Tax Law for Small Business Owners
Take it from one small business owner to another: Operating a business without the right tax knowledge is like skydiving without a parachute—certain to end in calamity.
Many business failures stem from ignoring the record keeping and taxes. Like it or not, the government is always your business partner.
Tax knowledge has powerful money-saving potential. It can give you a fatter bottom line than your competitors who don’t bother to learn. For instance, there are several ways to write off car expenses.
The right choice can mean a few thousand more after-tax dollars in your pocket each year.
Four Different Federal Taxes Affect Small Business Owners
- Income taxes (owed by everyone who makes a profit)
- Self-employment taxes (Social Security and Medicare taxes)
- Payroll taxes (if your business has employees), and
- Excise taxes (owed by only a few small businesses)
Thousands of federal tax laws, regulations, and court decisions deal with these four categories. We will look only at the relatively few rules most likely to affect you.
TIP: Small business or independent contractor?
Self-employed people often ask whether they are “businesses.” The IRS says “yes.” Whether you run a flower shop or work at home as a website designer, you’re a small business. This includes all kinds of self- employed people, from independent contractors, consultants, and freelancers, to the guy who owns the pizza parlor down the street.
How Tax Law Is Made and Administered: The Short Course
Think of this section as a high school government lesson, only try to stay awake this time—it could mean money in your pocket.
The federal government. Visualize a three- branched tree. Congress, the legislative branch of the federal government, makes the tax law. The executive branch, which includes the Treasury Department, administers the tax law through the IRS. The judicial branch comprises all the federal courts, which interpret the tax laws and overrule the IRS when it goes beyond the law.
The power to tax incomes was granted by the 16th Amendment to the U.S. Constitution; the first Income Tax Act was passed in 1913. Contrary to what fringe groups and con artists contend, income tax law and the IRS are legal and are not going away.
The code. Tax law begins with the Internal Revenue Code (referred to throughout this article as the tax code or IRC). Congress enacts and revises the tax code. The president signs it (usually), and it becomes law. One major reworking of the IRC was officially called the Tax Reform Act, but was known to tax pros as the Accountants’ and Tax Attorneys’ Relief Act.
The IRS. The Internal Revenue Service (IRS) is a division of the Treasury Department. It is headed up by the commissioner of Internal Revenue, a presidential appointee. The IRS is charged with enforcing the tax code.
The IRS is headquartered in Washington, but it is doubtful you will ever deal directly with anyone there. The real work is done at IRS satellite offices.
The courts. The United States Tax Court decides disputes between the IRS and taxpayers and interprets the tax code. It is pretty easy to go to tax court in most cases, even without an attorney. Tax disputes are also decided in U.S. District Courts and the Federal Court of Claims, but these require payment of the disputed tax first, unlike in the tax court. All decisions in those courts, for or against you, may be reviewed by higher courts, meaning the various U.S. Courts of Appeal and the U.S. Supreme Court. The exception is small case tax court decisions.
See, that wasn’t all that bad, was it? Now, venture forth and may the small business gods be with you.
CAUTION: Tax Laws are ever-changing
Some changes are made retroactive, others become law on the date they are signed by the president, and some won’t be effective until the next year or further into the future. Also, federal court decisions, which interpret the tax code, are released throughout the year and may change what is written here.
Where to Find Tax Rules
How to research tax law questions is covered later. Here’s a brief description of the main sources of federal tax law.
Federal statutes. Congress enacts tax laws, called codes, which make up the Internal Revenue Code. Each tax provision (called a code section) has its own number and title. For example, IRC § 183 refers to tax code Section 183, titled “Activities Not Engaged in for Profit.”
IRS publications. When Congress makes tax laws, it paints with a fairly broad brush. It’s then up to the Treasury Department (the IRS is a part of it) to determine how the tax code is to be applied. The details are filled in by IRS publications, such as Treasury Regulations.
These “regs” are numbered in the same order as their related tax code sections, but preceded by the numeral “1.” For example, the regulation explaining IRC § 183 is Reg. 1.183. (Not all IRC sections have corresponding regulations.)
Both the IRC and IRS publications are available at most public libraries, larger bookstores, and, of course, IRS offices. The IRC is online at the IRS website (www.irs.gov) and www.law.cornell.edu (search for U.S. Code, Title 26, Internal Revenue Code). IRS regulations are available on the IRS’s website.
Court cases. When the IRS and taxpayers go to court, a federal judge can reject the IRS interpretation of the tax law. The judges’ published opinions offer guidance on the correct interpretation of the tax code. Look up tax court opinions (from January 1, 1999, to the present) on the tax court’s website at www.ustaxcourt.gov or at a law library, courthouse, or law school.
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 marginal tax rate, it is the percentage at which the last dollar of income you earn will be taxed. You can find your tax rate in the annual federal income tax bracket tables published each year by the IRS. See www.irs.gov for current rates.
CAUTION: Don’t Forget About State and Local Taxes
While this article covers federal taxes, you and your business may also be taxed by your state and local agencies. Unfortunately, it can be even more time- consuming to comply with state tax laws than with federal tax laws, especially if your enterprise is a multistate affair.
State tax enforcement agencies are often more frustrating to deal with than the IRS. And many states have out-of-state enforcement offices or use private collection agencies to track you down anywhere in the United States. So, just because you live in Maryland, don’t think the tax hawks from California can’t get you.
Here are some state tax issues to watch out for:
- Income: Most states (41) have personal income taxes. Florida, Nevada, and Texas are the most notable exceptions.
- Sales: Most states have a sales tax on things sold within their borders. But each state has different rules for collection and exemptions.
- Use taxes: Most states tax things purchased out of state that were shipped into your state without paying sales
- Business transfer: Whenever a business changes hands, your state, county, or city may impose a tax on the buyer, the seller, or both.
- Inventory and other property: Some states and local governments impose annual taxes on personal property used in business, such as vehicles or equipment. And, most counties tax real estate, whether it is used for business or personal purposes.
- Internet: There is a federal moratorium on states’ imposing taxes on Internet transactions unless the seller has a physical presence in the state. However, some states impose a “use” tax for out-of- state purchases (see above), and Internet sales are taxed if the goods are delivered within your home state.
- Payroll: All states with income taxes have payroll tax, withholding, and collection systems similar to the federal system.
- Telecommuter: New York is one of a growing number of states that tax you if you work from home in another state (for instance, Connecticut), if the main business location is in New York.
- License: There are myriad state and local licenses that businesses must secure. Check with your local government agencies, chamber of commerce, or attorney.
- Out-of-state: As an employer, you can be responsible for withholding state income taxes on your out-of-state employees’ income for their home states.
- Estate: Most states impose an estate tax on the value of all of your assets, including your business, when the estate is large enough.
- State and local: To find your state tax and licensing agencies, go to www.statelocalgov.net or www.taxadmin.org for a listing of all the government agencies in your state, or look them up in your local phone book. Also, most states and many cities and counties have their own websites.
EXAMPLE: Janice is single, lives in New York, and reports $100,000 in income in 2015. Her marginal tax rate, or tax bracket, is 28% after her personal exemptions and deductions. Janice’s income tax is figured like this: The first $90,750 of income will be taxed in increments at the 10%, 15%, and 25% tax rates, and the remaining $9,250 will be taxed at 28%. Every additional dollar Janice earns will be taxed at 28% until it reaches more than $189,300 in income, at which point her marginal tax rate, or tax bracket, will jump up to 33%, and maybe as high as 39.6%.
If Janice factors in New York state and local income taxes and Social Security and Medicare tax, her true marginal tax rate may exceed 50%. Some types of income are taxed at different, lower rates, called capital gains.
TIP: What’s your marginal tax rate?
Determine the effect of additional business income or deductions by applying your marginal tax rate. For instance, if your marginal tax rate is 28%, 28¢ of every new dollar you earn goes to Uncle Sam. Conversely, you save 28¢ in federal income taxes on every additional dollar that qualifies as a deductible expense. Knowing your marginal tax rate can tell you how much you will be saving by increasing your tax deductions in any given year.
What Is—And Isn’t—Income
“Except as otherwise provided … income means all income from whatever source derived.” That’s how the tax code defines income. (IRC § 61.) Not too helpful, is it? Paraphrased, it means, “You make it, we’ll tax it.” It can’t get much broader than that.
Things That Count as Taxable Income
For the most part, Uncle Sam doesn’t care whether your income is from self-employment, wages, invest- ments, or organized crime. If it’s income, it is taxable.
First, anything of value received by you or your business is income unless it falls within the exclusions created by Congress. Here are some common noncash sources of taxable income.
Barter or trade. Goods and services received in a business deal are income unless they are consigned to you. When you barter (trade your goods or services), the fair market value of the item or service received is income.
EXAMPLE: Marvin designs a brochure for Beeline Mortgage Brokers, for which he would normally charge $500. In return, Beeline gets Marvin a new home mortgage without charging its customary
$500 fee. No money changed hands, but both Marvin and Beeline should report $500 income.
A lot of bartering goes on with small businesses and self-employed people, and the IRS is none the wiser. But getting away with something doesn’t make it legal, does it?
Side jobs. You can have business income even if you aren’t involved in a money-making activity on a regular or full time basis. If you performed a service and got paid for it only once during the year, it’s still income and reportable to the IRS.
Constructive income. Constructive income is a legal doctrine that taxes things that you don’t actually have in your hands, but that you have a right to. Whether you grab it or not, it’s income the moment it’s available.
EXAMPLE: On December 1, 2017, Raylene gets a $5,000 check from BigCo for her Web design services performed in November. Raylene looks at her books and sees she has already made so much that year that this $5,000 will be taxed at the highest individual tax rate (39.6%). Raylene is planning on taking a lot of time off traveling the following year, and her income will be drastically reduced. She would like to hold off cashing the
check until after January 1, 2018 so that she can be taxed at a lower tax rate. Can she do it? No. The $5,000 was constructively received in 2017, and so is income in that year, regardless of when she cashes the check.
Illegal and off-the-books income. The tax law is morally neutral, not distinguishing between the fruits of your labor or ill-gotten gains, so even dirty money is taxable. As the IRS is fond of telling us, the legendary Al Capone wasn’t sent to jail for murder, bootlegging, or racketeering. He went to Alcatraz for not reporting income from all those activities.
EXAMPLE: Rico is a hit man for the Soprano family. The cash, Cadillac, suits, and Cuban cigars he receives for his “work” are all taxable, and reportable, income.
Also in this category are kickbacks and bribes.
You don’t have to list the source of your illegal income for the IRS—you can claim your constitutional right against self-incrimination. If this sounds like something you might try, see a tax attorney first.
Foreign income. Income you earn from wages or self-employment or any source from anywhere in the world is taxable for American citizens and most residents, with two exceptions noted below.
EXAMPLE: While traveling in Hong Kong, Juliana, an antique dealer from California, spotted a rare Ming vase. She paid $200 for it and sold it to another dealer in Hong Kong for $4,800. Result: Julia must report $4,600 of taxable income to the IRS. Silver lining: If the primary purpose of the trip was for business transactions like this one, Juliana should be able to deduct at least some of her travel expenses.
Exception One: An American residing out of the United States for most of the year can exclude $107,600 (2020) from his or her income taxes. To get this foreign tax exclusion, you must file a tax return in the United States every year claiming the exclusion.
Two additional key points:
- You must still pay Social Security tax on all your foreign
- You must pay income tax on any investment income you make while living outside the country.
EXAMPLE: Charlene works as an English teacher in Spain for two years and earns $45,000 per year. She moves to Spain, not returning to her home in
Vermont until three years later. Charlene pays Social Security tax but doesn’t owe any income tax in the United States as long as she files a return each year and claims the exclusion. (This doesn’t mean that Charlene doesn’t pay taxes in Spain, though.)
Exception Two: If you pay taxes in another country on income not covered by the foreign tax exclusion, you may get a tax credit in the United States for the taxes you paid abroad.
EXAMPLE: Stanley, an independent contractor, goes to Norway for three months to extinguish an oil fire on an offshore rig in the North Sea. He is paid $100,000 for the job with $40,000 withheld and paid to the Norwegian government in income tax. Tax result: The $100,000 is taxable income that must be reported to the IRS, but Stanley gets a tax credit for the $40,000 he paid to Norway. He must file a U.S. tax return to get the credit.
For more information on these two exceptions, see IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Finally, even if you renounce your U.S. citizen- ship and move abroad, you are still subject to U.S. tax law on income and gains for ten years. So much for offshore tax havens.
Exclusions: Things That Aren’t Income
Some income isn’t taxable because it falls into the “except as otherwise provided” section of the tax law. (IRC § 61.) Here are the main legal exclusions—things that don’t have to be reported to the IRS.
Gifts and inheritances. Income tax never has to be paid by the recipient of gifts or inheritances, no matter how much is received.
EXAMPLE: Aunt Sophie leaves Ralphie, her favorite nephew, her mansion on Maui, her Kentucky Derby-winning horse, and $70 million. Tax result: Ralphie owes nothing to the IRS—but Aunt Sophie’s estate most likely paid a hefty estate tax.
Prizes and lottery winnings aren’t considered gifts, and are taxable.
EXAMPLE: The Publisher’s Clearing House Prize Patrol drops off a $10 million check at Mallory’s business. This windfall is not a gift, since Mallory had to do something for it: fill in the form, place about a hundred different stickers on it, and mail it in. Uncle Sam is due his share of the $10 million.
Fringe benefits. Many fringe benefits provided by businesses to owners and employees are not taxable income, but a few are. Bonuses, vacation pay, and the like are always taxable.
Return of capital. Getting back what you put into a business doesn’t have any tax consequences.
EXAMPLE: Elaine decides to move to New Zealand and sells her partnership interest in the Doggy Donut business to Marina for $15,000. She had owned a share of the business for only a few months and had $12,500 invested in it. Tax result: Elaine must report $2,500 of income (the gain on her investment in the partnership) on her tax return.
Loans. If the business has to pay it back, it’s not income.
EXAMPLE: Roxanne pays $40,000 for the small warehouse building she uses to store and ship costume jewelry. She refinances the building and takes out a mortgage of $30,000. This is a tax-free way for Roxanne to take money out of her business.
Consignments. Goods held by your business that belong to others are neither income nor inventory.
For more details on exclusions from income, see IRS Publication 525, Taxable and Nontaxable Income.
A Word About Tax Shelters
A so-called tax shelter can be a perfectly legal way for a small business owner to reduce his or her income tax bill. One of the more common forms of tax shelters is to own rental property where the cash and noncash tax deductions, interest, depreciation, and insurance exceed the rental income. The owner/taxpayer may be able to use the loss from the rental property to offset income from other sources (such as a small business) on his or her tax return. Any appreciation in the property is not taxable until the property is sold.
2020 Federal Personal Income Tax Brackets*
Income If Single
Income If Married Filing Jointly**
|10%||Up to $9,700||Up to $19,400|
|12%||$9,701 to $39,475||$19,401 to $78,950|
|22%||$39,476 to $84,200||$78,951 to $168,400|
|24%||$84,201 to $160,725||$168,401 to $321,450|
|32%||$160,726 to $204,100||$321,451 to $408,200|
|35%||$204,101 to $510,300||$408,201 to $612,350|
|37%||All over $510,301||All over $612,351|
|* These dollar amounts are subject to annual IRS adjustments for inflation. This table also does not take into account itemized or standard deductions that all taxpayers get for them-selves and their dependents. For 2020, the standard deduction is $12,400 (single) and $24,800 (married filing jointly). ** Tax brackets for heads of households and married people filing separately are somewhat different.|
This should not be confused, however, with the type of abusive tax shelters that the IRS is on the watch for. These deals, often marketed by self-styled financial experts or even some big named accounting firms, involve transactions with tax reduction motives but minimal or no economic substance.
They usually promise large tax deferrals, deductions, or write-offs beyond your investment cost—the tax equivalent of a free lunch. If you are audited, the IRS will demand that the proposal could stand on its own as a moneymaker, without the tax benefits.
The moral is, don’t buy into a tax savings scheme, whatever it is called, unless it has a reasonably good chance of making a profit—with tax savings as an added bonus. Many of these plans are so complicated that no one wants to admit they don’t understand them. If the promoter harps on the tax savings first, watch out. Don’t plunge in without checking with a trusted tax pro. If you get involved in a scheme that the IRS rules is abusive, you’ve got to give back any tax breaks, and pay penalties, interest, and any legal fees.