If you run a home-based business, you might be confused about what you can and cannot deduct as reasonable expenses. Some home-based businesses make critical mistakes and are red-flagged by the Internal Revenue Service. However, with a little guidance, you can start a business that will stay under the radar and keep you out of hot water:
Understand home office deductions. While you don’t have to have a separate room as a home office, the area you use must be used exclusively for conducting business. This includes a place where you meet clients, patients, or customers. You can also claim a home office deduction if you store inventory for your business. In the strictest sense of the word, a home office cannot include personal items, such as personal mail, your children’s toys, etc.
Incorporate your business. The IRS keeps an eye on home-based businesses. In fact, sole proprietorships, especially those that are home based business owners, are more frequently audited than corporations. One tactic that you can use to decrease your chance of an audit is to incorporate (form an LLC or corporation) your business. Incorporated businesses are audited far less frequently than home-based businesses. The IRS is more likely to question deductions in a home environment than a corporate setting.
Keep separate bank accounts for personal and business use. One of the biggest mistakes that small businesses make is to combine both personal and business expenses. Keep separate accounts for personal and business use. In case of an audit, it’s much easier to refer to an account that is used for one purpose than to wade through 12 months of personal and business expenses and attempt to separate them.
Deductions should be reasonable for your business. Avoid extravagant deductions. Another red flag for you home business is when the deductions are high in comparison to your income or the industry norm. Obviously, you’ll have deductions, but over-the-top claims will catch the eye of the IRS. If you have large deductions, keep the proof on file for at least three years.
Use specific amounts. Most costs don’t end in rounded numbers. Be specific. Rounded numbers imply estimates, and this could flag your business for an audit. Also, if you believe that a deduction will flag you for an audit, attach proof to substantiate your claim.
File online. Math errors are another audit magnet. While one small error probably won’t create a problem, multiple errors will most likely bring attention to your business. When you file online, the software will do the math for you, eliminating the margin of error.
Don’t underreport earnings. Keep in mind that in this technological age, the IRS can easily find your earnings. Don’t be tempted to underreport your income, or you could find yourself at the losing end of an audit.
Run your business like a business, not a hobby! Use some type of accounting software to track your monthly revenue and expenses so you can track your profit and loss. Running your business based upon your online checking account balance and ‘let’s just see how it goes,’ sounds more like a hobby to the IRS vs. a real business.
Operating a home-based venture is a rewarding experience and doesn’t have to create IRS headaches. Know the tax laws, keep good records, and your home business will thrive. For more information about what you can and cannot deduct as a business expense, go to the Internal Revenue website and download Publication 587: Business Use of Your Home.
