I want to start my own small business. What do I have to do to keep out of trouble with the IRS?
Start by learning a new set of '3 Rs' -- recordkeeping, recordkeeping and (you guessed it) recordkeeping. IRS studies show that poor records, not dishonesty, cause most small-business people to lose at audits or fail to comply with their tax reporting obligations, with resulting fines and penalties. Even if you hire someone to keep your records, you need to know how to supervise him -- because if he goofs up, you are the one held responsible. Consider using a computer to keep your records if you aren't already in the electronic age.

Keep all receipts and canceled checks for business expenses, and keep them organized and in a safe place. Separate the documents by category, such as:

  • auto expenses
  • rent
  • utilities
  • advertising
  • travel
  • entertainment, and
  • professional fees.

Put your documents into individual folders or envelopes. If you are ever audited, the IRS is most likely to zero in on business deductions for travel and entertainment and car expenses. Furthermore, the burden will be on you -- not the IRS -- to substantiate your deductions. If you're unsure how to get started or what documents you need to keep, consult a tax professional familiar with small business recordkeeping.

I have been operating my own business for several years, but I'm still often confused as to what is -- and isn't -- a tax-deductible business expense. Can you help me?
Just about any "ordinary, necessary and reasonable" expense that helps you earn business income is deductible. This term reflects the purpose for which the expense is made. For example, buying a computer, or even a sound system, for your office or store is an "ordinary and necessary" business expense, but buying the same items for your family room obviously isn't. In the latter case, the computer and stereo would be non-deductible personal expenses. The property must be used in a "trade or business," which means it is used with the expectation of generating income.

In addition to the "ordinary and necessary" rule, a few things are specifically prohibited by law from being deducted -- for instance, a bribe paid to a public official. Other deduction no-nos are traffic tickets, your home telephone line and clothing you wear on the job, unless it is a required uniform. As a rule, if you think it is necessary for your business, it is probably deductible. Just be ready to explain it to an auditor.

If I use my car for business, how much of that expense can I write off?
You must keep track of how much you use your car for business in order to figure out your deduction. (You'll also need to produce your records if you are audited.) Start by keeping a log showing the miles for each business use,always noting the purpose of the trip. At the end of the year, figure your deduction by using either the "mileage" method (you deduct a certain dollar amount, 34.5 cents for each business-related mile you drive in 2001) or the "actual expense" method (you can deduct the total you pay for gas, repairs, plus depreciation -- according to a tax code schedule -- multiplied by the percentage of business use). Figure it both ways and take the method that benefits you more.

Can I claim a deduction for business-related entertainment?
You may deduct only 50% of expenses for entertaining clients or customers, no matter how many martinis or Perriers you swigged. (Yes, this is a change. In the old days you could write off 100% of every entertainment expense, and until a few years ago, 80%.) Qualified business entertainment includes taking a client to a ball game, a concert or dinner at a fancy restaurant, or just inviting a few of your customers over for a Sunday barbecue at your home.

Parties, picnics and other social events you put on for your employees and their families are an exception to the 50% rule -- such events are 100% deductible. Keep in mind that if you are audited, you must be able to show some proof that the expense was either directly related to, or associated with business. So, keep a guest list and note the business (or potential) relationship of each person entertained.

I've heard that you can deduct 100% of some types of business supplies and equipment in the year they are purchased, but that you must deduct the purchase price of others over several years. Is this true?
Current expenses, which include the everyday costs of keeping your business going, such as office supplies, rent and electricity, can be deducted from your business's total income in the year you incurred them. But expenditures for things that will generate revenue in future years -- a desk, copier or car, for example -- must be written off over their useful life. Usually that period is three, five or seven years, according to IRS rules. There is one important exception to this rule, discussed next.