TAX STRATEGIES FOR THE SMALL BUSINESS OWNER

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TAX STRATEGIES FOR THE SMALL

USINESS OWNER

Reduce Your Taxes and Fatten Your Profits

Most small business owners would rather avoid thinking about taxes and get on with selling

goods and services. But guess what? The more you know about tax regulations, the fatter your

bottom line. And the more knowledge you have, the easier it is to open a letter from the IRS

without breaking into a sweat.

Tax Strategies for the Small Business Owner: Reduce Your Taxes and Fatten Your Profits is

designed to help entrepreneurs and small business owners manage taxes efficiently and maxi-

mize profits. As Enrolled Agent and tax expert Russell Fox shows you, taxes for the most part

follow commonsense rules. You just need to know what they are and how they affect your deci-

sions. That makes it much easier to make good tax-related decisions from the day you start the

business to the day you sell it: Should I lease or buy? Should I hire an employee or outsource

the task? How much will buying a building reduce my taxes and for how long? Should I change

the company structure to an LLC?

Fox explains the different business structures you can choose from, the taxes you must

learn to manage, documentation procedures, how to work with a tax professional, how to han-

dle an audit, and, in general, how to use the U.S. Tax Code to your advantage. Besides show-

ing you how to take full advantage of tax benefits, Fox helps you avoid potholes hidden in

startup and ongoing expenses, depreciation, payroll, and retirement plans, among others. Tax

Strategies for the Small Business Owner will:

• Show you how to choose a structure that’s right for your business

• Clarify the requirements for deducting expenses

• Help you fund your retirement with help from the business

• Explain how depreciation rules allow you to reduce taxable income

• Illustrate how to take the tax implications into account when making strategic

business decisions

• Tell you exactly what to do when you hear from the IRS

• Help you determine whether you need a tax professional to assist you

In short, Tax Strategies for the Small Business Owner will show you how to pay less in taxes—

legally.

9781430 248422

52499

ISBN 978-1-4302-4842-2

For your convenience Apress has placed some of the front

matter material after the index. Please use the Bookmarks

and Contents at a Glance links to access them.

Contents

About the Author ..........................................................................................vii

Acknowledgments...........................................................................................ix

Introduction .....................................................................................................xi

Part I Before the Business Opens ................................................................1

Chapter 1: The Business Entity ......................................................................................... 3

Chapter 2: An Overview of Taxation ............................................................................ 19

Chapter 3: Before Your Business Opens ....................................................................... 33

Part II Day-to-Day Expenses ......................................................................45

Chapter 4: The Basics of Expenses ................................................................................ 47

Chapter 5: Cost of Goods Sold ...................................................................................... 53

Chapter 6: The Office ....................................................................................................... 63

Chapter 7: The Car ............................................................................................................ 75

Chapter 8: Travel ................................................................................................................ 85

Chapter 9: Meals and Entertainment ............................................................................. 93

Chapter 10: Fixed Assets and Depreciation ................................................................. 105

Part III Employees, Payroll Taxes, and Benefit Plans .............................123

Chapter 11: Other Deductions ....................................................................................... 125

Chapter 12: Employees and Wages ................................................................................145

Chapter 13: Payroll Taxes .................................................................................................163

Chapter 14: Medical Expenses .........................................................................................179

Chapter 15: Retirement Plans .......................................................................................... 189

Part IV Other Items ..................................................................................201

Chapter 16: Other Taxes ..................................................................................................203

Chapter 17: Dear Valued Taxpayer: When You Hear from the IRS .......................217

Chapter 18: Other Topics.................................................................................................235

Index ..............................................................................................................255

Introduction

When I was just out of college, my father gave me Charles Adams’s classic

book on the history of taxes, For Good and Evil: The Impact of Taxes on the

Course of Civilization.

Since then, I’ve been fascinated with taxes and am

something of a tax nerd. As one of my clients said to me, “We’re glad someone

enjoys taxes.”

That’s not really accurate. I like working in tax, but I don’t know anyone who

truly enjoys paying taxes. I suspect we would all like to pay less. Meanwhile,

many Americans are facing the specter of tax increases on the federal, state,

and local levels.

That’s where this book comes in. This is a commonsense, practical guide to

taxes for the small business owner. The goal of the book to give small business

owners an understanding of what he or she needs to think about regarding

taxes—from when the business is formed to when it is sold.

The book is divided into four parts. “Before the Business Opens” focuses on

the types of business entities (and how they are taxed), the taxes a small

business owner faces, and the start-up phase and record-keeping requirements.

“Day-to-Day Expenses” looks at deductions you can take and what’s required

to take them. The third part, “Payroll, Payroll Taxes, and Benefit Plans,” looks at

paying yourself and employees, payroll taxes you must pay, retirement plans,

and medical expenses (with a focus on the new Affordable Care Act). The final

part, “Other Items,” reviews the documentation you generally need for taxes

besides the federal income tax, what to do when a tax agency contacts you,

and other topics (including electronic filing, foreign issues, using a tax

professional, and selling your business).

I tell my clients that tax is a combination of common sense and arcane rules.

I’ve tried to keep the minutiae of the rules, regulations, and laws to a minimum

in this text. I hope this book will set you on the course of paying the least

amount of tax you legally can.

Charles Adams, For Good and Evil: The Impact of Taxes on the Course of Civilization (2nd

Edition), (Toronto: Madison Books, 2001).

PART

Before the

Business Opens

There are several different types of business entities for a small business

owner to choose among, including sole proprietorships, partnerships,

corporations (both C and S), and limited liability companies. This is perhaps

the most critical decision a business makes, and Part I begins by exploring this

important area.

Chapter 2 looks at the types of taxes a small business owner must pay, the

definitions of income and expenses, and cash versus accrual accounting. The

last chapter in Part 1 covers the rules of the start-up phase: that part of the

business before you receive any revenue. The final part of Chapter 3 examines

the recordkeeping requirements of a small business in dealing with tax

agencies.

CHAPTER

The Business

Entity

The business of America is business.

—President Calvin Coolidge

You’ve been in business or you’re just starting out. You’ve picked up this book

because you’re wondering how to deal with taxes. You might expect the book

to start by looking at taxes; however, we won’t look directly at them at all in

this first chapter. That’s because the most important decision a business

owner can make is about the structure of the business.

You may have been told, “The best structure for a business is an LLC.” Perhaps

your buddy told you he has an S corporation, and it works great. If you

choose your business entity based on someone else’s business, you may be

making a major mistake. There is no one right business structure. Like many

things in tax (and business), the correct answer to “What is the best structure

for a business?” is: “It depends.”

Generally, all businesses calculate their income in the same manner: Figure

out the gross income, subtract all ordinary and necessary business expenses,

and whatever is left is profit. Of course, this is a simplification, but the general

principle holds. Why, then, is the choice of business entity so important?

• Different tax treatments. Though income is generally calculated

identically across business structures, the tax may not be.

• Legal consequences. Not only will different entities be treated

differently under the law, but the treatment can vary state by

state.

Chapter 1 | The Business Entity

• Your goals. Depending on your goals, you may be able to only

use one specific type of business entity.

In this chapter we take a look the different types of business entities, the

requirements for each, their pros and cons, and how they are taxed. We

discuss how you can change your type of entity and conclude with how you

should choose your form of business entity.

The Sole Proprietor

If you alone conduct your business without forming a separate legal entity,

you are a sole proprietor. This is the simplest form of business entity. Any

business conducted by an individual that is not another form of business entity

will be a sole proprietorship.

There is no such thing as wages or salary with a sole proprietorship. You are

the business, so wages would just be moving money from your left hand to

your right hand.

This is by far the simplest form of business entity. It’s just you conducting a

business. Of course, you must truly be conducting a business and not just

trying to make a hobby into a business.

Hobby Loss Test

Most of us have hobbies—activities we pursue for enjoyment, not to make

money. Many individuals attempt to turn their hobbies into businesses; after

all, activities we pursue for enjoyment can make the best businesses. That

said, to have a business for tax purposes, you must be trying to make money

at it. The Internal Revenue Service (IRS) is naturally skeptical of a “business”

that loses money year after year. A nine-factor test is used by the IRS and the

courts to determine whether an activity is being conducted as a business or a

hobby:

1. The manner in which the taxpayer carried on the activity;

2. The expertise of the taxpayer or his or her advisers;

3. The time and eort expended by the taxpayer in carrying on the

activity;

4. The expectation that the assets used in the activity may

appreciate in value;

Treasury Regulation §1.183-2(b).

Tax Strategies for the Small Business Owner

5. The success of the taxpayer in carrying on other similar or

dissimilar activities;

6. The taxpayer’s history of income or loss with respect to the

activity;

7. The amount of occasional prots, if any, which are earned;

8. The nancial status of the taxpayer; and

9. Elements of personal pleasure or recreation.

The effect of these rules for a business that’s considered a hobby is that gross

income is taxable but the expenses might not be deductible. Most of the time

you do not want your business to be considered a hobby.

One of the most important ways of avoiding this is to document all of your

expenses. My mother, a realtor, says that the cliché that real estate is location,

location, and location is true. Similarly, the most important thing for a business

owner is to document, document, and document.

■ Tip Keep good records! I cannot overemphasize this. You will see this point recurring

throughout this book because it really is that important.

Let’s look at a business that is a hobby. Say you’ve decided to buy a lot of

cosmetics, and you decide to become a distributor for a multilevel marketing

(MLM) company. By becoming a distributor for an MLM that markets

cosmetics, you can make a little bit of money on the side. MLMs typically pay

a residual to you for every product you order (and for product ordered by

others you recruit to the company). However, in this example you do not

have a profit motive: Your goal is solely to purchase cosmetics for your own

use. This “business” would clearly be a hobby.

I deliberately chose an MLM for this example because they have a reputation

for abuse with tax agencies. That does not mean that you should avoid MLMs

as your choice when starting a business. On the contrary, many people have

done quite well with businesses that are structured as MLMs. If you honestly

conduct your business with the goal of making money, you will likely be

considered to be running your business for the purpose of making a profit,

not as a hobby.

Sole Proprietorship: The Advantages

The main reason for choosing a sole proprietorship is its ease. The moment

you “hang up your shingle,” you’ve formed a sole proprietorship. Other than

Chapter 1 | The Business Entity

a local business license

and/or a fictitious business statement,

there are

usually no other requirements to form a sole proprietorship.

This makes it

one of the easiest businesses to create.

From a tax perspective, a sole proprietorship reports its income and expenses

on a Schedule C. This is part of your personal tax return, so no separate

business entity tax return is required.

A sole proprietorship is usually one of the least expensive businesses to run

from an organizational standpoint. Because there are few (if any) legal filings

required, legal costs are usually limited. Because there’s no separate tax return

required, there can be a savings on tax preparation costs.

It’s also easy to close a sole proprietorship: You simply stop working in that

business and don’t include the Schedule C on your tax return (though you

may need to cancel your business license or fictitious business statement).

Sole Proprietorship: The Disadvantages

The ease of forming a sole proprietorship is also one of its negatives. A sole

proprietorship is you conducting a business. You can be held personally liable

for anything that is conducted by your business.

Indeed, protection from legal liability is one of the main reasons that people

form business entities. I am not an attorney, and nothing written in this book

is meant as legal advice. That said, it’s safe to say that most individuals do not

want to be exposed to potential liability issues.

Second, a sole proprietorship is, by definition, you conducting a business by

yourself. With one exception,

there cannot be any other owners if you file as

a sole proprietorship.

Finally, according to IRS statistics, a business that files a sole proprietorship

has on average five to ten times the audit risk of a corporation or a partnership.

Business licenses are generally issued by cities and counties, though some states (such as

Nevada) also require them.

A fictitious business statement is required when you conduct a business in anything other than

your own name. In most jurisdictions, these statements are issued by counties.

A business conducted out of a home may be subject to zoning and/or homeowners

association restrictions. Consult an attorney familiar with your jurisdiction and legal issues to

determine whether this is a concern.

A married couple living in a community property state jointly conducting a business can file

their business as a sole proprietorship. The income and expenses of the business would be

split onto two Schedule C’s. I discuss this in the note in the next section.

2011 Internal Revenue Service Data Book: October 1, 2010, to September 30, 2011,

accessed at http://www.irs.gov/pub/irs=soi/11databk.pdf, page 22.

Tax Strategies for the Small Business Owner

Why is this the case? The IRS has found that tax returns for sole proprietor-

ships tend to have more errors than do corporate or partnership returns.

The IRS is a collection agency; they go where the money is. They get more

bang for their buck by examining sole proprietorships than investigating other

business entities (except for the largest C corporations). Audits are covered

in detail in Chapter 17.

Partnerships

A partnership is when two or more persons conduct a trade or business. Note

that I did not say “two or more individuals”; a partner in a partnership can be

a business entity, such as a corporation or an LLC (though this is rare). A

business does not have to have a written agreement to be considered a

partnership. Most states do not require partnerships to register with the

state; however, partnerships have the same requirements as sole proprie-

torships in obtaining business licenses and fictitious business statements.

Partnerships file an information return (Form 1065) noting their income and

expenses, but they generally do not pay income tax.

The income and expenses

from a partnership flow through to the partners’ own tax returns. Thus, a

partnership is a flow-through entity. A partnership issues Schedule K-1’s noting

each partner’s share of the income and expenses so that these items can be

reported on each partner’s personal tax returns.

As in sole proprietorships, individual owners in a partnership cannot be paid

wages. Instead, owners take draws of money from the business. Note that a

draw is not an expense; rather, it is the movement of earnings from the

partnership to the partners.

■ Note The married couple exception in community property states. There is one business

with two owners that can, if it wishes, file a Schedule C (sole proprietorship) rather than a

partnership return: a business operated by a married couple in a community property state (Arizona,

California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin; Alaska and

Puerto Rico allow for community property but it is not the default status). Such a business can file

a partnership return (Form 1065) or two Schedule C’s on their individual return (Form 1040). If the

owners choose to file Schedule C’s, the income and expenses would be split equally on the two

Schedule C’s. The pros and cons of this should be carefully considered before choosing a filing

method. Be aware that community property law is not identical in each community property state.

A few jurisdictions, such as Illinois, do charge tax on partnerships. Illinois calls its tax the

“Partnership Replacement Tax.”