Home Business Tax Deductions Keep What You Earn By Attorney Stephen Fishman 4th edition FOURTH EDITION NOVEMBER 2007 Editor DIANA FITZPATRICK Cover Design JALEH DOANE Book Design TERRI HEARSH Production MARGARET LIVINGSTON Proofreading PAUL TYLER Index BAYSIDE INDEXING Printing DELTA PRINTING SOLUTIONS, INC. ISSN: 1932-2402 ISBN-13: 978-1-4133-0720-7 ISBN-10: 1-4133-0720-5 Copyright © 2005, 2006, and 2007 by Nolo. ALL RIGHTS RESERVED. PRINTED IN THE U.S.A. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the publisher and the author. Reproduction prohibitions do not apply to the forms contained in this product when reproduced for personal use. Quantity sales: For information on bulk purchases or corporate premium sales, please contact the Special Sales Department. For academic sales or textbook adoptions, ask for Academic Sales. Call 800-955-4775 or write to Nolo, 950 Parker Street, Berkeley, CA 94710. Table of Contents Introduction Your Legal Companion for Home Business Tax Deductions 1 Home Business Tax Deduction Basics How Tax Deductions Work 6 How Businesses Are Taxed 9 What Businesses Can Deduct 14 Adding It All Up: The Value of Tax Deductions 16 2 Are You Really In Business? Proving That You Are in Business 24 Tax Consequences of Engaging in a Hobby 38 Investing and Other Income-Producing Activities 40 3 Avoiding the Start-Up Tax Trap What Are Start-Up Expenses? 50 When Does a Business Begin? 54 How to Deduct Start-Up Expenses 56 Expenses for Businesses That Never Begin 60 Avoiding the Start-Up Tax Rule’s Bite 61 4 Home Business Operating Expenses Requirements for Deducting Operating Expenses 64 Operating Expenses That Are Not Deductible 72 How to Report Operating Expense Deductions 73 5 Deducting Long-Term Assets Long-Term Assets 75 Section 179 Deductions 81 Depreciation 93 Tax Reporting and Record Keeping for Section 179 and Depreciation 119 Leasing Long-Term Assets 121 6 The Home Office Deduction Qualifying for the Home Office Deduction 126 Corporation Employees 139 Calculating the Home Office Deduction 139 IRS Reporting Requirements 156 Audit-Proofing Your Home Office Deduction 158 7 Meal and Entertainment Expenses What Is Business Entertainment? 162 Who You Can Entertain 164 Deducting Entertainment Expenses 164 Calculating Your Deduction 170 Reporting Entertainment Expenses on Your Tax Return 176 8 Car and Local Travel Expenses Deductible Local Transportation Expenses 178 The Standard Mileage Rate 181 The Actual Expense Method 185 How to Maximize Your Car Expense Deduction 205 Other Local Transportation Expenses 209 Reporting Transportation Expenses on Your Tax Return 210 When Clients or Customers Reimburse You 212 9 Business Travel What Is Business Travel? 214 Deductible Travel Expenses 220 How Much You Can Deduct 222 Maximizing Your Business Travel Deductions 237 Travel Expenses Reimbursed by Clients or Customers 239 10 Inventory What Is Inventory? 242 Maintaining an Inventory 245 Deducting Inventory Costs 247 IRS Reporting 252 11 Hiring Workers Employees Versus Independent Contractors 256 Tax Deductions for Employee Pay and Benefits 260 Reimbursing Employees for Business-Related Expenditures 269 Employing Your Family or Yourself 275 Tax Deductions When You Hire Independent Contractors 285 12 Medical Expenses The Personal Deduction for Medical Expenses 290 Deducting Health Insurance Premiums 291 Medical Reimbursement Plans 299 Health Savings Accounts 308 13 Retirement Deductions Why You Need a Retirement Plan (or Plans) 327 Individual Retirement Accounts (IRAs) 330 Employer IRAs 335 Keogh Plans 338 Solo 401(k) Plans 339 14 Additional Home Business Deductions Advertising 345 Business Bad Debts 347 Casualty Losses 353 Charitable Contributions 357 Dues and Subscriptions 357 Education Expenses 358 Gifts 361 Insurance for Your Business 361 Interest on Business Loans 363 Legal and Professional Services 368 Taxes and Licenses 370 Domestic Production Activities 374 15 Record Keeping and Accounting Basic Record Keeping for Tax Deductions 380 Records Required for Specific Expenses 393 How Long to Keep Records 407 What If You Don’t Have Proper Tax Records? 408 Accounting Methods 409 Tax Years 417 16 Claiming Tax Deductions for Prior Years Reasons for Amending Your Tax Return 420 Time Limits for Filing Amended Returns 425 How to Amend Your Return 428 How the IRS Processes Refund Claims 429 17 Staying Out of Trouble With the IRS What Every Home Business Owner Needs to Know About the IRS 432 Ten Tips for Avoiding an Audit 439 18 Help Beyond This Book Secondary Sources of Tax Information 450 The Tax Law 457 Consulting a Tax Professional 464 Index Introduction Your Legal Companion for Home Business Tax Deductions 2 HOME BUSINESS TAX DEDUCTIONS T his is a book about income tax deductions for home business owners. A tax deduction is money on which you don’t have to pay income taxes. The government has decided that business owners don’t have to pay tax on income they spend for certain business purposes. So, the trick to paying lower taxes—and keeping more of your hard-earned dollars—is to take advantage of every tax deduction available to you. If you have a legitimate home business, you may be able to deduct: •aportionofyourrentormortgage,utilities,maintenance,andother home office expenses •carexpensesforbusinesstrips •thecostoftravelingoutoftownforbusiness(youmayevenbeableto mix business with pleasure and still take a deduction) •moneyyouspendforofcefurnitureandequipment •halfthecostofbusiness-relatedmealsandentertainment •medicalexpensesforyourselfandyourfamily,and •contributionstospecialretirementaccountsavailableonlytobusiness owners. All of these deductions—and many others available to home business owners—can add up to substantial tax savings. Depending on your income tax bracket and the state where you live, every $1,000 you take in tax deductions can save you from about $280 to more than $400 in taxes. Business owners—whether they work at home or in outside offices—live in a different tax universe from wage earners—those who work for other people’s businesses or for the government. Wage earners have their income taxes withheld from their paychecks and can take relatively few deductions. The vast majority of business owners have no taxes withheld from their earnings and can take advantage of a huge array of tax deductions unavailable to employees. To take advantage of the benefits tax deductions offer, you’ll have to figure out which deductions you are entitled to take—and keep proper records docu menting your expenses. The IRS will never complain if you don’t take all the deductions available to you. In fact, the majority of home business owners miss out on many deductions every year simply because they aren’t aware of them—or because they neglect to keep the records necessary to back them up. INTRODUCTION: YOUR LEGAL COMPANION FOR HOME BUSINESS TAX DEDUCTIONS 3 That’s where this book comes in. It shows you how you can deduct all or most of your business expenses from your federal taxes. This book is not a tax preparation guide—it does not show you how to fill out your tax forms. (Bythetimeyoudoyourtaxes,itmaybetoolatetotakedeductionsyou could have taken if you had planned the prior year’s business spending wisely and kept proper records.) Instead, this book gives you all the information you need to maximize your deductible expenses—and avoid common deduction mistakes.Youcan(andshould)usethisbookallyearlong,sothatyou’re ready to take advantage of every available deduction opportunity come April 15th. Even if you work with an accountant or another tax professional, you need to learn about home business tax deductions. No tax professional will ever know as much about your business as you do; and you can’t expect a hired professional to search high and low for every deduction you might be able to take, especially during the busy tax preparation season. The information in this book will help you provide your tax professional with better records, ask betterquestions,andobtainbetteradvice.Itwillalsohelpyouevaluatethe advice you get from tax professionals, websites, and other sources, so you can make smart decisions about your taxes. Ifyoudoyourtaxesyourself(asmoreandmorehomebusinesspeople are doing, especially with the help of tax preparation software), your need for knowledge is even greater. Not even the most sophisticated tax preparation program can decide which tax deductions you should take or tell you whether you’ve overlooked a valuable deduction. This book can be your guide— providing you with practical advice and information so you can rest assured you are taking full advantage of the many deductions available to home business owners. [...]... running a business. ) Chapter 1: home business Tax Deduction Basics 9 How Businesses Are Taxed If your home business earns money (as you undoubtedly hope it will), you will have to pay taxes on your profits How you pay those taxes will depend on how you have structured your business So before getting further into the details of tax deductions, it’s important to understand what type of business you have... How Tax Deductions Work 6 Types of Tax Deductions 6 You Pay Taxes Only on Your Business Profits 7 You Must Have a Legal Basis for Your Deductions 8 You Must Be in Business to Claim Business Deductions 8 How Businesses Are Taxed 9 Basic Business Forms 9 Most Home Businesses Are Sole Proprietorships 9 Tax Treatment 12 What Businesses... Value of Tax Deductions 16 Federal and State Income Taxes 17 Self-Employment Taxes 18 Total Tax Savings 19 6 home business tax deductions O nce you start your own business, you can begin taking advantage of the many tax deductions available only to business owners The tax code is full of deductions for businesses—and you are entitled to take them whether you work... the value of a tax deduction How Tax Deductions Work A tax deduction (also called a write-off) is an amount of money you are entitled to subtract from your gross income (all the money you make) to determine your taxable income (the amount on which you must pay tax) The more deductions you have, the lower your taxable income will be and the less tax you will have to pay Types of Tax Deductions There... whether you run your business from home or from an outside office or workplace—either way, you are entitled to deduct your legitimate business expenses This book is about the many deductions available to people who are in business and who happen to work from home You Pay Taxes Only on Your Business Profits The federal income tax law recognizes that you must spend money to make money Virtually every home business, ... whether you work from home or from a fancy outside office Before you can start using these deductions to hang on to more of your hard-earned money, however, you need a basic understanding of how businesses pay taxes and how tax deductions work This chapter gives you all the ­nformation you i need to get started It covers: • how tax deductions work • how businesses are taxed • what expenses businesses can... how you will pay tax on your business s profit Need help figuring out how to structure your business? Although most home businesses are sole proprietorships, that may not be the best business form for you If you need to decide how to organize a new business or you want to know whether you should change your current business form, refer to LLC or Corporation? How to Choose the Right Form for Your Business, ... that your deduction wasn’t justified, it will deny the deduction and charge you back taxes, interest, in some cases, and penalties You Must Be in Business to Claim Business Deductions Only businesses can claim business tax deductions This probably seems like a simple concept, but it can get tricky Even though you might believe you are running a business, the IRS may beg to differ If your home business. .. operations If you re running a one-person home business and you haven’t incorporated or formed a limited liability company, you are a sole proprietor However, you can’t be a sole p ­ roprietor if two or more people own your home business, except in some states where a husband and wife can be co-sole proprietors (see Home Businesses Owned by Spouses,” below) 10 home business tax deductions Home Businesses... dollar you earn for the year falls is called your marginal tax bracket For example, if you have $60,000 in taxable income, your marginal tax bracket is 25% To determine how much federal income tax a deduction will save you, multiply the amount of the deduction by your marginal tax bracket For example, if your marginal tax bracket is 25%, you will save 25¢ in federal income taxes for every dollar you are . situation. ■ Chapter 1 Home Business Tax Deduction Basics How Tax Deductions Work 6 Types of Tax Deductions 6 You Pay Taxes Only on Your Business Profits 7 You Must Have a Legal Basis for Your Deductions 8 You Must. Contents Introduction Your Legal Companion for Home Business Tax Deductions 1 Home Business Tax Deduction Basics How Tax Deductions Work 6 How Businesses Are Taxed 9 What Businesses Can Deduct. The Value of Tax Deductions 16 Federal and State Income Taxes 17 Self-Employment Taxes 18 Total Tax Savings 19 6 HOME BUSINESS TAX DEDUCTIONS O nce you start your own business, you can begin