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We believe accurate, plain-English legal information should help you solve many of your own legal problems. But this text is not a substitute for personalized advice from a knowledgeable lawyer. If you want the help of a trained professional—and we’ll always point out situations in which we think that’s a good idea—consult an attorney licensed to practice in your state.
11th edition
Tax Savvy for Small Business
by Attorney Frederick W. Daily
ElEvEnth Edition Editor cover design production proofreading index printing
novEmbEr 2007 diana Fitzpatrick jalEh doanE Sarah hinman robErt wEllS mEdEa minnich conSolidatEd printErS, inc.
iSSn: 1939-3040 iSbn 10: 1-4133-0717-5 iSbn 13: 978-1-4133-0717-7
copyright © 1995, 1996, 1997, 1998, 1999, 2001, 2002, 2003, 2004, 2005, 2006, and 2007 by Frederick w. daily.
all rightS rESErvEd. printEd in thE U.S.a. no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without prior written permission. For information on bulk purchases or corporate premium sales, please contact the Special Sales department. For academic sales or textbook adoptions, ask for academic Sales. call 800-955-4775 or write to nolo, 950 parker Street, berkeley, ca 94710.
Dedication
to my wife, brenda, who has brought me everything that is good in life.
Acknowledgments
trying to translate the tax code into plain English for the small business owner was a challenge that all but overwhelmed me. without the help of many others i could not have done it. nolo has some of the most caring (and careful) editors on the face of this earth. First and foremost in both categories is mary randolph. other nolo folks with a hand in the project were jake warner, robin leonard, lisa goldoftas, and Steve Fishman. Stephanie harolde, Ely newman, robert wells, and Susan cornell made valuable contributions in copyediting, proofreading, and production. much thanks to beth laurence in updating the new editions. Thank you one and all for putting up with me. my peers in the tax community contributed immensely and without complaint. The most helpful in making sure the things you need to know were covered: chris kollaja, cpa; dewey watson, tax attorney (both in San Francisco); lew hurwitz, Ea (oakland); Steven mullenniex, Ea (berkeley); malcolm roberts, cpa, of roberts Schultz & co. in berkeley; and gino bianchini, tax attorney (newport beach). a special thanks to richard l. church, cpa (Southwest harbor, maine), and to jeff Quinn, cpa, of incline village, nevada. a special thanks in updating chapter 16, retirement plans, goes out to craig Schiller, cpc, owner of Schiller’s pension consulting in burlingame, california (craig@schillerspension.com). craig’s firm handles my retirement plan needs.
Table of Contents
I 1
Your Tax Savvy Companion......................................................................................1
Part 1: The Basics
Tax Basics ....................................................................................................................................3
How Tax Law Is Made and Administered: The Short Course .............................4 Where to Find Tax Rules .........................................................................................................5 Marginal Tax Rate and Tax Brackets.................................................................................7 The Alternative Minimum Tax (AMT)............................................................................8
2
Deductible Business Expenses and Income ..............................................9
What Is a Deductible Business Expense? ................................................................... 11 Is It a Current or Future Year Expense? ........................................................................ 13 Top 25 Deductions for Businesses .................................................................................. 14 The General Business Credit ............................................................................................. 24 Vehicle Expenses ...................................................................................................................... 25 How and Where to Claim Expense Deductions ..................................................... 30 What Is—And Isn’t—Income? .......................................................................................... 31
3
Writing Off Business Assets ................................................................................... 35
When Various Expenses May Be Deducted .............................................................. 37 Section 179: Expensing Business Assets ...................................................................... 39 Depreciating Business Assets ............................................................................................ 42 Tax Basis of Business Assets ............................................................................................... 49 Leasing Instead of Buying Assets ..................................................................................... 53 When You Dispose of Business Assets: Depreciation Recapture Tax ......... 55 Tax Errors in Depreciation .................................................................................................. 56
4
Bookkeeping and Accounting ............................................................................. 59
Why You Need a Bookkeeping System........................................................................ 60 Should You Hire a Bookkeeper? ...................................................................................... 61 Manual or Computer System?.......................................................................................... 61 What Kinds of Records to Keep ....................................................................................... 65 How Long Records Should Be Kept ............................................................................... 69 Bookkeeping Methods of Tracking Income and Expenses ............................... 70 Timing Methods of Accounting: Cash and Accrual ............................................. 71 Accounting Periods: Calendar Year or Fiscal Year ................................................. 73
5 6
Business Losses and Failures ................................................................................. 75
Unincorporated Business Losses ..................................................................................... 76 Incorporated Business Losses ........................................................................................... 78
Tax Concerns of Employers .................................................................................... 81
Employer Identification Numbers.................................................................................. 82 What Are Payroll Taxes? ....................................................................................................... 83 Reporting and Depositing Payroll Taxes ..................................................................... 85 Classifying Workers: Employee or Independent Contractor? ......................... 93 Misclassifying Employees as Independent Contractors ..................................... 96 IRS Filing and Payment Requirements for Employers ......................................... 99 Record Keeping for Your Workers ................................................................................100
Part 2: The Structure of Your Business
7
Sole Proprietorships....................................................................................................103
What It Means to Be a Solo—From a Tax Perspective......................................104 To Be or Not to Be—A Solo ...........................................................................................104 Solo Income and Expenses ...............................................................................................104 Solos’ Tax Forms: Schedule C Is Your Friend ..........................................................106 What If My Solo Biz Loses Money? ..............................................................................110 How Solos Are Taxed...........................................................................................................111 Record Keeping for Solos ..................................................................................................114 When a Solo Closes Up Shop..........................................................................................115 Death of a Solo........................................................................................................................115 Outgrowing the Solo ...........................................................................................................115
8
C Corporations.................................................................................................................117
Types of Corporations.........................................................................................................119 How C Corporations Are Taxed ....................................................................................121 Tax Benefits of C Corporations ......................................................................................126 Incorporating Your Business ..........................................................................................128 The Importance of Issuing Section 1244 Stock .....................................................131 Taking Money out of a C Corporation.......................................................................133 Tax Pitfalls of C Corporations .........................................................................................137 Dissolving a C Corporation ..............................................................................................137
9
S Corporations..................................................................................................................141
An Overview of S Corporations.....................................................................................142 Should You Choose S Corporation Status? .............................................................142 Tax Reporting for S Corporations .................................................................................145 How S Corporation Shareholders Are Taxed ........................................................148 Social Security and Medicare Taxes ............................................................................149 Electing S Corporation Status.........................................................................................149 Revoking S Corporation Status ......................................................................................151 Dissolving an S Corporation ............................................................................................152
10 Partnerships........................................................................................................................155 Partnership Tax Status ........................................................................................................157
Tax Reporting by Partnerships .......................................................................................157 Tax Obligations of Partners ..............................................................................................158 Partnership Losses .................................................................................................................163 Partnership Contributions ..............................................................................................164 Getting Money out of a Partnership...........................................................................167 Partnership Expenses .........................................................................................................167 Selling or Transferring a Partnership Interest .........................................................167 Ending a Partnership............................................................................................................169
11 Limited Liability Companies...............................................................................171 Taxes .............................................................................................................................................172
Comparing LLCs With Other Entities.........................................................................173 The Limited Liability Company (LLC) ........................................................................174 Terminating a Limited Liability Company ...............................................................176
12 Qualified Personal Service Corporations...............................................179 Qualified Personal Service Corporations (QPSCs) ..............................................180
QPSCs & Taxes ........................................................................................................................181 Fringe Benefits .........................................................................................................................182 Potential Tax Problems .......................................................................................................182 Transferring Shares ..............................................................................................................183 Dissolving a Qualified Personal Service Corporation ........................................183
Part 3: Thinking Small
13 Family Businesses...........................................................................................................185 The Legal Structure of a Family Business ..................................................................186
Income Splitting Lowers Taxes .......................................................................................186 A Spouse in the Business ...................................................................................................189 Preserving a Family Business After Death ................................................................190
14 Microbusinesses and ..........................................................................................197 Home-Based Businesses
Business Expenses Incurred at Home .........................................................................198 Deducting Part of the Cost of Your Home ..............................................................198 Calculating Your Home Office Deduction ..............................................................202 Tax When Selling the Home Office .............................................................................205 A Microbusiness as a Tax Shelter ..................................................................................206
Part 4: Fringe Benefits
15 Fringe Benefits ..................................................................................................................211 How Fringe Benefits Save Taxes .....................................................................................213
Retirement Benefits..............................................................................................................214 Motor Vehicles........................................................................................................................214 Meals ............................................................................................................................................214 Travel and Lodging................................................................................................................215 Clubs and Athletic Facilities ............................................................................................217 Association Dues and Subscriptions...........................................................................218 Health Benefits........................................................................................................................218 Day Care Benefits...................................................................................................................220 Education Benefits ................................................................................................................220
Gifts, Rewards, Discounts, and Free Services for Employees .........................221 Adoption Assistance............................................................................................................222 Special Benefits for C Corporation Employees Only .........................................222
16 Retirement Plans ............................................................................................................227 Advantages of Retirement Plans ...................................................................................228
Overview of Retirement Plan Types..............................................................................229 Details About Each Type of Retirement Plan ........................................................230 Where to Go for a Retirement Plan .............................................................................239 Potential Tax Problems With Retirement Plans ....................................................240 Withdrawing Money From Retirement Plans ........................................................241 Closing Your Business and Your Plans ........................................................................242
Part 5: Buying or Selling a Business
a 17 BuyingtheBusinessa...........................................................................................................245 Buying Assets of Business ....................................................................................246
Buying Shares of Stock ........................................................................................................247 Assigning a Price to Business Assets ...........................................................................250 State and Local Transfer Taxes........................................................................................253
18 Selling a Business............................................................................................................255 Reporting the Sale of a Sole Proprietorship ............................................................256
The Importance of an Arms-Length Deal ...............................................................257 How to Protect Yourself From IRS Challenges ......................................................258
Part 6: Dealing With the IRS
You Can’t Pay Your Taxes ......................................................................261 19 WhenOwe Less Than $25,000 ........................................................................................262 If You
Getting More Time to Pay ................................................................................................262 Payi..."
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