It’s tax season again. For home-based businesses, it’s time to round up receipts, invoices, and statements of a year’s worth of work from where commerce and personal life intersect. Business writer Erin McDermott recently chatted with Steven Warren, a CPA at the Minneapolis-based accounting firm Lehrman, Flom & Co., about what’s deductible for entrepreneurs who use home offices, why the risk of an audit for this group is elevated, and the importance of keeping track of what goes on in them and when.
EM: Home-based businesses are said to be in the highest-risk category when it comes to IRS audits, with an audit rate as high as three percent. What invites such scrutiny for this group?
SW: The IRS’s audit statistics indicate that this is an area where more incorrect reporting occurs than most due to a combination of taxpayers not understanding how to properly report their activity and intentional misreporting. [Editor’s note: See the IRS’s home-base business information pages here.]
EM: What can a home-based business deduct that a business elsewhere can't? As a refresher, what is the general equation on how much of the home is used, the cost of utilities, insurance, and basic services?
SW: Home-based businesses with qualifying home offices can deduct certain direct home-office expenses and a portion of other house-related expenses. Examples of direct home-office expenses can include office furniture, a dedicated business phone line, and office supplies. Examples of indirect expenses that are deductible based on the size of the office [relative] to the entire home can include depreciation on the home, homeowners insurance, utilities, cleaning service fees, and monthly security system maintenance fees.
Certain types of businesses can have more generous rules apply, such as licensed day-care providers.
EM: For most businesses, the tax accountant relationship is a year-round dialogue. During 2012, have you seen rule changes that have come as a surprise for home-based business clients? Anything that may prove a curveball?
SW: There are no new curveballs specific to home-based businesses for 2012 income tax returns. One new item that came as a surprise that affects many home-based and non-home-based business owners is the expansion of the self-employed health insurance deduction as it applies to Medicare premiums, along with the strict procedural requirements that must be followed to qualify for the deduction. Notably, there is a requirement that either the business must pay the premiums directly or the business must reimburse the business owner for premiums paid. [Here’s the IRS’s new instructions.]
EM: For home-based businesses buying, say, a laptop, there’s the hurdle of proving it is exclusively for business use. Realistically, here in the age of social media and various online distractions for even the most dedicated entrepreneur, how can you prove or catalog that exclusive use to allow for that deduction? How is today’s Wifi-enabled “work-anywhere” environment translating with this deduction?
SW: You don’t necessarily need to prove exclusive use, but the recordkeeping requirements can be onerous depending on the type of asset in question. For a laptop computer, under audit the IRS would like to see a usage log that demonstrates personal versus business use. This can be done on a sample basis with the ratio during the sample period applied to the remainder of the year when the use throughout the year is fairly consistent.
EM: Home-based businesses face a special challenge when it comes to advertising and promotions—being located in a residential district and not a commercial one makes them somewhat invisible. How does that deduction work and what should those owners keep in mind?
SW: Generally, advertising and promotions are fully deductible. When meals and entertainment, gift giving, and the taxpayer’s personal use or enjoyment of the promotion occur, the rules become more complex and the deductions are often limited.
EM: You’ve no doubt seen all kinds of organizational skills (and lack thereof) when it comes to clients’ receipts and recordkeeping. With home-based businesses, this paperwork is even more critical to proving expenses. What have you seen that works? How do you suggest wayward clients get it together? Is technology helping?
SW: The best method for recordkeeping will differ based on a taxpayer’s specific situation. When there is very little activity, a handwritten journal may be adequate, but tracking in spreadsheet software will normally work better. As the business grows and activity increases, switching to accounting software is generally preferable. For some businesses, accounting software is essential. If the business owner does not have the time or ability to work with the software, hiring a bookkeeper may be the way to go. Being organized and keeping up with entries throughout the year can save much time and frustration around tax time versus scrambling to put everything together later.
Business owners should keep their business activity separate from their personal activity. For example, separate checking accounts and credit cards should be maintained.
Disclaimer: The opinions expressed are solely those of the interviewee. As always, you should review the advice of a qualified CPA, tax advisor, financial planner, or other professional prior to changing your tax strategy, recordkeeping structure, or making other major financial decisions.