11th edition Tax Savvy for Small Business by Attorney Frederick W. Daily ELEVENTH EDITION NOVEMBER 2007 Editor DIANA FITZPATRICK Cover Design JALEH DOANE Production SARAH HINMAN Proofreading ROBERT WELLS Index MEDEA MINNICH Printing 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. ank you one and all for putting up with me. My peers in the tax community contributed immensely and without complaint. e 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 Your Tax Savvy Companion 1 Part 1: e Basics 1 Tax Basics 3 How Tax Law Is Made and Administered: e Short Course 4 Where to Find Tax Rules 5 Marginal Tax Rate and Tax Brackets 7 e 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 e 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 Business Losses and Failures 75 Unincorporated Business Losses 76 Incorporated Business Losses 78 6 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: e 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 e 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 e 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: inking Small 13 Family Businesses 185 e 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 Home-Based Businesses 197 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 17 Buying a Business 245 Buying the Assets of a 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 e Importance of an Arms-Length Deal 257 How to Protect Yourself From IRS Challenges 258 Part 6: Dealing With the IRS 19 When You Can’t Pay Your Taxes 261 If You Owe Less an $25,000 262 Getting More Time to Pay 262 Paying in Installments 263 What to Expect When the IRS Gets Serious 264 Dealing With a Monster Tax Bill 268 When the IRS Can Take Your Assets 270 20 Audits 275 Who Gets Audited? 277 How Long Do You Have to Worry About an Audit? 279 How the IRS Audits Small Businesses 279 e Auditor’s Powers 280 Should You Get Audit Help? 282 Preparing for Your Audit 283 What to Bring to an Audit 283 Don’t Rush a Field Audit 285 What Auditors Look for When Examining a Business 285 How to Behave at an Audit 290 How to Negotiate With an Auditor 291 Your Options After Getting an Audit Report 293 When Your Audit Is Final 295 21 Appealing IRS Audits 297 IRS Appeals 298 Contesting an Audit in Court 300 22 Penalties and Interest 305 Common Reasons for Penalties 306 Interest on Tax Bills 307 Understanding Penalty and Interest Notices 307 How to Get Penalties Reduced or Eliminated 308 How to Get Interest Charges Removed 310 Designating Payments on Delinquent Tax Bills 310 23 Help Beyond the Book 313 Finding Answers to Tax Questions 314 Finding and Using a Tax Pro 320 24 Answers to 25 Frequently Asked Tax Questions 325 G Glossary 333 A Appendix 343 IRS Publications List 344 Forms Checklist and Due Dates 345 Quick and Easy Access to IRS Tax Help and Tax Products (Publication 2053-A) 346 Index 347 [...]... choices and decisions for your business ● 1 C H A P TE R Tax Basics 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 4 | Tax Savvy for Small Business T ake it from one small business owner to another: Operating a business without tax savvy is like skydiving... Maryland, don’t think the tax hawks from California can’t get you Here are some state tax issues to watch out for: • Income taxes Most states have personal income taxes See Tax Reporting for C Corporations” in Chapter 8 and Tax Reporting for S Corporations” in Chapter 9 (corporate state income tax and franchise tax information); “State Taxes on LLCs” in Chapter 11; “Annual Partnership Tax Returns” in Chapter... Savvy for Small Business Don’t Forget About State and Local Taxes While this book covers federal taxes, you and your business may also be taxed by your state and local agencies Unfortunately, it can be even more timeconsuming to comply with state tax laws than with federal tax laws Especially if your enterprise is a multistate affair, you might find yourself drowning in paperwork So, figure state taxes... including your business, when the estate is large enough (See “Preserving a Family Business After Death” in Chapter 13.) Part 8 | Tax Savvy for Small Business The Alternative Minimum Tax (AMT) • passive income or loss As if the tax code weren’t diabolical enough, there is something called the alternative minimum tax (AMT) The AMT is not a business tax but is really a second (alternative) set of tax rates... Postal & 24 | Tax Savvy for Small Business • business interruption insurance, and • life insurance (deductible for C corporations only) 24 Research and Development Credits The tax code allows a tax credit for “research or experimental” expense This category is limited to the development of an invention, formula, or process to develop a product, process, or patent For instance, Gary Geok’s costs for developing... dollars in your pocket each year Four Different Federal Taxes Affect Small Business Owners • Income taxes (everyone who makes a profit owes these) • self-employment taxes (Social Security and Medicare taxes) • payroll taxes (if your business has employees) • excise taxes (only a few small businesses are subject to these) Thousands of federal tax laws, regulations, and court decisions deal with these... owners can claim charitable deductions made by the business on Schedule A of their Form 1040 tax returns Part 1 The Basics Tip 22 | Tax Savvy for Small Business Example: Belinda, a sole proprietor, buys a new nail gun and air compressor for her drywall contracting business She donates her old equipment to Habitat for Humanity Belinda originally paid $2,000 for the donated items and claimed $1,100 in deductions... corporate, and other tax rules, he decided not to expand chapter 1 | Tax Basics | 7 Don’t Forget About State and Local Taxes (continued) Marginal Tax Rate and Tax Brackets In our income tax system, the more money you make, the higher your tax rate Often referred to as your tax bracket, or marginal tax rate, it is the percentage at which the last dollar of income you earn will be taxed For example, Janice... second choice would reduce the tax bite Business and personal tax advice Small business folks’ personal and business tax concerns are always inseparable, so their tax pros necessarily deal with both concerns Tax pro fees are always deductible, but different rules apply When the advice is given at the same time, the accountant’s or tax pro’s bill should split out the business and personal portions The... same tax return Example: Aaron goes to Bridget, his accountant, for tax preparation and advice on how to reduce his family’s income taxes His self-employed income is from the model airplane newsletter he publishes, and his wife Clarinda’s salary as architect Bridget’s statement for services of $800 shows $550 for Aaron’s business and $250 for the couple’s personal tax matters Tax result: $550 is tax . ● 1 CHAPTER Tax Basics How Tax Law Is Made and Administered: e Short Course 4 Where to Find Tax Rules 5 Marginal Tax Rate and Tax Brackets 7 e Alternative Minimum Tax (AMT) 8 4 | TAX SAVVY FOR SMALL BUSINESS T ake. | TAX SAVVY FOR SMALL BUSINESS e Alternative Minimum Tax (AMT) As if the tax code weren’t diabolical enough, there is something called the alternative minimum tax (AMT). e AMT is not a business. you. Here are some state tax issues to watch out for: • Income taxes. Most states have personal income taxes. See Tax Reporting for C Corporations” in Chapter 8 and Tax Reporting for S Corporations”