Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.
Make $9,000 a month at home with your computer! Stuff envelopes and make $50 an hour! Make thousands a month in real estate! If these schemes really worked, they'd be virtually no need to advertise them. In many cases the worst that can happen is you're out your investment. Maybe a small price to pay for the lesson if it's only $100. (Consider what some investors learned in the last few years.) These get-rich-quick schemes do work--but the promoter is the one getting rich, not you. Get good advice before committing to any business venture. The more it's advertised, the more important it is to get advice.
But many of these schemes sweeten the deal by claiming you can take significant tax deductions for personal living expenses. (In more than a few cases, the tax deductions are the only benefit.) Do so and you're getting the IRS involved and that can quickly become expensive. Here are some pointers:
While being self-employed or having your own business and working from home can provide some extra tax benefits, they may not offset the extra cash outlay. For example, paying for your own business travel will give you a deduction, but, at best, you'll still be out of pocket 50% of the expense. That's not as good as working for a company and having them reimburse you for travel. Keep in mind that you'll be responsible for the recordkeeping. If the IRS disallows a deduction, you're the one that will have to pay. And it's the rare business with auto or travel and entertainment expenses that's audited and escapes some adjustment.
The discussion below includes some benefits advertised in work-from-home schemes and the tax reality.
Travel and entertainment. Scams frequently suggest that you can deduct travel, meals and entertainment expenses under the guise that everyone is a potential customer or client. Keep in mind that strict recordkeeping rules apply to travel and entertainment. In addition to time, date, amount, etc. you must show the business relationship and the business discussed. Just listing "potential customer" on a bunch of receipts isn't good enough. Taking friends and relatives to dinner isn't deductible unless you can show a valid business purpose. On the other hand, you can make a trip partially deductible. While the primary reason of the trip has to be business, side trips are allowed (but not deductible). For example, you drive from New York to Vermont to visit a customer. You spend 4 days working at his factory. On the weekend you see your grandmother 30 miles away. The trip to and from Vermont is deductible as are your meals and lodging for the 4 days. The trip to and from your grandmother's house and meals or other expenses related to the side trip aren't. And you can't deduct the expenses of taking your spouse with you on a trip unless there's a valid business purpose and she actually works for the business.
Auto expenses. Only actual business use of the auto is deductible. Personal use is not deductible. Again, strict recordkeeping rules apply and you must show the business relationship for the use. Claims of 100% business use without a second car available will likely generate additional inquiries if you're audited. If you're audited, there's a very high probability the IRS will review your auto expenses and auto log.
Payments to family members. Deducting payments to family members for routine household tasks that are not ordinary and necessary to the operation of the business, such as taking out the trash, mowing the lawn, washing the car, answering the telephone, etc. Also payments to family members that are excessive in relation to the services performed. While you can deduct payments for work performed related to your business, be sure you can demonstrate the payments were for actual work. The younger or more inexperienced the individual, the more documentation you should have. Keep in mind that the individual is likely to be an employee and not an independent contractor. That means you have to withhold federal and state income taxes, FICA, etc. and pay unemployment, file W-2s, etc. Failure to do so can result in a loss of the deduction along with penalties.
Business use of home. Abusive promoters often advise taxpayers to deduct excessive costs associated with the operation of the home. The promoters claim that the “exclusive use” restriction can be avoided by placing business-related items in each room of the house. A deduction for the business use of a home is limited to that area of the home that is used regularly and exclusively for business purposes (Section 280A). For example, merely placing a calendar or file cabinet in a room does not satisfy the “regular and exclusive business use” requirement. The IRS is tough on this one.
First, placing business related items in multiple rooms can be counterproductive. In one Tax Court case, the taxpayers legitimately used much of their home for their business. Unfortunately, the court noted that no one room was used exclusively for business and denied the taxpayers any deduction.
Second, while you'll gain a deduction against business expenses, your itemized deduction for mortgage interest and real estate taxes that you can take on Schedule A will be reduced by a like amount. A proportionate share of the insurance, maintenance, etc. will be deductible, but the amount will depend on the business percentage of the property and those expenses.
Third, there can be adverse tax consequences on the sale of the home if you claim a portion for business use.
Education expenses. Some schemes advise taxpayers that they may claim up to $5,250 per year in educational expenses for each family member. That's simply not true. The plan can't be discriminatory nor can more than 5% of the benefits provided to individuals who are owners (or their spouses or dependents) qualify. That pretty much eliminates a benefit to owners. Education expenses directly related to a legitimate business may be deductible, such as an accounting course so you can do your own bookkeeping.
Medical reimbursement plans. Abusive promoters assert that taxpayers can make their family’s medical expenses 100 percent deductible merely by employing their family member(s). In order for the medical expenses to be deductible under a self-insured medical reimbursement plan, a bona fide employer-employee relationship must exist. As discussed above, that means filing employment tax returns, withholding income taxes and FICA, etc. In addition, the plan has to meet other requirements (Treasury Regulation Section 1.105-11).
Record keeping. Taxpayers in these schemes are advised to maintain detailed records of all expenses incurred. While recordkeeping is vital to a deduction, the existence of such records does not negate the requirement that expenses be “ordinary and necessary” in relation to a legitimate business activity. The expenses must also satisfy any other deductibility requirements (Section 274).
Computers and other listed property. Even if you have a legitimate business it doesn't mean a computer automatically qualifies for a tax deduction. You have to show the business relationship and may have to keep a log of business vs. personal usage. The same applies to cell phones, cameras and other property that can have a significant element of personal use.
Hobby losses. Chances are you won't generate a profit from the business (assuming there is a business) and that could create a hobby loss. Consistent losses on Schedule C could generate an audit by the IRS. For more information, go to our article on Hobby Losses.
Penalties and interest. If you're audited and the IRS disallows some or all of the expenses, paying the taxes will be bad enough, but you're likely to get hit with penalties and interest. You may be earning only 1% on your savings account, but the IRS interest rate is now about 4%. The accuracy-related penalty may also apply in which case you can add another 20% to the tax liability.
Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 09/08/15