Tax Benefits for Work at Home Business Owners

There are many tax benefits for people who work at home. Unfortunately, many people aren’t aware of these benefits, or worse, they ignore them because they are afraid of Uncle Sam.

The truth is, the IRS wants people to start businesses because it boosts the economy and provides jobs (which means more revenue and more taxes That’s why there are so many tax benefits for small business and work at home professionals.

Business Expenses

First, you can deduct any expenses you incur to run your business against your business income. All “ordinary and necessary” business expenses reduce your business income, and thus your taxes. Ordinary and necessary business expenses include expenses that you must incur to run your business, like advertising costs, office supplies, inventory, etc.

This may seem like common sense to most of you, but you would be surprised at the number of people who don’t know that they can deduct their business expenses.

Since sole proprietors pay self employment tax and federal and state income taxes on their business profit, it’s crucial that you get all the deductions you are entitled to.

Use Business Losses to Offset Other Income

One of the greatest tax benefits for sole proprietors (small businesses who are not incorporated) is the ability to deduct losses against other income, such as wages, investment income, or rental income. If you don’t have other income to offset, your business income can offset future income (or you can even go back and amend the last 2 years). This is a huge benefit for sole proprietors, especially if you have a spouse with high income, and during the startup phase of your business.

Business Use of Your Car

One of the biggest expenses that you may have as a business owner is the business use of your car. Many work at home business owners do a lot of driving for their business.

You are allowed to take a deduction for automobile expenses on your income tax return when your car is used for business purposes. This includes driving to garage sales, thrift shops or other locations searching for inventory. It also includes trips to the office supply store, post office, your accountant’s office, etc. As long as the trip is for business purposes, it is deductible.

You can take your car expenses deduction on one of two ways: you can calculate your actual expenses (pro-rata based on business use of the vehicle), or you can take the standard mileage deduction. To take the standard mileage deduction you will need to keep track of your business miles for the year, and then multiply those miles by the IRS mileage rate for the year. The standard mileage rate is 50.5 cents per mile in 2008.

The standard mileage rate is almost always the best method to use as the rates are adjusted for gas prices each year (and sometimes mid-year if gas prices jump during the year). You will need to keep a travel log or a mileage log in your car and write down the miles every time you use your car for business.

Deducting Your Home Office

Another big benefit of working from home is the ability to deduct your home office. Many people are afraid to take this deduction because they believe it’s a red flag. I don’t agree. Being self employed is a red flag – you wouldn’t not have a business, or even worse, not report that business, just because it’s considered a red flag – so you shouldn’t ignore the home office deduction just because someone tells you it’s a red flag. It’s a legitimate deduction and as long as you follow the rules and don’t abuse this deduction, there’s no reason why you shouldn’t take it.

To qualify your home office needs to be your principal place of business, and you need to use it regularly and exclusively for business.

Expenses that can be deducted include mortgage interest, real estate taxes, utilities, insurance, repairs, security, and depreciation. Only the business use percentage of these expenses can be deducted. The business use percentage is calculated by dividing the square footage of the office space by the square footage of the home, or by dividing the number of rooms you use for business by the number of rooms in your home, if the rooms are of similar size.

Caution: Your business must earn a profit to take the home office deduction. If your home office expenses are larger than your business profits, you must carry the excess expenses forward to future years.

Hire Your Children to Save on Taxes

One of my favorite tax benefits for work at home business owners is the ability to hire your children in your business.

Wages paid to your children (between the ages 7 and 17) are a valid business deduction, as long as they do real work, and they are compensated fairly.

If your children are under age 18, you don’t have to pay Social Security or Medicare taxes on them. If they are under age 21, you do not have to pay unemployment taxes on them.

So you get to deduct wages paid to your children and your children can earn up to $5,450 (the standard deduction amount for 2008) before they will owe any income tax.

Even if you pay your children more than the standard deduction amount, you will still come out ahead. In most cases, your children will be in a lower tax bracket than you, so by paying them a wage, you are shifting income from your higher tax bracket to their lower tax bracket.

Strategy: If you are paying your children more than the standard deduction, they can shelter even more income from taxes by opening an IRA account.

Hiring your children does not raise a red flag with the IRS, but you should document your children’s salary and services to audit-proof your tax return. To do this, keep a time sheet showing the date, hours and services provided by your children, and write them a check for their wages.

Self employed health insurance

One of the biggest challenges that home based business owners face is the cost of private health insurance. Those that don’t have insurance available through a spouse’s plan face high insurance costs, and many go without.

The IRS recognizes the high cost of health insurance for self employed individuals and allows a deduction for the full cost of health insurance for yourself, your spouse and your dependents on page 1 of Form 1040.

This deduction is not allowed for any month(s) you were eligible for a group health insurance plan.

Medical Reimbursement Plans

If your spouse works in your business, you may benefit from establishing a medical reimbursement plan for your business.

You cannot deduct as a business expense medical expenses paid on behalf of yourself.

However, you can deduct medical expenses paid on behalf of your employees as a business expense. This includes your spouse-employee.

If your spouse is employed by your business, you can deduct his or her expenses, and you can be covered under the plan as part of your spouse’s family, which means your medical expenses can be deducted as a business expense as well.

This is important because business expenses reduce the amount of net profit subject to self employment taxes. Medical expenses deducted on Schedule A – Itemized Deductions only reduce your taxable income, not your net profit from business.

This is a great tax planning tool for businesses where your only employee is your spouse. Note that if you have other employees, they must be covered under the medical reimbursement plan also.

Retirement plans for self employed

Saving for retirement is even more important for solo-entrepreneurs because you don’t have a company sponsored pension plan or matching 401K contributions to rely on.

There are many retirement plans available to self employed individuals and small businesses, including traditional IRAs, Roth IRAs, SEP and Simple IRAs, Solo-401Ks, Keogh plans and more.

Each retirement plan has different rules and benefits, but with so many choices, there is sure to be a retirement plan that is right for your small business.

Conclusion

These are just a handful of the tax benefits available to work at home professionals. The important thing to remember is to be aware of the tax benefits for home based business owners so that you don’t overpay Uncle Sam.

About the Author: Kristine A. McKinley, CPA, and CFP®, offers financial and tax planning on an hourly, fee-only basis. She specializes in helping online business owners understand and minimize their income taxes. For more tax tips for online businesses, please visit Online Biz Tax Tips.