Do you operate your business from your home?

Tim Knox

The majority of online entrepreneurs do, and that entitles them to take some significant tax deductions if you meet certain IRS conditions.

For one, your home office must be used "exclusively" and "regularly" for business use. That means the primary purpose of that space is for business, such as contacting clients or managing your books. It also means that the space is not used for family or personal activities, unless you want to start dividing up that time by saying 75 percent of the time the home office is used for business and 25 percent of the time it's used for playing games or doing homework.

The second IRS stipulation is fairly easy for most online business owners to meet: Your home office must be your "principal place of business." Essentially, that phrase just means that the business activities you conduct in your home office can't be conducted anywhere else, such as in a rented office space.

If you meet both of those requirements, then you can deduct many of the costs associated with your home, including property taxes, utility bills, insurance costs, mortgage or rent payments, even the cost maintaining your property.

Of course, if your mortgage payment is $800 per month, you can't deduct that entire amount if you only use a small portion of your home for business. You need to determine what percentage of your home is used as a home office, then you'll use that figure to calculate the deductions you can take. For example, if your home office represents 10 percent of your home's square footage, and your mortgage payment is $800 per month, then you could deduct $80 every month, which would be $960 for the year. The same applies to all the other expenses related to your home.

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You do need to be aware of one thing when calculating these deductions: You can't use them to demonstrate a net loss during that tax year. For example, if your online business generated $50,000 in revenue in 2004, but you could claim $60,000 worth of home business deductions that year, then you can't claim a net loss of $10,000. Instead, you could only report zero net gain. However, you can carry that remaining $10,000 onto next year's taxes to help you reduce your tax burden.

To calculate your home office deductions, you'll need to complete Form 8829 and report that total amount on Schedule C. All of these forms are available online at the IRS's website.

Remember that you can also deduct other business expenses, such as the cost of owning your domain name, paying your web-hosting company, designing your website and accessing the internet. (These fees will have to be pro-rated, however, if your family or you use the internet for non-business-related activities.)

Another tax-related issue that might be bothering you is what to do with any and all of the people who did work for your online business, such as the web-design company that helped you establish a presence on the internet, the copywriters who created press releases and marketing letters to help you gain new business and publicity, and the person who answers your customer calls or responds to customer e-mails. By law, you have to report how much you paid these individuals during the tax year, but you also have to know how to report that information and which forms to send to those individuals.

You have two choices: They could be independent contractors or employees. There is a big difference between them. With independent contractors, you aren't responsible for paying Social Security, Medicare or unemployment taxes, while with an employee you have to cover all those expenses. For that reason, most online business owners choose to work with independent contractors.

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While the IRS has established a set of 20 questions that can help you determine whether an individual doing work for you is an employee or an independent contractor, one of the easiest ways to make that determination is to ask yourself one question: Do I control "what will be done and how it will be done"? If you answered yes, then the individual is an employee, and you will need to send him a W-2 regardless of how long he worked for you and how much money he earned.

If you answered no, then the individual is classified as an independent contractor by the IRS. With an independent contractor, you still can control "what will be done," but you can't control "how it will be done." You would send them a Form-1099 if they did more than $600 worth of work for you during the year.

Because classifying the individuals who do work for your online business is important (the IRS could force you to pay the back taxes and even a penalty if you misclassify an employee), you should always have them sign a contract stating that they are doing work for you as an independent contractor. That way, both parties know what their specific relationship is going to be from the beginning, and you don't have to sort everything out during tax time.

Home Based Business Tax Questions

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