Home-based businesses are becoming a popular way for people to fill financial gaps. Home-based businesses are businesses and must pay taxes. However, owners of these businesses do have a number of legal tax deductions they can use each year to reduce taxes. The IRS Publication 587explains how the taxation of home-based businesses is calculated and identifies deductible expenses. For example, home deductions are not allowed if business space in the home is rented by an employer.
The first consideration for calculating home-based business deductions is to determine how much space the business occupies in the home. The percentage of square footage used for the business influences the percentage of home-based business deductions in costs such as utilities, property tax, and mortgage payments. The way in which is home is used in business will play a part in this calculation. Three important tests determine which costs are deductible.
First, the “exclusive use” test means a certain area of the home is used exclusively for the business. The area can be a room or an identifiable space. The space used for the business does not have to be a separate room or marked by a permanent partition. Exceptions for the exclusive use test include if space is used in the house for inventory storage or product samples or if part of the house is used as a daycare.
The exception for the storage of business inventory or product samples need not pass the exclusive use test if five criteria are met. First, product sells are the purpose of the business. Second, inventory or product samples are normally stored in the house. Third, the home is the only fixed location of the business. Fourth, storage space is used on a regular basis. Fifth, business space is separate from storage space.
Second, the “regular use” test means the home business must use a specific area of the home for the business on a regular but not exclusive basis. Occasional business use does not qualify as regular use. The business must be for-profit and engage in product sales or offer trade services.
Principle Place of Business
Third, the “principle place of business” test means the business has more than one location in addition to the home for the transaction of business. The criteria for this test the relative importance of the activities performed in the home in comparison to the other locations, the amount of time spent at each location, and the home must be the primary location for a substantive amount of the administrative and managerial functions for the business.
Managerial and Administrative Expenses
A second aspect of calculating home-based business tax deductions is to deduct the costs associated with business administration. Deductible expenses include costs associated with billing, record-keeping, and supplies. Business administration costs in other locations are not deductible or costs associated with business transactions outside the home but not in a fixed location. Expenses are not deductible if other suitable space is available outside the home but the owner chooses to work at home.
The desire to start a home-based business is admirable, but the tax liabilities can be tricky. The wise entrepreneur will confer with tax professionals in setting up the books for the business so the owner can maximize tax deductions.