Like the timing of income, the timing of deductions – when to claim them – is determined by your tax year and method of accounting. Your form of business organization affects your choice of tax year and your accounting method.
Even when expenses are deductible, there may be limits on the timing of those deductions. Most common expenses are currently deductible in full. However, some expenses must be capitalized or amortized, or you must choose between current deductibility and capitalization. Capitalization generally means that costs can be written off ratably as amortized expenses or depreciated over a period of time. (Capitalized costs, such as for the purchase of machinery and equipment, are added to the balance sheet as company assets.) Amortized expenses include, for example, fees to incorporate a business and expenses to organize a new business. Certain capitalized costs may not be deductible at all, but are treated as an additional cost of an asset (basis).
Not all write-offs of business expenses are treated as deductions. Some can be claimed as tax credits. A tax credit is worth more than a deduction since it reduces your taxes dollar for dollar. Like deductions, tax credits are available only to the extent that Congress allows. In a couple of instances, you have a choice between treating certain expenses as a deduction or a credit. In most cases, however, tax credits can be claimed for certain expenses for which no tax deduction is provided. Business-related tax credits, as well as personal credits related to working or running a business, are included in this book.
As a small business owner, your obligations taxwise are broad. Not only do you have to pay income taxes and file income tax returns, but you must also manage payroll taxes if you have any employees. You may also have to collect and report on state and local sales taxes. Some businesses, such as farms, may have excise tax responsibilities. Finally, you may have to notify the IRS of certain activities on information returns.
It is very helpful to keep an eye on the tax calendar so you will not miss out on any payment or filing deadlines, which can result in interest and penalties. You might want to view the IRS's Tax Calendar for Businesses and Self-Employed (go to https://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/IRS-Tax-Calendar-for-Businesses-and-Self-Employed). You can use IRS CalendarConnector to filter the calendar to view dates that apply to you (go to https://www.irs.gov/pub/irs-pdf/p1518a.pdf).
You can obtain most federal tax forms online at www.irs.gov. Nonscannable forms, which cannot be downloaded from the IRS, can be ordered by calling toll free at 800-829-4933 during normal business hours.
PART 1
Organization
CHAPTER 1
Business Organization
Alert
At the time this book was completed, Congress was considering important tax changes that could affect 2017 tax returns and planning for 2018. Check the online Supplement in February 2018 at www.jklasser.com or www.barbaraweltman.com to see what changes have been enacted and when they are effective.
If you have a great idea for a product or a business and are eager to get started, do not let your enthusiasm be the reason you get off on the wrong foot. Take awhile to consider how you will organize your business. The form of organization your business takes controls how income and deductions are reported to the government on a tax return. Sometimes you have a choice of the type of business organization; other times, circumstances limit your choice. If you have not yet set up your business and do have a choice, this discussion will influence your decision on business organization. If you have already set up your business, you may want to consider changing to another form of organization.
According to the Tax Foundation, 92 % of all businesses in the United States are organized as sole proprietorships, partnerships, limited liability companies (LLCs), or S corporations, all of which are “pass-through” entities. This means that the owners, rather than the businesses, pay tax on business income. Nearly 50 % of the private sector workforce is employed by these pass-through entities. The way in which you set up your business impacts the effective tax rate you pay on your profits (after factoring income taxes and employment taxes). Taxes, however, are only one factor in deciding what type of entity to use for your business.
As you organize your business, consider which type of entity to use after factoring in taxes (federal and state) and other consequences. Also consider whether to change from your current form of business entity to a new one and what it means from a tax perspective. Finally, be sure to obtain your business's federal tax identity number (or a new one when making certain entity changes).
For a further discussion on worker classification, see IRS Publication 15-A, Employer's Supplemental Tax Guide.
Sole Proprietorships
If you go into business for yourself and do not have any partners (with the exception of a spouse, as explained shortly), you are considered a sole proprietor, and your business is called a sole proprietorship. You may think that the term proprietor connotes a storekeeper. For purposes of tax treatment, however, proprietor means any unincorporated business owned entirely by one person. Thus, the category includes individuals in professional practice, such as doctors, lawyers, accountants, and architects. Those who are experts in an area, such as engineering, public relations, or computers, may set up their own consulting businesses and fall under the category of sole proprietor. The designation also applies to independent contractors. Other terms used for sole proprietors include freelancers, solopreneurs, and consultants. And it includes “dependent contractors”: self-employed individuals who provide all (or substantially all) of their services for one company (often someone laid off from a corporate job who is then engaged to provide non-employee services for the same corporation). Further, it includes those working in the “gig” economy for such companies as Uber, Lyft, HopSkipDrive, and TaskRabbit (although some workers for these companies are claiming to be employees and courts are reviewing their worker status).
Sole proprietorships are the most common form of business. The IRS reports that one in 6 Form 1040s contains a Schedule C or C-EZ (the forms used by sole proprietorships). Most sideline businesses are run as sole proprietorships, and many start-ups commence in this business form.
There are no formalities required to become a sole proprietor; you simply conduct business. You may have to register your business with your city, town, or county government by filing a simple form stating that you are doing business as the “Quality Dry Cleaners” or some other business name other than your own (a fictitious business name, or FBN). This is sometimes referred to as a DBA, which stands for “doing business as.”
From a legal standpoint, as a sole proprietor, you are personally liable for any debts your business incurs. For example, if you borrow money and default on a loan, the lender can look not only to your business equipment and other business property but also to your personal stocks, bonds, and other property. Some states may give your house homestead protection; state or federal law may protect your pensions and even Individual Retirement Accounts (IRAs). Your only protection for your personal assets is adequate insurance against accidents for your business and other liabilities and paying your debts in full.
Simplicity is the advantage to this form of business. This form of business is commonly used for sideline ventures, as evidenced by the fact that half of all sole proprietors earn salaries and wages along with their business income. For 2015 (the most recent year for statistics), more than 24.7 million taxpayers filed returns as sole proprietors.
One type of sole proprietor is the independent contractor. To illustrate, suppose you used to work for Corporation X. You have retired, but X gives you a consulting contract under which you provide occasional services to X. In your retirement, you decide to provide consulting services not only to X, but to other customers as well. You are now a consultant. You are an independent