Home Based Businesses
Running a home-based business can offer significant flexibility and potential tax benefits, but it also comes with a set of tax-related challenges. Here are some of the key tax issues you might face:
- Home Office Deduction
Eligibility: To qualify for the home office deduction, a portion of your home must be used exclusively and regularly for business purposes. The area must be clearly defined in space – such as a spare bedroom. You cannot use a corner of another general purpose room (such as a dining or family room). It is important to take pictures of the business office and safeguard those – taxpayers move, and if an audit is commenced after the taxpayer has relocated, he or she may not be able to prove the nature and appearance of the alleged business office in the home with pictures.
Calculation Methods: The IRS offers two methods: the Simplified Option (a flat $5 per square foot, up to 300 square feet) and the Regular Method (calculating actual expenses such as mortgage interest, property taxes, association or HOA fees, utilities, insurance, cleaning, repairs, depreciation, and other costs of maintaining the residence). The regular method historically results in a larger tax deduction than the simplified option. The home office deduction is limted to the net profit from the business. - Self-Employment Taxes
Social Security and Medicare: Employees have FICA and Medicare taxes (averaging 7.65%) deducted from their wages. The employer matches the amount withheld and either deposits it into an account for the government periodically or sends in the total with quarterly employment tax returns. As a self-employed individual, you are responsible for paying both the employer and employee portions of Social Security and Medicare taxes. This is currently 15.3% of your net earnings. - Estimated Taxes
Quarterly Payments: You may need to make estimated tax payments quarterly to cover your accruing income tax and self-employment tax. Failing to make these payments can result in a significant estimated tax penalty. - Business Expenses
Deductible Expenses: Keeping track of business-related expenses (such as supplies, insurance, travel, business interest, advertising/marketing, professional fees, and insurance) is crucial. These can be deducted to reduce taxable income.
Personal vs. Business: It’s important to clearly separate personal and business expenses to avoid issues with the IRS. I recommend to clients to open a separate business account for depositing business receipts and paying business expenses. - Record-Keeping
Documentation: Maintain detailed and accurate records of all income and expenses. This is critical for substantiating deductions and for potential audits. I recommend that clients hire a bookkeeping service to record transactions and generate periodically income statement.
Digital Tools: Using accounting software can help streamline this process and ensure accuracy. There are many products available. As suggested above, retaining a bookkeeper who utilizes one of the available products may be a wise decision. This frees the owner up to focus on business growth and servicing their customers or clients. - Depreciation
Assets: If you purchase equipment or other assets for your business, you may be able to depreciate the cost over several years or, in some cases, write off the expense. - Sales Tax
Collection and Remittance: Depending on your business and location, you may be required to collect and remit sales tax on goods or services sold. It is important to check with the State concerning what are taxable and nontaxable transactions. - Local Taxes and Regulations
Zoning Laws: Ensure that running a business from your home complies with local zoning laws and regulations. Most cities have a requirement for home based businesses to have a license or permit. In Burbank when I was working out of that city, I had to apply for and annually renew my business license. In Santa Clarita, they only required a one-time application for a permit. Before opening your business, check with your city officials on the licensing/permit requirements.
Licenses and Permits: As mentioned above, you may need specific licenses or permits to operate your business legally. - Retirement Contributions
Self-Employed Retirement Plans: Consider setting up a SEP IRA, SIMPLE IRA, or Solo 401(k) to save for retirement and potentially reduce taxable income. - Health Insurance
Deduction: Self-employed individuals may be able to deduct health insurance premiums for themselves and their families. There are specific rules for doing this. If you qualify for this deduction (rather than taking it on Schedule A as an itemized deduction), it can reduce taxable income (not self-employment tax) while permitting the taxpayer to take the standard deduction.
Navigating these tax issues can be complex, so it is often beneficial to work with a tax professional who understands the intricacies of home-based businesses.