I want to start my own small business. What do I have to do to keep out of trouble with the IRS?

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": record keeping, record keeping, and (you guessed it) record keeping. IRS studies show that poor records -- not dishonesty - - cause most small business people to fail to comply with their tax reporting obligations and to lose at audits, with resulting fines and penalties.

Even if you hire someone to keep your records, you need to know how to supervise him or her -- because if your bookkeeper goofs up, you are 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 (and small businesses are about three times more likely to be audited than individuals), the IRS is most likely to zero in on business deductions for car expenses and travel and entertainment 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 who is familiar with small business record keeping.

What is -- and isn't -- a tax-deductible business expense?

Just about any "ordinary, necessary, and reasonable" expense that helps you earn business income is deductible. What's ordinary and necessary? The IRS has defined this as anything that's "helpful and appropriate" for your business. For example, buying a computer, or even a sound system, for your office or store can be an "ordinary and necessary" business expense. Buying the same items for your family room cannot be a business expense, however.

A few things are specifically prohibited by law from being deducted even if the expenses are for the purpose of conducting business -- 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.

If I use my car for business, how much of that expense can I write off?

You can calculate your vehicle deduction using the standard mileage method or the actual expense method. The standard mileage method is more commonly used because the record-keeping requirements are much simpler. Under this method, the IRS determines the amount you can deduct per mile. (For the tax year 2006, the rate is 44.5 cents per mile; from 1/1/05 to 8/31/05, the rate was 40.5 cents per mile; and from 9/1/05 to 12/31/05, the rate was 48.5 per mile.)

Under the actual expense method, you deduct the actual costs you incur each year to operate your car, plus depreciation you pay for gas and repairs (according to a tax code schedule). Your deductible costs include gas and oil, repairs and maintenance, license fees, insurance, tolls, and even car washing. If you use the car partly for personal use, you must multiply your actual expenses by your percentage of business use.

Most people use the standard mileage rate because they don't want to bother with a lot of record keeping. But this ease comes at a price -- you usually get a lower deduction using the standard mileage rate than you would with the actual expense method. You must use the standard mileage rate, however, if you claimed certain related deductions (such as under Section 179 of the IRC) in previous years.

To use either of these methods, you must keep track of how much you use your car for business. (And you'll need to produce your records if you are audited.) Keep a log showing the miles for each business use, always noting the purpose of trip.

You can also depreciate (write off) the cost of the vehicle over a number of years.

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