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Introduction
Once 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 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 information you need to get started. It covers:
- how tax deductions work
- how businesses are taxed
- what expenses businesses can deduct, and
- how to calculate the value of a tax deduction.
How Tax Deductions WorkA 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 DeductionsThere are three basic types of tax deductions: personal deductions, investment deductions, and business deductions. This book covers only business deductions -- the large array of write-offs available to business owners, including those who work out of their homes.
Personal DeductionsFor the most part, your personal, living, and family expenses are not tax deductible. For example, you can't deduct the food that you buy for yourself and your family. There are, however, special categories of personal expenses that maybe deducted, subject to strict limitations. These include items such as home mortgage interest, state and local taxes, charitable contributions, medical expenses above a threshold amount, interest on education loans, and alimony. This book does not
cover these personal deductions.
Investment DeductionsMany people try to make money by investing money. For example, they might invest in real estate or play the stock market. These people incur all kinds of expenses, such as fees paid to money managers or financial planners, legal and accounting fees, and interest on money borrowed to buy investment property. These and other investment expenses (also called expenses for the production of income) are tax deductible, subject to some important limitations. (See "Investing and Other Income-Producing Activities" in Chapter 2 for more on investment deductions.)
Business DeductionsHome business owners usually have to spend money on their businesses -- for example, for equipment, supplies, or business travel. Most business expenses are deductible sooner or later. It makes no difference for tax deduction purposes 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 ProfitsThe federal income tax law recognizes that you must spend money to make money. Virtually every home business, however small, incurs some expenses. Even someone with a low overhead business (such as a freelance writer) must buy paper, computer equipment, and office supplies. Some home businesses incur substantial expenses, even exceeding their income.
You are not legally required to pay tax on every dollar your business takes in (your gross business income). Instead, you owe tax only on the amount left over after your business's deductible expenses are subtracted from your gross income (this remaining amount is called your net profit). Although some tax deduction calculations can get a bit complicated, the basic math is simple: The more deductions you take, the lower your net profit will be, and the less tax you will have to pay.
Example: Karen, a sole proprietor, earned $50,000 this year from her consulting business, which she operates from her home office. Fortunately, she doesn't have to pay income tax on the entire $50,000 -- her gross income. Instead, she can deduct various business expenses, including a $5,000 home office deduction (see Chapter 6) and a $5,000 deduction for equipment expenses (see Chapter 5). She deducts these expenses from her $50,000 gross income to arrive at her net profit: $40,000. She pays income tax only on this net profit amount.
You Must Have a Legal Basis for Your DeductionsAll tax deductions are a matter of legislative grace, which means that you can take a deduction only if it is specifically allowed by one or more provisions of the tax law. You usually do not have to indicate on your tax return which tax law provision gives you the right to take a particular deduction. If you are audited by the IRS, however, you'll have to provide a legal basis for every deduction you take. If the IRS concludes 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 DeductionsOnly 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 doesn't turn a profit for several years in a row, the IRS might decide that you are engaged in a hobby rather than a business. This may not sound like a big deal, but it could have disastrous tax consequences: People engaged in hobbies are entitled to very limited tax deductions, while businesses can deduct all kinds of expenses. Fortunately, careful taxpayers can usually avoid this unhappy outcome. (See Chapter 2 for tips that will help you convince the IRS that you really are running a business.)
How Businesses Are TaxedIf 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 formed (a sole proprietorship, partnership, limited liability company, or corporation), and 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, by Anthony Mancuso (Nolo).
Basic Business FormsEvery business, from a part-time operation you run from home while in your jammies to a Fortune 500 multinational company housed in a gleaming skyscraper, has a legal structure. If you're running a business right now, it has a legal form -- even if you never made a conscious decision about how it should be legally organized.
Most Home Businesses Are Sole ProprietorshipsA sole proprietorship is a one-owner business. According to the Small Business Administration, 90% of all home businesses are sole proprietorships. Unlike the other business forms, a sole proprietorship has no legal existence separate from the business owner. It cannot sue or be sued, own property in its own name, or file its own tax returns. The business owner (proprietor) personally owns all of the assets of the business and controls its 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 proprietor 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).
