12 tax mistakes to avoid with a side business
By Dana Dratch • Bankrate.com

If you have a side business, you're probably focused almost solely on income. But you also need to think about income tax.

A mistake in telling the Internal Revenue Service about your entrepreneurial effort could erase much of your second job's financial advantage.

Here are a dozen tax missteps that a sideline business owner needs to avoid:

1. Missing legitimate deductions.
One often-overlooked tax break, says Barry Picker, CPA and author of "Barry Picker's Guide to Retirement Distribution Planning," is business use of your telephone. You can deduct any calls you make for business, plus any special features, such as call waiting, that you add for the benefit of your business, he says.

Are you subscribing to publications that relate to your sideline business? Those subscriptions are also deductible, Picker says.

"I think that people miss some of the obvious ones," says Stuart H. Sorkin, a tax attorney with Frank & Associates PC, a Bethesda, Md.-based law firm.

A big one is mileage. "People may not think that it's worth tracking," he says. But it really adds up, especially over a year.

Tax experts recommend you keep a notebook in your car and note the mileage every time you travel for your side business.

And don't forget the home-office deduction. You have to meet some specific criteria, says Picker. But if you pass the test, you can take a nice deduction.

2. Neglecting your retirement fund.
"If you have a side business, make sure you maximize your retirement contributions," says Picker. "You get a tax deduction, and it builds your retirement fund."

Not integrating a second income into retirement planning "is the biggest mistake people make," says Ed Slott, CPA and author of Ed Slott's IRA Advisor, a monthly IRA newsletter.

But it's a mistake made deliberately by many.

"Usually the reason you're making outside income is because you need the money," says Chris Farrell, author of Right on the Money: Taking Control of Your Personal Finances. And although self-employed retirement accounts are "a great tax shelter," the short-term cash need usually wins.

If you can spare some sideline income to invest toward your retirement, one of the easiest options is a simplified employee pension (SEP). "There are no extra administration fees," says Farrell, who is also economics editor at SmartMoney. "It's really designed for this kind of situation."

If your side business is incorporated, you can put away up to 25 percent of the wages you pay yourself in a SEP. If you're not incorporated, then you can bank up to 20 percent of your business's net income.

3. Incorporating your business too soon.
"Some guys take the cart before the horse," says Slott. "They go to a seminar, have a corporation and they don't even have clients.

"Just having a corporation in itself doesn't save you taxes. The only reason to have a corporation right off the bat is if you have liability issues."

If you want to shield yourself from many liability issues without having to file a separate return for the business, consider forming a limited liability company, says Sorkin.

"The concept is that it provides a separate entity for tort liability," he says. "And, once you build up the business sufficiently, you might not need a personal guarantee on corporate debt if you want to go out and borrow money."

4. Deducting your day job expenses.
In a word, don't. Besides being illegal, you're more likely to show a loss on your side business and that could trigger an audit, says Picker.

"The IRS looks for people who are wage earners and are consistently showing losses on a side business," he says.

5. Mixing business and personal funds.
"It's hard to pull them apart," says Slott, but co-mingling your money is a big mistake. If you're ever audited, either on the business or personal side, the examination will likely expand to include both, he notes.

Instead, open a separate bank account for business checks and to pay business expenses. "And show the IRS that you don't co-mingle your funds," he says.

Worried about paying an extra fee for another account? Use Bankrate to find a free or low-cost checking program. (Make sure to search for noninterest checking accounts; interest-bearing ones have fees attached.) Or apply to a local credit union.