Joys of Being Self-Employed

THE ‘JOYS’ OF BEING SELF-EMPLOYED [& TAXES]
Challenges, Trials & Tribulations
As presented to the

Steven L. Jager, CPA
Steven L. Jager, CPA, An Accountancy Corporation
15250 Ventura Boulevard, Suite 1100
Sherman Oaks, California 91403
Voice: (818)501-5797 · Fax: (818)501-8560
Email: sjager@cre8ivcpa.com
www.cre8ivcpa.com

8.1.1 Income Matching and Your 1099’s………………………..................9

IV. Resources…………………………………………………………………………. 14

This Treatise is distributed with the understanding that the author is not engaged in rendering legal, accounting or other professional advice and assumes no liability in connection with its use. Tax laws are constantly changing and are subject to differing interpretation. In addition, the facts and circumstances in your particular situation may not be the same as those presented here. If legal advice or other expert assistance is required, the services of a competent professional should be engaged.

Unfortunately, the odds are against you… almost 70% of small businesses do not last more than five years!

1.1 Managerial Skill – the most important factor in the success or failure of a business…

“Doing the right things right”

1.2 Wearing the hat of “manager”. What can you do about the odds against you??

B. Develop a budget – use it to monitor the key financial elements of the company. It is critical to understand what financial numbers really mean.

Do you need one? YES!!!! How do you know if you are doing well or not, unless you know what it was that you expected????

2.1 Main purpose of the budget is to control expenses and set goals… Know in advance what the numbers SHOULD BE...................

2.2 Your budget is a living, dynamic document which changes as conditions change… Change it
if it proves to be incorrect.

2.3 “Number-crunching” does not have to mean rocket science…Do not be afraid or
intimidated by the process.

2.3.1 Poor attitude toward financial data and record-keeping is a trait of poor management.

2.3.2 Lack of experience leads company manager to conclude that financial data is for bankers, accountants and the IRS, but not much value in the decision-making process.

¨ The inflows and outflows that you project must be based upon an honest assessment of what you think you can achieve in the coming period… take any necessary action to achieve the desired objectives.

b. Variance analysis – compare the actual expense to amount budgeted, on a line-by-line basis MONTHLY.

2.5.1 Strive to have a management information system that monitors properly prepared financial statements, cash balances, future cash needs, accounts receivable and inventories.

b. If not in your bank account, it is more than likely in accounts receivable and/or inventory.

1. Accounts Receivable: Monitoring and collecting accounts receivable is one of the business owner’s/manager’s most important functions… be professional and polite but firm and persistent in collecting YOUR money;

2. Inventory: The “fantasy asset”: Profits are easy to manipulate by manipulating the ending inventory.

c. Effective cash management involves doing cash flow forecasting as a matter of the monthly routine;

d. Wouldn’t it be nice to know exactly when you are likely to run short of cash so that you can take proactive steps to cover the shortfall (and figure out where it will come from)?

e. Cardinal rule about borrowing money from banks: When you can demonstrate that you do not need the money the banker will be happy to loan it to you… MAKE YOURSELF BANKABLE AS QUICKLY AS POSSIBLE!

3.1.2 Borrowing money from Mom, Sis, Brother, Aunt Matilda or Uncle Manny… the economic as well as the emotional costs!

a. Inter-family loans and the paper trail: Have a promissory note, use real-market interest rates and REPAY the money with interest! Treat it as a business transaction.

3.1.3 Using the equity in your home to start the business… Even better, if possible, use a different piece of real property to secure the loan.

b. Gift taxes: Federal estate and gift taxes and planning… there is an interplay between the two, and professional guidance from legal counsel is highly recommended in this area.

5.1.1 The term “accountant” is not generic. It is a licensed term, and only CPA’s are licensed.

5.1.2 What is the significance of this license? Only CPA’s can legally sign the “Accountants Report”attached to a financial statement prepared for a third party.

5.2 Talk to friends, family and your associates to get referrals to accountancy professionals that they know.

5.2.1 Referrals from attorneys, bankers, stockbrokers, insurance agents, Chamber of Commerce, etc;

5.3 Interview. Ask questions. Get to know this person who will likely become your most trusted advisor

5.3.1 Fees… How much? How charged? While a very fair question, it is usually asked way too quickly in the interview process;

5.3.2 Experience. In addition to how much, it is even more important to know what type of experience the accountant has. What type of clients does he/she have? Many accountants have niche areas/specialties;

b. Who will actually be assigned to do the work on your account? Who will be available to you when you have a question or need some advice?

c. Availability for telephone calls. What is the Firm’s policy on billing for telephone calls?

5.3.4 Most important: YOU must FEEL COMFORTABLE with hiring this person or Firm.

a. Is the Accountant comfortable with answering questions? Can difficult subjects be articulated and explained to you clearly? Undoubtedly, you will sometimes need the Accountant’s help in explaining strange (to you) concepts to you. You are not expected to already know this stuff!

b. As you are “shopping”, do not be driven by price alone. You are not buying a fungible commodity like toilet paper; rather, you are buying experience, expertise and knowledge. Look for the value offered, not purely at the dollars.

5.3.5 Expect to be asked to sign an engagement letter. It forms the basis of your contractual relationship with the Accountant. It is also quite common for Accountants to ask new clients for an advanced retainer payment, to be credited against services rendered.

a. Be open and communicative. Avoid being the passive-aggressive client. The Accountant will not know you well enough (at first) to be able to read your mind. If you feel there is a problem or potential disagreement, bring it up for discussion and resolution! Remember, your next Accountant will probably ask you why you are changing Accountants…

b. Pay all bills promptly. If you have any questions about a billing, bring them up SOON after getting the invoice. There is nothing worse than waiting a long time to question a billing. Communicate your “question” as seeking clarification in understanding the bill. Do not knit-pick. You may win a battle but you will both lose the war.

5.3.7 Confidentiality and “Privilege”. Everything is confidential, but “privilege” evaporates as soon as you really need it, unless the Accountant is hired by your own lawyer before any sensitive issues are discovered. BE VERY CAREFUL what you tell your CPA.

6. Business vs. Hobby – To be considered a business, you must have a “profit motive”; otherwise the government will likely assert that your business is “NOT engaged for profit”, and is therefore a “HOBBY” (Internal Revenue Code Section § 183).

6.1 A “hobby” cannot report losses in excess of income (except for any interest expense and taxes);

6.1.1 The IRS is especially interested in tax returns with large and consistent Schedule C losses are they are an easy target for hobby loss scrutiny.

                  6.2        An activity/venture is presumed to be engaged in for profit (i.e., a business) if it shows
                            a profit for three out of five consecutive years.   This is a rebuttable presumption,
                            as the government realizes that there are some legitimate businesses that are not
                            profitable even after three (or more) years.

                  6.3        Overcoming the IRS’ Challenge: The IRS looks at a nonexclusive list of nine relevant
                            factors in determining whether an activity is engaged in for profit (and therefore, a
                            legitimate business). No single factor, or even an existence of a majority of factors
                            is controlling.   See Appendix B

6.4.1 Engineering Activity Was For-Profit Trade or Business (J. P. Vo v. Comm., TCS 2001-38)

The facts: Jeffery Vo, from Portland Oregon, created a joint venture, under the name Solarsys Technology, to market solar powered generators to generate electricity that run household appliances for residential homes. The partners rented a 3-bedroom home in San Jose to demonstrate the generator for potential distributors and as office space. None of the partners lived in the property and all had their own personal residences. The business was a spectacular failure and the IRS said the activity was not for “income or profit.”

No tests used in decision, it just looked like a business to the court: The court felt it was unclear why the IRS did not consider the taxpayers’ activity a trade or business and the taxpayers’ provided credible testimony and evidence that they were engaged in business for the purpose of making a profit. The generators were marketed overseas and resulted in sales to five individuals. That the machines were eventually returned did not suggest that the taxpayers lacked a profit motive. Moreover, testimony adduced at trial supported a finding that costs associated with the use of residential property to test the generators were related to the business. The generators were intended as an alternative source of power for residential homes and none of the taxpayers used the property as their personal residence. The court found that the activity qualified as a trade or business engaged in primarily for profit. Consequently, the taxpayers were entitled to deduct those expenses that were ordinary and necessary to the business.

6.4.2 Artist Activity of CPA Not Engaged in for Profit; Negligence Penalties Imposed (Richard Stasewich v. Comm., T.C. Memo 2001-30)

The facts: Robert Stasewish, a Chicago CPA, failed to demonstrate that he pursued an artist activity with the requisite profit objective necessary to claim various Schedule C losses incurred from the activity. Even though he provided adequate substantiation for his expenses and had state licenses to sell personal property, he did not conduct the artist activity in a businesslike manner as he failed to show that his books and records were kept for the purpose of cutting expenses, increasing profits, and evaluating the overall performance of the operation; nor did he maintain a budget for the activity or make any sort of financial projections. Moreover, the taxpayer presented no evidence of a change in operating methods designed to reverse his uninterrupted 15 year history of losses relating to the activity, even though his activities changed from nude drawings to portraits. He had an independent source of income, his accounting business, and admitted painting afforded him personal pleasure.

Audit Point: The CPA was liable for an addition to tax for negligence (§6662(a)) in view of his training, experience, and failure to offer evidence at trial to defend against its imposition.

Another moral of the Story: Note the tremendous importance and weight of keeping adequate records (as discussed in #7 below);

6.4.3 Father’s Management of Son’s Amateur Motocross Racing Activity Not Engaged in for Profit (Anthony J. McCarthy v. Comm., TC Memo 2000-135)

The Facts: The 2nd Circuit Court of Appeals remanded this case back to the Tax Court on the grounds that the previous decision against the taxpayer erroneously gave dispositive weight to the son’s amateur status, not one of the nine accepted factors. For the second time, the court decided the individual’s management and promotion of his son’s amateur motocross racing activity was not conducted for profit; thus, he was denied a business loss deduction for expenses incurred with respect to the activity, even though he spent “most of his spare time” devoted to his son’s racing activity. The taxpayer had no written plan or financial analysis of the activity’s profit potential. He did not consult with any experts regarding potential income. The taxpayer did not engage in any other activity relating to racing management. He continued to work full-time in the construction industry. The personal satisfaction derived by the taxpayer and his son by the motocross activity outweighed the significant time and effort expended on the undertaking. Lastly, the racing activity had a history of foreseeable losses, and would not be able to produce a profit until the son became eligible to compete as a professional.

Additionally, since the taxpayer lacked a profit motive with respect to his son’s motocross activity, his expenses did not pass the threshold requirements to characterize the expenses as either startup costs or pre-opening expenses (on remand from CA-2, 98-2 USTC ¶50,577).

7.1 The entity theory. Your new business should be viewed as a separate economic entity
which is separate and distinct from the owner(s).

7.2 Choice of entity: sole proprietorship vs. partnership vs. “C” corporation vs. “S” corporation vs. LLC

7.3 Set your new business up AS a BUSINESS. A wise man once said: “If it looks like a duck,
quacks like a duck and walks like a duck, then it probably is a duck”.

7.3.1 Separate bank checking account (at least ONE). Do NOT try to run your business using the same checkbook as the one that you take to the grocery store!

7.3.2 Using Credit Cards: Designate at least one card as the business credit card. Remember: No commingling.

a. If your business is organized as a corporation, you will probably pay yourself a salary, subject to all payroll and withholding taxes;

b. If your business is organized as a sole proprietorship, or as a partnership with one or more other owners, then payments made to you will NOT be income… these are CAPITAL DRAWS, which deplete your capital investment (and basis) in the buisness;

c. If you are a sole proprietorship and you need money for personal expenses, write a check from the business’ checking account to yourself, and then deposit the check into your personal checking account. AVOID paying personal expenses directly out of your business’ checking account.

7.3.5 In general, try to pay for as many things as possible by check, and keep receipts.

7.3.6 Diaries/Journals/Appointment Book/Daytimer/PDA – Excellent to have contemporaneously recorded.

7.3.7 Entertainment and meals -- Presently, only 50% deductible. Keep all receipts. Tie into Daytimer.

7.3.8 Automobile and Travel Logs: YES! Record mileage periodically (weekly is ideal). At the very least, use your daytimer to record mileage periodically.

7.3.9 Maintenance of records: The simple reality – If you do not respect your business by maintaining adequate records, then no one else (i.e., the IRS, FTB, SBE, your banker) will either. See Appendix C

7.3.10 City Business License: Obtaining these has taken on a new significance (explained under business start-up expenses at 12, below).

7.3.11 Employer Identification Number: Obtain a federal employer identification number (FEIN). Complete Form SS-4. Ask your CPA to review your completed Form before submitting to the IRS (or even better, ask he/she to complete it for you).

7.4 Using your computer to keep financial records. That is why G-d invented computers!

7.4.1 Quicken, Microsoft Money, Quickbooks, etc. are wonderful and certainly very powerful!

7.4.2 However, as wonderful as these programs are, it is important to take the time to understand what the program can and cannot do for you; understand the software’s limitations. It is merely a tool… it will not solve your management problems; it cannot create form out of chaos. Moreover, if you plan to use and rely on such a program, then you must be committed to keeping the data up-to-date monthly.

7.5 With respect to financial reporting, recall that only CPA’s are licensed to sign the “Accountants Report” which accompanies every financial statement issued to a third party.

8. Form 1040, Schedule C – On an individual tax return, this is where the income and deductions of a “business or profession” will be reported.

8.1 Properly reporting your income – Certainly one of the reasons why tax returns with a Schedule C have a significantly higher probability of being audited, is because it is EASY to manipulate the Schedule. Only “single-entry” accounting (if any accounting method was used at all) is utilized. Consequently, income may disappear with an eraser and the stroke of a pencil!

8.1.1 Income Matching and Your 1099’s – To frustrate the ease with which income may be manipulated, thanks to computer technology, the IRS matches 100% of all 1099’s filed by payors against the tax returns of the recipients.

a. If you receive any 1099’s, make it easy for the IRS to find them on your Schedule C! Disclose! Disclose! Disclose!

8.1.2 Monies Deposited Into Your Bank Account – You should assume that if money was deposited into your bank account, it WILL be discovered in the event of an IRS audit, as Revenue Agents and Examiners routinely perform bank deposit analysis as a part of the audit of a Schedule C.

a. The IRS Examiner will presume that all of the deposits are income unless you can prove to the contrary. Keep copious (and contemporaneous) records of transfers between bank accounts, gifts, loan proceeds, inheritances, etc.

¨ Gifts – For gifts received by check, have the donor indicate the gift on the memo line of the check. For large gifts (when the total received from the donor exceeds $10,000 in a year), file gift tax return;

¨ Loans – For loans taken on credit cards, credit lines, etc., keep documentation/statements. For other loans (including and especially loans from other individuals), have a properly signed PROMISSORY NOTE, and follow its terms with respect to interest, loan repayments, etc. [Remember our earlier duck?]

8.1.3 Lifestyle/”Financial Status” – This is the IRS’ version of “profiling” which attempts to look beyond the “four corners of the tax return” when there are other indicators present that income has likely been significantly underreported. Essentially, the government scrutinizes the taxpayer’s lifestyle in an attempt to uncover income that must have been earned to sustain a lifestyle greater than that which is overtly apparent from a reading of the tax return and the “story”/explanations received from the taxpayer.

8.2 Properly reporting your business deductions -- Just as the IRS worries that income may have been underreported (or unreported), it also worries that deductions may be overstated (or even fictitious).

8.2.1 What business deductions are allowable? Essentially, ANYTHING is allowable so long as you can demonstrate that it is BOTH “ORDINARY” AND “NECESSARY”. [Internal Revenue Code Sec § 162]

· “Ordinary” means that the expense is ordinary or customary in the taxpayer’s business;

· “Necessary” means that the expense is appropriate and helpful in developing and maintaining your business

◊ Roll Royce Was Not Ordinary and Necessary Business Car (Mohan Roy, M.D., Vimal Roy v. Comm., (CA-9), U.S. Court of Appeals, 9th Circuit, 98-70774, 5/18/99, Affirming TC Memo. 1997-562)

The facts: The Roys failed to produce sufficient evidence such as vehicle expense records or mileage logs to substantiate the claimed business deductions for the corporation‘s Roll Royce. Moreover, the uncontroverted facts established that Mohan Roy infrequently used the Rolls Royce to travel to different hospitals during the applicable tax period and that the Roys each had a primary vehicle that they used for this purpose. Accordingly, the appellate court ruled that the tax court did not err in concluding that the claimed deductions for the Rolls Royce were not ordinary and necessary expenses under 26 U.S.C. §162(a). See Norgaard [91-2 USTC ¶50,378], 939 F.2d at 878-79; Inland Asphalt Co. v. Commissioner [85-1 USTC ¶9293], 756 F.2d 1425, 1427-29 (9th Cir. 1985).

8.2.2 Some special cases of “business deductions” (certainly NOT an exhaustive list):

a. “Bad Debts” – A cash basis taxpayer (which YOU probably are), cannot take a bad debt deduction unless the amount was previously included in income. This may happen when a check is returned for insufficient funds. However, a preferable way of recording bad checks is to back them out of the income account rather than start a bad debt expense account.

b. Costumes/Uniforms – In order to be a legitimate deduction, the outfit(s) must not be adaptable to street-wear… essentially, a clown costume would be deductible, but an evening gown or tuxedo would probably not be.

d. Club dues – e.g. health or athletic clubs, country clubs, etc. are NOT deductible, BUT specific business expenses (e.g. meals) incurred at these clubs would still be deductible (albeit at 50%), but only to the extent they were “directly related” to the active conduct of a trade or business.

e. Entertainment -- Who was the first President of the United States that said "let's do away with the deduction of the three martini lunch," and why did he say it? First, the answer to why: abuse - perceived or actual! Personal entertainment has never been deductible (Internal Revenue Code Sec §262) but business entertainment may be deductible (Internal Revenue Code Sec §162) when strict rules are followed (Internal Revenue Code Sec §274). Next, the answer to who: No, it was not Jimmy Carter. It was Richard Nixon, ten years before!

As with all business expenses, to be deductible, the expenses must be ordinary and necessary, and incurred in the operation of a business regularly carried on by the company (Internal Revenue Code Sec.§162). In addition, the expenses must meet the directly related to or the associated with tests (Internal Revenue Code Sec. §274(a)), or be statutorily exempt from having to meet either of these two test (Internal Revenue Code Sec. §274(e)). Stringent substantiation requirements are mandatory (Internal Revenue Code Sec. §274(d)), and yet the expense may be only 50% deductible (Internal Revenue Code Sec. §274(n)).

No matter what you might call it, to determine if an expense is entertainment, promotion, or travel, an objective test is used. "Thus, if an activity is generally considered entertainment, it will constitute entertainment...regardless of whether the expenditure can also be described otherwise"...even when called advertising or public relations (Regulation Sec. §1.274-2(b)).

Example: if it looks like a duck, and walks like a duck . . . In Danville Plywood Corp. v. US, 90-1 USTC ¶50,161, Danville originally hid these expenses by reporting them as "advertising expenses" on the return. Prior to disallowance, the court found they were properly recharacterized as entertainment during audit by an IRS agent applying the objective test of Regulation Sec. §1.274-2(b).

9. Surviving an Income Tax Audit -- The popular press has been replete with recent reports about the IRS’ declining audit rate and prevalence of tax cheats going unpunished. [see Forbes, March 16, 2001 and Money, April 2001]. While it may well be true that the audit rate has declined nationally, here locally, the IRS is still auditing tax returns. Furthermore, the statistics quoted in these newspapers and magazines is misleading, as they are only referring to in-person, face-to-face tax examinations. As mentioned above, thanks to technology, income on tax returns can be verified against 1099’s for nonemployee compensation, bank interest, dividends, royalties, rents, etc. – and these types of issues, which are handled by correspondence, are not included in the statistics.

9.1 Given the government’s limited resources, which tax returns are the most likely to be audited? Answer: Individual income tax returns filed with Schedule C (perhaps like YOURS), especially if the Schedule C indicates a loss, and most especially if the Schedule C indicates a loss together with evidence of a “day job”;

9.1.1 Living in Los Angeles: As the entertainment capital of the world, the IRS has become especially adept at ferreting out tax returns (in the entertainment industry) that are ripe for audit, and then auditing them fairly efficiently. There are at least two specialized local audit groups that only focus on the entertainment industry (which includes performing artists, entertainers, musicians, songwriters and composers, authors, agents, athletes, etc.);

9.1.2 Market Segment Specialization Program (MSSP). In the early 1990’s, the IRS began taking the wealth, breath and depth of knowledge learned right here in Los Angeles and has synthesized it into a specialized audit guide which is now uses nationwide to walk IRS Agents through tax examinations in this area.. This strategy of “market specialization” or stratification has been hugely successful for the IRS and has grown significantly. There are MSSP guides now for many different “market segments”/industries. The good news is that all of the MSSP guides are available at the IRS website at www.irs.gov.

9.2 So the keys to surviving an IRS audit are essentially to keep and present good records (as I preach in sections 6, 7 and 8 above), and to understand what the IRS is looking for when auditing a tax return (the MSSP guides are extraordinarily helpful).

9.3 Lowering your audit profile: What can you do to reduce your probability of being audited? Answer: nothing and no one can guarantee that you will not be audited, but you can take steps to lower your audit profile:

9.3.1 Report all of your income, being especially careful to disclose each and every 1099 that is issued to you (remember: give the IRS what their computers are looking for);

9.3.2 For deductions which are unusual in any particular year, disclose them with an explanation in the tax return. Even though the IRS computer itself does not read them, an IRS “Classifier” (i.e., a real person) should read those explanations in deciding whether or not to actually audit a tax return which has been “kicked out” and identified by the computer system. Such explanations can be very effective at putting the Classifier’s mind at ease and moving on to someone else’s tax return;

9.3.3 Talk to your CPA, EA or Tax Preparer about moving your business income and deductions to another type of tax return (e.g., it might make sense to form a corporation or limited liability company). These other types of entities are still probably less likely to be audited (as they involve increased accounting integrity by requiring double-entry bookkeeping which cannot simply be erased and changed with the stroke of a pencil). If you decide that this is appropriate for your circumstances, please realize that it will be more expensive in terms of professional fees! Make sure that the expected benefits to be gained will outweigh these additional costs.

9.4 Refer all IRS correspondence to your tax professional for resolution, and try not to interact with the government on your own. It is often penny-wise and pound-foolish to do so.

9.4.1 If you feel you must call the IRS on your own, then at least take notes of your conversation, and be sure and note the date, name and “badge number” of the person with whom you spoke. A confirming letter is always a good idea.

9.4.2 Do NOT try and represent yourself in an income tax audit. There are too many ways to unwittingly “trap” yourself, making it a real challenge to salvage your position or do “damage control” after-the-fact.

a. Revenue Agents and Tax Examiners are law enforcement officials. Whether conscious or not, overt or subtle, they will sometimes “leverage” you into positions that may be totally erroneous as a way of quickly settling a case and may not always tell you of alternate positions or solutions that may work out to your advantage. IRS Rev Proc. 64-22 is intended to curb this tendency, but it happens all-too-often, especially to lay persons who are emotionally involved and vulnerable;

b. You need not even be present at your own IRS audit, if you have retained a professional CPA or EA (and most of the time the CPA or EA prefers that you not be present!)

10. Estimated Tax Payments – Our Federal and California tax system is based upon “voluntary compliance”. Failure to follow the rules voluntarily results in unpleasant (and expensive) sanctions…

10.1 The “pay-as-you-go-system”: If you were an employee of a company earning a salary or wage, there would be federal and state withholding “captured” from each paycheck and paid in by the employer on your behalf (as an employee). For those that are self-employed, however, those equivalent payments are calculated and paid in quarterly as QUARTERLY ESTIMATED TAX PAYMENTS.

10.2 There is a tax penalty for failing to pay enough income tax (including self-employment/social security tax) during a calendar year. The penalty can be avoided if you qualify under one of three “safe harbors”:

b. You pay 100% of your prior year’s tax liability. This safe harbor is increased to 110% IF your adjusted gross income for the prior year was $150,000 or more (goes up to 112% for 2001);

11. Office-In-The-Home -- It is true that the “office-in-the-home” deduction has become much more liberalized since 1999, but that does NOT mean that it is always a good idea to have one!

11.1 Especially for Homeowners: If you own your own home, remember that you can always deduct your home mortgage interest and property taxes. Remember also that our principal residence presently enjoys a complete exclusion of any gain on sale up to $250,000 per individual ($500,000 on a joint tax return where the home is the principal residence of both husband and wife. Why then, would one want to taint such a happy result by making some relatively small portion of that house (in footage) subject to a later gain on the sale of the home?

11.2 For renters, the above is not true, and a home office, if otherwise appropriate, should be considered.

11.3 The office-in-the-home deduction is reported using IRS Form 8829. The resulting deduction is transferred to the Schedule C, line 30. The home office deduction cannot be used to bring a schedule C below zero (i.e., it cannot be used to create a loss), nor can it be used to make a loss any larger. Any amount not currently allowed (by this limitation) may be carried over to the next year.

11.4 For much more information about the Office-in-the-home, see Appendix F.

11.5 So is there any good news here? YES! For those that qualify for a home-office deduction, the best news is that now significantly more of their automobile usage will be deductible, as there will no longer be any commuting mileage!

11.6 Another piece of “good news” is that there are other creative (and legal) ways of obtaining the equivalent benefits of a home office deduction, particularly if it makes sense to create another entity.

12. Start-Up Costs (Internal Revenue Code Sec. § 195) – This has become very important in business start-ups, and is quite often overlooked by many accountants and tax preparers.

12.1 What are start-up costs? This Code Section is among the shortest in the entire Internal Revenue Code. See Appendix G. Very simply put, start-up costs are those which are paid and incurred prior to the date that your business begins. Such expenses would ordinarily be deductible, assuming that you were already IN BUSINESS. Query: When does business begin? The answer to this question is not always obvious… The Code says that business begins as and when defined by the Regulations to the Internal Revenue Code…

12.2It seems all so simple and straightforward enough, except that NO REGULATIONS have ever been issued in this area! With no official Regulations, this area has become very ripe for controversy.

12.2.1 The controversy comes down to this: The law says that start-up expenses are NOT deductible, but instead, may be capitalized and amortized over five years, BUT ONLY IF an election is made on a timely filed tax return (or a tax return on a valid extension).

12.2.2 In income tax audits involving new businesses, this issue arises often. First, the IRS argues that there is NO BUSINESS [asserting that it is a hobby (see # 6 above)]. When the government loses that argument (remember your duck from #7?), they will always raise the specter of start-up, claiming that many of the deductions taken were paid or incurred before the business actually began, and are therefore NOT deductible. If no election was made, then you risk losing these deductions FOREVER!

12.2.3 Moral of the story: Make at least a protective election on the very first tax return where the new business first appears.

12.3 So how do you rebut the argument? When does a business actually begin? It is a facts and circumstances test, and as noted in 12.1 above, in some types of businesses it can be very challenging and complex.

12.3.1 In the situation where a business is purchased, this is a moot issue, as the business begins as of the date acquired;

12.3.2 But in situations where a business is created “from scratch”, this is a very likely issue for conflict. Moreover, this is an area that has been litigated heavily. Interestingly enough, an important case [Richmond Television vs. Commissioner, 345 F. 2d 901 (4^th Cir. 1965)] held that business could not begin until its license was obtained…

A. Great business guide book entitled: Up Your Cash Flow, by Harvey Goldstein. Actual citation: Goldstein, Up Your Cash Flow, 1992, Granville Publications.

B. Mr. Goldstein has taken this work several steps further and has developed a software product of the same name which does a comprehensive job of running cash flow projections/forecasts and budgets. Check it out at his company’s website at: www.cashplan.com

C. The IRS maintains a website which is also very good! It has a plethora of useful information, including all of the MSSP guides (see #9.1.2 above). The website is at: www.irs.gov.

D. Please feel free to check my own website periodically for articles, etc. which may be helpful. My website is at: www.cre8ivcpa.com.

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CONTENTS

“Doing the right things right”