Small business owners have to be more in-tune with tax laws than your average working adult. After all, the home based business tax deductions you take at the end of the year has a direct impact on your bottom line… and the amount of taxes you owe.
But small business owners who run their businesses from their homes have a particularly tricky set of circumstances. How do you distinguish between business expenses and personal expenses? Mixing up personal and business expenses can come with dire consequences, including your business losing its legal status (LLC, etc.)!
These three tips will help you ensure that, come tax time, there’s absolutely no confusion.
1. Know what “ordinary” and “necessary” mean.
According to the IRS, when it comes to home based business tax deductions, business expense must be both ordinary and necessary. Luckily, this part of tax law is pretty straightforward once you understand these two terms.
“Ordinary” means that, within your trade or business type, the expense is common and acceptable. Needing a computer to run a modern small business is probably considered ordinary. Needing the newest Gucci handbag (depending on your industry) is probably not.
“Necessary” means the expense is helpful to your business. It doesn’t mean, however, that the expense has to be absolutely indispensable in order to deduct it. For example, if your business needs a new computer because the old one is running unreasonably slow, you can reasonably deduct the expense of that new computer. Even though your old one still technically works (albeit poorly), the new one will be “helpful and appropriate” for your business and is therefore deductible.
2. Keep separate bank accounts.
The easiest and most surefire way to keep track of business expenses (and keep them separate from your personal expenses) is to keep separate bank accounts.
The most common concern of IRS auditors is whether personal expenditures are being claimed as business expenses. How do you assuage their fears? Keep your money completely separate! If you’re a sole proprietor, you might convince yourself that all the money is “yours” so it shouldn’t matter, but if you’re deducting expenses, it absolutely matters to the IRS.
Set up a business checking account or credit card, and use it for all your business-related expenses: meals to maintenance, training to travel. Then, once you get these accounts set up, make sure you’re not using your business card to book vacations or your personal account to pay for your office space.
NerdWallet offers lists of free business checking accounts, based on your location. The best part is that keeping your accounts separate doesn’t have to be expensive! Home based business tax deductions have never been easier!
3. Don’t get swept up in wishful thinking.
While you can’t deduct personal expenses, sometimes you can deduct part of a mixed expense. But don’t get tempted by wishful thinking.
The IRS gives this example: If you borrow money and use 70% for business and 30% for personal, you can deduct 70% of the interest on that loan.
Most of the time, though, these mixed expenses are not so obviously defined. Cell phones, home office space, utilities, and car usage are all potential points of confusion for home-based business owners.
You can deduct the business use of part of your home, as long as that area of your home is used exclusively for conducting business and is your principal place of business. That means that if your home office also has a bed in it for the occasional visitor, it’s not a deductible expense (so maybe opt for a pull out couch instead!). Don’t let wishful thinking convince you that this distinction doesn’t apply just because no one stayed in that room this year!
4. Don’t miss these deductions!
All advertising and promotional expenses are tax deductible, provided they are directly related to running the business!
If you’re Self-employed and paying your own health insurance premiums, these costs are 100% deductible.
Office furniture, office supplies, and utilities costs that relate to your home office are all A-OK to deduct!
You can deduct the FULL cost of the business calls that you make for business from home. Simply make a note of the business calls each month on your phone bill (be sure to keep a copy of each marked bill).
And don’t forget, you can deduct half of the contribution on your 1040 (because as a self employed person, you pay your contribution and “the business'” contribution.
If you’re wondering whether or not an expense counts as a valid home based business tax deductions, ask a tax professional. But you can also ask yourself if it passes the “laugh” test. Would a tax professional, IRS auditor, or judge laugh at you if you tried to explain how your private plane taking you to Hawaii is a necessary business expense? If so, then you may have just answered your own question.