One benefit of having your own business
is that often regular daily expenses become business expenses under the U.S.
Internal Revenue Code and are allowable as deductions from business income. In
effect this means these expenses are paid with before-tax dollars and buy more
value than if they were paid from your regular after-tax income. One well-known
business expense (not the subject of this article) is the home office
deduction. We’ll discuss lesser-known expenses that can legally reduce
your Federal income tax bill.
Pay attention to the ideas discussed
here. You will save time by not having to look up so many regulations and
perhaps you will find some deductions that will save your tax dollars as well.
When reading the publications from the IRS, keep in mind they are often written
in language suggesting that no deductions related to a home-based business are
allowable at all. Then, after most people decide to avoid a business
altogether—or at least decline to use a deduction—the regulations
will proceed to tell how you can use these deductions. Sick isn’t it? What
this should tell you is to drill down through the publications and see how you
can use allowable expenses. Congress wrote the regulations so entrepreneurs can
retain the rewards of their labor. Use them to your advantage all you can.
Before talking about these deductions, a
few points are in order:
Using authorized deductions is part of a
strategy to legally avoid a portion of your income tax. Tax evasion, on the
other hand, is illegal and carries serious consequences including jail time;
use extreme care not to become involved in any evasion scheme. Some home-based
business opportunities are marketed on the basis they provide ways to deduct
nearly all personal living expenses. See what the IRS says about
these.
Many believe having a sideline business
automatically causes your returns to be audited. I have talked with several
successful entrepreneurs who have terminated their business after two or three
audits. Just because you operate a small business will NOT cause you to be
audited. None of these people gave me any other details about their returns. It
could be they deducted too many non-deductible or questionable items.
Good records are a must for
substantiating every deduction you make. No matter how good your records may
be, they will not substantiate expenses that aren’t “ordinary and
necessary” for the conduct of a real business operated with the intent of
making a profit.
Do not fear an audit. Even if you
aren’t self-employed, your return could receive a computer score
subjecting you to further investigation. Everyone should always use the
deductions available to pay only their just share of tax but no more. Sometimes
deduction items or income sources will raise a flag in the IRS computer
program. No need to fear anything unless you intentionally did something wrong.
With your good records and good intentions what is the worst that could happen?
You may have to pay some additional tax and possibly a penalty. If your mistake
is honest, these charges will likely amount to very little.
The investigation may also turn up a
mistake that may lower your tax (this happens seldom, but it does happen). The
point is anyone is subject to audit, and if you aren’t a crook, you have
nothing to fear. It is certainly no reason to avoid going into a business of
your own.
Speaking of audits, what are your
chances of being audited? There is less than a 1% audit chance for those with
incomes under $25,000; even if your income exceeds $100,000 the chance is still
less than 2%. Remember these probabilities could point to you anyway if the
computer score picks up questionable items on your return. Unfortunately there
is no way to tell what score you may have.
What kinds of people have greater than
average chances of audit? Your chances for an audit increase a little bit if
you are a doctor, lawyer, or accountant. A cash business may increase your
audit profile, as will having very large deductions or charitable
contributions. Audit risk should not discourage anyone from going into
business; every taxpayer is subject to a possible audit no matter what you do
or don’t do. The computer scores every return and you may be audited even
if you work for someone else and use a standard deduction. Some misconceptions
about your audit probabilities are discussed
here. The audit chance is absolutely no reason for not
having your own business.
One other thing you should do is be sure
to conduct your business in a manner acceptable to the IRS so you won’t be
considered as only engaging in a hobby where you don’t expect to make a
profit. Hobby losses can’t be used to offset any other income and so the
value of your deductions could be lost. If you conduct your activities as a
serious business and you make a profit in at least three of the past five
years, you will usually be considered as carrying on your activities for profit
by the IRS. You can find more information on hobby vs. business
here.
Consider this idea about being sure your
business is profitable in three years. You can simply reduce your deductions,
even if you have them, in order to show profitability in a year. You may have
to pay Self-Employment tax, but you will protect your business deductions and
your loss offsets in unprofitable years. If you fail the hobby test in an
audit, you could lose important deductions in previous years; we hope you are
profitable without having to use this little idea, but it’s available if
you do.
Many home business expenses will have some aspect of personal use
and must be allocated part to business and part to personal with the personal
part
non-deductible. An example of this might be borrowing money
and using 40% of it for personal expenditures and 60% of it for business
expenditures. You may deduct 60% of the interest as a business expense. The
other 40% is a personal expense and therefore not deductible.
Here are some expenses that are
allowable deductions. These are by no means every deduction possible. If you
have questions refer
here as a starting point or ask a professional tax
consultant:
- Monthly fees and business kits often required by
network marketing and MLM companies.
- Licenses and permits required by local
governments.
- Subscriptions to business magazines, newspapers,
and e-zines.
- Supplies like computer paper, business cards, pens
and pencils, envelopes, other items used in your business.
- Advertising in newspapers, magazines, e-zines,
classified ad Websites, pay-per-click, domain names, hosting fees, Website
development, and promotion of your domain to search engines.
- Anything you give away free as promotions like
services or product samples.
- You may not deduct the cost of one phone line to
your home even if you have your office there; you may deduct cost of business
long distance on any phone.
- Additional phones used exclusively for business or
cell phones used for business are deductible.
- Internet connections used for business are
deductible such as dial-up, DSL, satellite, or other kinds.
- Bank fees for your business account such as
monthly service charges, returned check charges, overdraft fees, and
stop-payment cost.
- Business postage with receipts.
- Shipping fees you pay to ship items to
customers.
- Shipping charges you pay for goods shipped to you;
if these are for assets acquired they may be part of the cost (check with your
tax advisor or IRS regulations).
- Shipping paid by your customers is never
deductible by you; you need to record these charges so they will not be
included as income to you in case of an audit.
- Cost of computers, upgrades, external drives,
scanners, printers, cameras used for business, and any other computer-related
equipment is usually deductible. See
Section 179.
- Software used for your business also is usually
deductible (also Section 179).
- Membership fees for organizations devoted strictly
to business are deductible. Some of these are Chambers of Commerce, Civic or
public service groups, professional organizations, trade associations and
some others.
Please note these comments about Section
179 mentioned above. This section allows up to $105,000 of asset purchases to
be deducted as an expense without the requirement of depreciation. There is an
income limit up to the amount of taxable income. A quick read of this section
might lead a reader to think if there is no taxable income, the related costs
can’t be deducted. Closer reading allows taxable income to be computed
without using any Section 179 deduction; this enables the taxpayer to use
enough of the 179 deduction to reduce taxable income to zero but any unused
portion cannot be taken against other current income. The excess 179 amount may
be carried over to another year to decrease taxable income in that year.
Transportation costs are an important part of every business’s expenses,
especially in these times of extreme fuel prices. Here are some (but probably
not all) of the allowable transportation and related deductions and
considerations about them:
- Round trip transportation expenses from your
legitimate home office to your client’s or customer’s place of
business are
generally deductible.
- Actual car expenses or mileage rate.
- Records required for vehicle mileage expenses are
discussed
here.
- If you must travel away from your home
office for duties related to your business your reasonable and necessary
expenses are
normally deductible.
Just because a seminar is promoted as
business-related
does not mean the entire trip cost is deductible. You must
always be able to show the business purpose of your travel activities.
Here is a complete list of forms and publications you can
download from the IRS.
When you consider whether to take actual
vehicle expenses or the mileage rate, remember actual costs require a lot of
extra records. Mileage may be easier for most situations. Even using mileage,
you should keep a notebook in the vehicle and list all mileage use including
personal for the entire year. That way you can prove exactly what your business
use was in the event of an audit.
Much is said in the IRS literature about
there being no way to convert personal expenses into business expenses. This
simply is not true. If you use the home office deduction, you have converted a
significant personal expense into an allowable deduction. The same is true of
travel expenses; your legitimate business expenses are always deductible. If
you take your spouse or companion along their expenses are not deductible but
their use of your hotel room is certainly a conversion of personal expenses
into a deduction.
When you go on a business visit to a
customer or make a trip to the supply store or the bank and on the way drop off
or pick up your child at school, you have converted a personal expense to an
allowable expense. There are many ways a legitimate business deduction can
result in a personal expense conversion. You can save tax dollars by planning
trips and other activities so you can cover personal items with normal business
expenses. There is nothing wrong with this.
Always take every deduction you think
you can lawfully use. Every taxpayer may be subject to an audit; there is
nothing you can do to reduce your chances. As we have said, “What is the
worst thing that can happen?” You may have to pay some additional tax;
good records will probably prevent that from happening. Just be sure you
don’t fail to report income and be sure not to inflate your deductions. If
you’ve done none of these illegal acts, there is nothing to fear.
By all means start your business; risk
of an audit is absolutely NOT A REASON for staying away from becoming a
successful entrepreneur.
