Home Business
Tax Deductions
Keep What You Earn
By Attorney Stephen Fishman
4th edition
FOURTH EDITION NOVEMBER 2007
Editor DIANA FITZPATRICK
Cover Design JALEH DOANE
Book Design TERRI HEARSH
Production MARGARET LIVINGSTON
Proofreading PAUL TYLER
Index BAYSIDE INDEXING
Printing DELTA PRINTING SOLUTIONS, INC.
ISSN: 1932-2402
ISBN-13: 978-1-4133-0720-7
ISBN-10: 1-4133-0720-5
Copyright © 2005, 2006, and 2007 by Nolo.
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Table of Contents
Introduction
Your Legal Companion for
Home Business Tax Deductions
1

The Home Office Deduction
Qualifying for the Home Office Deduction 126
Corporation Employees 139
Calculating the Home Office Deduction 139
IRS Reporting Requirements 156
Audit-Proofing Your Home Office Deduction 158
7
Meal and Entertainment Expenses
What Is Business Entertainment? 162
Who You Can Entertain 164
Deducting Entertainment Expenses 164
Calculating Your Deduction 170
Reporting Entertainment Expenses on Your Tax Return 176
8
Car and Local Travel Expenses
Deductible Local Transportation Expenses 178
The Standard Mileage Rate 181
The Actual Expense Method 185
How to Maximize Your Car Expense Deduction 205
Other Local Transportation Expenses 209
Reporting Transportation Expenses on Your Tax Return 210
When Clients or Customers Reimburse You 212
9
Business Travel
What Is Business Travel? 214
Deductible Travel Expenses 220
How Much You Can Deduct 222
Maximizing Your Business Travel Deductions 237
Travel Expenses Reimbursed by Clients or Customers 239
10

Charitable Contributions 357
Dues and Subscriptions 357
Education Expenses 358
Gifts 361
Insurance for Your Business 361
Interest on Business Loans 363
Legal and Professional Services 368
Taxes and Licenses 370
Domestic Production Activities 374
15
Record Keeping and Accounting
Basic Record Keeping for Tax Deductions 380
Records Required for Specific Expenses 393
How Long to Keep Records 407
What If You Don’t Have Proper Tax Records? 408
Accounting Methods 409
Tax Years 417
16
Claiming Tax Deductions for Prior Years
Reasons for Amending Your Tax Return 420
Time Limits for Filing Amended Returns 425
How to Amend Your Return 428
How the IRS Processes Refund Claims 429
17
Staying Out of Trouble With the IRS
What Every Home Business Owner Needs to Know About the IRS 432
Ten Tips for Avoiding an Audit 439
18
Help Beyond This Book
Secondary Sources of Tax Information 450

Business owners—whether they work at home or in outside offices—live
in a different tax universe from wage earners—those who work for other
people’s businesses or for the government. Wage earners have their income
taxes withheld from their paychecks and can take relatively few deductions.
The vast majority of business owners have no taxes withheld from their
earnings and can take advantage of a huge array of tax deductions unavailable
to employees.
To take advantage of the benefits tax deductions offer, you’ll have to figure
out which deductions you are entitled to take—and keep proper records
docu menting your expenses. The IRS will never complain if you don’t take
all the deductions available to you. In fact, the majority of home business
owners miss out on many deductions every year simply because they aren’t
aware of them—or because they neglect to keep the records necessary to
back them up.
INTRODUCTION: YOUR LEGAL COMPANION FOR HOME BUSINESS TAX DEDUCTIONS 3
That’s where this book comes in. It shows you how you can deduct all or
most of your business expenses from your federal taxes. This book is not a
tax preparation guide—it does not show you how to fill out your tax forms.
(Bythetimeyoudoyourtaxes,itmaybetoolatetotakedeductionsyou
could have taken if you had planned the prior year’s business spending wisely
and kept proper records.) Instead, this book gives you all the information you
need to maximize your deductible expenses—and avoid common deduction
mistakes.Youcan(andshould)usethisbookallyearlong,sothatyou’re
ready to take advantage of every available deduction opportunity come April
15th.
Even if you work with an accountant or another tax professional, you need
to learn about home business tax deductions. No tax professional will ever
know as much about your business as you do; and you can’t expect a hired
professional to search high and low for every deduction you might be able to
take, especially during the busy tax preparation season. The information in

You Must Have a Legal Basis for Your Deductions 8
You Must Be in Business to Claim Business Deductions 8
How Businesses Are Taxed 9
Basic Business Forms 9
Most Home Businesses Are Sole Proprietorships 9
Tax Treatment 12
What Businesses Can Deduct 14
Start-Up Expenses 15
Operating Expenses 15
Capital Expenses 15
Inventory 16
Adding It All Up: The Value of Tax Deductions 16
Federal and State Income Taxes 17
Self-Employment Taxes 18
Total Tax Savings 19
6 HOME BUSINESS TAX DEDUCTIONS
O
nce you start your own business, you can begin taking advantage of
the many tax deductions available only to business owners. The tax
code is full of deductions for businesses—and you are entitled to
take them whether you work from home or from a fancy outside office. Before
you can start using these deductions to hang on to more of your hard-earned
money, however, you need a basic understanding of how businesses pay taxes
and how tax deductions work. This chapter gives you all the information you
need to get started. It covers:
•howtaxdeductionswork
•howbusinessesaretaxed
•whatexpensesbusinessescandeduct,and
•howtocalculatethevalueofataxdeduction.
How Tax Deductions Work

Home business owners usually have to spend money on their businesses—
forexample,forequipment,supplies,orbusinesstravel.Mostbusiness
expenses are deductible sooner or later. It makes no difference for
tax deduction purposes whether you run your business from home or
from an outside office or workplace—either way, you are entitled to
deduct your legitimate business expenses. This book is about the many
deductions available to people who are in business and who happen to
work from home.
You Pay Taxes Only on Your Business Profits
The federal income tax law recognizes that you must spend money to
make money. Virtually every home business, however small, incurs
someexpenses.Evensomeonewithalowoverheadbusiness(suchas
afreelancewriter)mustbuypaper,computerequipment,andofce
supplies. Some home businesses incur substantial expenses, even
exceeding their income.
Youarenotlegallyrequiredtopaytaxoneverydollaryourbusiness
takesin(yourgrossbusinessincome).Instead,youowetaxonlyonthe
amount left over after your business’s deductible expenses are subtracted
fromyourgrossincome(thisremainingamountiscalledyournetprot).
Although some tax deduction calculations can get a bit complicated, the
basic math is simple: The more deductions you take, the lower your net
profit will be, and the less tax you will have to pay.
8 HOME BUSINESS TAX DEDUCTIONS
ExamplE: Karen, a sole proprietor, earned $50,000 this year from
her consulting business, which she operates from her home office.
Fortunately, she doesn’t have to pay income tax on the entire
$50,000—her gross income. Instead, she can deduct various business
expenses,includinga$5,000homeofcededuction(seeChapter
6)anda$5,000deductionforequipmentexpenses(seeChapter5).
She deducts these expenses from her $50,000 gross income to arrive

ship, limited liability company, or corporation), and how you will pay
tax on your business’s profit.

Need help figuring out how to structure your business? Although
most home businesses are sole proprietorships, that may not be the
best business form for you. If you need to decide how to organize a new
business or you want to know whether you should change your current
business form, refer to LLC or Corporation? How to Choose the Right Form
for Your Business, by Anthony Mancuso (Nolo).
Basic Business Forms
Every business, from a part-time operation you run from home while
in your jammies to a Fortune 500 multinational company housed in a
gleaming skyscraper, has a legal structure. If you’re running a business
right now, it has a legal form—even if you never made a conscious
decision about how it should be legally organized.
Most Home Businesses Are Sole Proprietorships
A sole proprietorship is a one-owner business. According to the
Small Business Administration, 90% of all home businesses are sole
proprietorships. Unlike the other business forms, a sole proprietorship
has no legal existence separate from the business owner. It cannot sue
or be sued, own property in its own name, or file its own tax returns.
Thebusinessowner(proprietor)personallyownsalloftheassetsof
the business and controls its operations. If you’re running a one-person
home business and you haven’t incorporated or formed a limited liability
company, you are a sole proprietor. However, you can’t be a sole
proprietor if two or more people own your home business, except in
somestateswhereahusbandandwifecanbeco-soleproprietors(see
“HomeBusinessesOwnedbySpouses,”below).
10 HOME BUSINESS TAX DEDUCTIONS
Home Businesses Owned by Spouses

together to earn a profit and don’t incorporate or form a limited
liability company. Thus, if you’re running a home business with
somebodyelse,youareinapartnershiprightnow(unlessyou’ve
formed an LLC or a corporation). Although many partners enter
into written partnership agreements, no written agreement is
requiredtoformapartnership.
•
Corporations: Unlike a sole proprietorship or partnership, a
corporation cannot simply spring into existence—it can only
be created by filing incorporation documents with your state
government. A corporation is a legal entity distinct from its
owners. It can hold title to property, sue and be sued, have
bank accounts, borrow money, hire employees, and perform
other business functions. For tax purposes, there are two types
ofcorporations:Scorporations(alsocalledsmallbusiness
corporations)andCcorporations(alsocalledregularcorporations).
The most important difference between the two types of corpora-
tions is how they are taxed. An S corporation pays no taxes
itself—instead, its income or loss is passed on to its owners, who
must pay personal income taxes on their share of the corporation’s
profits. A C corporation is a separate taxpaying entity that pays
taxesonitsprots(see“TaxTreatment,”below).
•Limited Liability Companies:Thelimitedliabilitycompany(LLC)is
likeasoleproprietorshiporpartnershipinthatitsowners(called
members) jointly own and manage the business and share in the
profits. However, an LLC is also like a corporation. Because its
owners must file papers with the state to create the LLC, it exists
as a separate legal entity, and the LLC structure gives owners some
protection from liability for business debts.
12 HOME BUSINESS TAX DEDUCTIONS

Because Lisa is a sole proprietor, she can deduct this $5,000 loss
from any income she has, including her $100,000 annual salary from
her engineering job. This saves her about $2,000 in total taxes for
the year.
CHAPTER 1: HOME BUSINESS TAX DEDUCTION BASICS 13
Although pass-through entities don’t pay taxes, their income and
expenses must still be reported to the IRS as follows:
•Sole proprietors must file IRS Schedule C, Profit or Loss From
Business, with their tax returns. This form lists all the proprietor’s
business income and deductible expenses.
•Partnershipsarerequiredtoleanannualtaxform(Form1065,
U.S. Return of Partnership Income) with the IRS. Form 1065 is used
to report partnership revenues, expenses, gains, and losses. The
partnership must also provide each partner with an IRS Schedule
K-1, Partner’s Share of Income, Credits, Deductions, etc., listing
thepartner’sshareofpartnershipincomeandexpenses(copiesof
these schedules must also be attached to IRS Form 1065). Partners
must then file IRS Schedule E, Supplemental Income and Loss,
with their individual income tax returns, showing their partnership
income and deductions.
•S corporations must file information returns with the IRS on Form
1120S, U.S. Income Tax Return for an S Corporation, showing how
much the business earned or lost and each shareholder’s portion of
the corporate income or loss.
•LLCs with only one member are treated like a sole proprietorship
for tax purposes. The member reports profits, losses, and deduc-
tions on Schedule C—just like a sole proprietor. An LLC with two
or more members is ordinarily treated like a partnership: The
LLC must prepare and file IRS Form 1065, Partnership Return
of Income, showing the allocation of profits, losses, credits, and

four broad categories of business expenses:
•start-upexpenses
•operatingexpenses
•capitalexpenses,and
•inventorycosts.
Thissectionprovidesanintroductiontoeachofthesecategories(they
are covered in greater detail in later chapters).

You must keep track of your expenses. You may deduct only those
expenses that you actually incur. You need to keep records of these
expenses to (1) know for sure how much you actually spent, and (2) prove to
the IRS that you really spent the money you deducted on your tax return, in
case you are audited. Accounting and bookkeeping are discussed in detail
in Chapter 15.
CHAPTER 1: HOME BUSINESS TAX DEDUCTION BASICS 15
Start-Up Expenses
Start-up expenses are expenses you incur to get your home business
up and running—such as license fees, advertising costs, attorney and
accounting fees, market research, and office supplies expenses. Start-
up costs are not currently deductible—that is, you cannot deduct them
all in the year in which you incur them. However, you can deduct
up to $5,000 in start-up costs in the first year your new business is
in operation. You must deduct amounts over $5,000 over the next 15
years. Most home business owners should be able to avoid incurring
substantialstart-upexpenses.(SeeChapter3foradetaileddiscussionof
deducting start-up expenses.)
Operating Expenses
Operating expenses are the ongoing day-to-day costs a business incurs
to stay in business. They include such things as rent, utilities, salaries,
supplies, travel expenses, car expenses, and repairs and maintenance.

customers.Inventorydoesn’tincludetools,equipment,orotheritems
that you use in your business; it refers only to items that you buy or
make to sell.
You must deduct inventory costs separately from all other business
expenses—you deduct inventory costs as you sell the inventory.
Inventory that remains unsold at the end of the year is a business
asset,notadeductibleexpense.(SeeChapter10formoreondeducting
inventory.)
Adding It All Up: The Value of Tax Deductions
Most taxpayers, even sophisticated businesspeople, don’t fully appreciate
just how much money they can save with tax deductions. Of course,
only part of any deduction will end up back in your pocket as money
saved. Because a deduction represents income on which you don’t have
to pay tax, the value of any deduction is the amount of tax you would
have had to pay on that income had you not deducted it. So a deduction
of $1,000 won’t save you $1,000—it will save you whatever you would
otherwise have had to pay as tax on that $1,000 of income.
CHAPTER 1: HOME BUSINESS TAX DEDUCTION BASICS 17
Federal and State Income Taxes
To determine how much income tax a deduction will save you, you
must first figure out your income tax bracket. The United States has a
progressive income tax system for individual taxpayers with six different
taxrates(calledtaxbrackets),rangingfrom10%oftaxableincometo
35%(seethechartbelow).Thehigheryourincome,thehigheryourtax
rate.
You move from one bracket to the next only when your taxable
income exceeds the bracket amount. For example, if you are a single
taxpayer, you pay 10% income tax on all your taxable income up to
$7,825.Ifyourtaxableincomeexceeds$7,825,thenexttaxrate(15%)
applies to all your income over $7,825—but the 10% rate still applies

15% $7,826 to $31,850 $15,561 to $63,700
25% $31,851 to $77,100 $63,701 to $128,500
28% $77,101 to $160,850 $128,501 to $195,850
33% $160,851 to $349,700 $195,851 to $349,700
35% All over $349,700 All over $349,700
You can also deduct your business expenses from any state income
tax you must pay. The average state income tax rate is about 6%,
althoughsevenstates(Alaska,Florida,Nevada,SouthDakota,Texas,
Washington, and Wyoming) don’t have an income tax. You can find your
state’s tax rates at www.taxadmin.org/fta/rate/ind_inc.
State Income Tax Deductions May Differ
Generally, you may deduct the same business expenses for state tax
purposes as you do for your federal taxes. However, there are some
exceptions. You should contact your state tax agency for details. Every
state tax agency has a website; you can find links to all of them at
www.taxsites.com/state.
Self-Employment Taxes
Everyonewhoworks—businessownerandemployeealike—isrequired
to pay Social Security and Medicare taxes. Employees pay one-half of
these taxes through payroll deductions; the employer must pony up the
other half and send the entire payment to the IRS. Business owners must
pay all of these taxes themselves. Business owners’ Social Security and
Medicare contributions are called self-employment taxes.
Self-employment taxes consist of a 12.4% Social Security tax on
self-employment income up to an annual limit; in 2007, the limit was
$97,500. Medicare taxes are levied on all self-employment income at