Publication 583 (3/2006), Starting a Business and Keeping Records

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Pub. 583, Starting a Business and Keeping Records

2005 Tax Year

Publication 583 - Main Contents

Table of Contents

What New Business Owners Need To Know

As a new business owner, you need to know your federal tax responsibilities. Table 1, below, can help you learn what those responsibilities are. Ask yourself each question listed in the table, then see the related discussion to find the answer.

In addition to knowing about federal taxes, you need to make some basic business decisions. Ask yourself:

What are my financial resources?
What products and services will I sell?
How will I market my products and services?
How will I develop a strategic business plan?
How will I manage my business on a day-to-day basis?
How will I recruit employees?

The Small Business Administration (SBA) is a federal agency that can help you answer these types of questions. For information on how to contact the SBA, see page 26.

Forms of Business

The most common forms of business are the sole proprietorship, partnership, and corporation. When beginning a business, you must decide which form of business to use. Legal and tax considerations enter into this decision. Only tax considerations are discussed in this publication.

Your form of business determines which income tax return form you have to file. See Table 2 on page 6 to find out which form you have to file.

Sole proprietorships. A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. The business has no existence apart from you, the owner. Its liabilities are your personal liabilities. You undertake the risks of the business for all assets owned, whether or not used in the business. You include the income and expenses of the business on your personal tax return.

More information. For more information on sole proprietorships, see Publication 334, Tax Guide for Small Business. If you are a farmer, see Publication 225, Farmer's Tax Guide.

Partnerships. A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor, or skill, and expects to share in the profits and losses of the business.

A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership's items on his or her tax return.

More information. For more information on partnerships, see Publication 541, Partnerships.

Corporations. In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. A corporation can also take special deductions.

The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. However, shareholders cannot deduct any loss of the corporation.

More information. For more information on corporations, see Publication 542, Corporations.

S corporations. An eligible domestic corporation can avoid double taxation (once to the corporation and again to the shareholders) by electing to be treated as an S corporation. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss.

More information. For more information on S corporations, see the instructions for Form 2553, Election by a Small Business Corporation, and Form 1120S, U.S. Income Tax Return for an S Corporation.

Limited liability company. A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. None of the members of an LLC are personally liable for its debts. An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in regulations section 301.7701-3. For more information, see the instructions for Form 8832, Entity Classification Election.

Identification Numbers

You must have a taxpayer identification number so the IRS can process your returns. The two most common kinds of taxpayer identification numbers are the social security number (SSN) and the employer identification number (EIN).

An SSN is issued to individuals by the Social Security Administration (SSA) and is in the following format: 000-00-0000.
An EIN is issued to individuals (sole proprietors), partnerships, corporations, and other entities by the IRS and is in the following format: 00-0000000.

You must include your taxpayer identification number (SSN or EIN) on all returns and other documents you send to the IRS. You must also furnish your number to other persons who use your identification number on any returns or documents they send to the IRS. This includes returns or documents filed to report the following information.

Interest, dividends, royalties, etc., paid to you.
Any amount paid to you as a dependent care provider.
Certain other amounts paid to you that total $600 or more for the year.

If you do not furnish your identification number as required, you may be subject to penalties. See Penalties, later.

Employer Identification Number (EIN)

EINs are used to identify the tax accounts of employers, certain sole proprietors, corporations, partnerships, estates, trusts, and other entities.

If you don't already have an EIN, you need to get one if you:

Have employees,
Have a qualified retirement plan,
Operate your business as a corporation or partnership, or
File returns for:
1. Employment taxes, or
2. Excise taxes.

Applying for an EIN. You may apply for an EIN:

Online—Click on the EIN link at www.irs.gov/businesses/small. The EIN is issued immediately once the application information is validated.
By telephone at 1-800-829-4933 from 7:30 a.m. to 5:30 p.m. in the applicant's local time zone.
By mailing or faxing Form SS-4, Application for Employer Identification Number.

When to apply. You should apply for an EIN early enough to receive the number by the time you must file a return or statement or make a tax deposit. If you apply by mail, file Form SS-4 at least 4 to 5 weeks before you need an EIN. If you apply by telephone or through the IRS website, you can get an EIN immediately. If you apply by fax, you can get an EIN within 4 business days.

If you do not receive your EIN by the time a return is due, file your return anyway. Write “Applied for” and the date you applied for the number in the space for the EIN. Do not use your social security number as a substitute for an EIN on your tax returns.

More than one EIN. You should have only one EIN. If you have more than one EIN and are not sure which to use, contact the Internal Revenue Service Center where you file your return. Give the numbers you have, the name and address to which each was assigned, and the address of your main place of business. The IRS will tell you which number to use.

More information. For more information about EINs, see Publication 1635, Understanding Your EIN.

Payee's Identification Number

In the operation of a business, you will probably make certain payments you must report on information returns (discussed later under Information Returns). The forms used to report these payments must include the payee's identification number.

Employee. If you have employees, you must get an SSN from each of them. Record the name and SSN of each employee exactly as they are shown on the employee's social security card. If the employee's name is not correct as shown on the card, the employee should request a new card from the SSA. This may occur, for example, if the employee's name has changed due to marriage or divorce.

If your employee does not have an SSN, he or she should file Form SS-5, Application for a Social Security Card, with the SSA. This form is available at SSA offices or by calling 1-800-772-1213. It is also available from the SSA website at www.ssa.gov.

Other payee. If you make payments to someone who is not your employee and you must report the payments on an information return, get that person's SSN. If you make reportable payments to an organization, such as a corporation or partnership, you must get its EIN.

To get the payee's SSN or EIN, use Form W-9, Request for Taxpayer Identification Number and Certification. This form is available from IRS offices or by calling 1-800-829-3676. It is also available from the IRS website at www.irs.gov.

If the payee does not provide you with an identification number, you may have to withhold part of the payments as backup withholding. For information on backup withholding, see the Form W-9 instructions and the General Instructions for Forms 1099, 1098, 5498, and W-2G.

Tax Year

You must figure your taxable income and file an income tax return based on an annual accounting period called a tax year. A tax year is usually 12 consecutive months. There are two kinds of tax years.

Calendar tax year. A calendar tax year is 12 consecutive months beginning January 1 and ending December 31.
Fiscal tax year. A fiscal tax year is 12 consecutive months ending on the last day of any month except December. A 52-53-week tax year is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month.

If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, you must continue to use the calendar year unless you get IRS approval to change it or are otherwise allowed to change it without IRS approval.

You must use a calendar tax year if:

You keep no books.
You have no annual accounting period.
Your present tax year does not qualify as a fiscal year.
You are required to use a calendar year by a provision of the Internal Revenue Code or the Income Tax Regulations.

For more information, see Publication 538, Accounting Periods and Methods.

First-time filer. If you have never filed an income tax return, you adopt either a calendar tax year or a fiscal tax year. You adopt a tax year by filing your first income tax return using that tax year. You have not adopted a tax year if you merely did any of the following.

Filed an application for an extension of time to file an income tax return.
Filed an application for an employer identification number.
Paid estimated taxes for that tax year.

Changing your tax year. Once you have adopted your tax year, you may have to get IRS approval to change it. To get approval, you must file Form 1128, Application To Adopt, Change, or Retain a Tax Year. You may have to pay a fee. For more information, see Publication 538.

Accounting Method

An accounting method is a set of rules used to determine when and how income and expenses are reported. You choose an accounting method for your business when you file your first income tax return. There are two basic accounting methods.

Cash method. Under the cash method, you report income in the tax year you receive it. You usually deduct or capitalize expenses in the tax year you pay them.
Accrual method. Under an accrual method, you generally report income in the tax year you earn it, even though you may receive payment in a later year. You deduct or capitalize expenses in the tax year you incur them, whether or not you pay them that year.

For other methods, see Publication 538.

If you need inventories to show income correctly, you must generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for sale. Inventories are explained in Publication 538.

Certain small business taxpayers can use the cash method of accounting and can also account for inventoriable items as materials and supplies that are not incidental. For more information, see Publication 538.

You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income. In general, any accounting method that consistently uses accounting principles suitable for your trade or business clearly shows income. An accounting method clearly shows income only if it treats all items of gross income and expense the same from year to year.

More than one business. When you own more than one business, you can use a different accounting method for each business if the method you use for each clearly shows your income. You must keep a complete and separate set of books and records for each business.

Changing your method of accounting. Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in accounting method not only includes a change in your overall system of accounting, but also a change in the treatment of any material item. For examples of changes that require approval and information on how to get approval for the change, see Publication 538.

Business Taxes

The form of business you operate determines what taxes you must pay and how you pay them. The following are the four general kinds of business taxes.

Income tax.
Self-employment tax.
Employment taxes.
Excise taxes.

See Table 2 on page 6 for the forms you file to report these taxes.

You may want to get Publication 509. It has tax calendars that tell you when to file returns and make tax payments.

Income Tax

All businesses except partnerships must file an annual income tax return. Partnerships file an information return. Which form you use depends on how your business is organized. See Table 2 on page 6 to find out which return you have to file.

The federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. An employee usually has income tax withheld from his or her pay. If you do not pay your tax through withholding, or do not pay enough tax that way, you might have to pay estimated tax. If you are not required to make estimated tax payments, you may pay any tax due when you file your return.

Table 2. Which Forms Must I File?

IF you are a...	THEN you may be liable for...	Use Form...
Sole proprietor	Income tax	1040 and Schedule C ¹ or C-EZ (Schedule F ¹ for farm business)
	Self-employment tax	1040 and Schedule SE
	Estimated tax	1040-ES
	Employment taxes:
	• Social security and Medicare taxes and income tax withholding	941 (943 for farm employees)
	• Federal unemployment (FUTA) tax	940 or 940-EZ
	• Depositing employment taxes	8109 ²
	Excise taxes	See Excise Taxes
Partnership	Annual return of income	1065
	Employment taxes	Same as sole proprietor
	Excise taxes	See Excise Taxes
Partner in a partnership (individual)	Income tax	1040 and Schedule E ³
	Self-employment tax	1040 and Schedule SE
	Estimated tax	1040-ES
Corporation or S corporation	Income tax	1120 or 1120-A (corporation) ³ 1120S (S corporation) ³
	Estimated tax	1120-W (corporation only) and 8109 ²
	Employment taxes	Same as sole proprietor
	Excise taxes	See Excise Taxes
S corporation shareholder	Income tax	1040 and Schedule E ³
	Estimated tax	1040-ES

¹ File a separate schedule for each business.

² Do not use if you deposit taxes electronically.

³ Various other schedules may be needed.

Estimated tax. Generally, you must pay taxes on income, including self-employment tax (discussed next), by making regular payments of estimated tax during the year.

Sole proprietors, partners, and S corporation shareholders. You generally have to make estimated tax payments if you expect to owe tax of $1,000 or more when you file your return. Use Form 1040-ES, Estimated Tax for Individuals, to figure and pay your estimated tax. For more information, see Publication 505, Tax Withholding and Estimated Tax.

Corporations. You generally have to make estimated tax payments for your corporation if you expect it to owe tax of $500 or more when you file its return. Use Form 1120-W, Estimated Tax for Corporations, to figure the estimated tax. You must deposit the payments as explained on page 8 under Depositing Taxes. For more information, see Publication 542.

Self-Employment Tax

Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. Your payments of SE tax contribute to your coverage under the social security system. Social security coverage provides you with retirement benefits, disability benefits, survivor benefits, and hospital insurance (Medicare) benefits.

You must pay SE tax and file Schedule SE (Form 1040) if either of the following applies.

Your net earnings from self-employment were $400 or more.
You had church employee income of $108.28 or more.

Use Schedule SE (Form 1040) to figure your SE tax. For more information, see Publication 533, Self-Employment Tax.

You can deduct one-half of your SE tax as an adjustment to income on your Form 1040.

The Social Security Administration (SSA) time limit for posting self-employment income. Generally, the SSA will give you credit only for self-employment income reported on a tax return filed within 3 years, 3 months, and 15 days after the tax year you earned the income. If you file your tax return or report a change in your self-employment income after this time limit, the SSA may change its records, but only to remove or reduce the amount. The SSA will not change its records to increase your self-employment income.

Employment Taxes

This section briefly discusses the employment taxes you must pay, the forms you must file to report them, and other forms that must be filed when you have employees.

Employment taxes include the following.

Social security and Medicare taxes.
Federal income tax withholding.
Federal unemployment (FUTA) tax.

If you have employees, you will need to get Publication 15, Circular E, Employer's Tax Guide. If you have agricultural employees, get Publication 51, Circular A, Agricultural Employer's Tax Guide. These publications explain your tax responsibilities as an employer.

If you are not sure whether the people working for you are your employees, see Publication 15-A, Employer's Supplemental Tax Guide.That publication has information to help you determine whether an individual is an employee or an independent contractor. If you classify an employee as an independent contractor, you can be held liable for employment taxes for that worker plus a penalty. An independent contractor is someone who is self-employed. Generally, you do not have to withhold or pay any taxes on payments to an independent contractor.

Federal Income, Social Security, and Medicare Taxes

You generally must withhold federal income tax from your employee's wages. To figure how much federal income tax to withhold from each wage payment, use the employee's Form W-4 (discussed later under Hiring Employees) and the methods described in Publication 15.

Social security and Medicare taxes pay for benefits that workers and their families receive under the Federal Insurance Contributions Act (FICA). Social security tax pays for benefits under the old-age, survivors, and disability insurance part of FICA. Medicare tax pays for benefits under the hospital insurance part of FICA. You withhold part of these taxes from your employee's wages and you pay a matching amount yourself. To find out how much social security and Medicare tax to withhold and to pay, see Publication 15.

Which form do I file? Report these taxes on Form 941, Employer's Quarterly Federal Tax Return. (Farm employers use Form 943, Employer's Annual Federal Tax Return for Agricultural Employees.)

Federal Unemployment (FUTA) Tax

The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. You report and pay FUTA tax separately from social security and Medicare taxes and withheld income tax. You pay FUTA tax only from your own funds. Employees do not pay this tax or have it withheld from their pay.

Which form do I file? Report federal unemployment tax on Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return. Or, if you qualify, you can use the simpler Form 940-EZ instead. See Publication 15 to find out if you can use this form.

Hiring Employees

Have the employees you hire fill out Form I-9 and Form W-4. If your employees qualify for and want to receive advanced earned income credit payments, they must give you a completed Form W-5.

Form I-9. You must verify that each new employee is legally eligible to work in the United States. Both you and the employee must complete the U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification. You can get the form from USCIS offices or from the USCIS website at http://uscis.gov. Call the USCIS at 1-800-375-5283 for more information about your responsibilities.

Form W-4. Each employee must fill out Form W-4, Employee's Withholding Allowance Certificate. You will use the filing status and withholding allowances shown on this form to figure the amount of income tax to withhold from your employee's wages.

In certain circumstances, you may be required to send a copy of an employee's Form W-4 to the IRS. If you have an employee who submits a Form W-4 claiming more than 10 withholding allowances, or claiming an exemption from withholding when the employee's wages are normally more that $200 a week, see Publication 15.

Form W-5. An eligible employee who has a qualifying child is entitled to receive advance earned income credit (EIC) payments with his or her pay during the year. To get these payments, the employee must give you a properly completed Form W-5, Earned Income Credit Advance Payment Certificate. You are required to make advance EIC payments to employees who give you a completed and signed Form W-5. For more information, see Publication 15.

Form W-2 Wage Reporting

After the calendar year is over, you must furnish copies of Form W-2, Wage and Tax Statement, to each employee to whom you paid wages during the year. You must also send copies to the Social Security Administration. See Information Returns, later, for more information on Form W-2.

Excise Taxes

This section describes the excise taxes you may have to pay and the forms you have to file if you do any of the following.

Manufacture or sell certain products.
Operate certain kinds of businesses.
Use various kinds of equipment, facilities, or products.
Receive payment for certain services.

For more information on excise taxes, see Publication 510.

Form 720. The federal excise taxes reported on Form 720, Quarterly Federal Excise Tax Return, consist of several broad categories of taxes, including the following.

Environmental taxes.
Communications and air transportation taxes.
Fuel taxes.
Tax on the first retail sale of heavy trucks, trailers, and tractors.
Manufacturers taxes on the sale or use of a variety of different articles.

Form 2290. There is a federal excise tax on certain trucks, truck tractors, and buses used on public highways. The tax applies to vehicles having a taxable gross weight of 55,000 pounds or more. Report the tax on Form 2290, Heavy Highway Vehicle Use Tax Return. For more information, see the instructions for Form 2290.

Form 730. If you are in the business of accepting wagers or conducting a wagering pool or lottery, you may be liable for the federal excise tax on wagering. Use Form 730, Monthly Tax Return for Wagers, to figure the tax on the wagers you receive.

Form 11-C. Use Form 11-C, Occupational Tax and Registration Return for Wagering, to register for any wagering activity and to pay the federal occupational tax on wagering.

Depositing Taxes

You generally have to deposit employment taxes, certain excise taxes, corporate income tax, and S corporation taxes before you file your return.

Electronic deposit of taxes. Generally, taxpayers whose total deposits of social security and Medicare taxes and withheld income tax during previous years exceeded certain amounts are required to deposit taxes through the Electronic Federal Tax Payment System (EFTPS).

Starting in January 2004, any business that has a federal tax obligation and requests a new EIN will automatically be enrolled in EFTPS. Through the mail, the business will receive an EFTPS PIN package that contains instructions for activating its EFTPS enrollment.

If a business is not required to use EFTPS, it can make deposits with an authorized financial institution. These deposits must be accompanied by a deposit coupon. See Deposit coupons, later.

Taxpayers not required to make deposits by EFTPS may enroll in the system, which will allow tax deposits without coupons, paper checks, or visits to an authorized depositary. For more information, see Publication 15.

Making deposits with coupons. Mail or deliver deposits with completed deposit coupons to an authorized financial institution unless you make the deposits electronically, as discussed earlier.

Generally, a mailed deposit will be considered timely if the taxpayer establishes that it was mailed in the United States at least 2 days before the due date. You may be charged a penalty for not making deposits when due, unless you have reasonable cause. See Penalties, later.

To help ensure proper crediting of your account, include the following on your check or money order.

Your EIN.
Type of tax.
Tax period for the payment.

Deposit coupons. Use Form 8109, Federal Tax Deposit Coupon, to deposit taxes. On each coupon, you must show the deposit amount, the type of tax, the period for which you are making a deposit, and your telephone number. Use a separate coupon for each tax and period. You must include a coupon with each deposit you make.

If you apply for a new EIN and have a federal tax obligation, you will be mailed one deposit coupon. If you want to order a coupon book, call 1-800-829-4933. You should receive the coupon book within 4 to 6 weeks of ordering.

If you have a deposit due and there is not enough time to obtain a coupon book, you can get a blank coupon (Form 8109-B) by calling 1-800-829-4933.

If you have not received your EIN and must make a deposit, mail your payment with an explanation to the Internal Revenue Service Center where you file your return. Make your check or money order payable to the United States Treasury. On the payment, write your name (exactly as shown on Form SS-4), your address, the kind of tax, the period covered, and the date you applied for an EIN. Do not use Form 8109-B in this situation.

Information Returns

If you make or receive payments in your business, you may have to report them to the IRS on information returns. The IRS compares the payments shown on the information returns with each person's income tax return to see if the payments were included in income. You must give a copy of each information return you are required to file to the recipient or payer. In addition to the forms described below, you may have to use other returns to report certain kinds of payments or transactions. For more details on information returns and when you have to file them, see the General Instructions for Forms 1099, 1098, 5498, and W-2G.

Form 1099-MISC. Use Form 1099-MISC, Miscellaneous Income, to report certain payments you make in your trade or business. These payments include the following items.

Payments of $600 or more for services performed for your business by people not treated as your employees, such as subcontractors, attorneys, accountants, or directors.
Rent payments of $600 or more, other than rents paid to real estate agents.
Prizes and awards of $600 or more that are not for services, such as winnings on TV or radio shows.
Royalty payments of $10 or more.
Payments to certain crew members by operators of fishing boats.

You also use Form 1099-MISC to report your sales of $5,000 or more of consumer goods to a person for resale anywhere other than in a permanent retail establishment.

Form W-2. You must file Form W-2, Wage and Tax Statement, to report payments to your employees, such as wages, tips, and other compensation, withheld income, social security, and Medicare taxes, and advance earned income credit payments. For more information on what to report on Form W-2, see the Instructions for Forms W-2 and W-3.

Form 8300. You must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, if you receive more than $10,000 in cash in one transaction or two or more related business transactions. Cash includes U.S. and foreign coin and currency. It also includes certain monetary instruments such as cashier's and traveler's checks and money orders. For more information, see Publication 1544, Reporting Cash Payments of Over $10,000 (Received in a Trade or Business).

Penalties

The law provides penalties for not filing returns or paying taxes as required. Criminal penalties may be imposed for willful failure to file, tax evasion, or making a false statement.

Failure to file tax returns. If you do not file your tax return by the due date, you may have to pay a penalty. The penalty is based on the tax not paid by the due date. See your tax return instructions for more information about this penalty.

Failure to pay tax. If you do not pay your taxes by the due date, you will have to pay a penalty for each month, or part of a month, that your taxes are not paid. For more information, see your tax return instructions.

Failure to withhold, deposit, or pay taxes. If you do not withhold income, social security, or Medicare taxes from employees, or if you withhold taxes but do not deposit them or pay them to the IRS, you may be subject to a penalty of the unpaid tax, plus interest. You may also be subject to penalties if you deposit the taxes late. For more information, see Publication 15.

Failure to follow information reporting requirements. The following penalties apply if you are required to file information returns. For more information, see the General Instructions for Forms 1099, 1098, 5498, and W-2G.

Failure to file information returns. A penalty applies if you do not file information returns by the due date, if you do not include all required information, or if you report incorrect information.
Failure to furnish correct payee statements. A penalty applies if you do not furnish a required statement to a payee by the required date, if you do not include all required information, or if you report incorrect information.

Waiver of penalty. These penalties will not apply if you can show that the failures were due to reasonable cause and not willful neglect.

In addition, there is no penalty for failure to include all the required information, or for including incorrect information, on a de minimis number of information returns if you correct the errors by August 1 of the year the returns are due. (To be considered de minimis, the number of returns cannot exceed the greater of 10 or ½ of 1% of the total number of returns you are required to file for the year.)

Failure to supply taxpayer identification number. If you do not include your taxpayer identification number (SSN or EIN) or the taxpayer identification number of another person where required on a return, statement, or other document, you may be subject to a penalty of $50 for each failure. You may also be subject to the $50 penalty if you do not give your taxpayer identification number to another person when it is required on a return, statement, or other document.

Business Expenses

You can deduct business expenses on your income tax return. These are the current operating costs of running your business. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business, trade, or profession. A necessary expense is one that is helpful and appropriate for your business, trade, or profession. An expense does not have to be indispensable to be considered necessary.

The following are brief explanations of some expenses that are of interest to people starting a business. There are many other expenses that you may be able to deduct. See your form instructions and Publication 535, Business Expenses.

Business Start-Up Costs

Business start-up costs are the expenses you incur before you actually begin business operations. Your business start-up costs will depend on the type of business you are starting. They may include costs for advertising, travel, surveys, and training. These costs are generally capital expenses.

You usually recover costs for a particular asset (such as machinery or office equipment) through depreciation (discussed next). You can elect to deduct up to $5,000 of business start-up costs and $5,000 of organizational costs paid or incurred after October 22, 2004. The $5,000 deduction is reduced by the amount your total start-up or organizational costs exceed $50,000. Any remaining cost must be amortized.

For more information about amortizing start-up and organizational costs, see chapter 9 in Publication 535.

Depreciation

If property you acquire to use in your business has a useful life that extends substantially beyond the year it is placed in service, you generally cannot deduct the entire cost as a business expense in the year you acquire it. You must spread the cost over more than one tax year and deduct part of it each year. This method of deducting the cost of business property is called depreciation.

Business property you must depreciate includes the following items.

Office furniture.
Buildings.
Machinery and equipment.

You can choose to deduct a limited amount of the cost of certain depreciable property in the year you place the property in service. This deduction is known as the “section 179 deduction.” You can take a special depreciation allowance for certain property you acquire and place in service before January 1, 2005. For more information about depreciation, the section 179 deduction, and the special depreciation allowance, see Publication 946, How To Depreciate Property.

Depreciation must be taken in the year it is allowable. Allowable depreciation not taken in a prior year cannot be taken in the current year. If you do not deduct the correct depreciation, you may be able to make a correction by filing Form 1040X, Amended U.S. Individual Income Tax Return, or by changing your accounting method. For more information on how to correct an incorrect depreciation deduction, see chapter 1 in Publication 946.

Business Use of Your Home

To deduct expenses related to the business use of part of your home, you must meet specific requirements. Even then, your deduction may be limited.

To qualify to claim expenses for business use of your home, you must meet both the following tests.

Your use of the business part of your home must be:
1. Exclusive (however, see Exceptions to exclusive use, later),
2. Regular,
3. For your trade or business, AND
The business part of your home must be one of the following:
1. Your principal place of business (defined later),
2. A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business, or
3. A separate structure (not attached to your home) you use in connection with your trade or business.

Exclusive use. To qualify under the exclusive use test, you must use a specific area of your home only for your trade or business. The area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition.

You do not meet the requirements of the exclusive use test if you use the area in question both for business and for personal purposes.

Exceptions to exclusive use. You do not have to meet the exclusive use test if either of the following applies.

You use part of your home for the storage of inventory or product samples.
You use part of your home as a daycare facility.

For an explanation of these exceptions, see Publication 587, Business Use of Your Home (Including Use by Daycare Providers).

Principal place of business. Your home office will qualify as your principal place of business for deducting expenses for its use if you meet the following requirements.

You use it exclusively and regularly for administrative or management activities of your trade or business.
You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

Alternatively, if you use your home exclusively and regularly for your business, but your home office does not qualify as your principal place of business based on the previous rules, you determine your principal place of business based on the following factors.

The relative importance of the activities performed at each location.
If the relative importance factor does not determine your principal place of business, the time spent at each location.

If, after considering your business locations, your home cannot be identified as your principal place of business, you cannot deduct home office expenses. However, for other ways to qualify to deduct home office expenses, see Publication 587.

Which form do I file? If you file Schedule C (Form 1040), use Form 8829, Expenses for Business Use of Your Home, to figure your deduction. If you file Schedule F (Form 1040) or you are a partner, you can use the worksheet in Publication 587.

More information. For more information about business use of your home, see Publication 587.

Car and Truck Expenses

If you use your car or truck in your business, you can deduct the costs of operating and maintaining it. You generally can deduct either your actual expenses or the standard mileage rate.

Actual expenses. If you deduct actual expenses, you can deduct the cost of the following items:

Depreciation	Lease payments	Registration
Garage rent	Licenses	Repairs
Gas	Oil	Tires
Insurance	Parking fees	Tolls

If you use your vehicle for both business and personal purposes, you must divide your expenses between business and personal use. You can divide your expenses based on the miles driven for each purpose.

Example.

You are the sole proprietor of a flower shop. You drove your van 20,000 miles during the year. 16,000 miles were for delivering flowers to customers and 4,000 miles were for personal use. You can claim only 80% (16,000 ÷ 20,000) of the cost of operating your van as a business expense.

Standard mileage rate. Instead of figuring actual expenses, you may be able to use the standard mileage rate to figure the deductible costs of operating your car, van, pickup, or panel truck for business purposes. You can use the standard mileage rate for a vehicle you own or lease. The standard mileage rate is a specified amount of money you can deduct for each business mile you drive. It is announced annually by the IRS. To figure your deduction, multiply your business miles by the standard mileage rate for the year.

Generally, if you use the standard mileage rate, you cannot deduct your actual expenses. However, you may be able to deduct business-related parking fees, tolls, interest on your car loan, and certain state and local taxes.

Choosing the standard mileage rate. If you want to use the standard mileage rate for a car you own, you must choose to use it in the first year the car is available for use in your business. In later years, you can choose to use either the standard mileage rate or actual expenses.

If you use the standard mileage rate for a car you lease, you must choose to use it for the entire lease period (including renewals).

Additional information. For more information about the rules for claiming car and truck expenses, see Publication 463, Travel, Entertainment, Gift, and Car Expenses.

Recordkeeping

This part explains why you must keep records, what kinds of records you must keep, and how to keep them. It also explains how long you must keep your records for federal tax purposes. A sample recordkeeping system is illustrated at the end of this part.

Why Keep Records?

Everyone in business must keep records. Good records will help you do the following.

Monitor the progress of your business. You need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make. Good records can increase the likelihood of business success.

Prepare your financial statements. You need good records to prepare accurate financial statements. These include income (profit and loss) statements and balance sheets. These statements can help you in dealing with your bank or creditors and help you manage your business.

An income statement shows the income and expenses of the business for a given period of time.
A balance sheet shows the assets, liabilities, and your equity in the business on a given date.

Identify source of receipts. You will receive money or property from many sources. Your records can identify the source of your receipts. You need this information to separate business from nonbusiness receipts and taxable from nontaxable income.

Keep track of deductible expenses. You may forget expenses when you prepare your tax return unless you record them when they occur.

Prepare your tax returns.