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Important Caveats

How many of you still aren't breathing because that word audit was mentioned a few paragraphs ago? Relax. You can take steps to minimize your chances of an audit and to minimize the pain such an audit would otherwise cause. Making sure that you have proof, as discussed earlier, is just one way of protecting your home business deduction. But there are some other ways:

  • Hire a good accountant. As you may have realized, taxes can be complex for a home business, particularly if you're a homeowner. The more complex your taxes, the more you should consider hiring a good accountant, whose full-time job is to make his or her way through the intricate web known as the tax code. In addition to her own CPA work, Forman says, "I spend more than 80 hours a year in classes." Think about it—Forman is already well-versed in "everything taxes," and yet she spends at least an additional two weeks a year learning the latest tax law changes and implications of tax-related decisions.

  • Drop the idea that your taxes are just like everyone else's. Our current tax laws are quite nuanced, so the chances are very unlikely that your Uncle Eddie's home-repair shop has all of the same tax issues as your own home-based graphic-design studio. Even if you and your uncle were in the same business, such issues as who owns your home, how it's owned, marital status, family structure, and whether anyone else in your household participates in your business will all have an impact on your taxes.

  • Sorry, TurboTax may not be for you. Just as I encouraged you to let go of the 1040EZ, consider dropping canned tax-preparation software, which can cause your return to be flagged for an audit if you also have a fairly complex return (such as one involving a home business). Why? Forman explains, "Many people don't understand the tax law well enough to use the program correctly." The IRS is aware of this problem, and looks closely at very complex, involved returns done with software usually meant to handle more standard returns.

  • Understand the difference between capitalizing and expensing. Simply put, capitalizing means considering the cost as a long-term investment, as opposed to a short-term expense. For instance, your home isn't written off as a one-time expense, but is considered a capital investment. Forman says that business owners sometimes expense items they should be capitalizing, drawing questions from the IRS. "For example, they may take a franchise fee of $20,000 and try to expense it. That should be capitalized," she explains.

  • Acknowledge that the IRS knows when something looks odd. Forman comments, "The IRS will flag a return if something is out of whack or unusual. If 50% of your home is claimed as a home office, that might flag the return." That doesn't mean there aren't instances in which 50% of a home is used as a home office—but if you fall into that category, keep excellent records. And if you don't fall into that category, don't be greedy.

  • Don't fall for the too-good deal. You've probably seen the ads: Deduct your entire vacation, your kids' school supplies, your weekly groceries, and so on. Don't believe it, and don't base your tax return on such bogus advice. "There's a lot of abusive stuff out there, and the IRS shuts them down all the time," Forman explains. Vacations are usually not considered a legitimate business expense, for instance. "If you're taking a class while on vacation, keep track of how long you were in class as opposed to vacationing with your family" There may be some portion you can deduct.

  • Remember that your accountant is not a lawyer. "Our confidentiality is very limited and is only in terms of tax advice," Forman says. So if your tax issues are going to raise legal questions, such as the appearance of money laundering or insider trading, head right for an attorney. (Or better yet, stick to honest work.)

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