This post tries to provide answers to 25 most frequently asked tax questions from the basic to somewhat complex issues of any professions, any business lines. It is [though any post provided on this site] proposed by no meant complete and perfect, but this answers some basic day-to-day tax matters.
1. Do I have to file a federal income tax return for my business if I lost money?
Technically no, but you should do it anyway. Your loss could provide you with a tax benefit by reducing your other taxable income in that year or in past or future years. To report this loss, either attach a written statement to the loss year’s tax return, or attach IRS Form 3621, Net Operating Loss Carry-Over. (Note: If you weren’t active in the business, but merely an investor, your ability to deduct a business loss is limited). If your business is incorporated, you must file an annual tax return whether or not you have any income. Plus, the loss rules for small corporate shareholders are more generous.
2. What does the term “depreciation” mean?
Depreciation refers to the annual tax deduction the IRS allows for a business asset that has a useful life of more than a year. The theory is that an asset loses value as it wears out over time, and you get a tax break reflecting that. The amount you may deduct per year, and the length of time over which you must take these deductions, depends on how the tax code classifies the property.
3. How long do I have to keep my business records?
The bare minimum period for keeping those dust-catching boxes is three years from the date you file your tax return. This is the normal IRS statute of limitations on audits. However, some state tax agencies have longer periods to audit, and the IRS can go beyond three years for serious underreporting. For this reason, as much as it may pain you, hold on to those boxes for at least six years.
4. I’m a doctor and I had patients who didn’t pay their medical bills. Can I deduct this as bad debt expense?
The prognosis is not favorable, Doctor. The tax code specifically excludes the value of services provided from the definition of tax deductible bad debt. However, any out-of-pocket expenses (medications, needles, or supplies) in connection with providing these services to deadbeat patients are deductible.
5. If I incorporate my one-man consulting operation, will I reduce my audit risks?
Probably. In the past, the IRS audit rate for incorporated small businesses with under $1,000,000 gross receipts has been less than half of similar unincorporated ventures. The IRS vows that it will equalize audit rates in the future, but who knows? Investigate the initial costs and recurring expenses of incorporating before you rush out and add “Inc.” to your name—operating a corporation is more complex than operating as a sole proprietor.
6. Do I need any kind of prior IRS approval or registration before I start my business?
Not if you are starting off as a sole proprietor without employees. Just use your own Social Security number when corresponding or filing anything with the IRS. But if you form any kind of business entity (a corporation, a partnership, or an LLC ) or have one or more employees, you must get a federal employer identification number at the time you begin operations. You can obtain a federal employer identification number using IRS Form SS-4. You will use this number on any forms you file with the IRS. Also, check with your state employment and tax authorities for their requirements.
7. I make dollhouse furniture in my spare time and sell a few items to friends and at craft fairs. Overall, I lose money every year, but have a good time at it. Are my losses tax deductible?
Possibly. The best way to pass muster with the IRS is to show that you had a profit motive and operated in a businesslike fashion. If you are ever audited, the auditor may try to argue that the dollhouse business was really a nondeductible hobby, and disallow your losses. Keep good records to show your efforts to turn a profit, and do some advertising or business promotion, just like any real business. Keep in mind that you only have to show that you tried to make a profit—it doesn’t matter whether you actually did (although an IRS auditor might try to tell you otherwise).
8. Do IRA, SEP, 401(k), and other retirement plans for the self-employed really provide much of a tax break?
Absolutely. There is no better tax benefit available to the small business owner than a retirement plan. With the exception of the Roth IRA, you’ll get an immediate tax savings for every year you contribute, and the money you invest in your plan will accumulate interest, dividends, and capital gains—with the tax deferred until you withdraw it. Also, although retirement may be many years away, you can often make early withdrawals for buying a home or for medical reasons. Don’t wait—the sooner you start contributing to a plan, the sooner your money can start making money for you.
9. Should I choose a fiscal year or calendar tax year accounting period for my business?
For most small-time operators, the accounting period is rarely a big deal either way. The vast majority of small businesses use a calendar year (January 1 to December 31). To choose any other tax period, you must have a good reason and get permission from the IRS. If, for instance, your business is seasonal, such as farming, and you think you might benefit from a non-calendar fiscal year, see an accountant to discuss the ramifications.
10. If I claim a home office deduction for my consulting business, will I be audited?
Several years ago, home offices were IRS targets. Today, while a home office deduction increases your chances of audit, it’s only a slight increase unless the deduction is particularly large (50% or more) relative to your business income.
11. I use my car to call on customers and make deliveries. Am I better off leasing a vehicle or buying it?
As a rule, the more expensive the car, the bigger tax deduction you get from leasing. The price point at which leasing becomes more favorable is about $15,800. When you get up in $50,000 territory, vehicle deductions are much greater than with owning. However, if you are thinking of a big truck or a heavy SUV, you might be better off buying, because the annual tax deductions are far bigger than with passenger car tax rules. And, using Section 179, you might be able to write 100% off in the year of purchase!
12. There is a trade show in San Francisco coming up and I’d like to take my wife and spend a few extra days after the show. Can I still deduct the trip expenses?
Yes, but you can’t deduct any expenses (such as airfare and food) solely attributable to your wife unless she is an employee of your business and is there for business reasons, too. However, you can deduct all of your airfare, the full cost of your shared hotel room (for the business days, but not the extra days), and the rental car for the business days. And, if you can find one of those “companion flies free” deals, you don’t have to account for your wife’s airfare at all. Make sure to take her for a drink at the Cliff House at sunset.
13. Two friends and I want to go into business building and fixing stock cars for racing. What’s the simplest way to do this taxwise?
Consider forming a limited liability company (LLC). Your other alternatives are a partnership or a corporation, which may be more complicated taxwise and legally than an LLC. The best advice I can give you is to meet with a business lawyer and talk to a tax pro about your plans and get advice tailored to your situation.
14. Will the IRS be upset if I hire my 14-year-old kid to help in my video store after school, sweeping floors, answering the phone, and so on? [I would pay him about $50 a week].
Hiring Junior and Little Susie is perfectly okay (and it keeps the kids off the streets). In fact, it’s a good family tax saver, too. It takes income from your tax bracket and transfers it to the child’s lower bracket. Make the kids do real work, and don’t overpay them—their (tax deductible) salaries shouldn’t be just disguised weekly allowances. As an added benefit, the kids can put money into retirement plans and deduct the contributions. This makes good tax sense even if they take the money out for college—long before retirement age.
15. My cousin Luigi and his wife own a multimillion-dollar floor covering business. His daughter and one son work in the business. Could operating the business as a family limited partnership save estate taxes on his death?
If Luigi plans far enough ahead, yes, putting the floor covering operation into a family limited partnership (FLP) can reduce the size of his taxable estate and cut probate time and costs. Luigi could gradually transfer ownership of the business to his children over a period of years through annual tax-free gifts (right now, the maximum amount Luigi and his wife can contribute tax-free is $24,000 in partnership assets to each family member per year).
16. I frequently give my employees gift certificates and special occasion items to keep them loyal. What are the tax rules for deducting the costs of these things?
First, congratulations for your enlightened approach to holding on to valuable employees. You can deduct all of the costs of gifts to employees; the catch is that anything totaling more than $25 per year must be reported as additional income by the employee. For a service business, you can provide “excess capacity” things (services that wouldn’t be used anyway, such as an available hotel room) to your employees tax-free. And, owners can give “good habit” rewards of up to $400 per year, or with a qualified award plan, you can give items valued up to $1,600 per year. Check with your tax pro for more information.
17. I’m buying a small injection molding company that has gross receipts of about $500,000 per year. Do I have to tell the IRS about this deal?
If you are buying an unincorporated business, both you and the seller must agree on the value of each category of assets being transferred. This means things like equipment, real property, goodwill, the seller’s covenant not to compete, and so on. Both sides report these allocations with their annual tax return filings on an IRS Form 8594, Asset Acquisition Statement. However, if you buy shares of stock in a corporation, then there is no special IRS reporting form to file.
18. My auto dealership went through some rough times last year. I got behind in payroll tax deposits for $120,000 and I owe suppliers, the landlord, and others even more. Can these payroll taxes be wiped out in bankruptcy?
Sorry, no can do. Congress (in conjunction with the IRS, no doubt) says that payroll taxes can never be discharged in a bankruptcy. The best thing to do is use whatever assets you can to make the payroll tax payments and then file for bankruptcy. The suppliers’ bills are most likely dischargeable in bankruptcy, so pay the IRS first. The IRS is tenacious when it comes to collecting payroll taxes, and you could lose more than just your business. You may be able to make a deal with the IRS under an Offer in Compromise.
19. I am being audited by the IRS. The auditor says a number of my business expenses will be disallowed in his report. Do I have to accept this?
Absolutely not. The IRS has an administrative process that allows you to appeal an auditor’s decision to the IRS Appeals Office—a completely separate division of the IRS. Their job is to settle the dispute with you so you don’t take the IRS to tax court. And, in most cases, they will compromise on an audit report—although your odds of being let off the hook completely are slim. If you can’t reach a compromise, the filing fee for tax court is only $60 and, if the amount you are contesting is less than $50,000, the procedures are fairly simple.
20. I save a lot of taxes hiring independent contractors for my print shop instead of employees, but my accountant says I’m crazy to take the risk that they’ll be reclassified as employees. What do you think?
Your accountant is right to be wary. Most small business owners love the tax savings they get from hiring independent contractors—they don’t pay the employer’s share of payroll taxes or unemployment taxes, or withhold income taxes as required by law. That’s fine if the workers are legally independent contractors. But if you are providing a workplace on your premises, setting the hours of work, and presumably directing the workers, then they probably aren’t independent contractors, but employees—and you could be in big trouble with the IRS. The IRS is very aware of the tax benefits of hiring independent contractors and makes a habit of auditing businesses that hire a lot of independent contractors. Also, watch out for fines and penalties from your state tax agency as well if—and when—you are caught.
21. I’m thinking of opening a cosmetic store and I project about $250,000 in sales the first year. Should I try to keep records by hand or with my computer?
Unless you are completely hopeless with a computer—and most people can pick up at least a few skills—forget the pencil and paper. Tracking many relatively small sales, keeping inventory, sales tax reporting, and other such items is the stuff computers were made for. Most small business owners wouldn’t dream of operating their business without a computer and a program.
22. Our state has both a corporate and personal income tax. I’ve read that incorporating out of state (like in Delaware or Nevada) will save on costs and taxes; is this true?
No, just the opposite. You will still have to register and file corporate and personal tax returns in your home state, because that is where you are doing business. (That’s the law in 50 of the 50 states.) Incorporating in a no- or low-tax state will result in higher overall costs and taxes, considering the expenses of forming and maintaining the out of- state corporation. The legitimate reasons for incorporating out of state are all non-tax—like favorable liability laws or greater privacy. If you’re still tempted, talk to a business attorney and tax pro first.
23. I am a sole proprietor with a huge self-employment tax bill. Is there any way to lower my tax bite?
Yes, by putting your business into an S corporation, and becoming an employee of the corporation. You would no longer pay self-employment taxes. However, there are payroll taxes, but you would probably come out ahead. The catch: There are costs and legal fees for setting up and maintaining the corporation as well as tax pro fees for corporate tax return filings. For the average small business these costs shouldn’t be more than $2,000 per year—and they are all tax deductible. And, a side benefit is the personal liability shield that a corporation provides. But before spending the money, get legal and tax advice from pros in your area.
24. I notice that expert often recommend hiring tax professionals, but I can’t afford that. Why can’t I just read your posts here and call the IRS for free if I have any tax questions?
There are at least two reasons for not relying on this post (or any other post here) and any textbook in general and the IRS as your sole sources of tax advice. First, everyone’s overall tax circumstances are different. For instance, a $1,000 tax deduction may save a high-earner like Patricia $400 in federal and state income taxes but may not save a part-time student like Patrick a dime. It depends, on their tax rates, other deductions, dependents, and dozens of other highly individual considerations. IRS publication is only a one-size-fits-all overview. Second, calling a live person at the IRS or relying on something in its publications or website is dangerous. Why? Believe it or not, the IRS is not legally liable for its oral advice or what is stated in its publications! Also, keep in mind that paying a private tax pro for advice is tax deductible, which should take part of the sting out of paying those fees.
25. My tax preparer typically says “no” whenever I ask if I can take a deduction that she thinks might bring down the IRS on me. Is she being too careful, or is she acting in my best interests?
Get someone else to do your taxes. You are likely overpaying your income taxes by hundreds or even thousands of dollars every year. Of course the powers of the IRS should be respected, but you don’t have to be a scared rabbit. For one thing, chances of an IRS audit nowadays are very low, and even if you are audited, it doesn’t necessarily mean you will lose. Interview several tax pros. Ask them about taking deductions, and about their attitude toward the IRS. When you find a good fit, make the switch.