« How do you get audited? | Main | Tax Issues For Foreign Students – F Visa & Opt Status »
Tax Tips for Small Businesses
By cpa | April 8, 2008
Most of unincorporated business are considered “sole proprietors.” A sole proprietor is just another way of saying “self-employed,” “independent contractor,” or “freelancer.” Income and expenses related to your self-employment is reported on your 1040, Schedule C.
However, IRS is fully aware of the tax benefits of being self-employed. They are on the lookout for individuals who (1) have a high business loss, or (2) have business losses year after year.
If you are in one of these situations, you need to start thinking about how to protect yourself in case the IRS audits.
The basic tax planning strategy goes like this: reduce your taxable income, shift taxable income into nontaxable income, take advantage of tax credits, and pay the right amount of estimated taxes.
The first step to getting organized is to separate your freelance income from other types of income. Keep a record of all your business-related income. Have a separate business bank account and a separate credit card.
Your clients may send you a Form 1099-MISC to report 2007 payments to you. Form 1099-MISC is like a W-2, it is used to report income you received. The IRS also gets a copy of any 1099s. Your total business income on Schedule C Line 1 must be greater than or equal to the total amount of income reported on your 1099-MISC forms. If you report less income on your Schedule C than reported on your 1099s, you will get an audit notice. The easiest way to avoid an audit is to report all your income, whether you received a Form 1099 or not.
The second step to getting organized is taking a look especially at the various types of business-related expenses you can report. I highly recommend you start tracking your business-related expenses using different categories. For example, advertising, insurance, legal and professional services, auto, office expenses, repair, rent, supplies, education, due and subscription, computer, travel, meal and entertainment, utilities, telephone, home office and others. You can track your expenses using folders to sort receipts, or using a spreadsheet program, or using a personal finance program such as Excel, Quicken, QuickBooks, Microsoft Small Business.
You need to make sure your expenses are necessary and ordinary. That way the IRS auditor will see that your expense was clearly related to your business activity.
Claiming expenses for your home office need to follow the IRS rules.
Accounting for Your Business Assets. A business asset is any property with a useful life longer than one year and which is used to produce income. Thus your website, computer, software programs, and office furniture can all be considered business assets. You have two choices for accounting for these purchases. You can treat them as ordinary expenses and deduct the full cost of purchase in the year the property is bought by using Section 179, or you can treat them as capital expenses and spread out the cost of the purchase over a number of years.
The basic equation for a Schedule C, is income minus expenses equals profit. If the profit figure is a positive number, it increases both your regular income tax and your Self-Employment Tax. The Self-Employment Tax, figured on Form 1040 Schedule SE , is 15.3% of your net profit and represents the Social Security and Medicare taxes owed on your business profit. As an employee (on a W-2), you only pay half of the Social Security and Medicare taxes (7.65%), and your employer pays the other half. As a self-employed, you are your own employer, so you pay both halves.
Most self-employed people get into tax trouble because of the Self-Employment Tax. You need to set aside money at least every quarter, or better yet every month, towards your Self-Employment Tax. Let’s say you anticipate having a net profit of around $1,000. Well, your Self-Employment Tax would be ($1,000 x 15.3%) $153. If you divide that into four quarterly payments, you should be paying $38.25 every quarter to the IRS as an estimated tax payment. You should also calculate your anticipated regular income tax. If you are in the 25% tax bracket, the additional income tax on your business profit would be ($1,000 x 25%) $250. So you should set aside $403 ($153 + $250) over the course of the year towards your estimated taxes. Freelancers who fail to make reasonable estimates of their future taxes often end up owing at the end of the year. Paying a balance due can be a hardship for struggling freelancers. Protect yourself from tax troubles by planning ahead, and making a sincere effort to pre-pay your taxes.
If the net profit figure on your Schedule C is a negative number, you have a business loss. Your business loss reduces your total income. If you have a W-2 job, you can use the business loss to offset your W-2 income. This means you will get a bigger refund compared to someone who earned the same amount of wages but did not have a side business.
Reducing your taxes in this way is an excellent tax strategy. However, the IRS disallows a hobby loss. What is a Hobby Loss? The IRS expects new businesses to incur a loss. It is normal for a business to have a year or two of losses before becoming profitable. But if a business reports a net loss in 3 out of 5 years, it is presumed to be a hobby.
You can still be fine if you can still prove your profit motive using the following nine factors:
- You carry on the activity in a businesslike manner,
- The time and effort you put into the activity indicate you intend to make it profitable,
- You depend on income from the activity for your livelihood,
- Your losses are due to circumstances beyond your control (or are normal in the start-up phase of your type of business),
- You were successful in making a profit in similar activities in the past,
- The activity makes a profit in some years, and how much profit it makes, and
- You can expect to make a future profit from the appreciation of the assets used in the activity.
An audit to defend your business losses can be a very expensive and time consuming. If you lose, the IRS will disallow the loss and expenses. You will have to repay some of your income tax, plus penalties and interest. You also have a higher chance to be audited.
If you are self-employed, you must carry on your freelance work in a very businesslike manner. This means keeping good records, keeping a business diary showing meetings with clients, deadlines, and projects, having business cards and a web site that promotes your business, and so forth.
The hobby loss rule-of-thumb applies to sole proprietors filing a Schedule C. One of the surest ways to prove you are serious about doing business is to form some sort of separate business entity. Businesses are separate entities for tax purposes, and so setting up a business for your freelance will provide a way for you to separate your personal income and expenses from your business income and expenses.
Incorporating your business in a formal way for you to separate your business activities from your personal activities. I will discuss incorporating your business and protecting your losses in a separate article.
Topics: Businesses |
April 10th, 2008 at 11:42 pm
[...] Tax Tips for Small Businesses Accounting for Your Business Assets. A business asset is any property with a useful life longer than one year and which is used to produce income. Thus your website, computer, software programs, and office furniture can all be … [...]