Home-based Business - Tax Issues

Here are some important issues that you need to be aware of before investing your time, money, and effort into a new home-based business.

Basically, the IRS will tax you on the difference between your business income (lower in earlier years – higher in later years) and business expenses (higher in earlier years – lower in later years). It is very common for a home-based business to show an overall loss in the first year, break-even in the second year and show profits in the third year.

The goal of any home-based business is to stay in business long enough to show profits.

Most home-based businesses will file their tax returns on their normal 1040 and add an additional form called a Schedule C (Income or Loss from a business) unless they have incorporated. If you incorporate as a LLC, S corp or C corp than you may have to file a 1120 which gets more complicated.

In general, business expenses are the cost of carrying on a trade or business. These expenses are usually deductible if the business is operated to make a profit. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

If your business manufactures products or purchases them for resale, you generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your expenses may be included in figuring the cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for certain production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs.

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called capital expenses. Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize; business start-up costs, business assets
and improvements (such as remodeling a store-front).

Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts and deduct the business part.

If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. However, this technique can trigger an audit and you have to pay back the government when you sell your house for the tax benefit your received.

I personally think that it is not worth it to deduce the cost of the home office except for specific equipment used in the business such as a computer, fax machine, business telephone and the like. Be careful that certain types of business assets cannot be deducted in their entirety due to limitation rules.

If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage.

In addition, common business expenses include employee wages, retirement plans, rent, interest, federal taxes, state taxes, local taxes, and insurance.