Mom & Pop's

Using Your Home For Business

A lot of small businesses don’t have an office or storefront, they work from their homes. For them, the IRS has created a special business tax deduction called the Office in Home Deduction. As part of a full disclosure, I do want to point out that a variation of this deduction is also available to employees who are required to work from home. If you think you might qualify after reading this post, please talk to your tax professional about the special guidelines and handling for employees. Also, for non-sole proprietors (partnerships and S-corps), check with your tax professional for specifics on how this needs to be handled.

The Office in Home (OIH) deduction allows the business owner to take a deduction against their business income for a percentage of the costs of operating their home. There are a few special requirements which have to be met. First, the office must be used exclusively for business. A spare bedroom that is not used for anything but the business meets the requirement. But if the bedroom is used by guests or when the grandkids sleep over, then the room doesn’t meet the exclusive test and there is no deduction. The key is to be a “special identifiable space.” So, a screened off end of the family room could qualify if the other requirements are met but not the den where you work on the business, pay personal bills and handle your investments. Next, the area must be the principle place of business for the business. Specifically, it is the place where the administrative and management functions take place. If you have an office at your shop and also have a set up to bring work home, that doesn’t qualify for OIH. But, if your shop doesn’t have an office space and all paperwork is done at home, the home space many qualify. The area must be used regularly. A dedicated business office still isn’t deductible if it’s only used occasionally. You also need to have a business that has a profit making objective. Hobby and investment activities do not qualify for OIH.

There are a couple of exceptions to these rules, after all this is taxes we’re talking about. The exclusivity test does not apply to in home day care facilities. A licensed day care can factor in the business hours the home is used into the calculations for the deduction. Also, storage areas for inventory or demonstration materials have a little looser exclusivity requirement. A few shelves in the garage or part of a closet will quality for OIH. Finally, if the home business area is a separate building from the home, it might qualify for an exception to the principle place of business test. A retail shop owner might keep season decorations and extra racks and shelves in a separate building at home and still qualify for OIH although no business takes place there.

The actual Office in Home is calculated on Form 8829 and then carries to the Schedule C or F. The first issue is to determine the use percentage. This is the square footage of the qualifying “office” divided by the square footage of the whole building. This is further modified by hours actually used if the area is used for daycare or if usage began during the year. OIH expenses types are direct and indirect. Direct expenses are those which only apply to the area used by the business. The storage shed with a business’ inventory has a broken window; the repair cost is a direct cost. But most OIH expenses are indirect costs. These include mortgage interest, qualified mortgage insurance premiums and real estate taxes. The balance after the office in home deduction is subtracted can be used on the taxpayer’s Schedule A. Other OIH expenses are home insurance, rent, utilities, repairs and maintenance to the whole property and depreciation.

The catch? The Office in Home for a business can only be used to offset income from the business. Sort of.  OIH expenses don’t come into play until all other business expenses are deducted from the business income. A tentative profit/loss is created and the OIH deduction can be taken into consideration. Form 8829 breaks the home expenses into three categories. The first are the mortgage interest, house taxes and mortgage insurance premiums. Since these are potentially deductible expenses on the Schedule A, they can create or increase a loss on the Schedule C or F. But other operating expenses (like insurance or rent) and the depreciation can’t cause or increase a loss. In that case, the unused expense deduction is carried forward to the next year.

If a small business qualifies, the Office in Home deduction can be a great benefit to the business owner. It allows him/her to deduct for the use of their home. But even better is the effect it has on commuting miles. Without the OIH, the miles to the first job or errand are commuting and not deductible. A valid OIH allows the business owner to log and deduct the miles they drive for business when they leave their home. Their commute is a very short walk.

Office in Home can be very confusing and as mentioned in this post, there several sets of rules. So, please check with your tax professional to see if you qualify. 

A Very Short Course in Depreciation

This is for basic information. Depreciation is a complex subject and it could fill a book. I want to make business owners aware of the theory so that they can plan. Please talk to your tax profession about specifics for your business.

On a trip to the local office supply store, you buy a new color laser printer and a set of replacement cartridges for your business. Since you keep your books up as you go, you add the purchase to your bookkeeping system and plan to use to whole purchase against this years income. The problem is that you really can’t do that. The ink cartridges are current expenses and fully deductible but the printer that has to be depreciated.

Depreciation is required for any asset used in a business (it could be equipment, capital improvements, or software, for example) that has a useful life of over one year and is not inventory. Simply, depreciation does two things. First it allocates the cost of purchase over the life of the asset. The IRS says that the laser printer has a life of 5 years. Divide the cost of the printer by five and that gives you’re the amount that you can depreciate for each year. The second use of depreciation is that it represents the effect of usage on the values of the asset. Say, you buy the new laser printer for $500. That’s the value that time. However, a year later, you could not sell that printer for $500 because of the wear and tear on the asset.

There are also two kinds of depreciation: “Book” and “tax.” “Book” depreciation is used for bookkeeping records and evenly spreads the reduction in value over the life of the asset. Our 5year printer would lose $100 in value each year for 5 years. It could continue to be used but it would not have any impact on the profit and loss of the business. “Tax” depreciation is a creation of the tax code and, for the most part, is considered accelerated deprecation. That is more depreciation is taken in the first years than in the final years. For simplicity, the IRS published the allowed depreciation in charts based on the life of the asset. As if depreciation wasn’t confusing enough, there are several charts of percentages. Your choice will depend many factors such as, when in the year the asset is put into service, if the asset is being used on a farm, are you calculating Alternative Minimum Tax or electing to spread out the depreciation out evenly instead of taking more at the start. To further confuse matters, there are special forms of depreciation that allow even more of the cost to be taken in the first year. Please see your tax profession about what options are available to you.

Are you confused yet?

What do you really need to know? You need to know that some of the things you buy for your business need special treatment. You need to keep track of them separately. But, use some common sense. Yes, the stapler will last more than one year and should be depreciated but that doesn’t mean that it can’t be lumped with other small equipment and depreciated that way. I do that with the off the shelf software and little things like calculators and staplers. The big thing you need to understand that you’re required to depreciate assets on your tax return. But that means that when you sell that asset the gain/loss must reflect the amount of depreciation taken. Let’s say you decide to sell that printer for $250 after you’ve had it for three years. You have taken $300 in depreciation off its value. The math looks like this: $500 original cost minus $300 in depreciation leaves a $200 basis. That is subtracted from the $250 you sell the printer for and you have a $50 gain on the sale. And that is taxable.

Keep track of long term purchases so that they can be treated correctly on your books and tax returns. And ask for help until you get the hang of depreciation.

IRS Videos

Information resources are vital to small business owners who have to wear so many hats. To help all taxpayers, especially small businesses, the IRS has created a website, the IRS Video Portal, to house all the non-written info they have created. The website has audio and video programs on a wide variety of topics. The programs can last a few minutes to hours and cover not just business topics but info for individuals too. There are some videos in Spanish too.

Topics range from starting or closing a business to contractors to audits. Of special interest to someone just starting a business,  is the Virtual Small Business Tax Workshop. This is a program the IRS has long shared with the public on CDs and is an excellent overview of the tax issues a business can face. (Note-The CD is in several languages but only in English on the video)

All the info on the Video Portal can be found in written form on the IRS's website but let's face it, sometimes hearing or seeing the info can help us understand what we're read better. So bookmark the page and check it out when you have a tax related question.

 

More Dangerous Money

I just talked about payroll "trust fund" taxes and the need to make sure they are paid and reported on time. I forgot, however, to mention that the same applies to sales tax.

Sales tax isn't your money. You collect it from your customers and send it in for them. If you are required to charge sales tax, you need to create procedure to track this money and not spend it. Missing reports are caught quickly (at least in Kansas) and if you don't sent the report as requested the state may "estimate" your sales for you. If you don't make payments on time, you risk an audit of not only your sales tax liabilities but your compensating use tax liabilities. (Comp use is the sales tax on your internet and phone purchases where no sales tax is collected because the company doesn't have a presence in that state. In this case, the seller doesn't collect it from you so you are expected to pay it yourself. There has been a lot of talk, lawsuits, and legislation on this issue but you still pay it.)

So, you need to work out some procedure for saving sales tax you collect back and not spending it. And get the reports and payments in on time.

Dangerous Money

In a previous post, I talked about the reporting forms that are required for business payroll. In this post, I want to focus on the business killer - trust fund mis-management. As you pay employees, you withhold money from their paycheck and then submit it to the IRS and states for them. The deposits should be made electronically and you will need to set up the accounts before you need them. And you have to understand that the deposits may be made on a different schedule than filing the 941 and state payroll reports.

For Example: You agree to pay Sue $500 a week salary. That $500 will be reduced by her Social Security and Medicare contributions of $28.25 (current reduced rate) and her Federal and state withholding. That means you are writing her a check for say $378.97. That $121.03 that you withheld from her check is the most dangerous money, Trust Fund. It's called Trust Fund money since you are only holding it for Sue in trust until you are required to deposit it (based on the schedules the IRS and State gave you.) Of that $121.03, $28.25 is her SS and Medicare and $60.77 for Federal withholding and $32.01 for the state. You will also be expected to match the $38.25 (full rate) for your part of SS and Medicare. And you will be kicking in for Federal and state unemployment; say another $10. So: $378.97 paycheck + $121.03 trust fund money + $38.25 matching SS/Med + $10 for unemployment=$548.25 is what Sue's week really cost you. You write her a check for $378.97 and then what do you do with the remaining $169.28? That is where too many employers get into trouble. That money is allotted to be paid in a few days to months but it's still sitting in the checkbook where it can be spent on other things. Since Sue is your only employee, I would guess you'll be set up for quarterly deposit. At the end of the quarter, you fill out the Federal 941 and your state's forms for withholding and unemployment. Then you discover the IRS wants a check/deposit of say $1527.24 to cover this quarter payroll liabilities. And the state and state unemployment will want their shares too. Which by this time, you don't have.

If you are going to hire employees, you have to find a way to not be in this predicament. Some employers use a separate checking account for payroll and move into it the salary plus employer's obligations before they write the paychecks ($548.25 for this example). Other employers subtract the whole about out of the checkbook at the time. No matter what system you come up with, you have to do it religiously. If you don't, the letters will start.

The IRS catches shorts in payroll deposits and filings a lot quicker than short in income taxes. They have to because these problems can grow huge quickly. Penalties on Trust Fund money (what came out of employee's paychecks) can be up to 100%. Even a few days late will see a penalty. Remember this is the employee's money. You promised Sue $500 a week not $378.97. Withholding, Social Security and Medicare are credited to her accounts whether you pay them or not. The IRS needs to deter/scare employers into keeping payroll obligations current. That is the reason for the high penalties and tough enforcement.

If you find yourself in this situation, don't panic but don't ignore it. Put into place procedures so this won't happen again. File your reports and send in what you can. Call the IRS or your state department of revenue and work with them. Don't make promises you can't keep but get caught up and stay that way.

Payroll Reports

It’s time to take on the employee issue, at least the tax part of having employees. There are a lot of rules and things you should know when you add an employee. Most I’m not qualified to discuss such as labor laws. You’ll have to do your research to make sure that you are following the laws in your state. But I can outline the tax issues. I’m going to keep it simple and focus on payroll withholding and reporting. Issues such as setting up retirement and health insurance plans I leave to the experts.

Back when you applied for your EIN and state business numbers, you were asked to estimate your annual payroll. If you said you were not hiring at that time, you need to get a hold of the IRS and your state (and in a few cases local) tax people to tell them this has changed. They will set you up for a payment (actually a submission) schedule for your deposits and payroll reports. As an employer, you will have payroll reports for the Federal and state, payroll deposits for Federal and state, unemployment reports and payments for your state and an annual unemployment report for the IRS. This is on top of W-2 and W-3s for the year. Now you understand why employers could be tempted to treat employees as contract labor, less paperwork.

Let me skirt around the 800lb gorilla, money, until the next post and concentrate on reporting. Please understand that this is general info, so follow the requirements the IRS and your state has set up for you.

On the Federal level, you will need to file a form 941 on a quarterly basis. This reports (among a few other things) how much you paid in wages for the quarter, how much money should be credited to Social Security, Medicare and for Federal Withholding. It also tracks deposits of that money. You may also have a state report. The actual report and its frequency will depend on the state. In Kansas, there isn’t a report separate from the money until you send them the W-2s at the end of the year. Then once a year, the IRS wants a form 940 which reports and pays the Federal unemployment due. This form also gives you credit for the unemployment you have been paying your state Unemployment organization. Again, each state has their own rules and forms and you will need to do some research. In Kansas, it’s filed and paid on a quarterly basis.

This is where a good payroll bookkeeping system can come in very handy. If you want to run afoul of the IRS and States quickly, don’t follow these schedules. They will let you know within a few months about missing forms. Then the penalties begin. But more about those in the next post.

Employee Or Not?

The worse problem with being a tax preparer is that I don’t hear about an issue until the client comes in to get their taxes done. That’s when they tell me about the 401K distribution, starting social security, a new business or hiring an employee. Too often, I’m told that the business paid $XXX in labor costs. No 1099MISC was issued and serious questions if those paid are really employees not contract labor. Then I have to clean up the mess.

A major issue with the IRS is the classification of an employee as an independent contractor. For the business owner, an independent contractor is easier. There is no withholding, only one form to file at the end of the year and the costs are lower. For the employee, being an independent contractor is great on payday but a killer at the end of the year when you have to pay self employment taxes and have no withholding. Big tax bills with no way to pay it off. No wonder the IRS is concerned.

When it comes to the employee vs. independent contractor issue, the IRS looks at the control the employer has over the worker. Someone hires me to do their bookkeeping as an independent contractor. We have an agreement about what work will be done but I do it at my office on my timetable. They have no control over my work procedures as long as I get the work done when they need it. At the other end of the scale, is the receptionist I hire during tax season. She has very little control over the job. I set the times she works and provide her with all the equipment and materials. I specify how I want the work done and supervise her. She is an employee. It can get gray in between the two end points. And let’s not forget the business owner trying to save money and work by treating employees as if they had their own businesses.

Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can be completed by the worker or business owner to clear up the gray areas. The completed form can be used by the business to document their classification decision. Or it can be submitted to the IRS and based on that information  they will determine if the worker is an independent contractor or employee. The forms covers issues like who decides what work is done, when it’s done and how it’s done. Who provided the tools and materials? How is payment made, expenses reimbursed, what benefits are provided? Who is in control basically? Whoever makes the determination, the proper procedures for that classification (employee or contract labor) will need to be followed.

If the IRS is involved because the SS-8 was submitted to them or they initiated the investigation, there is a possibility that the business will have to go back pay the back taxes for the now employee. That’s why it’s better to get this right from the start.

Business or Hobby

Is your “business” for profit or a hobby? Now, don’t get riled up. I’m not trying to insult you. I’m not talking about what the business does but how you approach the business. Yes, we all want to make money but is that your main factor for starting the business? If it’s not, that is fine. Great businesses have developed from someone’s garage when they found a market for their passion.  They became a for-profit business. It doesn’t matter if they are making computers or doilies as long as they treat it as a for profit business. At the same time, there are owners who treat their business as a toy and it goes nowhere. How many restaurants or stores limp on because the owners are having too much fun being in business and not running the business enough. It’s up to you the owner. Oh, yeah, and the IRS too.

First, what is profit? To start, I’ll define “profit” as the money remaining after the entity’s income is offset by the expenses. You open your business with $500 in the checking. As the year goes by, you deposit the business income and write checks for the business expenses. If you have more than $500 on December 31^st, you have a profit. The idea is to increase that profit as the business grows. So, what is a hobby? For the IRS, it comes down to the profit motive. A business is to make money and if it’s not making money, the owner changes the business or closes. If not, it’s a hobby. IRS’s “hobby” is not about the actual business but how the business is being run. Is the owner really trying to make money?

The IRS uses a concept of “presumption of profit.” to evaluate a business. Section 183(d) says that if a business makes a profit in 3 of the last 5 years (2 of 7 if horses are involved) it is presumed the business is being carried on for profit and it is not a hobby. But if a business doesn’t met those guidelines it can still be considered for profit? Yes, but it needs to be objectively evaluated. Some factors to consider:

• Does management keeps good books and tracks the results of the business’s activities? Do they try new methods and ideas to bring in more income or reduce expenses?
• How knowable is management about the field and business in general. How are they keeping up with the latest developments?
• How much time and effort is the owner putting into the business? It can be a part time activity but the owner need to regularly working it.
• Has the owner had other businesses before and how successful were they?
• Is this a dry spell for a previously successful business? What is the ratio of profits to losses?
• Does the owner depend on this business for their livelihood?
• Is the recreation/fun element of the business greater for the owner than profit element?
• I also look at what the expenses are. Would there be a profit if there was no depreciation or mileage or Office in Home?

 

Why the distinction? I can think of 2 reasons. The first is taxes. Income and losses from a hobby are handled differently than the income and losses from a business. Let’s look at 2 sole proprietors- very simplified of course. But remember this could be 2 partnerships, LLCs or S- Corps.

Business “P” will report its activities on a Schedule C or F on its owner’s Form 1040. All income, expenses and depreciation of the business will be reported and a profit or loss will result. The profit or loss will then carry to the front page of the 1040 and add to or decrease the owner’s other income. If there is a profit, it is also carried to Schedule SE and the self-employment tax is calculated and added to the owner’s other taxes. An adjustment for half of the self-employment tax is also carried to the first page of the 1040 and lessens the total income.

Business “H” doesn’t use a Schedule C or F. The income is reported on the “other income” line of the owner’s 1040. The only expense that can be taken off here is the cost of goods to manufacture the items being sold. (On the Sch. C, this would be the gross profit.) All the rest of Business “H’s” expenses have to be reported on the Schedule A and are limited to the remaining income. Business “H” can’t use a loss to offset other income. The expenses also have to be divided into 3 classes. The first class, are expenses which anyone can deduct on the Sch. A; mortgage interest and real estate taxes are the most common. The second class of expenses includes anything that doesn’t change the basis of the business assets. The final class is depreciation. The big catch is that both of these classes are reported a Misc. Deductions and are reduced by 2% of the income from the 1040 return. Then, the total of all the itemized deductions from the Sch. A has to be higher than the standard deduction to actually do any good. So it is possible for Business “H’s” expenses to be un-usable in reducing the tax on the income. Now the good news; Business “H” does not have to pay self-employment on any profits from their activities.

Now I’m sure someone has decided to make the decision between a hobby or for profit based on how their year went.  You’re a hobby in a year where you make money and avoid the SE tax and for profit when you have a loss to reduce your other income. Not a good idea. Can you say audit?

The other reason to think about the distinction between for profit and hobby has to do with how you approach your business and what that shows to others. There is nothing wrong with a business being considered a hobby for tax purposes, if that is what the owner wants. But if the IRS is treating you like a hobby, you can’t expect a bank, vendor or investor to treat you like a business. They don’t have to see your tax return to know if you are running the business for profit. They will look the same types of information as the IRS and come up with the same conclusion. Your decision not to be for profit will be transmitted to customers and employees by the way you approach the business hobby. The business may not work or you may have bad years. Businesses close all the time. Failure is okay. But don’t create the failure because you don’t want to work the business.

Direct Seller Webinar

The IRS is holding a webinar about tax issues for direct sellers on July 27th (time depends on timezone). These are business that are selling products through parties and catalogs. So if you are a rep for Avon, Tupperware, Amway or any of that kind of retailer, this might be helpful for you.

The webinar is free but you must register.

Get Your Numbers

Numbers – you have a Social Security Number, a Driver’s License Numbers, credit card numbers, numbers, numbers… But to start a business, you will want new numbers; an Employee Identification Number (EIN) and state business numbers. It is possible to do without an EIN if you are a sole proprietorship that will not be subject to sales tax or payroll withholding. You can always get one later if you need it. But check into what you will need to set up a checking account for your business and what your state requires.

 Getting an EIN is simple. You can get the form off the IRS Web Site (You need a SS-4) Once you have that filled out, you can mail or fax the SS-4 to the IRS, or immediately get a number by phone or online. You will receive a letter in a few weeks for your records. If you have questions, ask your preparer or call the IRS. Basically, the form wants info on the firm, what type of entity and who is in charge. It asks you to make an estimate of payroll and income for the first year. The payroll number gives the IRS an idea how often to set up you payroll tax deposits. Keep track of the number and how you named your business on the application.

Once you have your EIN, you can move on to the state numbers. This you will have to research since every state has a different set up. Check with the tax department to see what you need for payroll, sales, or use tax. Don’t forget specialty taxes. Kansas has special requirements if you are selling alcohol, tobacco products, or are running a dry cleaner. If there is a special state tax, I would make sure that there is not some Federal registration, too. Hopefully, your research has turned that up and you’re ahead of me on that.

If you haven’t done it before, this is the time to register with any other state department. In Kansas, partnerships, corporations, LLCs all register with the Secretary of State (and pay and annual fee) as part of setting up the business. Some states require sole proprietors to also register.

 So now you are ready to start your business. This series was never meant to be a step by step guide to opening a business. My purpose is to keep you out of tax trouble and get you thinking as a business person. If you need more help, look at the start up resources suggested in the “Research” post. However, there are still a lot of tax issues that can get a business own into trouble and I will cover them. But please remember that some of these are very complex issues and I will only be doing an overview.