A: The two key words here are “ordinary” and “necessary.” The tax code allows a deduction for the expenses of carrying on a trade or business as long as they meet the criteria of being ordinary and necessary.
These two words are part of the “art of tax” in that they are not specifically defined, but have been the subject of countless court cases, regulations, dissertations and IRS pronouncements over the years. I believe all this writing can be summed up as a reasonableness test. Does common sense tell you that the cash you spent was needed to properly run your business?When you are about to make a purchase ask yourself, “Why am I buying this product or service?” If the answer is, “It is going to help me sell more of my product or service,” then you have probably met the ordinary-and-necessary test. If the answer is, “Wow, this is something I’ve always wanted!” or “This will be good for Little Johnny,” you should consider putting your business checkbook away and pull out your personal checkbook.
Separate bank account
Notice I mentioned your business checkbook and your personal checkbook.The first task any business owner should undertake, whether home-based or otherwise, is to establish a separate bank account for the business.There is no better way to invite an IRS agent to camp out at your place of business for a long, drawn-out audit than to commingle your personal and business money in one account. Unfortunately the IRS knows that not doing a good job of segregating your personal money from your business money is a very common cause for finding additional taxes that are owed. (We haven’t even talked about forming a separate business entity such as a corporation or limited liability company – that is a whole book in itself!)
Since you are running a home-based business, consideration must be given for what can be deducted for use of your household. The tax code allows a deduction for expenses attributable to the portion of your home that is used exclusively and on a regular basis as your principal place of business. The IRS has often taken a hard line on this issue and may request evidence that the test is met. If you do meet this test, a portion of your mortgage interest and property taxes (which are deductible anyway if you itemize), as well as a portion of your utilities, Internet, homeowners insurance and other household expenses can be deducted. The amount is determined based upon the square footage of the space used for business and the total square footage of the house.
Document, document, document
Keep great (not good, but great) records and receipts. You need to have an excellent accounting system in place, whether that is a formal, computer-based accounting package such as QuickBooks, a well-organized and complete Excel spreadsheet, or just a fantastic filing system that can be referenced at tax time. Be ready to immediately hand over complete documentation for every expenditure if the IRS (or your banker) ever knocks on your door.And second, use some common sense. You want to take every allowable deduction, but don’t get greedy.
Remember one of the tax profession’s favorite sayings: “Pigs get fat; hogs get slaughtered.”
Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates. CliftonLarsonAllen, LLP is one of the ten largest public accounting firms in the nation offering unprecedented emphasis on serving privately held businesses and their owners, nonprofits, and governmental entities.
Have a question? Email your question firstname.lastname@example.org. Enter “Talking Tax” in the subject line.
To ensure compliance imposed by IRS Circular 230, any U. S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.