So you want to start and build an Internet business... What's the number one secret to having your own homebased business?
The fabulous, I mean incredible tax write offs. You just won't believe it!
Congratulations! Your pursuit of a lower tax bill has ended. As the owner of a home-based business, you have tapped into a gold mine of tax write-offs. It's true that Congress has slammed the door on many tax shelters; but, the ultimate tax shelter is still standing as strong. Your own business - especially if you work out of your home - is all the tax shelter you'll ever need. So long as you are actively building your business, you can convert many of your otherwise nondeductible personal expenses into legal tax write-offs. Almost anything you spend money on, if you're self-employed, can be tax-deductible, if you plan carefully and keep detailed records.
Take advantage of every tax benefit the law has to offer. Click on any of the topics for tax and recordkeeping information.
Tax Laws are subject to change. The content provided on this site is for information purposes only. It is ultimately up to you to be aware of the current tax laws.
Demonstrators, Samples, and Promotional Tools
The success of your sales efforts depends upon the presentation. To paraphrase the Chinese, one sample is worth a thousand words.
Fortunately, demonstrator items and samples are deductible. These include:
Any products purchased by you to be tested in your home. You may deduct the cost of at least one of each product for testing to determine its effectiveness, quality, durability or reliability to you own satisfaction.
The cost of the initial start-up package of products and tools.
The cost of products (including brand X) used for demonstration.
The costs of items to loan to people after they have seen the program.
Any tapes you buy either to loan out, to train yourself, or to give away to promote business.
Books used to help you build the business.
Promotional items such as cassette players that cost less than $100. Items costing more than $100 that have a life expectancy in excess of one year are considered capital equipment and must be depreciated.
Pins, plaques, or any form of awards associated with achieving goals that you decide to use.
Gifts costing up to $25 each that you give to people important to your business. This is a once per year limitation. There is no limit on the number of people to whom you may give gifts provided they are business-related.
Be careful, though, if you order these items on the same order form as products for sale. Do not include them as purchases in determining your cost of goods sold, or you will be claiming the expense twice. You should deduct the cost of samples and demonstrators as operating expenses under Part II, Schedule C. A good practice is to buy these items on a separate order form to prevent year-end confusion.
The same caution must be exercised if you order products for your own personal use. Again, these personal-use items must be subtracted from the total of your order forms to determine the amount of merchandise ordered for actual sale. If you occasionally take a sample for personal use, you must subtract the cost of the item from your deductible sample expense.
Do you sometimes use demonstrator products for personal purposes? If so, you will have to allocate the cost between the time the product is used for business and the time it is used for personal reasons. Only the business portion of the cost is deductible.
Depreciation
You may depreciate all capital items or equipment used for the operation of your business. A capital item is normally defined as something with a useful life of more than one year and costing more than $100. The $100 is a guideline and does not always apply. If, for example, you had a number of related items with a life greater than one year, costing less than $100, that together made up a fairly large dollar figure, they would be figured as capital items. Capital items include but are not limited to:
All furniture and equipment utilized in the business areas such as
(a) meeting room furniture,
(b) office furniture (desks, chairs, etc.),
(c) items used to affect the appearance of these areas such as pictures, etc.,
(d) lamps,
(e) end tables and tables used in conducting demonstrations.
Other equipment such as
(a) computer,
(b) adding machines,
(c) tape playing or recording equipment,
(d) video equipment (if used in your business), and
(e) shelves, bins, or boxes.
Vehicles.
Home-based Business Tax Breaks
Congratulations! Your pursuit of a lower tax bill has ended. As the owner of a home-based business, you have tapped into a gold mine of tax write-offs. It's true that Congress has slammed the door on many tax shelters; but, the ultimate tax shelter is still standing as strong. Your own business - especially if you work out of your home - is all the tax shelter you'll ever need. So long as you are actively building your business, you can convert many of your otherwise nondeductible personal expenses into legal tax write-offs. Almost anything you spend money on, if you're self-employed, can be tax-deductible, if you plan carefully and keep detailed records.
Take advantage of every tax benefit the law has to offer. Click on any of the topics for tax and recordkeeping information.
Tax Laws are subject to change. The content provided on this site is for information purposes only. It is ultimately up to you to be aware of the current tax laws.
Warning: Tax Laws are subject to Change. Content provided on this site is for information purposes only. It is ultimately up to you to be aware of the current tax laws.
Automobile
As a business owner, you may deduct the cost of driving in the course of your business, including trips to business meetings or seminars, to entertain clients outside your home, to pick up products and office supplies, to make deliveries, and to do business banking. If you are engaged in a network marketing business, the cost of visiting prospective clients and persons you would like to recruit into your sales organization is deductible, even if the trip is not successful.
If your home-based business is your only employment, all of your driving to and from your home office, which is your principal place of business, and different business locations is deductible. But if you also hold a job or are self-employed at a second business, figuring your deductible business mileage is slightly more complicated.
The reason is that commuting between your home and work is normally considered a personal expense and is not deductible. In order to deduct business mileage from your home office to another job, therefore, you must show that your home is your principal place of work. Your principal place of business is where you regularly meet with clients or customers, where your more important work is done, or where you spend most of your time. If your home serves as your office for a secondary job, driving from home to your primary business will not be deductible.
However, the cost of going from your home office to a related business location is deductible, even if your home office is the site of a secondary business or job. For example, driving from home to the bank to deposit business checks could be written off.
Where a home-based business is only worked part time, be sure to conduct business in your home before going to a related business location, such as the bank above, or you will risk losing the deduction. Keep a daily record of your business activities at home to prove you were traveling between two business locations on that day.
Computing Your Auto Expense
There are two methods of computing your automobile expense:
(1) the mileage rate or
(2) the actual expenses method. The use of both methods is optional. You will, obviously, want to use the method that gives you the higher deduction.
Mileage Rate. You may deduct 36.5¢ per mile for business driving. If you use this method, you must combine the mileage for all cars driven for the same business.
If you use the mileage rate, you may also deduct parking fees and tolls.
Actual expenses method. Alternately, you may deduct the business portion of the expenses of operating your car, such as gas, oil, repairs, insurance, car washes, tires, personal property taxes, auto loan interest, and depreciation.
Generally, if you bought a new car during the year, the actual expenses method will exceed the mileage rate. This presumes, of course, that you keep complete records of your expenses throughout the year. If not, you should use the mileage rate instead.
Only expenses attributable to your business use of the car are deductible. This means you must allocate your operating costs and depreciation according to your percentage of business use. Parking fees and tolls do not have to be allocated, however.
Special rules apply if the business use of your car is less than 50%.
Business Income
You must report all income you receive from your business.
This includes:
Income from sales - payments from your customers for products or from clients for services you perform
Commissions or bonuses you receive for sales and the sales of others who work for you or who are downline from you.
Prizes and awards you receive because of sales you make.
Income From Sales
Only money you receive directly from customers or clients is sales income. If products are purchased directly from a company with which you are affiliated, you do not have sales income. Any commission or bonus you receive for such a purchase is reportable by you, however.
The first step in computing your net profit or loss is to determine your gross income from your business. Gross income is gross receipts minus any cost of goods sold. Business income from other sources, such as interest income, must also be reported.
Report your business income on Schedule C, Profit (or Loss) from Business or Profession.
Do not use Schedule C for the following income items: (1) gains or losses on the sale of property used in your business (use Form 4797); and (2) dividends from stock held in the course of your business (use Schedule B).
Gross Profit
Gross receipts minus cost of goods sold equals your gross profit.
Your gross receipts or sales is the total amount you collected, before expenses, from all of your product lines or different services. For example, if you sell vitamins, you would report not only the fees you received for your services, but any income from downline sales as well.
Returns and Allowances
Subtract the amount of any money refunded or credited to customers that you previously included in gross receipts.
Cost of Goods Sold
If you make or buy products to sell, you may deduct this cost from your gross receipts. If you provide only services, you do not have a "cost of goods sold."
Your cost of goods sold is your capital investment in your business. The fee or price you charge is supposed to return, or reimburse, your capital expenditure -- and to produce a profit, too. The portion of your sales price or fee that recoups your investment is not taxable. Only your profit is. By subtracting the cost of the goods you sold, you are arriving at your gross profit. This is the amount from which the operating expenses of your business will be deducted.
Computing cost of goods sold is usually a three-step process if you have inventory:
(1) beginning inventory;
(2) plus purchases, supplies, and labor;
(3) minus your ending inventory.
Cost of goods sold also includes the cost of labor expended to manufacture a product. Merchandising businesses usually do not have labor costs attributable to cost of goods sold. Do not deduct "wages" paid to yourself.
Personal Use
You must subtract the cost of any merchandise or goods you withdraw from your business for personal or family use.
Other Costs Related to Goods Sold
Examples of other deductible costs of goods sold include packaging and containers, freight or delivery charges, and overhead expenses allocable to a manufacturing operation.
Note: You cannot have a negative cost of goods sold. If you arrive at a negative number, recheck your figures. Perhaps you have not subtracted out enough to cover personal use. Or maybe you made a mistake in counting your ending inventory.
Other Income
Include interest income, amounts recovered from bad debts you deducted in a prior year, and other miscellaneous income. You must report all income, even if you received it in a form other than cash. For example, you might trade or barter services or products with someone else. The value of the property you receive in exchange is income to you.
If you are a network marketer, you probably receive a commission on your sales or purchases. Other terms for this payment are "bonus" and "percentage." The amount can be based on both your own sales and those of others working under you or on purchases made directly from the company with which you are affiliated.
Report the entire amount of commissions you receive, even if you pay a portion of it to other sellers working under you. Don't worry: You will deduct the commissions you pay out as an operating expense further down on the Schedule C.
If you receive prizes or awards for your stellar marketing efforts, you must report the value of those as other business income. Examples include cash, free merchandise, use of a car, expense-paid trips, membership in clubs, and jewelry.
Report any noncash items you receive at their "fair market value." This is the amount a buyer would pay in the open market.
Your net sales reduced by your cost of goods sold and increased by other income gives you gross income. Gross income should never be less than zero.
Business Gifts
In taxes, as in more charitable aspects of life, "It is more blessed to give than to receive." Gift-giving is deductible. As with all gifts, though, it's the thought that counts, and for tax purposes, that thought must be business.
Like its tax cousin, entertainment, a business gift must be presented with the expectation of earning a profit. However, you do not have to actually profit from each and every gift in order to deduct the cost.
There must also be some business connection between you and the recipient of your gift, either as a current or prospective customer or client. This is especially true if you want to deduct gifts you make to relatives and friends.
Your write-off for business gifts is limited to $25 per person per year. When adding up your $25, do not add in gift-wrapping, engraving on jewelry, packaging, and mailing.
If you make gifts to members of the family of an individual who has a business relationship with you, all of the gifts will be considered as being made to that one individual. But, if the spouse or another family member has a bona fide independent business relationship with you, the gift to both family members will be deductible.
For purposes of applying the $25 limitation, a husband and wife are not persons in their own right. They are always treated as one taxpayer, limited to a deduction of $25 for each recipient annually.
Certain items, such as theater tickets, could be deducted as either gifts or entertainment. Generally, where an expense meets the deductibility requirements for both, it is considered entertainment rather than a gift.
Business Meals and Entertainment
Fun and taxes are not incompatible. You have your government's permission to have a good time. You can live it up and write it off at the same time.
What's the catch? Deductible entertainment must be for business. There's a limit to how much you can write off, too. Generally, only 50% of the cost of business meals and entertainment is deductible. Besides food, beverages, and entertainment, expenses subject to this 50% rule include admission and cover charges, taxes and tips, room rental, and valet and parking fees. Transportation to and from the meal or entertainment is fully deductible.
"Entertainment" means the same fun happening to the IRS that it does to you. This includes entertaining at nightclubs, restaurants, theaters, sporting events, and on hunting, fishing, and vacation trips. It even includes entertaining in your home.
Not surprisingly, however, the more entertaining an activity is, the less it is "entertainment" under the tax law. That's because it must be provided to a customer, client, or business associate (including an employee). Have too much fun, and it will be hard to convince the IRS you conducted business.
That does not mean you cannot have fun. But to be deductible, entertainment must pass two separate tests:
(1) ordinary and necessary and
(2) directly related to or associated with.
The first test applies to all business expenses. An expense is "ordinary" if it normally occurs or is customary within an industry. For example, business meals are normal for commissioned salespersons and are, therefore, ordinary. The same cannot be said for bank tellers. A "necessary" expense is one made to further the profitability of your business.
Your entertainment must be "reasonable," too. Jetting a customer to Paris for lunch would probably fail this standard.
To meet its second test, entertainment must be "directly related to" or "associated with" the active conduct of your business. To qualify as "directly related," entertainment must meet all of the following requirements:
There must be an expectation of some business benefit:
You must actively engage in business during the entertainment period;
The primary character of the combined entertainment and business must be the transaction of business; and
The deductible amount of the expense must be allocable to you and the person being entertained.
An expense can also squeak by as "directly related" if:
(1) it was incurred in a clear business setting or
(2) it was a prize or compensation.
To be "associated with" the conduct of your business, entertainment must take place directly before or after substantial and bona fide business discussions. Entertainment happening at any hour on the same day as the business discussion is automatically considered to be "associated with."
Entertainment Facilities
The costs of operating entertainment facilities (such as yachts, skybox rentals, and fishing lodges) are generally not allowed. Out-of-pocket expenses for food, drinks, catering, or gasoline provided during entertainment at an entertainment facility may be deductible (subject to the 50% limitation), if they meet the general tests for entertainment expenses.
No deduction is allowed for dues paid to any club run for business, pleasure, recreation, or other social purpose. Exceptions: business leagues, trade associations, chambers of commerce, boards of trade, real estate boards, professional groups, and civic and public service organizations.
Demonstrators, Samples, and Promotional Tools
The success of your sales efforts depends upon the presentation. To paraphrase the Chinese, one sample is worth a thousand words.
Fortunately, demonstrator items and samples are deductible. These include:
Any products purchased by you to be tested in your home. You may deduct the cost of at least one of each product for testing to determine its effectiveness, quality, durability or reliability to you own satisfaction.
The cost of the initial start-up package of products and tools.
The cost of products (including brand X) used for demonstration.
The costs of items to loan to people after they have seen the program.
Any tapes you buy either to loan out, to train yourself, or to give away to promote business.
Books used to help you build the business.
Promotional items such as cassette players that cost less than $100. Items costing more than $100 that have a life expectancy in excess of one year are considered capital equipment and must be depreciated.
Pins, plaques, or any form of awards associated with achieving goals that you decide to use.
Gifts costing up to $25 each that you give to people important to your business. This is a once per year limitation. There is no limit on the number of people to whom you may give gifts provided they are business-related.
Be careful, though, if you order these items on the same order form as products for sale. Do not include them as purchases in determining your cost of goods sold, or you will be claiming the expense twice. You should deduct the cost of samples and demonstrators as operating expenses under Part II, Schedule C. A good practice is to buy these items on a separate order form to prevent year-end confusion.
The same caution must be exercised if you order products for your own personal use. Again, these personal-use items must be subtracted from the total of your order forms to determine the amount of merchandise ordered for actual sale. If you occasionally take a sample for personal use, you must subtract the cost of the item from your deductible sample expense.
Do you sometimes use demonstrator products for personal purposes? If so, you will have to allocate the cost between the time the product is used for business and the time it is used for personal reasons. Only the business portion of the cost is deductible.
Depreciation
You may depreciate all capital items or equipment used for the operation of your business. A capital item is normally defined as something with a useful life of more than one year and costing more than $100. The $100 is a guideline and does not always apply. If, for example, you had a number of related items with a life greater than one year, costing less than $100, that together made up a fairly large dollar figure, they would be figured as capital items. Capital items include but are not limited to:
All furniture and equipment utilized in the business areas such as
(a) meeting room furniture,
(b) office furniture (desks, chairs, etc.),
(c) items used to affect the appearance of these areas such as pictures, etc.,
(d) lamps,
(e) end tables and tables used in conducting demonstrations.
Other equipment such as
(a) computer,
(b) adding machines,
(c) tape playing or recording equipment,
(d) video equipment (if used in your business), and
(e) shelves, bins, or boxes.
Vehicles.
Figuring depreciation
In order to compute the amount of depreciation allowed for business property placed in service during the taxable year, you must first determine its useful life. The tax law provides a Modified Accelerated Cost Recovery System (MACRS) that may be used in determining this. Personal property (any assets other than real estate) is classified into two categories: Five-year property which includes autos, computers, computer peripherals, telephones, and software. Seven-year property includes office furnishings and other equipment not included in the five-year category.
The first-year allowance for five-year property is 20%, 32% in the second year, 19.2% in the third year, 11.52% in the fourth and fifth years, and 5.76% in the sixth year.
For seven-year property, the first-year depreciation would be 14.29%, followed by 24.49% in the second year, 17.49% in the third year, 12.49% in the fourth year, 8.93% in the fifth and seventh years, 8.92% in the sixth year, and 4.46% in the eighth year.
The reason the first-year percentage is lower than the second is to make allowance for the fact that the property may be put in service any time during the year and still receive the percentage specified.
The straight-line method of deprecation may be used by simply dividing the number of years of useful life into the value of the property. If you elect the straight-line method for a particular class of property, i.e., five or seven years, then you must use the straight-line method for all types of property in this class. You must also use the half-year convention. In other words, if the property is place in service during the first half of the year, you may assume it was in service for the entire year. If it is placed in service during the second half of the year, you may assume it was in service for one-half the year.
If you happen to sell any of your depreciated property for more than its depreciated value, i.e., the amount you paid minus the amount you have written off, then any amount you receive over the depreciated value -- up to what you originally paid for it -- must be reported that year as ordinary income (this is called recapture). If you sell it for more than its original cost, then the additional amount over what you originally paid is reported as capital gain. The items used in your business and depreciated will not normally be sold for more than the depreciated value and, therefore, this problem rarely occurs. If the property becomes worthless before the end of the depreciation period, the balance may be written off at that time.
A first-year deduction of $24,000 may be expensed in addition to the depreciation ($12,000 married filing separate). Expensing this amount in the first year lowers the amount that is depreciated.
If you use equipment and furniture that you already owned prior to going into business, you may start to depreciate these items as soon as you place them into service (commence operation). Even if the value of the items has appreciated to a point where they are worth more than you paid for them, you may not use a figure in excess of their original purchase price to determine your depreciation. If you have had the items for a while before entering the business and if you can demonstrate that you could not purchase a comparable item for less than you paid, then you may use your original price as the cost basis for depreciation, provided that you have not depreciated them for any other business use in prior years. If the items were given to you, you may use the donor's basis - in other words, what the person who gave them to you paid.
Home Entertainment
A wined and dined client is a loyal one, and a prospective customer wooed with food is likely to express his gratitude by placing an order. Because of its proven profit potential, business entertainment has long been tax deductible.
You don't have to conduct business with a waitress hovering in the background, however.
The cost of entertaining in your home is equally deductible.
A few conditions apply:
1. You must have a business purpose for getting together. But if your clients are also friends, you don't have to treat them like strangers. You can engage in small talk and exchange pleasantries as well as discuss business.
2. Food and drink must be served in an atmosphere conducive to a business discussion. There should be no distractions. A party would hardly qualify. Nor would a meeting in the family room with the television on and the children whizzing paper airplanes.
3. Limit the gathering to business guests. This is not a hard-and-fast rule, but entertaining a group that includes nonbusiness guests raises the presumption that the primary character of the entertainment was not business, but a ripping good time.
Before you hunt for the punch bowl, there is one limitation you should be aware of. Only 50% of business meals and entertainment is deductible. So you may want to skip the champagne and caviar.
Because a home is an informal setting, the IRS tends to be skeptical about the business nature of home entertaining. To back up your deductions, be sure to buy food and drink you intend to serve to business guests separately from other groceries.
Keep the supermarket receipt, and write the following five required items of information on it:
(1) the date;
(2) the place;
(3) the amount spent;
(4) the name of the person(s) entertained (use last names); and
(5) the business purpose of the entertainment or any business benefit gained.
You may also want to have business guests sign a guest book.
If you set aside a certain area of your home exclusively for entertaining clients or prospective clients, you may include that floor space in your home office calculation.
Home Office
Is a portion of your home used solely for your business or job? It can be a spare bedroom that serves as your base of operations, or a remodeled basement where you meet with patients, clients, or customers regularly. If so, you may be able to reduce the income and self-employment taxes on your business income by taking an office-in-home deduction.
Before you get too excited about the potential deductions, you should know that tax laws may limit this year's deduction or even wipe out in subsequent years any tax that you save now.Who can deduct?
To meet the Internal Revenue Service (IRS) rules for a home office, the area that you set aside must be used exclusively for work on a regular basis. If you worked on a special project at home for a month, your office doesn't meet the rule. Also, this means the computer room that you share with your kids doesn't qualify. Sorry, but that's the law.
If you're an employee, the business use of your home must also be for the convenience of your employer. If your boss prefers that you work in the company office, you'd have a hard time justifying your office-in-home deduction if you were audited.What can you deduct?
If you own your home, you probably already know that you can deduct mortgage interest and property taxes. Taking an office-in-home deduction lets you deduct additional expenses, such as:
Insurance (homeowners and mortgage)
Repairs and maintenance
Utilities and services
Depreciation
Security system
Rent (if you don't own your home) How much can you deduct?
If you're self-employed, you're in the unenviable position of paying both income tax and self-employment tax. Deducting office-in-home expenses can save you a lot. You may pay 40% or more of your self-employment income in taxes. Deducting office-in-home expenses can:
Let you deduct expenses that wouldn't otherwise be deductible.
Shift expenses that are already deductible to reduce self-employment income.
Several factors limit the amount that you can deduct. Here are a few items that you should consider before you plan that trip to Maui.
Size of your office Most of the deductible expenses pertain to your entire house, rather than to your home office. Your office takes up only a percentage of the square footage in your house. You multiply this percentage by your expenses to come up with the portion of the expenses that are deductible against your business income. Expenses that are directly related to your home office aren't limited to this percentage. For example, if you paint your home office, this expense is fully deductible.
Business income If you have a loss on your business before claiming a home office, you cannot get any tax benefit from your office this year. Go ahead and claim the office-in-home deduction, even if it doesn't reduce your taxes this year. You can carry over the current year's deduction to use against next year's business income.
Employee's itemized deductions
An employee can also claim an office-in-home deduction as a miscellaneous itemized deduction. So if you claim the standard deduction rather than itemizing deductions, you cannot receive benefit of an office-in-home deduction as an employee. If you do claim these expenses as itemized deductions, they're reduced by 2% of your adjusted gross income before any amount is deductible.
Depreciation If you own your home, you can deduct depreciation for the wear and tear on the part of it that you use for business. The office percentage of your home cost is deducted as depreciation over 39 years.
Repairs versus permanent improvements A permanent improvement increases the value of your property or adds to its life. For example, replacing electric wiring or plumbing, adding a new roof or addition, or remodeling your home are considered permanent improvements. Why do you care? A repair is an expense, and your business percentage can be deducted in the year paid. A permanent improvement, however, must be depreciated over the office's 39-year life. Planning to sell your home sooner rather than later?
Before you claim an office-in-home deduction, consider when you plan to sell your home.
The sale of your personal residence is usually not taxable. However, by claiming an office-in-home deduction, you've turned a portion of your home into business property. The sale of business property is taxable.
To determine whether a house is your personal residence, the IRS asks whether you lived in the home for two of the last five years. If so, you can use the special rules for sale of personal residence. To avoid being taxed on any portion of your gain on the sale, you generally should not claim the office-in-home deduction for two full years before you sell the house.A great deduction in the right situation
The tax savings from claiming a home office can be large, particularly if you're self-employed. Before you claim it, however, be sure that your office meets the IRS rule that it is used exclusively and regularly in your business.
You can deduct expenses related to your house that aren't normally deductible, as well as depreciation for wear and tear. Many things can limit the amount of office-in-home expenses that you're allowed to deduct, including the size of your office and the amount of your business income. Any tax preparation software will help you with the depreciation calculations and the calculations for each of the limits.
If in doubt, consult with a tax professional before claiming the deduction for a home office.
Inventory
Obviously, if you perform services, you have no inventory to worry about. Many direct sellers have little or no inventory either. Products are shipped directly from the company with which they are affiliated.
If you stock any products at all, you need to know how to compute your year-end inventory. This involves taking a physical count of your inventory, figuring how much those items cost, and putting a value on them.
The first step is to count all the merchandise on your shelves. (A good bookkeeping system is a lifesaver here.) Include unsold products, but don't include any being held for pick-up after sale. Also include goods you have bought, but not yet received, unless they are being sent C.O.D. If you have been billed, but have not yet paid, for unsold goods, you are treated as having title and must add them to inventory.
Count partly finished goods and raw materials and supplies that will become a part of your sale items. Add in goods that are out on consignment or are in display rooms away from your place of business, too.
Do not include in inventory goods that are consigned to you. Assets, such as land, buildings, and equipment used in your business, as well as accounts receivable, are not inventory items. Nor is real estate held for sale by you as a real estate dealer in the ordinary course of your business.
Valuation Methods
You need a method of valuing your inventory items in it. Because the value affects your taxable income, the method you choose is important. The two most common methods are:
1. Cost
2. Lower of cost or market value
Under the cost method, you value inventory items according to the amount you originally paid for them. When the lower of cost or market-value method is used, you set the value of each item by comparing its current market value with its original cost and using the lower value. Under this second method, each item must be compared separately to arrive at the value of your entire inventory.
You must use the same method to value your entire inventory, and you may not change to another method without the permission of the IRS.
Suppose your inventory contains unsalable goods, that is , items that have been damaged, or are imperfect, shopworn, or obsolete due to changes of style or improvements.
Naturally such goods should not be valued normally. Instead, you should value them at their selling prices minus direct costs of disposing of them. Do not use a value less than scrap value.
If you lack a computerized, perpetual inventory system, you may want to use one of two conventions for valuing inventories of smaller products:
FIFO and LIFO.
FIFO stands for first-in, first-out. It is a method that assumes that the first item you buy is the first item you sell. If you use FIFO, you may value your inventory at either cost or lower of cost or market value. The last-in, first-out (LIFO) method presumes just the opposite - that the newest product is the one that sells first.
Why would you choose one method over another? Inventory is a factor in computing your cost of goods sold, which in turn determines how much taxable profit you made. The higher your cost of goods sold, the lower your gross income.
In times of inflation, LIFO will produce a higher cost of goods sold because the price you pay for the newest item (assumed to be the first one you sold) will be more than the price paid earlier in the year. On the other hand, FIFO results in a higher cost of goods sold when prices are tending downward.
Beginning and Ending Inventory
You need to know your inventory at the beginning and end of each tax year. If this is not your first year in business, the ending inventory on your last year's return is your beginning inventory in the current year. If you're new to self-employment, your beginning inventory will be zero.
If the ending inventory is lower than the inventory at the beginning of the year, more goods were sold than purchased. If the inventory increased by year's end, then more items were purchased than sold.
Record Keeping
Introduction
If there's one thing more annoying than record keeping, it's paying unnecessary taxes because you didn't keep track of your expenses. If you haven't amassed a mound of receipts, canceled checks, and credit card slips by year-end, how are you going to do justice to your return at tax time? Come April, when you are racking your brain, trying to remember how many miles you drove for business and how many three-martini lunches you lavished on clients, you will wish those papers you discarded with such abandon were still available.
There's another reason for adding record keeping to your list of hobbies: the dreaded audit. The Internal Revenue Code, section 6001, makes you responsible for keeping books and records that are adequate for audit purposes. "Adequate" means they exist, are in proper form, and are readily available. Section 6001 has a partner, section 7602, which empowers an auditor to compel you to produce the records needed to conduct an audit of your return.
Without records, you can only lose in an audit. This is because the burden of proof in an audit is on you. Unless you can prove the items on your return, the auditor is free to assume you didn't really incur the losses or expenses you claimed. In that case, the amounts you deducted are disallowed (added back to income), and you find yourself with a bill for additional tax due.
What Business Records to Keep
Now that you have mastered the how, let's tackle the what. What receipts, checks, cash register tapes, and other scraps of paper from the operation of your business should you keep?
Business Income. Cash receipts journal; bank statements or passbooks for all checking, savings, and trust accounts; duplicate deposit slips, sales invoices, cash register tapes or other records of income; records of all loans and canceled checks or receipts showing repayment; 1099s; information on any nontaxable income; brokerage statements; records for purchases or sales of real estate or other property.
General Business Expenses.
Accounting ledgers and journals; worksheets used in preparing your return; purchase invoices for cost of goods sold and purchase of capital items; copies of Forms 940 and 941 (payroll tax returns), plus state payroll tax returns; state sales tax returns; canceled checks and receipts for all other expenses.
Automobile. Mileage log or diary showing the date of each business trip and the business mileage driven; odometer reading at beginning and end of year; receipts, credit card slips, or canceled checks for gasoline, oil, automobile insurance, lease payments, automobile repair bills, license fees, car washes, parking, tolls; purchase invoice for business automobile.
Note: You can prove business use by keeping records of your car's use for a portion of the year if you can show by other evidence, such as invoices and paid bills, that your driving during this period was representative of the entire year.
Travel Away from Home. Diary stating business purpose or nature of the business benefit derived or expected as a result of all business trips; destination, and dates of departure and return for each trip; receipts, credit card slips, or canceled checks for airline tickets, meals and lodging, and automobile rental; log of tips and taxi fares if receipts are not available. An itemized bill is required to verify lodging -- a credit card charge receipt is not sufficient. However, the statement you receive from an airline, showing the costs and itineraries, when you fly using a paperless, electronic airplane ticket, is acceptable proof.
Entertainment. Records, including receipts, credit card slips, or canceled checks showing all of the following:
(1) date;
(2) amount;
(3) place, including address or location and description of type of entertainment, such as restaurant or nightclub, if not evident;
(4) name of the person(s) entertained (include last names); and
(5) business purpose or relationship to you. A diary must also be kept, detailing the above information if you have not written it on your receipt. Your diary entries should be keyed to your receipts.
Gifts. Records, including the following information:
(1) the cost of each gift;
(2) the date given;
(3) a description of the gift;
(4) the name of the recipient; and
(5) the business reason for the gift or any business benefit gained or expected to be gained.
When Receipts are Not Required. According to Treasury regulations, a receipt or other statement is not required to prove expenses (other than lodging) of $75 or less. A diary entry is sufficient. Moreover, receipts for expenses over $75 are required only where they are easy to obtain, such as for air fare. In practice, however, it is generally advisable to keep receipts for all expenses regardless of amount because it adds to your credibility in an audit. Your employer may set stricter receipt requirements.
Home Office.
Receipts for interest and taxes or rent, home insurance, utilities, repairs to office, office furniture, and equipment; record of total floor area in your home and the portion used as an office; a photograph of the office area, if available.
Education expenses. A transcript of courses taken and period of enrollment, canceled checks or receipts for tuition, travel and transportation, books, meals and lodging while away from home overnight, and other education-related expenses.
Disposing of Records
How long must your tax records take up space? The general rule is that receipts may be discarded three years from the date the return is filed or due (or two years from the date the tax was paid), whichever is later.
Some records should be kept longer. If you own a business, save those records for seven years and any records on employees for four years.
Property records should be retained as long as they are needed to determine the basis of the original property or the property that replaced it.
Receipts for major purchases should be saved until you dispose of the property.
Telephone
Does your home phone have a split personality -- part social, part business? If you are using the family telephone to make business calls, you may deduct only the long-distance and toll charges incurred directly for business. None of te service charges on the first phone line in your home are deductible.
A second, business telephone is another matter. You may deduct the installation charge, and after that, as long as the phone is used exclusively for business, you may deduct the entire bill, service charges and all. You may deduct all long-distance calls made in connection with the business, either for recruiting, training, motivating, ordering, or calls relative to the sale or use of the products.
Because a business phone is more expensive than a home phone, you will probably pay more than you save in taxes by installing a business phone in the initial stages of your home-based business.
Travel
The cost of business travel temporarily away from home is deductible. Travel expenses include transportation fares, lodging, 50% of meals, rental cars, baggage charges, tips, telephone expenses, taxis, and airport buses.
Your travel must have a business purpose. There are two standards for judging business purpose, depending on whether your travel is domestic or foreign.
For domestic travel, the primary purpose of your trip must be business. If you pass this test, you may deduct the cost of transportation to and from your destination, plus lodging, 50% of meals, and all other ordinary and necessary travel expenses, not only for the days you engage in business activity, but for time you spend sightseeing or enjoying other nonbusiness activities at your destination as well.
The costs of recreational activities, tickets, postcards, and souvenirs during the personal portion of your trip are not deductible, however. And the expense of incidental nonbusiness side trips is limited to what you would have spent for meals (subject to the 50% rule) and lodging had you stayed at your business destination. But the cost of a vacation taken at a nonbusiness destination before or after reaching your business destination is not deductible .
If you fail the primary purpose test, only expenses directly attributable to conducting business are deductible. You may not take transportation fares or meals and lodging for time spent on nonbusiness activities.
Foreign travel must meet time tests. Your foreign trip will be considered entirely for business if you are outside the U.S. for one week or less, or less than 25% of your time was spent on nonbusiness activities. You may also pass this test if you had no substantial control over the trip or you can establish that a vacation was not a major consideration for your trip. If your foreign travel is entirely for business, all of your transportation, lodging, and 50% of meals are deductible. If your primary purpose was business, but your travel was not entirely for business, your travel expenses must be allocated according to the number of business days.
Conventions and Cruises
Attendance at a convention connected with your business is deductible. However, you may not deduct the cost of attending investment, political, social, or fraternal conventions.
No deduction is allowed for the expenses of attending conventions outside the North American area, unless the convention was directly related to your business and it was reasonable to meet in a foreign location. The North American area includes Canada, Mexico, Puerto Rico, U.S. possessions, U.S. Virgin Islands, Guam, Samoa, and the Trust Territory of the Pacific Islands. Conventions may also be held in "eligible" Caribbean countries.
Cruise ship expenses directly related to the active conduct of a trade or business are deductible up to $2,000 a year. All the ports of call must be in the United States or its possessions, and the ship must be registered in the United States.
A written statement signed by an officer of the group sponsoring your foreign convention or cruise must be attached to your return. In addition, you must attach your own statement showing the total days spent at the convention, the number of hours each day devoted to business activities, and a copy of the convention program.
If at least 6 hours per day are scheduled for business activities and you attend at least two-thirds of the total hours of scheduled activities, each day of the convention or cruise will be considered a business day.
Expenses of Your Spouse
If you take your spouse along on a convention or business trip, his or her travel expenses are nondeductible personal expenses, unless
(1) your spouse is also an partner in your business or an employee of your or your employer's company,
(2) your spouse's presence has a bona fide business purpose, and
(3) your spouse's expenses would be otherwise deductible.
If your spouse does not accompany you for a business purpose, the amount by which your hotel expenses exceed the single rate and the cost of your spouse's meals are not deductible.
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Congratulations! Your pursuit of a lower tax bill has ended. As the owner of a home-based business, you have tapped into a gold mine of tax write-offs. It's true that Congress has slammed the door on many tax shelters; but, the ultimate tax shelter is still standing as strong. Your own business - especially if you work out of your home - is all the tax shelter you'll ever need. So long as you are actively building your business, you can convert many of your otherwise nondeductible personal expenses into legal tax write-offs. Almost anything you spend money on, if you're self-employed, can be tax-deductible, if you plan carefully and keep detailed records.
Take advantage of every tax benefit the law has to offer. Click on any of the topics for tax and recordkeeping information.
Tax Laws are subject to change. The content provided on this site is for information purposes only. It is ultimately up to you to be aware of the current tax laws.
Demonstrators, Samples, and Promotional Tools
The success of your sales efforts depends upon the presentation. To paraphrase the Chinese, one sample is worth a thousand words.
Fortunately, demonstrator items and samples are deductible. These include:
Any products purchased by you to be tested in your home. You may deduct the cost of at least one of each product for testing to determine its effectiveness, quality, durability or reliability to you own satisfaction.
The cost of the initial start-up package of products and tools.
The cost of products (including brand X) used for demonstration.
The costs of items to loan to people after they have seen the program.
Any tapes you buy either to loan out, to train yourself, or to give away to promote business.
Books used to help you build the business.
Promotional items such as cassette players that cost less than $100. Items costing more than $100 that have a life expectancy in excess of one year are considered capital equipment and must be depreciated.
Pins, plaques, or any form of awards associated with achieving goals that you decide to use.
Gifts costing up to $25 each that you give to people important to your business. This is a once per year limitation. There is no limit on the number of people to whom you may give gifts provided they are business-related.
Be careful, though, if you order these items on the same order form as products for sale. Do not include them as purchases in determining your cost of goods sold, or you will be claiming the expense twice. You should deduct the cost of samples and demonstrators as operating expenses under Part II, Schedule C. A good practice is to buy these items on a separate order form to prevent year-end confusion.
The same caution must be exercised if you order products for your own personal use. Again, these personal-use items must be subtracted from the total of your order forms to determine the amount of merchandise ordered for actual sale. If you occasionally take a sample for personal use, you must subtract the cost of the item from your deductible sample expense.
Do you sometimes use demonstrator products for personal purposes? If so, you will have to allocate the cost between the time the product is used for business and the time it is used for personal reasons. Only the business portion of the cost is deductible.
Depreciation
You may depreciate all capital items or equipment used for the operation of your business. A capital item is normally defined as something with a useful life of more than one year and costing more than $100. The $100 is a guideline and does not always apply. If, for example, you had a number of related items with a life greater than one year, costing less than $100, that together made up a fairly large dollar figure, they would be figured as capital items. Capital items include but are not limited to:
All furniture and equipment utilized in the business areas such as
(a) meeting room furniture,
(b) office furniture (desks, chairs, etc.),
(c) items used to affect the appearance of these areas such as pictures, etc.,
(d) lamps,
(e) end tables and tables used in conducting demonstrations.
Other equipment such as
(a) computer,
(b) adding machines,
(c) tape playing or recording equipment,
(d) video equipment (if used in your business), and
(e) shelves, bins, or boxes.
Vehicles.
Home-based Business Tax Breaks
Congratulations! Your pursuit of a lower tax bill has ended. As the owner of a home-based business, you have tapped into a gold mine of tax write-offs. It's true that Congress has slammed the door on many tax shelters; but, the ultimate tax shelter is still standing as strong. Your own business - especially if you work out of your home - is all the tax shelter you'll ever need. So long as you are actively building your business, you can convert many of your otherwise nondeductible personal expenses into legal tax write-offs. Almost anything you spend money on, if you're self-employed, can be tax-deductible, if you plan carefully and keep detailed records.
Take advantage of every tax benefit the law has to offer. Click on any of the topics for tax and recordkeeping information.
Tax Laws are subject to change. The content provided on this site is for information purposes only. It is ultimately up to you to be aware of the current tax laws.
Warning: Tax Laws are subject to Change. Content provided on this site is for information purposes only. It is ultimately up to you to be aware of the current tax laws.
Automobile
As a business owner, you may deduct the cost of driving in the course of your business, including trips to business meetings or seminars, to entertain clients outside your home, to pick up products and office supplies, to make deliveries, and to do business banking. If you are engaged in a network marketing business, the cost of visiting prospective clients and persons you would like to recruit into your sales organization is deductible, even if the trip is not successful.
If your home-based business is your only employment, all of your driving to and from your home office, which is your principal place of business, and different business locations is deductible. But if you also hold a job or are self-employed at a second business, figuring your deductible business mileage is slightly more complicated.
The reason is that commuting between your home and work is normally considered a personal expense and is not deductible. In order to deduct business mileage from your home office to another job, therefore, you must show that your home is your principal place of work. Your principal place of business is where you regularly meet with clients or customers, where your more important work is done, or where you spend most of your time. If your home serves as your office for a secondary job, driving from home to your primary business will not be deductible.
However, the cost of going from your home office to a related business location is deductible, even if your home office is the site of a secondary business or job. For example, driving from home to the bank to deposit business checks could be written off.
Where a home-based business is only worked part time, be sure to conduct business in your home before going to a related business location, such as the bank above, or you will risk losing the deduction. Keep a daily record of your business activities at home to prove you were traveling between two business locations on that day.
Computing Your Auto Expense
There are two methods of computing your automobile expense:
(1) the mileage rate or
(2) the actual expenses method. The use of both methods is optional. You will, obviously, want to use the method that gives you the higher deduction.
Mileage Rate. You may deduct 36.5¢ per mile for business driving. If you use this method, you must combine the mileage for all cars driven for the same business.
If you use the mileage rate, you may also deduct parking fees and tolls.
Actual expenses method. Alternately, you may deduct the business portion of the expenses of operating your car, such as gas, oil, repairs, insurance, car washes, tires, personal property taxes, auto loan interest, and depreciation.
Generally, if you bought a new car during the year, the actual expenses method will exceed the mileage rate. This presumes, of course, that you keep complete records of your expenses throughout the year. If not, you should use the mileage rate instead.
Only expenses attributable to your business use of the car are deductible. This means you must allocate your operating costs and depreciation according to your percentage of business use. Parking fees and tolls do not have to be allocated, however.
Special rules apply if the business use of your car is less than 50%.
Business Income
You must report all income you receive from your business.
This includes:
Income from sales - payments from your customers for products or from clients for services you perform
Commissions or bonuses you receive for sales and the sales of others who work for you or who are downline from you.
Prizes and awards you receive because of sales you make.
Income From Sales
Only money you receive directly from customers or clients is sales income. If products are purchased directly from a company with which you are affiliated, you do not have sales income. Any commission or bonus you receive for such a purchase is reportable by you, however.
The first step in computing your net profit or loss is to determine your gross income from your business. Gross income is gross receipts minus any cost of goods sold. Business income from other sources, such as interest income, must also be reported.
Report your business income on Schedule C, Profit (or Loss) from Business or Profession.
Do not use Schedule C for the following income items: (1) gains or losses on the sale of property used in your business (use Form 4797); and (2) dividends from stock held in the course of your business (use Schedule B).
Gross Profit
Gross receipts minus cost of goods sold equals your gross profit.
Your gross receipts or sales is the total amount you collected, before expenses, from all of your product lines or different services. For example, if you sell vitamins, you would report not only the fees you received for your services, but any income from downline sales as well.
Returns and Allowances
Subtract the amount of any money refunded or credited to customers that you previously included in gross receipts.
Cost of Goods Sold
If you make or buy products to sell, you may deduct this cost from your gross receipts. If you provide only services, you do not have a "cost of goods sold."
Your cost of goods sold is your capital investment in your business. The fee or price you charge is supposed to return, or reimburse, your capital expenditure -- and to produce a profit, too. The portion of your sales price or fee that recoups your investment is not taxable. Only your profit is. By subtracting the cost of the goods you sold, you are arriving at your gross profit. This is the amount from which the operating expenses of your business will be deducted.
Computing cost of goods sold is usually a three-step process if you have inventory:
(1) beginning inventory;
(2) plus purchases, supplies, and labor;
(3) minus your ending inventory.
Cost of goods sold also includes the cost of labor expended to manufacture a product. Merchandising businesses usually do not have labor costs attributable to cost of goods sold. Do not deduct "wages" paid to yourself.
Personal Use
You must subtract the cost of any merchandise or goods you withdraw from your business for personal or family use.
Other Costs Related to Goods Sold
Examples of other deductible costs of goods sold include packaging and containers, freight or delivery charges, and overhead expenses allocable to a manufacturing operation.
Note: You cannot have a negative cost of goods sold. If you arrive at a negative number, recheck your figures. Perhaps you have not subtracted out enough to cover personal use. Or maybe you made a mistake in counting your ending inventory.
Other Income
Include interest income, amounts recovered from bad debts you deducted in a prior year, and other miscellaneous income. You must report all income, even if you received it in a form other than cash. For example, you might trade or barter services or products with someone else. The value of the property you receive in exchange is income to you.
If you are a network marketer, you probably receive a commission on your sales or purchases. Other terms for this payment are "bonus" and "percentage." The amount can be based on both your own sales and those of others working under you or on purchases made directly from the company with which you are affiliated.
Report the entire amount of commissions you receive, even if you pay a portion of it to other sellers working under you. Don't worry: You will deduct the commissions you pay out as an operating expense further down on the Schedule C.
If you receive prizes or awards for your stellar marketing efforts, you must report the value of those as other business income. Examples include cash, free merchandise, use of a car, expense-paid trips, membership in clubs, and jewelry.
Report any noncash items you receive at their "fair market value." This is the amount a buyer would pay in the open market.
Your net sales reduced by your cost of goods sold and increased by other income gives you gross income. Gross income should never be less than zero.
Business Gifts
In taxes, as in more charitable aspects of life, "It is more blessed to give than to receive." Gift-giving is deductible. As with all gifts, though, it's the thought that counts, and for tax purposes, that thought must be business.
Like its tax cousin, entertainment, a business gift must be presented with the expectation of earning a profit. However, you do not have to actually profit from each and every gift in order to deduct the cost.
There must also be some business connection between you and the recipient of your gift, either as a current or prospective customer or client. This is especially true if you want to deduct gifts you make to relatives and friends.
Your write-off for business gifts is limited to $25 per person per year. When adding up your $25, do not add in gift-wrapping, engraving on jewelry, packaging, and mailing.
If you make gifts to members of the family of an individual who has a business relationship with you, all of the gifts will be considered as being made to that one individual. But, if the spouse or another family member has a bona fide independent business relationship with you, the gift to both family members will be deductible.
For purposes of applying the $25 limitation, a husband and wife are not persons in their own right. They are always treated as one taxpayer, limited to a deduction of $25 for each recipient annually.
Certain items, such as theater tickets, could be deducted as either gifts or entertainment. Generally, where an expense meets the deductibility requirements for both, it is considered entertainment rather than a gift.
Business Meals and Entertainment
Fun and taxes are not incompatible. You have your government's permission to have a good time. You can live it up and write it off at the same time.
What's the catch? Deductible entertainment must be for business. There's a limit to how much you can write off, too. Generally, only 50% of the cost of business meals and entertainment is deductible. Besides food, beverages, and entertainment, expenses subject to this 50% rule include admission and cover charges, taxes and tips, room rental, and valet and parking fees. Transportation to and from the meal or entertainment is fully deductible.
"Entertainment" means the same fun happening to the IRS that it does to you. This includes entertaining at nightclubs, restaurants, theaters, sporting events, and on hunting, fishing, and vacation trips. It even includes entertaining in your home.
Not surprisingly, however, the more entertaining an activity is, the less it is "entertainment" under the tax law. That's because it must be provided to a customer, client, or business associate (including an employee). Have too much fun, and it will be hard to convince the IRS you conducted business.
That does not mean you cannot have fun. But to be deductible, entertainment must pass two separate tests:
(1) ordinary and necessary and
(2) directly related to or associated with.
The first test applies to all business expenses. An expense is "ordinary" if it normally occurs or is customary within an industry. For example, business meals are normal for commissioned salespersons and are, therefore, ordinary. The same cannot be said for bank tellers. A "necessary" expense is one made to further the profitability of your business.
Your entertainment must be "reasonable," too. Jetting a customer to Paris for lunch would probably fail this standard.
To meet its second test, entertainment must be "directly related to" or "associated with" the active conduct of your business. To qualify as "directly related," entertainment must meet all of the following requirements:
There must be an expectation of some business benefit:
You must actively engage in business during the entertainment period;
The primary character of the combined entertainment and business must be the transaction of business; and
The deductible amount of the expense must be allocable to you and the person being entertained.
An expense can also squeak by as "directly related" if:
(1) it was incurred in a clear business setting or
(2) it was a prize or compensation.
To be "associated with" the conduct of your business, entertainment must take place directly before or after substantial and bona fide business discussions. Entertainment happening at any hour on the same day as the business discussion is automatically considered to be "associated with."
Entertainment Facilities
The costs of operating entertainment facilities (such as yachts, skybox rentals, and fishing lodges) are generally not allowed. Out-of-pocket expenses for food, drinks, catering, or gasoline provided during entertainment at an entertainment facility may be deductible (subject to the 50% limitation), if they meet the general tests for entertainment expenses.
No deduction is allowed for dues paid to any club run for business, pleasure, recreation, or other social purpose. Exceptions: business leagues, trade associations, chambers of commerce, boards of trade, real estate boards, professional groups, and civic and public service organizations.
Demonstrators, Samples, and Promotional Tools
The success of your sales efforts depends upon the presentation. To paraphrase the Chinese, one sample is worth a thousand words.
Fortunately, demonstrator items and samples are deductible. These include:
Any products purchased by you to be tested in your home. You may deduct the cost of at least one of each product for testing to determine its effectiveness, quality, durability or reliability to you own satisfaction.
The cost of the initial start-up package of products and tools.
The cost of products (including brand X) used for demonstration.
The costs of items to loan to people after they have seen the program.
Any tapes you buy either to loan out, to train yourself, or to give away to promote business.
Books used to help you build the business.
Promotional items such as cassette players that cost less than $100. Items costing more than $100 that have a life expectancy in excess of one year are considered capital equipment and must be depreciated.
Pins, plaques, or any form of awards associated with achieving goals that you decide to use.
Gifts costing up to $25 each that you give to people important to your business. This is a once per year limitation. There is no limit on the number of people to whom you may give gifts provided they are business-related.
Be careful, though, if you order these items on the same order form as products for sale. Do not include them as purchases in determining your cost of goods sold, or you will be claiming the expense twice. You should deduct the cost of samples and demonstrators as operating expenses under Part II, Schedule C. A good practice is to buy these items on a separate order form to prevent year-end confusion.
The same caution must be exercised if you order products for your own personal use. Again, these personal-use items must be subtracted from the total of your order forms to determine the amount of merchandise ordered for actual sale. If you occasionally take a sample for personal use, you must subtract the cost of the item from your deductible sample expense.
Do you sometimes use demonstrator products for personal purposes? If so, you will have to allocate the cost between the time the product is used for business and the time it is used for personal reasons. Only the business portion of the cost is deductible.
Depreciation
You may depreciate all capital items or equipment used for the operation of your business. A capital item is normally defined as something with a useful life of more than one year and costing more than $100. The $100 is a guideline and does not always apply. If, for example, you had a number of related items with a life greater than one year, costing less than $100, that together made up a fairly large dollar figure, they would be figured as capital items. Capital items include but are not limited to:
All furniture and equipment utilized in the business areas such as
(a) meeting room furniture,
(b) office furniture (desks, chairs, etc.),
(c) items used to affect the appearance of these areas such as pictures, etc.,
(d) lamps,
(e) end tables and tables used in conducting demonstrations.
Other equipment such as
(a) computer,
(b) adding machines,
(c) tape playing or recording equipment,
(d) video equipment (if used in your business), and
(e) shelves, bins, or boxes.
Vehicles.
Figuring depreciation
In order to compute the amount of depreciation allowed for business property placed in service during the taxable year, you must first determine its useful life. The tax law provides a Modified Accelerated Cost Recovery System (MACRS) that may be used in determining this. Personal property (any assets other than real estate) is classified into two categories: Five-year property which includes autos, computers, computer peripherals, telephones, and software. Seven-year property includes office furnishings and other equipment not included in the five-year category.
The first-year allowance for five-year property is 20%, 32% in the second year, 19.2% in the third year, 11.52% in the fourth and fifth years, and 5.76% in the sixth year.
For seven-year property, the first-year depreciation would be 14.29%, followed by 24.49% in the second year, 17.49% in the third year, 12.49% in the fourth year, 8.93% in the fifth and seventh years, 8.92% in the sixth year, and 4.46% in the eighth year.
The reason the first-year percentage is lower than the second is to make allowance for the fact that the property may be put in service any time during the year and still receive the percentage specified.
The straight-line method of deprecation may be used by simply dividing the number of years of useful life into the value of the property. If you elect the straight-line method for a particular class of property, i.e., five or seven years, then you must use the straight-line method for all types of property in this class. You must also use the half-year convention. In other words, if the property is place in service during the first half of the year, you may assume it was in service for the entire year. If it is placed in service during the second half of the year, you may assume it was in service for one-half the year.
If you happen to sell any of your depreciated property for more than its depreciated value, i.e., the amount you paid minus the amount you have written off, then any amount you receive over the depreciated value -- up to what you originally paid for it -- must be reported that year as ordinary income (this is called recapture). If you sell it for more than its original cost, then the additional amount over what you originally paid is reported as capital gain. The items used in your business and depreciated will not normally be sold for more than the depreciated value and, therefore, this problem rarely occurs. If the property becomes worthless before the end of the depreciation period, the balance may be written off at that time.
A first-year deduction of $24,000 may be expensed in addition to the depreciation ($12,000 married filing separate). Expensing this amount in the first year lowers the amount that is depreciated.
If you use equipment and furniture that you already owned prior to going into business, you may start to depreciate these items as soon as you place them into service (commence operation). Even if the value of the items has appreciated to a point where they are worth more than you paid for them, you may not use a figure in excess of their original purchase price to determine your depreciation. If you have had the items for a while before entering the business and if you can demonstrate that you could not purchase a comparable item for less than you paid, then you may use your original price as the cost basis for depreciation, provided that you have not depreciated them for any other business use in prior years. If the items were given to you, you may use the donor's basis - in other words, what the person who gave them to you paid.
Home Entertainment
A wined and dined client is a loyal one, and a prospective customer wooed with food is likely to express his gratitude by placing an order. Because of its proven profit potential, business entertainment has long been tax deductible.
You don't have to conduct business with a waitress hovering in the background, however.
The cost of entertaining in your home is equally deductible.
A few conditions apply:
1. You must have a business purpose for getting together. But if your clients are also friends, you don't have to treat them like strangers. You can engage in small talk and exchange pleasantries as well as discuss business.
2. Food and drink must be served in an atmosphere conducive to a business discussion. There should be no distractions. A party would hardly qualify. Nor would a meeting in the family room with the television on and the children whizzing paper airplanes.
3. Limit the gathering to business guests. This is not a hard-and-fast rule, but entertaining a group that includes nonbusiness guests raises the presumption that the primary character of the entertainment was not business, but a ripping good time.
Before you hunt for the punch bowl, there is one limitation you should be aware of. Only 50% of business meals and entertainment is deductible. So you may want to skip the champagne and caviar.
Because a home is an informal setting, the IRS tends to be skeptical about the business nature of home entertaining. To back up your deductions, be sure to buy food and drink you intend to serve to business guests separately from other groceries.
Keep the supermarket receipt, and write the following five required items of information on it:
(1) the date;
(2) the place;
(3) the amount spent;
(4) the name of the person(s) entertained (use last names); and
(5) the business purpose of the entertainment or any business benefit gained.
You may also want to have business guests sign a guest book.
If you set aside a certain area of your home exclusively for entertaining clients or prospective clients, you may include that floor space in your home office calculation.
Home Office
Is a portion of your home used solely for your business or job? It can be a spare bedroom that serves as your base of operations, or a remodeled basement where you meet with patients, clients, or customers regularly. If so, you may be able to reduce the income and self-employment taxes on your business income by taking an office-in-home deduction.
Before you get too excited about the potential deductions, you should know that tax laws may limit this year's deduction or even wipe out in subsequent years any tax that you save now.Who can deduct?
To meet the Internal Revenue Service (IRS) rules for a home office, the area that you set aside must be used exclusively for work on a regular basis. If you worked on a special project at home for a month, your office doesn't meet the rule. Also, this means the computer room that you share with your kids doesn't qualify. Sorry, but that's the law.
If you're an employee, the business use of your home must also be for the convenience of your employer. If your boss prefers that you work in the company office, you'd have a hard time justifying your office-in-home deduction if you were audited.What can you deduct?
If you own your home, you probably already know that you can deduct mortgage interest and property taxes. Taking an office-in-home deduction lets you deduct additional expenses, such as:
Insurance (homeowners and mortgage)
Repairs and maintenance
Utilities and services
Depreciation
Security system
Rent (if you don't own your home) How much can you deduct?
If you're self-employed, you're in the unenviable position of paying both income tax and self-employment tax. Deducting office-in-home expenses can save you a lot. You may pay 40% or more of your self-employment income in taxes. Deducting office-in-home expenses can:
Let you deduct expenses that wouldn't otherwise be deductible.
Shift expenses that are already deductible to reduce self-employment income.
Several factors limit the amount that you can deduct. Here are a few items that you should consider before you plan that trip to Maui.
Size of your office Most of the deductible expenses pertain to your entire house, rather than to your home office. Your office takes up only a percentage of the square footage in your house. You multiply this percentage by your expenses to come up with the portion of the expenses that are deductible against your business income. Expenses that are directly related to your home office aren't limited to this percentage. For example, if you paint your home office, this expense is fully deductible.
Business income If you have a loss on your business before claiming a home office, you cannot get any tax benefit from your office this year. Go ahead and claim the office-in-home deduction, even if it doesn't reduce your taxes this year. You can carry over the current year's deduction to use against next year's business income.
Employee's itemized deductions
An employee can also claim an office-in-home deduction as a miscellaneous itemized deduction. So if you claim the standard deduction rather than itemizing deductions, you cannot receive benefit of an office-in-home deduction as an employee. If you do claim these expenses as itemized deductions, they're reduced by 2% of your adjusted gross income before any amount is deductible.
Depreciation If you own your home, you can deduct depreciation for the wear and tear on the part of it that you use for business. The office percentage of your home cost is deducted as depreciation over 39 years.
Repairs versus permanent improvements A permanent improvement increases the value of your property or adds to its life. For example, replacing electric wiring or plumbing, adding a new roof or addition, or remodeling your home are considered permanent improvements. Why do you care? A repair is an expense, and your business percentage can be deducted in the year paid. A permanent improvement, however, must be depreciated over the office's 39-year life. Planning to sell your home sooner rather than later?
Before you claim an office-in-home deduction, consider when you plan to sell your home.
The sale of your personal residence is usually not taxable. However, by claiming an office-in-home deduction, you've turned a portion of your home into business property. The sale of business property is taxable.
To determine whether a house is your personal residence, the IRS asks whether you lived in the home for two of the last five years. If so, you can use the special rules for sale of personal residence. To avoid being taxed on any portion of your gain on the sale, you generally should not claim the office-in-home deduction for two full years before you sell the house.A great deduction in the right situation
The tax savings from claiming a home office can be large, particularly if you're self-employed. Before you claim it, however, be sure that your office meets the IRS rule that it is used exclusively and regularly in your business.
You can deduct expenses related to your house that aren't normally deductible, as well as depreciation for wear and tear. Many things can limit the amount of office-in-home expenses that you're allowed to deduct, including the size of your office and the amount of your business income. Any tax preparation software will help you with the depreciation calculations and the calculations for each of the limits.
If in doubt, consult with a tax professional before claiming the deduction for a home office.
Inventory
Obviously, if you perform services, you have no inventory to worry about. Many direct sellers have little or no inventory either. Products are shipped directly from the company with which they are affiliated.
If you stock any products at all, you need to know how to compute your year-end inventory. This involves taking a physical count of your inventory, figuring how much those items cost, and putting a value on them.
The first step is to count all the merchandise on your shelves. (A good bookkeeping system is a lifesaver here.) Include unsold products, but don't include any being held for pick-up after sale. Also include goods you have bought, but not yet received, unless they are being sent C.O.D. If you have been billed, but have not yet paid, for unsold goods, you are treated as having title and must add them to inventory.
Count partly finished goods and raw materials and supplies that will become a part of your sale items. Add in goods that are out on consignment or are in display rooms away from your place of business, too.
Do not include in inventory goods that are consigned to you. Assets, such as land, buildings, and equipment used in your business, as well as accounts receivable, are not inventory items. Nor is real estate held for sale by you as a real estate dealer in the ordinary course of your business.
Valuation Methods
You need a method of valuing your inventory items in it. Because the value affects your taxable income, the method you choose is important. The two most common methods are:
1. Cost
2. Lower of cost or market value
Under the cost method, you value inventory items according to the amount you originally paid for them. When the lower of cost or market-value method is used, you set the value of each item by comparing its current market value with its original cost and using the lower value. Under this second method, each item must be compared separately to arrive at the value of your entire inventory.
You must use the same method to value your entire inventory, and you may not change to another method without the permission of the IRS.
Suppose your inventory contains unsalable goods, that is , items that have been damaged, or are imperfect, shopworn, or obsolete due to changes of style or improvements.
Naturally such goods should not be valued normally. Instead, you should value them at their selling prices minus direct costs of disposing of them. Do not use a value less than scrap value.
If you lack a computerized, perpetual inventory system, you may want to use one of two conventions for valuing inventories of smaller products:
FIFO and LIFO.
FIFO stands for first-in, first-out. It is a method that assumes that the first item you buy is the first item you sell. If you use FIFO, you may value your inventory at either cost or lower of cost or market value. The last-in, first-out (LIFO) method presumes just the opposite - that the newest product is the one that sells first.
Why would you choose one method over another? Inventory is a factor in computing your cost of goods sold, which in turn determines how much taxable profit you made. The higher your cost of goods sold, the lower your gross income.
In times of inflation, LIFO will produce a higher cost of goods sold because the price you pay for the newest item (assumed to be the first one you sold) will be more than the price paid earlier in the year. On the other hand, FIFO results in a higher cost of goods sold when prices are tending downward.
Beginning and Ending Inventory
You need to know your inventory at the beginning and end of each tax year. If this is not your first year in business, the ending inventory on your last year's return is your beginning inventory in the current year. If you're new to self-employment, your beginning inventory will be zero.
If the ending inventory is lower than the inventory at the beginning of the year, more goods were sold than purchased. If the inventory increased by year's end, then more items were purchased than sold.
Record Keeping
Introduction
If there's one thing more annoying than record keeping, it's paying unnecessary taxes because you didn't keep track of your expenses. If you haven't amassed a mound of receipts, canceled checks, and credit card slips by year-end, how are you going to do justice to your return at tax time? Come April, when you are racking your brain, trying to remember how many miles you drove for business and how many three-martini lunches you lavished on clients, you will wish those papers you discarded with such abandon were still available.
There's another reason for adding record keeping to your list of hobbies: the dreaded audit. The Internal Revenue Code, section 6001, makes you responsible for keeping books and records that are adequate for audit purposes. "Adequate" means they exist, are in proper form, and are readily available. Section 6001 has a partner, section 7602, which empowers an auditor to compel you to produce the records needed to conduct an audit of your return.
Without records, you can only lose in an audit. This is because the burden of proof in an audit is on you. Unless you can prove the items on your return, the auditor is free to assume you didn't really incur the losses or expenses you claimed. In that case, the amounts you deducted are disallowed (added back to income), and you find yourself with a bill for additional tax due.
What Business Records to Keep
Now that you have mastered the how, let's tackle the what. What receipts, checks, cash register tapes, and other scraps of paper from the operation of your business should you keep?
Business Income. Cash receipts journal; bank statements or passbooks for all checking, savings, and trust accounts; duplicate deposit slips, sales invoices, cash register tapes or other records of income; records of all loans and canceled checks or receipts showing repayment; 1099s; information on any nontaxable income; brokerage statements; records for purchases or sales of real estate or other property.
General Business Expenses.
Accounting ledgers and journals; worksheets used in preparing your return; purchase invoices for cost of goods sold and purchase of capital items; copies of Forms 940 and 941 (payroll tax returns), plus state payroll tax returns; state sales tax returns; canceled checks and receipts for all other expenses.
Automobile. Mileage log or diary showing the date of each business trip and the business mileage driven; odometer reading at beginning and end of year; receipts, credit card slips, or canceled checks for gasoline, oil, automobile insurance, lease payments, automobile repair bills, license fees, car washes, parking, tolls; purchase invoice for business automobile.
Note: You can prove business use by keeping records of your car's use for a portion of the year if you can show by other evidence, such as invoices and paid bills, that your driving during this period was representative of the entire year.
Travel Away from Home. Diary stating business purpose or nature of the business benefit derived or expected as a result of all business trips; destination, and dates of departure and return for each trip; receipts, credit card slips, or canceled checks for airline tickets, meals and lodging, and automobile rental; log of tips and taxi fares if receipts are not available. An itemized bill is required to verify lodging -- a credit card charge receipt is not sufficient. However, the statement you receive from an airline, showing the costs and itineraries, when you fly using a paperless, electronic airplane ticket, is acceptable proof.
Entertainment. Records, including receipts, credit card slips, or canceled checks showing all of the following:
(1) date;
(2) amount;
(3) place, including address or location and description of type of entertainment, such as restaurant or nightclub, if not evident;
(4) name of the person(s) entertained (include last names); and
(5) business purpose or relationship to you. A diary must also be kept, detailing the above information if you have not written it on your receipt. Your diary entries should be keyed to your receipts.
Gifts. Records, including the following information:
(1) the cost of each gift;
(2) the date given;
(3) a description of the gift;
(4) the name of the recipient; and
(5) the business reason for the gift or any business benefit gained or expected to be gained.
When Receipts are Not Required. According to Treasury regulations, a receipt or other statement is not required to prove expenses (other than lodging) of $75 or less. A diary entry is sufficient. Moreover, receipts for expenses over $75 are required only where they are easy to obtain, such as for air fare. In practice, however, it is generally advisable to keep receipts for all expenses regardless of amount because it adds to your credibility in an audit. Your employer may set stricter receipt requirements.
Home Office.
Receipts for interest and taxes or rent, home insurance, utilities, repairs to office, office furniture, and equipment; record of total floor area in your home and the portion used as an office; a photograph of the office area, if available.
Education expenses. A transcript of courses taken and period of enrollment, canceled checks or receipts for tuition, travel and transportation, books, meals and lodging while away from home overnight, and other education-related expenses.
Disposing of Records
How long must your tax records take up space? The general rule is that receipts may be discarded three years from the date the return is filed or due (or two years from the date the tax was paid), whichever is later.
Some records should be kept longer. If you own a business, save those records for seven years and any records on employees for four years.
Property records should be retained as long as they are needed to determine the basis of the original property or the property that replaced it.
Receipts for major purchases should be saved until you dispose of the property.
Telephone
Does your home phone have a split personality -- part social, part business? If you are using the family telephone to make business calls, you may deduct only the long-distance and toll charges incurred directly for business. None of te service charges on the first phone line in your home are deductible.
A second, business telephone is another matter. You may deduct the installation charge, and after that, as long as the phone is used exclusively for business, you may deduct the entire bill, service charges and all. You may deduct all long-distance calls made in connection with the business, either for recruiting, training, motivating, ordering, or calls relative to the sale or use of the products.
Because a business phone is more expensive than a home phone, you will probably pay more than you save in taxes by installing a business phone in the initial stages of your home-based business.
Travel
The cost of business travel temporarily away from home is deductible. Travel expenses include transportation fares, lodging, 50% of meals, rental cars, baggage charges, tips, telephone expenses, taxis, and airport buses.
Your travel must have a business purpose. There are two standards for judging business purpose, depending on whether your travel is domestic or foreign.
For domestic travel, the primary purpose of your trip must be business. If you pass this test, you may deduct the cost of transportation to and from your destination, plus lodging, 50% of meals, and all other ordinary and necessary travel expenses, not only for the days you engage in business activity, but for time you spend sightseeing or enjoying other nonbusiness activities at your destination as well.
The costs of recreational activities, tickets, postcards, and souvenirs during the personal portion of your trip are not deductible, however. And the expense of incidental nonbusiness side trips is limited to what you would have spent for meals (subject to the 50% rule) and lodging had you stayed at your business destination. But the cost of a vacation taken at a nonbusiness destination before or after reaching your business destination is not deductible .
If you fail the primary purpose test, only expenses directly attributable to conducting business are deductible. You may not take transportation fares or meals and lodging for time spent on nonbusiness activities.
Foreign travel must meet time tests. Your foreign trip will be considered entirely for business if you are outside the U.S. for one week or less, or less than 25% of your time was spent on nonbusiness activities. You may also pass this test if you had no substantial control over the trip or you can establish that a vacation was not a major consideration for your trip. If your foreign travel is entirely for business, all of your transportation, lodging, and 50% of meals are deductible. If your primary purpose was business, but your travel was not entirely for business, your travel expenses must be allocated according to the number of business days.
Conventions and Cruises
Attendance at a convention connected with your business is deductible. However, you may not deduct the cost of attending investment, political, social, or fraternal conventions.
No deduction is allowed for the expenses of attending conventions outside the North American area, unless the convention was directly related to your business and it was reasonable to meet in a foreign location. The North American area includes Canada, Mexico, Puerto Rico, U.S. possessions, U.S. Virgin Islands, Guam, Samoa, and the Trust Territory of the Pacific Islands. Conventions may also be held in "eligible" Caribbean countries.
Cruise ship expenses directly related to the active conduct of a trade or business are deductible up to $2,000 a year. All the ports of call must be in the United States or its possessions, and the ship must be registered in the United States.
A written statement signed by an officer of the group sponsoring your foreign convention or cruise must be attached to your return. In addition, you must attach your own statement showing the total days spent at the convention, the number of hours each day devoted to business activities, and a copy of the convention program.
If at least 6 hours per day are scheduled for business activities and you attend at least two-thirds of the total hours of scheduled activities, each day of the convention or cruise will be considered a business day.
Expenses of Your Spouse
If you take your spouse along on a convention or business trip, his or her travel expenses are nondeductible personal expenses, unless
(1) your spouse is also an partner in your business or an employee of your or your employer's company,
(2) your spouse's presence has a bona fide business purpose, and
(3) your spouse's expenses would be otherwise deductible.
If your spouse does not accompany you for a business purpose, the amount by which your hotel expenses exceed the single rate and the cost of your spouse's meals are not deductible.
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