Tax Tips for Small Businesses

These articles offer helpful tips you can use when planning your tax strategy and preparing your tax returns.

For more help with tax planning, see the Tax Planning FAQs here...



How New Tax Law Increases Retirement Plan Wealth-Building

$40 billion of additional tax relief is on its way to what is already the largest legitimate tax shelter in the U.S. economy: the tax-favored retirement plan. This relief is in the big 2001 tax cut bill President Bush signed June 7.

Enhancing tax-favored retirement benefits was a major aim of that law--in one sense, the major aim, since more than half of the law's 127 pages deal with retirement plans. If you're a self-employed person without employees, here's what the law has to offer the retirement plans--Keogh plan, SEP, SIMPLE and IRA--that you might adopt.

  • Larger deductible contributions to a Keogh "money purchase" type of pension plan--as high as $40,000 a year.
  • Larger deductible contributions to a Keogh profit-sharing plan. Deduction can now be as large as with money purchase plans.
  • Larger annual retirement benefits under a Keogh "defined benefit" type of pension plan--allowing a pension as high as $160,000 a year. This and other changes allow higher deductible contributions to such plans.
  • Larger deductible contributions to SEP (also called SEP IRA) plans--as high as $40,000 a year.
  • Larger contributions to SIMPLE (SIMPLE IRA) plans--as high as $14,000 in 2002, higher in later years.
  • Larger after-tax (nondeductible) contributions to Keogh plans. These are contributions owner-employees make wearing their employee hat.
  • A new deductible catch up contribution wearing the employee hat for owner-employees age 50 or over: up to $1,000 in 2002, higher in later years. Available for contributions to Keoghs and SEPs; for SIMPLEs the contribution ceiling is halved (up to $500 in 2002).
  • Larger contributions to traditional or Roth IRAs--as high as $3,000 in either case (not more than $3,000 in all if combined) for 2002--2004; higher in later years. Deduction for traditional IRAs tested under current rules; Roth IRA contributions continue nondeductible.
  • New catch up contributions to traditional or Roth IRA for persons age 50 and over, up to $500 for 2002--2005, higher thereafter. Deduction determined under current rules. This catch up contribution is in addition to deductible catch up contribution described above (contribution as employee made to Keogh, SEP or SIMPLE plans).
  • New tax credit allowed low-income taxpayers for plan contributions, available to self-employed persons for contributions to a SEP or SIMPLE, or Keogh after-tax contribution as employee. A comparable credit is available for contribution to a traditional or Roth IRA. The maximum credit (rarely available) is $1,000.
  • Rollovers from IRAs to Keoghs are now allowed and may, within limits, include after-tax contributions.
  • Plan loans are eased. Department of Labor approval to borrow from your own plan is no longer required. Loans are now allowed up to $50,000.

When. All these changes became effective in 2002 or, as designated, starting in 2002 and increasing in later years.

So--wait till next year? Not if you have no plan now. A plan you adopt and fund this year can mean big tax savings this year--much bigger than your 2001 tax cut.

For example, with taxable income and self-employment earnings of $80,000 for 2001 (disregarding self-employment tax), the Bush tax cut saves $559 for 2001. If you invest the maximum allowed in a money purchase ($16,000) on your own behalf, you save a further $4,802 in taxes--more than 8 times the Bush tax cut. This $16,000 is your own money, growing tax-free in your own Keogh investment account.Ý

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Tax Deductions for the Self-Employed

by Christina K. Bailey, CPA

It's been said many times that having your own business is the "last great tax shelter". To a certain extent, that statement is quite true. Having your own business can convert what would otherwise be personal expenses to deductible ones. Also, instead of non-reimbursed employee business expenses being limited to the excess of 2% of adjusted gross income (and possibly subjecting you to Alternative Minimum Tax), for the self-employed the same business expenses would be fully deductible on Schedule C.

But I'm getting ahead of myself. Most people choose self-employment due to the flexible schedule and additional income it can provide. There are many "entity" choices, but this article will focus on the sole proprietor, which is the easiest to form and the least expensive to maintain.

When you are self-employed, the tax implications are tremendously different than that of being an employee. Your clients don't withhold taxes when they pay you! As such, you must be disciplined to earmark a percentage of gross receipts to cover your taxes. This percentage will be the total of:

  • Federal taxes
  • State taxes
  • Self-employment taxes

This last item, the dreaded self-employment (S/E) tax, is the one that catches some self-employed people off-guard. When you're an employee, you pay one-half of the FICA tax (7.65%) through withholding. When you self-employed, you pay both halves (remember, you are the employer and the employee) of the FICA tax (15.3%). This appears on line 47 of Form 1040. However, keep in mind that the S/E tax is assessed on net income (after business expenses), not gross receipts.

It's important to keep separate records to summarize your gross receipts and business expenses. Keep a separate checking account; use an accounting program to track income and expenses—something as simple as Quicken should be adequate for many small businesses.

Important deductions for self-employed individuals

Business use of automobile:

The standard mileage rate for 1997 is 31.5 cents per business mile. If you prefer to use the "actual expenses" method (including depreciation), your deduction depends on the ratio of business miles to total (business and personal) miles driven. Also, be sure to consider leasing a business vehicle; it may yield a higher deduction. Parking and tolls are separately fully deductible.

Medical expenses:

Hire your spouse, and deduct amounts reimbursed to your employee-spouse under your business health plan for medical expenses your spouse incurs him- or herself or on behalf of you and your children. The reimbursements are not considered taxable income to your spouse.

Business trip/vacations:

The travel costs cannot be written off unless the trip's primary purpose is business. Can also be tax-deductible for your spouse, but only if he or she is employed by the business and has a legitimate reason for being there. If your do a small amount of business, however, you can still deduct a pro-rata portion of your hotel bill and meals.

Expensing business assets:

The IRS allows you to elect to expense up to $18,000 of the cost of new or used equipment used in a trade or business. This includes the business use percentage of your home computer and peripherals. The maximum dollar will be increased to $25,000 in the year 2003. However, you cannot expense more than the amount of your net trade or business income. Note that "trade or business income" has been shown to include a spouse's wage income (when filing a joint return).

Office in the home:

Due to the Soliman Supreme Court ruling, many entrepreneurs who work in their home have lost their home office deductions. Basically, you have to spend the majority of your time and do the most important part of your job in your home office to qualify. The new tax bill reinstates the home office deductions starting in 1999 for self-employeds that have no other office but the one in their home to conduct the administrative or managerial functions of the business. If you qualify, you can write off the business use square footage percentage of the following items:

  • mortgage interest or rent
  • real estate taxes
  • home insurance
  • utilities
  • repairs and maintenance
  • home security system depreciation

Retirement plans:

Every self-employed individual should have a retirement plan! A SEP-IRA is the easiest to set up and maintain; you can put away approximately 13% of your Schedule C modified net income. It can be established and funded as late as the extended due date of your tax return.

For example, if you've "double-extended" your 1997 Form 1040, you can still deduct your 1997 SEP contribution as long as it is made by October 15, 1998.

You can put away even more under a money-purchase Keogh plan (up to 20%), but the plan must be established before year-end (but can be funded also up to the extended due date of the return).

Also, don't forget to deduct: 40% of your medical insurance premiums and one-half of your S/E tax.

This is just the tip of the iceberg; every small business needs a good tax adviser to get the details on all the tax implications of being self-employed.

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Clearing Up Some Tax Misconceptions

Misconception #1:
Using the automatic 4-month extension of filing your tax return by April 15 exposes you to a greater risk of being audited.

Wrong. There's no correlation between using the automatic extension and getting audited.

Misconception #2:
Using the preprinted label on your return increases your chances of being audited.

Wrong. The preprinted label is used to speed up return processing. There's no correlation between using the preprinted label and being audited.

Misconception #3:
You can't claim your parents as dependents unless they live with you.

Wrong. Parents need not live with you their children to be claimed as dependents. If other requirements regarding amount of support and amount of parents income are satisfied you can claim your parents as dependents even though they do not live with you.

Misconception #4:
Money received as a gift or inheritance is taxable.

Wrong. Not as a general rule. Money or property received as a gift or inheritance is exempt from income tax. Payment of the gift or estate tax is the responsibility of the donor or the decedent's estate. However, if the gift or estate tax isn't paid the IRS can collect the tax from the donee or heir.

Misconception #5:
Creating a revocable living trust saves income and/or estate taxes.

Wrong. The creation of a revocable living trust has no effect on income and/or estate taxes. A living trust may save probate fees and speed up the time it takes to transfer assets to beneficiaries.

Misconception #6:
Distributions from tax-free funds are always tax-free.

Wrong. In addition to income, tax-free funds sometimes make capital gains distributions. The capital gains distributions are subject to income taxes even though they are distributed by tax-free funds.

Misconception #7:
You can not make an IRA contribution if you earn more than $35,000 as a single filer or $50,000 as a married filer.

Wrong. If you or your spouse is not covered by a qualified retirement plan you can make a deductible IRA contribution regardless of how much income you earn. If you or your spouse are covered by a qualified plan you can still make a non-deductiblecontribution to an IRA. The advantage of making non-deductible contributions to an IRA is that the investment grows on a tax deferred basis.

Misconception #8:
Canceled checks are always accepted as proof of charitable contributions.

Wrong. A written acknowledgment from the charity is required for all charitable contributions of $250 or more. A canceled check is not considered sufficient substantiation for contributions of $250 or more.

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55 Commonly Omitted Tax Deductions

The following list contains 55 deductions that are often overlooked. The list is meant to serve as a quick-reference checklist. It's neither all-inclusive nor are all the items applicable to everyone. Your specific circumstances will determine which deductions you qualify for.

Medical

  • 1. Contact lenses
  • 2. Insurance for contact lens
  • 3. Hearing aids
  • 4. Contraceptives, if by prescription
  • 5. Alcoholism and drug-abuse treatment
  • 6. Lead paint removal
  • 7. Orthopedic shoes
  • 8. Special schools for a handicapped child
  • 9. Special equipment for the disabled or handicapped
  • 10. Self-employed persons can deduct 30% of health insurance premiums paid for themselves and their dependents
  • 11. Travel mileage related to medical treatment (ten cents per mile)
  • 12. Special foods prescribed by your doctor and taken in addition to your normal diet
  • 13. Lodging while away from home under medical care
  • 14. Prescription drugs

Taxes:

  • 15. Personal property taxes on automobiles
  • 16. Self employed persons can deduct half of self employment tax
  • 17. Foreign taxes

Charity:

  • 18. Out-of-pocket expenses relating to charitable activities
  • 19. Standard deduction of 12 cents a mile for use of your auto in charitable activities
  • 20. Parking and tolls when using your auto in charitable activities
  • 21. Fair market value of items given to charities
  • 22. Appraisal fees paid to value property donated to charities

Investments:

  • 23. Penalty on early withdrawal of savings
  • 24. Safe deposit boxes
  • 25. IRA trustee's administrative fees if billed separately
  • 26. Failing to add the amount of reinvested funds (e.g., dividends) to your cost when computing gain or loss on the sale of mutual funds
  • 27. Worthless stock or securities

Casualty:

  • 28. Theft or embezzlement losses
  • 29. Casualty losses

Work-related:

  • 30. Business tools
  • 31. Dues to labor unions
  • 32. Employment agency fees
  • 33. Uniform and work clothes
  • 34. Newspapers and trade publications that you purchase to check employment ads
  • 35. Education that maintains and improves your skills
  • 36. Employee contributions to state disability funds
  • 37. Business gifts to a maximum of $25 per recipient
  • 38. Cellular telephones
  • 39. Passport fees for business travel
  • 40. Cleaning and laundry bills when on a business trip
  • 41. Resume preparation costs in connection with a search for a new job in your present occupation
  • 42. Travel expenses (local and out of town) in connection with a job search for a new job in your present occupation ... even if you don't get the job

Miscellaneous:

  • 43. Mortgage prepayment penalties
  • 44. Gambling losses to the extent of gambling winnings
  • 45. Points or origination fees on a mortgage to purchase a residence
  • 46. Accounting fees for tax preparation
  • 47. Fees paid to financial planners
  • 48. Depreciation on home computers to the extent used for business or investments

Carry-over Items:

These are items weren't deductible in prior years because of limitations on the amounts permitted to be deducted in that particular year but that could be carried ahead and deducted in subsequent years.

  • 49. Capital losses carry forward
  • 50. Investment interest
  • 51. Charitable contributions
  • 52. Equipment expensing election
  • 53. Alternative minimum tax credit
  • 54. Business operating losses
  • 55. Passive losses

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