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Taxation of Your Home Business

by: SBC Staff

So your home business is finally producing revenues that exceed your expenses.  Congratulations!  Now the government is going to want their share!  It is amazing how many people either forget to include this income on their tax returns or mistakenly believe they don't have to.

U.S. citizens are taxed on their worldwide income.  This includes all income from whatever source, wherever earned.  Income from a home business is taxable just like any other income.  It will also be subject to self-employment tax at a rate of 15.3 percent.  The self-employment tax is the equivalent of the Social Security and Medicare tax that you would have had withheld if you worked for someone else plus the employer's matching tax.  In other words, if you don't have an employer to withhold and pay the tax, you have to pay both pieces yourself.  The self-employment tax is limited just as Social Security tax is limited.  You only pay the Social Security portion at 12.4% of the first $80,400 of earnings.  The Medicare portion is payable at 2.9% of all earnings without limit.

There are two important points to note about the self-employment tax:

  • self-employment tax is imposed on your NET income from your home business, and

  • if you have a regular job and your employer withholds Social Security and Medicare tax, your earnings from your job will count toward the limit.

With respect to the first issue, you need to understand how to compute your net earnings from your home-based business.  Net earnings is your total revenue less the expenses related to producing that revenue.  This can be difficult because some expenses need to be allocated between business and personal use.  For example, your monthly payment to your Internet service provider is used to do your marketing but you also use it for personal surfing.  You would need to allocate this expense based on the amount of time you spend marketing versus surfing.  Similarly, your phone bill would need to be allocated as well.  Other costs, such as the cost of having your web site hosted is directly allocable to your business and may be deducted in full.  You will need to go through all your expenses to determine those costs that are related to your business.  Make a list of those that are directly allocable and those that have to be allocated.  Total up the lists and deduct these expenses from your revenue and you have your net earnings from your home business, also known as net earnings from self employment.  This is the amount you use to compute your self employment tax and it is the amount that you report as taxable income on your tax return.

You report your income from your home-based business on Schedule C.  Schedule C includes a listing of most of the types of expenses you might incur in running your business and a separate schedule for you to write in other expenses that aren't listed.  The net income reported on this form transfers to page one of your 1040 to be added in with your other income.  Your self employment tax is computed from the net earnings reported on Schedule C.

You are allowed to write off expenses related to your home on Schedule C.  If, for example, you use an office in your home and that office takes up 25% of the space of your home, you may write off 25% of your rent or take depreciation on 25% of your home if you own it.  There is one very important caution we need to issue here: if you depreciate your home to reduce your income from your home-based business, that portion of your home will not qualify for deferral of gain (rollover) when you sell your home.  This can result in a tremendous tax liability when you sell your home.  Let me give you an example:

Let's say your home cost you $100,000 when you bought it.  You use your home 25% for business.  You compute depreciation on this $25,000 each year for five years and deduct the depreciation against your home business earnings.  You will likely be depreciating the $25,000 over 30 years using straight line depreciation so you have deducted $4,167 of depreciation.  This depreciation reduces your basis in the business portion of your house from $25,000 to $20,833.  If you sell your house for $150,000, 25% of the proceeds must be allocated to the business portion of your house, which totals $37,500.  Proceeds of $37,500 less your adjusted basis of $20,833 equals a gain of $16,667 which you will have to report on your income tax return in the year you sell your house.  This gain would ordinarily be indefinitely deferred or permanently non-taxable.  In summary, you have generated a tax gain of $16,667 five years down the road for a deduction of $833 in each of those five years.  Unless you plan on never selling your house, it's just not worth it.  Of course, if you rent your home or apartment, you don't have this problem.

Even if you decide computing depreciation on your home is not worth it, don't ignore other expenses such as your electric bill, the office furniture, your computer and other expenses related to the space you use for your office.  All or a portion of these expenses should be deductible.  Other expenses you need to consider are the costs of joining your affiliate programs, advertising costs, office supplies, costs for products you have sold, and any other expenditure directly related to your business.

You should develop a system for accumulating your business costs during the year.  If your business is big enough, get an accounting system.  If not, at least use Quicken or some other financial management software to accumulate and categorize your costs.  Accounting for your business and preparing your tax return doesn't have to be a dreaded chore if you organize yourself.

 

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