Sometimes it pays to be small. The tax laws contain a number of special rules exclusively for small businesses. But what is a small business? The average size of a small business in the United States is one with fewer than 20 employees with annual revenue under $2 million. The SBA usually defines small business by the number of employees – size standards range from 500 employees to 1,500 employees, depending on the industry or the SBA program. The SBA also uses revenue for certain business size standards (e.g., average annual gross receipts for many nonmanufacturing industries). Size matters because only “small businesses” can qualify for SBA-guaranteed loans and for special consideration with federal contracting.
For tax purposes, however, the answer varies from rule to rule, as explained throughout this book. Sometimes, it depends on your revenues, the number of employees, or total assets. In Table I.1 are more than 2 dozen definitions from the Internal Revenue Code on what constitutes a small business. You may be a small business for some tax rules but not for others.
Table I.1 Examples of Tax Definitions of Small Business
While taxes are figured on your bottom line – your income less certain expenses – you still must report your income on your tax return. Generally, all of the income your business receives is taxable unless there is a specific tax rule that allows you to exclude the income permanently or defer it to a future time.
When you report income depends on your method of accounting. How and where you report income depends on the nature of the income and your type of business organization. Over the next several years, the possibility of declining tax rates (clarified in the Supplement) for owners of pass-through entities – sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations – require greater sensitivity to the timing of business income.
The IRS reported a “tax gap” (the spread between revenues that should be collected and what actually is collected) of $450 billion a year and that $122 billion of this can be traced to entrepreneurs who underreport or don't report their income, or overstate their deductions. While audit rates have recently been at historic lows, the IRS continues to look carefully at self-employed individuals in an attempt to detect intentional or unintentional reporting errors.
You pay tax only on your profits, not on what you take in (gross receipts). In order to arrive at your profits, you are allowed to subtract certain expenses from your income. These expenses are called “deductions.”
The law says what you can and cannot deduct (see below). Within this framework, the nature and amount of the deductions you have often vary with the size of your business, the industry you are in, where you are based in the country, and other factors. The most common deductions for businesses include car and truck expenses, utilities, supplies, legal and professional services, insurance, depreciation, taxes, meals and entertainment, advertising, repairs, travel, rent for business property and equipment, and in some cases, a home office.
Are your deductions typical? Back in January 2004, the Government Accountability Office (formerly the General Accounting Office) compiled statistics on deductions claimed by sole proprietors for 2001 (no data more current is available). These numbers showed the dollars spent on various types of deductions, the percentage of sole proprietors who claimed the deductions, and what percentage of total deductions each expense represented. For example, 25 % of sole proprietors with business gross receipts under $25,000 claimed a deduction for advertising costs. This percentage rose to 65 % when gross receipts exceeded $100,000. You can view these old statistics at www.gao.gov/new.items/d04304.pdf.
Deductions are a legal way to reduce the amount of your business income subject to tax. But there is no constitutional right to tax deductions. Instead, deductions are a matter of legislative grace; if Congress chooses to allow a particular deduction, so be it. Therefore, deductions are carefully spelled out in the Internal Revenue Code (the Code).
The language of the Code in many instances is rather general. It may describe a category of deductions without getting into specifics. For example, the Code contains a general deduction for all ordinary and necessary business expenses, without explaining what constitutes these expenses. Over the years, the IRS and the courts have worked to flesh out what business expenses are ordinary and necessary. “Ordinary” means common or accepted in business and “necessary” means appropriate and helpful in developing and maintaining a business. The IRS and the courts often reach different conclusions about whether an item meets this definition and is deductible, leaving the taxpayer in a somewhat difficult position. If the taxpayer uses a more favorable court position to claim a deduction, the IRS may very well attack the deduction in the event that the return is examined. This puts the taxpayer in the position of having to incur legal expenses to bring the matter to court. However, if the taxpayer simply follows the IRS approach, a good opportunity to reduce business income by means of a deduction will have been missed. Throughout this book, whenever unresolved questions remain about a particular deduction, both sides have been explained. The choice is up to you and your tax adviser.
Sometimes, the Code is very specific about a deduction, such as an employer's right to deduct employment taxes. Still, even where the Code is specific and there is less need for clarification, disputes about applicability or terminology may still arise. Again, the IRS and the courts may differ on the proper conclusion. It will remain for you and your tax adviser to review the different authorities for the positions stated and to reach your own conclusions based on the strength of the different positions and the amount of tax savings at stake.
A word about authorities for the deductions discussed in this book: There are a number of sources for these write-offs in addition to the Internal Revenue Code. These sources include court decisions from the U.S. Tax Court, the U.S. district courts and courts of appeal, the U.S. Court of Federal Claims, and the U.S. Supreme Court. There are also regulations issued by the Treasury Department to explain sections of the Internal Revenue Code. The IRS issues a number of pronouncements, including Revenue Rulings, Revenue Procedures, Notices, Announcements, and News Releases. The IRS also issues private letter rulings, determination letters, field service advice, and technical advice memoranda. While these private types of pronouncements cannot be cited as authority by a taxpayer other than the one for whom the pronouncement was made, they are important nonetheless. They serve as an indication of IRS thinking on a particular topic, and it is often the case that private letter rulings on topics of general interest later get restated in revenue rulings.
The answer depends on your tax bracket. The tax bracket is dependent on the way you organize your business. If you are self-employed and in the top tax bracket of 39.6 % in 2017, then each $100 deduction will save you $39.60. Had you not claimed this deduction, you would have had to pay $39.60 of tax on that $100 of income that was offset by the deduction. If you have a personal service corporation, a special type of corporation for most professionals, the corporation pays tax at a flat rate of 35 %. This means that the corporation is in the 35 % tax bracket. Thus, each $100 deduction claimed saves $35 of tax on the corporation's income. Deductions are even more valuable if your business is in a state that imposes income tax. The impact of state income tax and special rules for state income taxes are not discussed in this book.