haven't been deducting my invention expenses because I was told I had to wait until I start making the product. Is  that right? According to tax maven Steve Fishman, the general rule is that you can begin making these tax deductions once your inventing business begins using its assets to produce products for sale. However, it’s not necessary that the products be completed or sales be made. Thus, for example, courts have held that a writer’s business begins when he or she starts working on a writing project. The act of production itself is “carrying on” the trade or business of writing. Similarly, courts  have found that inventors who worked on inventions -- but never completed or patented them -- were carrying on a business. Under the logic of these court decisions, your inventing business begins for tax purposes on the day you actually begin developing an invention. Thinking or dreaming about an invention is not sufficient. You must do real work on it -- but it is not necessary for you to finish it, patent it or make money from it. A thorough and complete inventor’s notebook documenting your work is the best evidence you can have to prove when you started working on your invention.
Startup expenses. Startup expenses are a whole different topic. Unlike business operating expenses, start-up expenses cannot all be deducted in a single year. This is because the money you spend to start an inventing (or any other) business is a capital expense -- a cost that will benefit you for more than one year. Normally, you can’t deduct these types of capital expenses until you sell or otherwise dispose of the business. However, a special tax rule allows you to deduct up to $5,000 in start-up expenses the first year you are in business, and then deduct the remainder, if any, in equal amounts over the next 15 years. (IRC Sec. 195.)

When Inventors Hire Employees

Dear Rich: I patented a car accessory and outsourced the manufacturing. Now I'm getting ready to distribute it and I'm considering hiring a cousin to manage distribution. What kinds of concerns should I have about hiring someone? Our suggestions have to do with paperwork and taxes. If you're providing any confidential or proprietary information -- or alternatively, if your cousin is creating any proprietary information -- you'll want to have an appropriate independent contractor agreement. (You can read the details about inventors and employees here.)  As for taxes, here is an article explaining what's needed when inventors hire employees. (And here's more information on inventors and taxes.) Also, we hope you and your cousin are a good match because one thing they say about hiring relatives is that they're easy to hire and tough to fire.

Crafts Inventory and Taxes

Dear Rich: I have been making crafts for gifts for many years. Over the years I have accumulated much inventory, including several sewing machines, yards of various fabrics and ribbons, etc. I have recently decided to start a business selling on etsy.com. When doing my taxes, how do I claim the existing inventory accumulated over the last 20 years, much of what I will use in my new business? WARNING! Entry may cause drowsiness. Do not read while driving.
Right, you had a question. Short answer: You probably can't count your 20 years of supplies as inventory unless you have incorporated those materials in finished (and unsold) works or works in progress.
The Basic Inventory Rules.  Inventory includes completed but unsold crafts work, raw materials used to create the crafts work, crafts works in process and certain supplies that become part of your crafts work. In other words it's all the stuff you've created that's unsold as well as all of the direct costs to make that stuff. The IRS wants you to calculate your inventory value (or "cost of goods") at the beginning and ending of each tax year. These costs include:

• the money spent on materials that become an integral part of the finished product, or materials consumed in the manufacturing process and are identified with the crafts goods
• the money spent on labor associated with each crafts items -- payments for employees, contractors, payroll taxes, etc.
• indirect costs necessary for production of each item other than direct production costs. (You may not have any of these unless you can calculate things like variable and fixed overhead expenses).

If you don't know how to calculate the direct costs of materials and labor for your goods, there's an explanation in our book for crafts artists as well as the explanation in this IRS circular.
Can you deduct 20-year old ribbon and fabrics? Although we talked about raw materials as part of the inventory, the IRS position seems to be that only finished (or partly finished) merchandise should be included in inventory. According to Code of Federal Reg. 1.471.1, raw materials and supplies should only be included in inventory to the extent that the goods have been acquired for sale or will physically be part of the merchandise intended for sale. So, unless your past purchases are incorporated in finished works or works in progress, they should not be counted as inventory. 

What about sewing machines and other equipment? Sewing machines and other equipment used in production are considered to be long-term assets (assets with a useful life of more than one year). They can be deducted in one year under Section 179, or they can be depreciated.

When tax time arrives ... you may want to consult a tax expert, at least for the first year you calculate inventory. Your beginning inventory for subsequent years will be your ending inventory for the previous year.

How Do I Deduct Crafts Inventory on My Taxes?

Dear Rich: Last year we started selling handmade jewelry at places like Etsy. We had a good year but we ran into few problems at tax time and filed for an extension. We got your book but we're confused about how to calculate inventory. It's not that bad doing the calculations if you use a tax software program (we've used TurboTax Home and Business). But even if you use software, you'll still need to know your cost of goods (COGS) for the year. The IRS explains how to figure it out on its website by walking you through lines 35 through 42 of Schedule C. Here's a summary:

• Line 35: Beginning of year inventory. If this is your first year of operations, beginning inventory would be zero. If it's not your first year, this amount should be identical to the prior year's closing inventory. (If it isn't, you must explain why to the IRS.) Include the total cost of raw materials, work in process, finished goods, and materials and supplies used in manufacturing the crafts, but only those that were part of inventory at the beginning of the year. The IRS provides an explanation on valuing inventories (scroll down to "Inventories"). 
• Line 36: What did you purchase this year? Here you provide the cost of all merchandise you purchased during the year. Include the costs of all materials you purchased in the year that were necessary to manufacture your crafts. Subtract the cost of any items withdrawn for personal use.
• Line 37: Labor costs. Calculate labor costs — the amounts paid to employees for making your crafts. Do not include any amounts paid to yourself. (If you have employees that are not involved in manufacturing items for sale, their labor costs will be deducted elsewhere on the tax return and are not included in the cost of goods sold.)
• Line 38: Other manufacturing supplies. If you need glues, chemicals or other crafts supplies to manufacture your goods for sale, list the amount paid for these supplies.
• Line 39: Packaging costs. If you manufacture goods for sale, you can list additional costs such as containers and packages that are part of the manufactured product, costs of freight to bring in supplies, and overhead expenses — for example, rent, heat, light, power, insurance, depreciation, taxes, and maintenance — that are direct and necessary manufacturing expenses.
• Line 40: Total lines 35 through 39. This represents the total cost of inventory that your business held in the year.
• Line 41: End of year inventory. On Line 41, you enter the value of the inventory unsold at the end of the year. Keep in mind that the value of the remaining inventory is not the price you plan to sell it for; it is the amount you paid for it. This amount will become your beginning inventory for the next year — that is the number you will use on Line 35 of the following year's tax return. Note that most businesses do a "physical" inventory at the end of the year; that is, actually count and record the type and number of each remaining inventory item. The results of this work will provide the basis for the year-end inventory calculation. Physical inventories also allow you to inspect and discard inventory if it is damaged or of no value, thereby "writing it off" of year-end inventory and increasing the costs of your 'goods sold' deduction. A physical count also will alert you to items missing from your inventory.
• Line 42: COGS deduction. On Line 42, you subtract the amount listed on line 41 (ending inventory) from line 40 (all inventory costs). The result is the amount you claim as your COGS deduction.

For more information on inventories, see the Cost of Goods Sold section in Chapter 7 of IRS Publication 334, Tax Guide for Small Businesses, and IRS Publication 538, Accounting Periods and Methods.
By the way ... Some cities also have a tax on business inventory. This is another reason why some retail businesses have inventory sales -- to reduce their stock before the tax date.

He Wants to Avoid Paying Taxes for Band

Dear Rich: I just purchased your book online called "Music Law: How to Run Your Band's Business." I Paid For Rush Order As I Need Advice Before Friday And Not Sure My Book Will Arrive On Time So I Took The Chance Of Writing To You With Fingers Crossed You Read This And May Have An Answer For Me. My Husband Is A Professional Musician And Tours A Few Times A Year. When He Is Home He Just Plays Gigs Around Town In Different Bands And Plays At Church Every Week. He Does Not Have A Trademarked Or Serious Band Or Anything Like That Himself. He Usually Just Plays With Other Bands When He Gets Off Tour And They Pay Him By Check. They Give Him A 1099 At The End Of The Year If He Makes Over $600 With Them. My Husband Is Set Up As A "Section C" For His Taxes. My Husband Has Never Booked A Band And Does Not Really Know Anything About Signing Band Contracts For Club/Venues. A Club Just Approached Him To Play And Put A New Band Together For His Club. My Husband Is Supposed To Go To The Club On Friday And Sign A Contract. They Want Him To Play At The Club About 2 Times A Month. The Pay Is $800 Per Band And They Only Pay By Check To The Person Who Signs The Contract. I Am Very Nervous About My Husband Signing And What He Is Opening Himself Up To In Relation To Taxes At The End Of The Year. If He Signs The Contract He Will Be Responsible For The Entire Band Taxes For That Year-Correct? (If They Play 2 X Month For 1 Year That Will Be $19,200 Total Band Taxable Income.......$3,840 Per Individual Band Member). How Can He Book Gigs And Protect Himself And Not Get Stuck With Paying All The Taxes For The Entire Band And What Are His Options? Since you're in a hurry and we're in a hurry, we didn't bother to uncapitalize your question but we are curious about this grammatical aberration. Not to be rude, but what's up? If using all caps in email is like shouting, is this less than shouting but still intended to convey a sense of urgency? Curious as many are, but FYI, it makes it a bit tiring to read.
Right, you had a question (and you're in a hurry). Your husband should take the gig and take the payment. You won't have any problem with your taxes because your husband can deduct all of the payments he makes to the other band members (on his Schedule C). After that, he would only have to pay taxes on the remainder (which should be his payment). If he pays the other individual musicians more than $600 in a year, he must issue 1099s. That's not hard to do (we've done it ourselves and you can even automate the process online).  The Music Law book explains all this and you'll have plenty of time to read it before tax time.