January, 2005 Tax Newsletter

Tax Advantages of Starting a Home-Based Business

Perhaps next to owning one’s own home. owning one’s own business operated in that home is a dream that many of us share.  I have been telling people for years that our homes are fast becoming tomorrow’s high rises.  Wouldn’t it be nice to earn extra income and get started in a new and exciting career while, at the same time, obtain significant tax benefits that would shelter a major portion, if not all, of the income you earn?  Stay tuned.

With the advent of new technology and ready access to the internet, it has become a relatively simple matter to run a business from your home.  In addition, some favorable tax provisions provide a great subsidy to get the business off on the right foot.

The business deductions that are available to a business operated outside the home are every bit as available to a home-based business.  This includes, business car use, business telephone use, supplies, meals and entertainment, travel, office expenses, business subscriptions and publications, business equipment, advertising, and many other expenses.  As often is the case in a business’s early years, these expenses may produce a loss which can be deducted against other income reported on the return.  The tax savings is a subsidy from the IRS to provide a boost to the new business.

Let’s now jump ahead a couple years to when the business is operating profitably.  The amount of profits that can be sheltered from tax in a qualified retirement plan has been increased dramatically.

Prior to a 2001 change in the tax law (effective in 2002), an owner of an unincorporated business could contribute up to 20% of its income in a profit sharing Keogh retirement plan.  However, as a result of the 2001 tax law which authorized a self-employed 401(k) plan, 100% of the first $14,000 (for 2005) of income can be sheltered ($18,000 for persons age 50 or over), plus.20% of all self-employment income up to a maximum of $41,000 ($44,000 if age 50 or over).  See “Self-employed Can Benefit From a 401(k) Plan”, my February, 2003 Tax Tip at my website www.rontaxcpa.com. 

In doing the math, a person age 50 or over with $20,000 of income could shelter the entire $20,000 from income tax in 2005, while a person under age 50 could shelter $18,000.  NOTE:  While income tax may be sheltered, there would still be self-employment tax if self-employment income exceeds $400.

As this is the Holiday Season, we’re not yet through with the goodies!!  Tax law changes made a few years ago have essentially removed all obstacles to taking tax deductions for a home office.  Working from home saves the cost of renting an office and, assuming you qualify to take a home office deduction, also allows you to deduct home ownership costs that could not be deducted if there were no home office, such as insurance, utilities, maintenance, pest control, and depreciation.  To qualify as a deductible home office, a portion of the home must be used exclusively and regularly  as the principal place where you conduct a business, or a location required for administrative and record-keeping tasks relating to work conducted elsewhere because you have no other office to perform these tasks.

Another major tax advantage of a home-based business relates to commuting.  Travel between two places of work is a deductible business expense.  Having a qualified work location in your home may convert what would be non-deductible commuting from home to your work location into deductible business travel.

Finally, there are yet more savings available if you hire your children to be bona fide employees of your business.  The child’s salary is deductible by you for income and self-employment tax purposes, while the child’s salary will be taxed to him or her at his or her presumably low or zero tax rate.  The child can use the earned income to fund a traditional IRA or a Roth IRA up to a maximum of $4,000 in 2005.  A Roth should definitely be considered as there will be many decades of fund appreciation which can ultimately be distributed tax-free.  No social security tax is due on the salary of a child under age 18 who is employed by a parent’s proprietorship.

You may ask if there is any audit risk or downside to a home-based business.  The answer is only if you are using the business as a long-term tax shelter with a consistent pattern of deducting losses year after year.  If that is the case, the IRS will likely take the position that you are not engaged in the business with a profit motive and disallow all loss deductions.  The key is to show a profit in any three of five consecutive years.  If you do, it is presumed that you have a profit motive so that your loss year deductions will be allowed.  For a discussion on this issue, see “Is Your Business Really Monkey Business”, my February, 2004 Tax Newsletter at my website. www.rontaxcpa.com.