From the Nolo eCommerce Center
These answers to common tax questions will help you stay out of trouble with the IRS.
- I want to start my own small business. What do I have to do to keep out of trouble with the IRS?
- What is – and isn’t – a tax-deductible business expense?
- If I use my car for business, how much of that expense can I write off?
- Can I claim a deduction for business-related entertainment?
- When can you deduct 100% of business supplies and equipment in the year they are purchased, and when do you have to deduct the purchase price over several years?
- If I buy a new computer system this year, do I have to spread the deduction over a period of five years?
- Does incorporating a small business start-up offer tax breaks?
- Is it safe and sensible for me to keep my own books and file my own tax returns? (My business can’t afford a business accountant or tax preparer.)
- I am thinking about setting up a consulting business with two of my business associates. Do we need to have partnership papers drawn up? Does it make any difference tax-wise?
- I work in my home part-time. Can I take the home-office tax deduction?
- I am planning a trip to a trade show. Can I take my family along for a vacation and still be able to deduct the expenses?
- I need to hire people quickly for a big job coming up. Should I hire independent contractors or employees?
Start by learning a new set of ’3 Rs’ – recordkeeping, recordkeeping and (you guessed it) recordkeeping. IRS studies show that poor records, not dishonesty, cause most small business people to fail to comply with their tax reporting obligations and lose at audits, with resulting fines and penalties. Even if you hire someone to keep your records, you need to know how to supervise him – because if he goofs up, you are the one held responsible. Consider using a computer to keep your records if you aren’t already in the electronic age.
Keep all receipts and canceled checks for business expenses, and keep them organized and in a safe place. Separate the documents by category, such as:
- auto expenses
- entertainment, and
- professional fees.
Put your documents into individual folders or envelopes. If you are ever audited, the IRS is most likely to zero in on business deductions for travel and entertainment and car expenses. Furthermore, the burden will be on you – not the IRS – to substantiate your deductions. If you’re unsure how to get started or what documents you need to keep, consult a tax professional familiar with small business recordkeeping.
Just about any “ordinary, necessary and reasonable” expense that helps you earn business income is deductible. These terms reflects the purpose for which the expense is made. When buying goods, the items must be used in a “trade or business,” which means it is used with the expectation of generating income. For example, buying a computer, or even a sound system, for your office or store is an “ordinary and necessary” business expense, but buying the same items for your family room isn’t. In the latter case, the computer and stereo would be non-deductible personal expenses.
A few things are specifically prohibited by law from being deducted even if the expenses are for the purpose of conducting business– for instance, a bribe paid to a public official. Other deduction no-nos are traffic tickets, your home telephone line and clothing you wear on the job, unless it is a required uniform. But as a general rule, if you think it is necessary for your business, it is probably deductible. Just be ready to explain it to an auditor.
You must keep track of how much you use your car for business in order to figure out your deduction. (You’ll also need to produce your records if you are audited.) Start by keeping a log showing the miles for each business use, always noting the purpose of the trip. At the end of the year, figure your deduction by using either the “mileage” method (you deduct a certain dollar amount, 36.5 cents for each business-related mile you drive in 2002) or the “actual expense” method (you can deduct the total you pay for gas, repairs, plus depreciation – according to a tax code schedule – multiplied by the percentage of business use). Figure it both ways and use the method that benefits you more.
You may deduct only 50% of expenses for entertaining clients or customers for business purposes, no matter how many martinis or Perriers you swigged. (Yes, this is a change. In the old days you could write off 100% of every entertainment expense, and until a few years ago, 80%.) Qualified business entertainment includes taking a client to a ball game, a concert or dinner at a fancy restaurant, or just inviting a few of your customers over for a Sunday barbecue at your home. Parties, picnics and other social events you put on for your employees and their families are an exception to the 50% rule – such events are 100% deductible.
Keep in mind that if you are audited, you must be able to show some proof that the entertainment expense was either directly related to, or associated with business. So, keep a guest list and note the business (or potential) relationship of each person entertained.
Current expenses include the everyday costs of keeping your business going, such as office supplies, rent and electricity, and can be deducted from your business’s total income in the year you incur them. But expenditures for things that will help to generate revenue in future years – a desk, a copier or a car, for example – are called capital expenses and must be written off over their useful life. Usually that period is three, five or seven years, according to IRS rules.
There is one important exception to the capital expense deduction rules, called the Section 179 deduction, which may let you deduct even capital expenses in the year you incur them.
While the cost of “capital equipment” – equipment that has a useful life of more than one year, such as a computer system– must normally be deducted over a number of years, there is one major exception. Internal Revenue Code Section 179 allows you to deduct a certain amount of capital assets per year ($24,000 in 2001 and 2002; $25,000 in 2003) against your business income. (Some small businesses can fit all of their capital expenditures each year into this allotted amount.) Note that even if you buy a computer system on credit, with no money down, you can still qualify for this deduction.
Keep in mind that most tax benefits flow to profitable, established corporations, not to start-ups in their first few years. For example, corporations can offer more tax-flexible pension plans and greater medical deductions than sole proprietors or partnerships, but few start-ups have the cash flow needed to take advantage of these tax breaks. Similarly, the ability to split income between a corporation and its owners – thereby keeping some income in lower corporate tax brackets – is effective only if the business is solidly profitable.
In addition, incorporating adds state fees, as well as legal and accounting charges. So unless you are sure that substantial profits will begin to roll in immediately, you may want to hold off incorporating your business.
To keep your own books, consider using a check-register type computer program such as Quicken (by Intuit) to track your expenses. If you are doing your own tax return, use the companion program, Turbotax for Home and Business. To ensure that you’re on the right track, it’s a good idea to run your bookkeeping system by a savvy small business tax pro. With just a few hours of work, she should help you avoid most common mistakes and show you how to dovetail your bookkeeping system with tax filing requirements.
When your business is firmly in the black, consider hiring a bookkeeper to take care of your day-to-day payables and receivables. An outside tax pro can handle your heavier-duty tax work – not only are his fees a tax-deductible business expense, but chances are your business will benefit if you put more of your time into running it and less into completing routine paperwork.
If you go into business with other people and split the expenses and profits, under the tax code you are in partnership, whether you have signed a written agreement or not.This means that you will have to file a partnership tax return (Form 1065) every year, in addition to your individual tax return.
Even though a formal partnership agreement doesn’t affect your tax status, it’s essential to prepare one to establish all partners’ rights and responsibilities vis-à-vis each other.
A while back, the Supreme Court told a doctor who was taking work home from the hospital that he couldn’t take a depreciation deduction for the space used at his condo. But this is quite different from maintaining a home-based business. If you run a business out of your home, you can usually claim a deduction for the portion of the home used for business. Also, you can deduct related costs – utilities, insurance, remodeling.
If you take others with you on a business trip, you can deduct business expenses for the trip no greater than if you were traveling alone. If, for example, on the trip your family rides in the back seat of the car and stays in one standard motel room, then you can fully deduct your automobile and hotel expenses. But you can’t claim a deduction for your family’s meals or jaunts to Disneyland or Universal Studios.
You can fully deduct the cost of your airline ticket even if it features a two-for-one or “companion” discount. If you extend your stay and partake in some of the fun after the business is over, the expenses attributed to the non-business days aren’t deductible, unless you extended your stay to get discounted airfare (the “Saturday overnight” requirement). In this case, your hotel room and meals would be fully deductible.
If you will be telling your workers where, when and how to do their jobs, you should treat them as employees, because that is how the IRS will classify them. Generally, you can treat workers as independent contractors only if they have their own businesses and offer their services to several contractors – for example, a specialty sign painter with his own shop or a freelancer who works for many clients. If in doubt, err on the side of treating workers as employees.
While classifying your workers as contractors would save you money in the short run (you wouldn’t have to pay the employer’s share of payroll taxes or have an accountant keep records and file payroll tax forms), it may get you into big trouble if the IRS later audits you. The IRS may reclassify your “independent contractors” as employees and assess hefty back taxes, penalties and interest against you.