Microbusinesses & Home-Based Businesses
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“Of course there’s a
different law for the rich and the poor; otherwise who would go into business?”
— E. Ralph Stewart
According to Time magazine, big business of the future will
consist of a relatively small core of central employees and a mass of smaller
firms working for it under contract.
Millions of Americans already operate very
small businesses, many of them home-based. Quite a few of these ventures
supplement a regular job or another business. Most tax rules are the same
whether your business has 500 employees and is based in its own building or
it’s just you, working alone from home. Nevertheless, a few tax code
restrictions are aimed at home-based and other small enterprises that look more
like hobbies than businesses to the IRS.
This chapter focuses on sole proprietorships,
but most of these principles apply to any type of unincorporated business.
Microbusinesses and
Home-Based Businesses In a Nutshell
1. Business expenses are deductible no matter
where they are incurred. But to deduct part of your home rent or depreciation
for a home office, you must meet strict tax law requirements.
2. Losses from home-based and sideline businesses
can be claimed against your other income to reduce your overall individual tax
bill.
3. If you claim losses from your small business,
an IRS auditor may challenge you, saying your business was really a hobby.
Defend your business loss by showing a “profit motive.”
4. Unless you run the very smallest of
businesses, you are responsible for making estimated tax payments and paying
self-employment taxes.
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A. Business
Expenses Incurred at Home
Most expenses related to your
business are tax-deductible, no matter where they are incurred—at home, on the
road or in a traditional office or shop.
Tax-deductible home office expenses include: office supplies, materials,
professional and trade memberships and dues, travel, business use of your auto,
meal and entertainment expenses, insurance premiums for business assets, local
and long-distance telephone calls on the home phone (but not the cost of the
basic monthly service), maintenance and repair of office computers and other
equipment, depreciation (or IRC § 179 write-off) of furniture and
other business assets, interest on business debts, employee wages and benefits,
publications and software, advertising.
You can claim home-based business expenses without a
home-based office. You may deduct all of the above kinds of home-based business
expenses whether or not you qualify for the “home office” deduction discussed
below.
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B. Deducting Part of the Cost
of Your Home
If you operate out
of your home, you may (or may not) qualify to tax-deduct part of your rent or
take a depreciation deduction. This tax break is commonly called the “home
office” deduction. Regardless of what you might have heard, the home office
deduction is alive and well. About 1.6 million folks claim a home office
deduction each year, according to the IRS. Undoubtedly, more people could
legally claim the deduction, but don’t know how or are scared they will be
audited if they do.
A house, apartment, condominium, mobile home,
motor home, boat or just about anywhere else with sleeping and cooking
facilities can qualify for the home office deduction.
First, you need to know whether or not you
qualify to take the deduction at all. If you don’t, your housing costs are
nondeductible personal living expenses (except for home mortgage interest and
real estate tax deductions available to every home owner).
To claim a home office deduction, your home
office must be:
• The principal place of your business, and
• A separately identifiable space in your home,
and
• Regularly and exclusively used for business.
All three of the rules must be satisfied, and
are discussed in detail next. (IRC § 280A.)
1.
Principal
Place of Business
Determining whether
or not your home is the “principal place” of your business is not as simple as
it sounds. And if it is not, there’s no tax deduction for depreciation or rent.
If your only jobsite is at home, and you spend
most of your working hours there, it is your principal place of business. But
if you conduct the business at a site outside your home and just bring home
work sometimes, the home is not the principal place of business.
Example: Jake, a plumber, works out of his home office. He keeps a
full-time employee there to answer phones and do bookkeeping. Jake is working
at his home office ten hours a week and in the field 40 hours a week.
He is entitled to a deduction for rent or depreciation, and can
deduct all other ordinary business expenses, such as the salary of his employee
working at his house.
Taxpayers Win:
Soliman Overturned by Congress!
Beginning Jan. 1,
1999, the Taxpayer Relief Act of 1997 expanded the meaning of principal place
of business. Congress undoubtedly recognized the advances in technology
favoring the home office and current business trends of downsizing and
outsourcing. Now a home office deduction is available if:
1. You use the home office to conduct
“administrative or management activities” of a trade or business.
2. There is no other “fixed location of the trade
or business” where you conduct “substantial administrative or management
activities” of the trade or business.
3. You
meet the rest of the home office rules discussed below requiring a separately identifiable
space and regular and exclusive use.
So now service providers and professionals, as well
as outside sales persons and tradespersons who spend most of their time at job
sites, are entitled to the home office deduction.
2.
Separately
Identifiable Space
Assuming your home
is the principal place of your business, let’s move on to the second rule. The
space in which you work must be separate from the rest of your home to qualify
for the home office deduction.
A completely separate structure works best as
proof of a legitimate home office to the IRS—for example, a detached garage converted
to an office. But many self-employed people just convert a spare bedroom to a
legitimate home office by removing the bed and personal items. To pass IRS
muster, if your home office is not physically divided by walls, some kind of
demarcation should be evident between the business and personal space.
3. Regular and
Exclusive Use
If you still
qualify, then let’s go to the last hurdle. It isn’t usually enough to use the
home office space occasionally—one or two days a month—for business. The tax
code requires “regular” business use, which is, admittedly, vague. If you meet
business customers or clients at your home office, it should satisfy the
regular use test. Keeping a record of appointments, in case you’re ever
questioned by an IRS auditor, is wise.
“Exclusive use” is more straightforward. It
means you can’t use the space for any other reason than business. This
eliminates the kitchen table, or the room in which you watch TV with the kids,
as your home office. This rule is akin to the “separately identifiable space”
rule above.
Don’t be afraid of a legitimate
home office deduction. Claiming a home office depreciation or rent expense on your
tax return increases your audit risk. As described below, a home office
deduction is reported on IRS Form 8829, attached to your tax return, so it is
easy to spot.
However, even if taking the deduction doubled
your chances of audit, statistically, there’s only a one in 20 chance of an IRS
confrontation. And then, you would lose only if you failed to meet the home
office qualifications discussed above. If audited, you will have plenty of
time to make sure your home office appears “office-like.” Take some photographs
of the home office to show the auditor, unless the auditor makes a rare
personal visit.
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C. Calculating
Your Home Office Deduction
If your home office
qualifies, calculate the amounts you are entitled to deduct on IRS Form 8829, Expenses
for Business Use of Your Home. This form is filed with your individual income
tax return.
This form is intimidating, taking considerable
time and patience to complete. If you don’t use Form 8829, and claim the
deduction anyway, you risk the wrath of the IRS.
Limitation on your overall home office deduction. The deduction cannot be greater than the profit generated by your
home-based business. For instance, if your business made a profit of $2,700
before taking into account a home office deduction, the deduction can’t be
larger than $2,700.
In calculating your home office deduction,
first divide the number of square feet used for your home business by your
home’s total square footage. The resulting percentage of business use
determines how much of your rent or depreciation is deductible each year.
Also, if the business use of the home is for
less than 12 months, you must prorate to the nearest month. For instance, three
months business use means 3/12 of the home office is deductible.
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D. Self-Employment
(SE) Tax
All of your
business’s net profits are subject to “self-employment” tax, Social Security
and Medicare. This is equivalent to the payroll tax for employees of a
business. The SE tax is 15.3% on all
net self-employment income (after deducting business expenses).
Under current law, your obligation for the
Social Security tax stops when your total earned income (from all sources)
reaches $84,900 (2002). (IRC § 1401.) This amount is subject to annual
cost of living adjustment. You are subject to tax only on the Medicare portion
of the SE tax (2.9%) on all further earned income.
Example: Wing, who is self-employed, earns $97,700 total this year. The
first $84,900 is taxed at the rate of 15.3% ($12,990) and the next $17,300 at
2.9% ($502), for a total SE tax of $13,492.
You are still liable for the SE tax on business income even if you are currently drawing Social Security or Medicare benefits.
Paying self-employment taxes qualifies you for
a tax break as well as Social Security benefits. One-half of the SE taxes are deductible.
(IRC § 164.) This is not an expense claimed on the business schedule
of your tax return. Instead, it is deducted on the first page of your Form 1040
tax return from your total adjusted gross income.
Example: Carol quits her job and operates Carol’s Catering as a
full-time business. During her first year she makes a profit and pays
self-employment taxes of $1,102. She is in the 27% bracket. Carol can deduct
one-half of her SE taxes, $551. This shaves $149 (27% x $1,102 x 50%) off her
income tax bill.
A one-time job may not be subject to SE tax. For example: John, a retired mechanic, took a short-term job—less
than a month—installing windows in an office building. The Tax Court held that
this did not establish John in a “trade or business,” so he wasn’t liable for
the self-employment tax. Of course, the income was subject to income tax,
though. (John A. Batok, TC Memo 1992-727.)
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