The Home office

Posted by Bruce Mc on Mar 22, 2011 in Home office, Information | 0 comments

Guest post by Mariette Knoblauch of Ballard Beancounters 

In the economic chaos of the past few years, many people have turned to self-employment. If you have a home-based business, you may very well have a home office, and a convenient deduction on your federal income taxes.

What makes a home office deductible?

There are several combinations of criteria that qualify.

Regular and exclusive use for business. 

The area must used only for your business. It can’t be your kitchen table, no matter how much work you do there. It doesn’t have to be an entire room with walls and a door, just a separate identifiable area that isn’t used for anything else. 

 Principal place of business.

This is either the place you spend the greatest amount of time doing your work,

or

If you do the kind of work that’s performed at client job sites (like this intrepid anæsthesiologist), it’s where you do administrative tasks for your business such as invoicing, paying bills, (and filling out Form 8829 for your home office deduction), and you have no other place available to do these activities.

If you meet clients or customers in your home, an office that you use exclusively and regularly for that purpose can be deducted, even if it’s not your principal place of business and you have another office somewhere else.

If there is a separate structure on your home property, such as a free-standing studio or garage, that you use exclusively and regularly for your business, it can be a home office even if it’s not your principal place of business.  (Why not put up a yurt in your backyard?)

Or, if you are a wholesale or retail seller who stores inventory, it doesn’t even have to be exclusive use. As long as you don’t have any other place to keep your items, wherever you keep your not-yet-sold products can be a home office.

To figure the deduction, measure the square footage of your office space, and divide it by the total square footage of your residence to get the percentage of your home expenses that will be deductible. Homeowners can take a percentage of mortgage interest and real estate taxes (the rest goes on Schedule A as usual), and renters can deduct a portion of their rent. Other partially deductible expenses include utilities and insurance. Homeowners can also take depreciation expenses – talk to your tax person about this.

Another often overlooked bonus of having an office in your home is that just about every place you go for work is business mileage. There’s no commuting exception for the first and last trip of the day. Going to see clients, vendors, business prospects, delivery, even a trip to Staples to buy more toner – it’s all business mileage the minute you leave your driveway.

Bruce here:

I want to Thank Mariette, who sent this in to help keep the blog going while I am doing tax work. Thank you very much for the post.

Misconceptions Business Owners Have About Their Returns

Posted by Bruce Mc on Dec 2, 2010 in Information, Tax Planning, Tax Preparation | 0 comments

Regardless of how life changes, one of the biggest hurdles you’ll face in running your own business is to stay on top of your numerous obligations to federal, state, and local tax agencies. A tax headache is only one mistake away, be it a missed payment or filing deadline, an improperly claimed deduction, or incomplete records.

You can safely assume that a tax auditor presenting an assessment of additional taxes, penalties, and interest will not look kindly on an “I didn’t know I was required to do that” claim. The old legal saying that “ignorance of the law is no excuse” is perhaps most often applied in tax settings. On the other hand, it is surprising how many small businesses actually overpay their taxes. They often neglect to take deductions they’re legally entitled to, or just don’t know about certain breaks that can help them lower their tax bill.

Adding to the mayhem, we have tax codes that seem to be in a constant state of flux. Creating exceptions for special groups has resulted in a steady stream of new and revised tax laws, which have lengthened the Internal Revenue Code to over 4,500 pages and rendered it barely understandable to even the most experienced tax professionals. Often one section can run up to several hundred pages. A special tax service used by tax professionals explains the meaning and application of each part of the code. It is contained in another 12 volumes! The harder Congress tries to simplify the code, the more complex it becomes.

Preparing your taxes and strategizing how to keep more of your hard-earned dollars in your pocket becomes increasingly difficult with each passing year. Your best course of action to save time, frustration, MONEY, and (God forbid) an auditor knocking on your door, is to have a professional accountant handle your taxes. Tax professionals have years of experience with tax preparation, religiously attend tax seminars, read scores of journals, magazines, and monthly tax tips, among other things, to correctly interpret the changing tax code and gain the advantage over the IRS.

Nevertheless, many accountants don’t understand the mammoth tax code and end up being too conservative with your tax deductions. The more conservative they are, the more taxes you end up paying.

Unfortunately, the cryptic and mystifying nature of the tax code generates a lot of folklore and misinformation that also leads to costly mistakes. Here is a list of some common small business tax misconceptions:

All Start-Up Costs Are Immediately Deductible

Business start-up costs are the expenses you incur before you actually begin business operations. Your business start-up costs will depend on the type of business you are starting. They may include costs for advertising, travel, surveys, and training. These costs are generally capital expenses.

You usually recover costs for a particular asset (such as machinery or office equipment) through depreciation. You can elect to deduct up to $5,000 of business start-up costs and $5,000 of organizational costs paid or incurred in the year that you start a business. The $5,000 deduction is reduced by the amount your total start-up or organizational costs exceed $50,000. Any remaining cost must be amortized.

The only catch is that in order to take advantage of the immediate deduction you must spread out the remainder of your start-up costs over 15 years (180 months).

Overpaying The IRS Makes You “Audit Proof”

The IRS doesn’t care if you pay the right amount of taxes or overpay your taxes. They do care if you pay less than you owe and you can’t substantiate your deductions. Even if you overpay in one area, the IRS will still hit you with interest and penalties if you underpay in another. It is never a good idea to knowingly or unknowingly overpay the IRS. The best way to “Audit Proof” yourself is to properly document your expenses and make sure you are getting good advice from your tax accountant.

Being incorporated enables you to take more deductions.

Aside from health insurance, deductions for the self-employed (sole-proprietors and S Corps) are pretty much equivalent to corporate deductions. For many small businesses, being incorporated is an unnecessary expense and burden. Start-ups can spend $1,000 in legal and accounting fees to set up a corporation, only to determine shortly after that they want to change their name or company direction. Plenty of small business owners who incorporate don’t make money for the first few years and find themselves saddled with minimum corporate tax payments and no income.

The home office deduction is a red flag for an audit.

This is no longer as true as it once was. Because of the proliferation of home offices, tax officials cannot possibly audit all tax returns containing the home office deduction. A high deduction-to-income ratio tends to lead to an audit.

If you don’t take the home office deduction, business expenses are not deductible.

You are still eligible to take deductions for business supplies, business-related phone bills, travel expenses, printing, wages paid to employees or contract workers, depreciation of equipment used for your business, and other expenses related to running a home-based business, whether or not you take the home office deduction.

Taking an extension on your taxes is an extension to pay taxes.

Extensions enable you to extend your filing date only. If you do not pay taxes on time, penalties and interest begin accruing from the due date.

Part-time business owners cannot set up self-employed pensions.

If you start up a company while you have a salaried position complete with a 401K plan, you can still set up a SEP-IRA for your business and take the deduction.

Besides avoiding these pitfalls, possessing basic knowledge of how the tax system works is also beneficial. After all, even if you delegate the tax preparation to someone else, you are still liable for the accuracy of your tax returns. If your accountant messes up, you pay the penalty, not him.

A SIMPLE Retirement Plan for the Self-Employed

Posted by Bruce Mc on Sep 14, 2010 in Information, Retirement thoughts | 0 comments

Of all the retirement plans available to small business owners, the SIMPLE plan is the easiest to set up and the least expensive to manage.

These plans are intended to encourage small business employers to offer retirement coverage to their employees. SIMPLE plans work well for small business owners who don’t want to spend time and high administration fees associated with more complex retirement plans.

SIMPLE plans really shine for self-employed business owners. Here’s why…

Self-employed business owners contribute both as employee and employer, with both contributions made from self-employment earnings.

SIMPLEs calculate contributions in two steps:

1. Employee out-of-salary contribution. The limit on this “elective deferral” is $11,500 in 2010, after which it can rise further with the cost of living. Catch-up. Owner-employees age 50 or over can make a further $2,500 deductible “catch-up” contribution as employee in 2010.
2. Employer “matching” contribution The employer match equals 3% of employee’s earnings.

Example: A 52-year-old owner-employee with self-employment earnings of $40,000 could contribute and deduct $11,500 as employee plus a further $2,500 employee catch-up contribution, plus $1,200 (3% of $40,000) employer match, or a total of $15,200.

The SIMPLE plan is good for the home-based business and can be ideal for the moonlighter – the full-time employee, or the homemaker, with modest income from a sideline self-employment business.

With living expenses covered by your day job (or your spouse’s job), you could be free to put all your sideline earnings, up to the ceiling, into SIMPLE retirement investments.

A Truly Simple Plan

The SIMPLE plan really is simpler to set up and operate than most other plans. Contributions go into an IRA you set up. Those familiar with IRA rules – in investment options, spousal rights, creditors’ rights – don’t have a lot new to learn.

Requirements for reporting to the IRS and other agencies are negligible. Your plan’s custodian, typically an investment institution, has the reporting duties. And the process for figuring the deductible contribution is a bit simpler than with other plans.

What’s Not So Good About SIMPLEs

Other plans can do better than SIMPLE once self-employment earnings become significant.

Example: If you are under 50 with $50,000 of self-employment earnings in 2010, you could contribute $11,500 as employee to your SIMPLE plus a further 3% of $50,000 as an employer contribution, for a total of $13,000. In contrast, a Keogh 401(k) plan would allow a $25,500 contribution.

With $100,000 of earnings, it would be a total of $14,500 with a SIMPLE and $35,500 with a 401(k).

Because investments are through an IRA, you’re not in direct control. You must work through a financial or other institution acting as trustee or custodian, and you will in practice have fewer investment options than if you were your own trustee, as you would be in a Keogh.

It won’t work to set up the SIMPLE plan after a year ends and still get a deduction that year, as is allowed with Simplified Employee Pension Plans, or SEPs. Generally, to make a SIMPLE plan effective for a year, it must be set up by October 1 of that year. A later date is allowed where the business is started after October 1; here the SIMPLE must be set up as soon thereafter as administratively feasible.

There’s this problem if the SIMPLE is for a sideline business and you’re in a 401(k) in another business or as an employee: the total amount you can put into the SIMPLE and the 401(k) combined can’t be more than $16,500 (2010 amount) – $21,500 if catch-up contributions are made to the 401(k) by someone age 50 or over.

So someone under age 50 who puts $8,000 in her 401(k) can’t put more than $8,500 in her SIMPLE in 2010. The same limit applies if you have a SIMPLE while also contributing as an employee to a 403(b) annuity (typically for government employees and teachers in public and private schools).

How to Get Started in a SIMPLE

You can set up a SIMPLE on your own by using IRS Form 5304-SIMPLE or 5305-SIMPLE – but most people turn to financial institutions.

SIMPLES are offered by the same financial institutions that offer IRAs and Keogh master plans.

You can expect the institution to give you a plan document and an adoption agreement. In the adoption agreement you will choose an “effective date” – the beginning date for payments out of salary or business earnings. That date can’t be later than October 1 of the year you adopt the plan, except for a business formed after October 1.

Another key document is the Salary Reduction Agreement, which briefly describes how money goes into your SIMPLE. You need such an agreement even if you pay yourself business profits rather than salary.

Printed guidance on operating the SIMPLE may also be provided. You will also be establishing a SIMPLE IRA account for yourself as participant.

Keoghs, SEPs, and SIMPLES Compared

Hiring Family Members For your Business

Posted by Bruce Mc on Jul 8, 2010 in Employee, Information | 0 comments

Employing your Child – A reasonable salary paid to a child reduces the self-employment income and tax of the parents (business owners) by shifting income to the child.

If the business is unincorporated and the wages are paid to a child under age 18, he or she will not be subject to FICA – Social Security and Hospital Insurance (aka Medicare or HI) – taxes since employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 while employed by a parent. accordingly, the child will not be required to pay the employee’s share of the FICA taxes and the business won’t have to pay its half either.  In addition, by paying the child, and consequently reducing the business’s net income.

A similar but more liberal exemption applies for FUTA, which exempts from federal unemployment tax the earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his parents.  However, the exemptions do not apply to businesses that are incorporated or a partnership that includes non-parent partners. However, there’s no extra cost to your business if you’re paying a child for work that you would pay someone else to do anyway.

Retirement Plan Savings – Additional savings are possible if the child is paid more (or works part-time past the summer) and deposits the extra earnings into a traditional IRA. For 2010, the child can make a tax-deductible contribution of up to $5,000 to his or her own IRA. The business also may be able to provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child’s age, and the number of hours worked. By combining the standard deduction ($5,700) and the maximum deductible IRA contribution ($5,000) for 2010, a child could earn $10,700 of wages and pay no income tax.

Hiring Your Spouse – Reasonable wages paid to a spouse entitles the employer-spouse to a business deduction.  The wages are subject to FICA taxes, and the spouse may qualify for Social Security benefits to which he or she might not otherwise be entitled.  In addition, the spouse may also be eligible to receive coverage under the business’ qualified retirement plan, and the employer-spouse may obtain a business deduction for health insurance premium payments made on behalf of the employed spouse.  While maintaining the same family coverage, the business deductions could be increased by providing the spouse with family health insurance coverage as an employee.

If the spouse was unemployed (worked less than 40 hours) during the prior 60-day period, the employer will qualify for exemption from the employer’s 6.2% share of the Social Security payroll tax on the spouse’s wages for the remainder of 2010.  If the spouse continues to work for an uninterrupted period of 52 weeks, the business would also be entitled to a retention credit of up to $1,000 in 2011. (Unemployed relatives such as children, siblings or parents whom you may hire are not qualified employees for this credit.)

Originally written for another blog.  Edited here by Sandi and republished for your information.