It is almost tax time. Some of us have been working from home and some of us have become unemployed and have decided to “hang out shingles” and start a new business from home.
This article is intended to shed some light on what you should do or consider not doing when starting a new venture. It also examines some of the tax consequences of the home office tax deduction as an employee and as an independent contractor.
Let us first assume that you have now decided to start a business from your home in fulfillment of a long-held dream and want to use this opportunity to fulfill this dream. Assuming that you know exactly what you want to do, the first thing is to think of a name for your business and have it incorporated with the state. You do not need an attorney or CPA to incorporate a business. Simply go on the State of Michigan website, download the required form, attach a check for the fee that is required and mail it to the state. Save yourself a couple of hundred dollars that you will really need going forward.
The next step is to apply for an Employee Identification Number (EIN) from the IRS. This process is also very simple and is free. The EIN will be used to identify your business and most importantly you will not have to use your social security number for business purposes. You do not want to expose your social security number to your vendors or customers.
Informing the business, you would have to select the type of business entity. There are many forms of business entities, but I will discuss in this article the type of entities that would be most beneficial from a tax perspective as well as from a liability perspective.
If you are married, get the spouse involved from the beginning. He or she does not have to ride with you on the truck each day. Once the spouse is involved in the business, your business can be formed as a “Qualified Joint Venture”, a designation that the IRS has made specifically for married couple enterprises where both spouses are active in the business. Generally, when two or more individuals form a business entity. It is referred to as a partnership or in some cases a corporation. However, for a married couple venture, the IRS makes an exception. This makes the tax filing at the end of the year much simpler than a regular partnership.
With a qualified joint venture, the entity’s tax return will show the amount of business income of loss attributed to each spouse on the joint tax return at the end of the year. The return will also show each spouse’s share of the social security tax separately. These taxes will be credited to each spouse’s Social Security and Medicare eligibility benefits.
If only one spouse is actively involved in the business, registering the business as a “Single Member Limited Liability Company” (SMLLC) is the best option. When you establish a business, it is of utmost importance that you protect your personal assets from lawsuits that may result from running the business. The SMLLC will have the limited liability of a corporation but will also have the advantages of a sole proprietorship. With a solo-proprietorship, the profits or losses derived from running the business will be reported on a Schedule C of your personal tax return. If the company makes a profit, self-employment tax will probably be owed and credited as a Medicare and Social Security contribution. The self-employment tax is typically the combined amount of the payroll tax that is paid by both employers and employees. If self-employment tax is owed, half of the tax is deductible when computing taxable income.
If the company incurs a loss, which is very often the case during the earlier years of operation, the loss will offset taxable income from other sources. If the married couple earned $100,000 in wages and incurred $20,000 in business losses, taxes will be paid on $80,000 rather than $100,000. A word of caution, however, the objective of going into business is not to generate losses to offset other income but to eventually make a profit. The IRS is very strict on this issue. Your business could be considered a hobby rather than a business if certain IRS rules are not met.
Now let me briefly discuss the home office deduction. Prior to the 2017 Tax Cuts and Jobs Act, employees who worked from home and incurred expenses related to their job could, with some limitations, deduct these expenses on their tax returns. Under the new law, the deduction was eliminated.
The above example was for an individual working as an employee. As a business owner or an independent contractor, the home office deduction is available to you. This applies to individuals who own a home, rent an apartment or condo, or mobile home. There are two basic requirements that must be met in order to use this deduction. The portion of the house or apartment being used must be used “regularly” and “exclusively” for business purposes.
There are two methods to compute the deduction. The simplified method and the regular method. With the simplified method, measure the area that is being used for the business and multiply that area (limited to 300 square feet), by $5. That number will be your home deduction on your tax return.
The regular method involves a little more computation. First, you determine the total square feet of your home. After that, you determine the square feet of the area being used for business. Divide the number of square feet of the office space by the area of the entire residence. You will get a percentage and multiply that number by the amount of utilities, rent (if you rent) mortgage interest, etc. For most small business owners, I strongly recommend the simplified method.
This article was written by Abraham M. Benson, CPA, EA. Mr. Benson runs an accounting and tax practice in Westland, Michigan. Questions and comments can be forwarded to [email protected] or 248-331-6653.