“This plain-English guide will show you how to make the most of your tax deductions.” BUSINESSWEEK Free Legal Updates at Nolo.com Frederick W. Daily, Tax Attorney and author of Stand Up to the IRS 15th Edition Ta x Sav v y for Small Business • Deal with the IRS • Maximize your deductions • Write off long-term assets INCLUDES THE LATEST TAX LAW CHANGES Books & Software Get in-depth information. Nolo publishes hundreds of great books and software programs for consumers and business owners. Order a copy—or download an ebook version instantly—at Nolo.com. Legal Encyclopedia Free at Nolo.com. Here are more than 1,400 free articles and answers to common questions about everyday legal issues including wills, bankruptcy, small business formation, divorce, patents, employment and much more. Plain-English Legal Dictionary Free at Nolo.com. Stumped by jargon? Look it up in America’s most up-to-date source for defi nitions of legal terms. Online Legal Documents Create documents at your computer. Go to Nolo.com to make a will or living trust, form an LLC or corporation or obtain a trademark or provisional patent. For simpler matters, download one of our hundreds of high-quality legal forms, including bills of sale, promissory notes, nondisclosure agreements and many more. Lawyer Directory Find an attorney at Nolo.com. Nolo’s consumer-friendly lawyer directory provides in-depth profi les of lawyers all over America. From fees and experience to education and expertise, you’ll fi nd all the information you need to choose and contact the right lawyer. Free Legal Updates Keep up to date. Check for free updates at Nolo.com. Under “Products,” fi nd this book and click “Legal Updates.” You can also sign up for our free e-newsletters at Nolo.com/newsletters. Products & Services “ In Nolo you can trust.” THE NEW YORK TIMES “ Nolo is always there in a jam as the nation’s premier publisher of do-it-yourself legal books.” NEWSWEEK “ Nolo publications…guide people simply through the how, when, where and why of the law.” THE WASHINGTON POST “ [Nolo’s]…material is developed by experienced attorneys who have a knack for making complicated material accessible.” LIBRARY JOURNAL “ When it comes to self-help legal stuff , nobody does a better job than Nolo…” USA TODAY “  e most prominent U.S. publisher of self-help legal aids.” TIME MAGAZINE “ Nolo is a pioneer in both consumer and business self-help books and software.” LOS ANGELES TIMES  e Trusted Name (but don’t take our word for it) 15th Edition Tax Savv y for Small Business Attorney Frederick W. Daily LAW for ALL Fifteenth Edition JANUARY 2012 Editor DIANA FITZPATRICK Cover Design JALEH DOANE Book Design TERRI HEARSH Proofreading NICOLE THOMAS Index MEDEA MINNICH Printing BANG PRINTING International Standard Serial Number (ISSN): 1939-3040 ISBN 978-1-4133-1640-7 (pbk.) — ISBN 978-1-4155-1663-6 (epub e-book) Copyright © 1995, 1996, 1997, 1998, 1999, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, and 2011 by Frederick W. Daily. All rights reserved.  e NOLO trademark is registered in the U.S. Patent and Trademark Offi ce. 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. Reproduction prohibitions do not apply to the forms contained in this product when reproduced for personal use. For information on bulk purchases or corporate premium sales, please contact the Special Sales Department. Call 800-955-4775 or write to Nolo, 950 Parker Street, Berkeley, California 94710. Please note 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. 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, Bob Wells, and Susan Cornell made valuable contributions in copyediting, proofreading, and production. Much thanks to Beth Laurence and Diana Fitzpatrick 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, and 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. About the Author Fred Daily graduated from the University of Florida College of Law in 1968. He later received a tax law degree and is now a practicing tax attorney in Idaho and Florida. He is a frequent speaker at continuing education programs for tax professionals and is a former adjunct professor at Golden Gate University’s Graduate School of Taxation. He has appeared on numerous radio and national television programs, including “Good Morning America.” Fred is also the author of Stand Up to the IRS (Nolo), a problem-solving manual for individuals dealing with the IRS. He strongly believes that an educated taxpayer can beat the IRS at its own game. In his free time, Fred does some world traveling, enjoys numismatics, Shakespeare, and rides his motorcycle. You may contact the author by writing to him c/o Nolo, 950 Parker Street, Berkeley, California 94710, or by email: suirs@aol.com, or you can check his website at www.TaxAttorneyDaily.com. Reader feedback is always appreciated. Table of Contents Your Tax Saving Companion 1 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 5 A Word About Tax Shelters 7 e Alternative Minimum Tax (AMT) 8 2 Deductible Business Expenses 9 What Is a Deductible Business Expense? 11 Is It a Current or Future Year Expense? 13 Top Deductions for Businesses 14 e General Business Credit 26 Vehicle Expenses 26 How and Where to Claim Expense Deductions 32 What Is—And Isn’t—Income 33 3 Writing Off Long-Term Business Assets 37 Tax Treatment of Business Costs 39 Section 179: ExpensingBusinessAssets 40 Depreciating Business Assets 44 How to Report Depreciation and Section 179 Deductions 50 Inventory 52 Tax Basis of Business Assets 53 Leasing Instead of Buying 55 When You Dispose of Business Assets: Depreciation Recapture 58 Tax Errors in Depreciation 59 4 Bookkeeping and Accounting 61 Why You Need a Bookkeeping System 62 Should You Hire a Bookkeeper? 63 Manual or Computer System? 63 What Kinds of Records to Keep 67 How Long Records Should Be Kept 71 Bookkeeping Methods of Tracking Income and Expenses 71 Timing Methods of Accounting: Cash and Accrual 72 Accounting Periods: CalendarYear or Fiscal Year 74 5 Business Losses and Failures 77 Unincorporated Business Losses 78 Incorporated Business Losses 80 6 Tax Concerns of Employers 83 Employer Identification Numbers 84 What Are Payroll Taxes? 86 Reporting and Depositing Payroll Taxes 88 Classifying Workers: Employee or Independent Contractor? 95 Misclassifying Employees as Independent Contractors 98 IRS Filing and Payment Requirements for Employers 101 Record Keeping for Your Workers 102 7 Sole Proprietorships—Solos, Freelancers, and Independent Contractors 105 What It Means to Be a Solo—From a Tax Perspective 106 To Be or Not to Be—A Solo 106 Solo Income and Expenses 107 Solos’ Tax Forms: ScheduleCIs Your Friend 108 What If My Solo Biz Loses Money? 113 How Solos Are Taxed 114 Record Keeping for Solos 119 When a Solo Closes Up Shop 120 Death of a Solo 120 Outgrowing the Solo 120 8 C Corporations 123 Types of Corporations 124 How C Corporations Are Taxed 126 Tax Benefits of C Corporations 134 Incorporating Your Business 136 e Importance of Issuing Section 1244 Stock 139 Taking Money Out of a C Corporation 141 Tax Pitfalls of C Corporations 144 Dissolving a C Corporation 145 9 SCorporations 147 An Overview of Scorporations 148 Should You Choose S Corporation Status? 149 Tax Reporting for Scorporations 152 How S Corporation Shareholders Are Taxed 155 Social Security and Medicare Taxes 156 Electing S Corporation Status 158 Revoking S Corporation Status 158 Dissolving an S corporation 159 10 Partnerships 161 Partnership Tax Status 162 Tax Reporting 162 Tax Obligations of Partners 164 Partnership Losses 168 Partnership Contributions 169 Getting Money Out of a Partnership 171 Partnership Expenses 172 Selling or Transferring a Partnership Interest 172 Ending a Partnership 174 11 Limited Liability Companies 177 Taxes 178 Comparing LLCs With Other Entities 179 Operating Your Limited Liability Company (LLC) 180 Terminating a Limited Liability Company 182 12 Qualified Personal Service Corporations 185 Qualified Personal Service Corporations (QPSCs) 186 QPSCs and Taxes 187 Fringe Benefits 188 Transferring Shares 188 Dissolving a Qualified Personal Service Corporation 188 [...]... A P T E 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 5 A Word About Tax Shelters 7 The Alternative Minimum Tax (AMT) 8 1 4 | Tax Savvy for Small Business T ake it from one small business owner to another: Operating a business without tax savvy is like... help, taxwise • top fringe benefits for small businesses • ways to legally minimize taxes and lower your odds of an audit, and • what to do if the IRS ever challenges your business tax reporting or sends you a tax bill you don’t agree with Owning and operating a small business, full or part time, has been called the little guy’s tax shelter The self-employed (like your author) get tax benefits for expenditures... gods be with you 6 | Tax 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 State tax enforcement agencies are often... pays for The symphony trip satisfies the associated-with rule Extravagant entertainment An IRS auditor can reject entertainment deductions that are lavish and Part 1 The Basics and $250 for the couple’s personal tax matters Tax result: $550 is tax deductible for Aaron’s business (Schedule C) and $250 for miscellaneous items (Schedule A) on Aaron and Clarinda’s joint tax return 18  |  Tax Savvy for Small. .. overall tax bill, and • travel and vacations can qualify in whole or in part as deductible business expenses Sound interesting? With all of these possibilities, your business can earn less than if 2  |  Tax Savvy for Small Business you were working for someone else, and you still can come out ahead Of course, by going into business, you might be trading an eight-hour-aday job for a 24-hour one But for. .. 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 However, capital gains rates typically apply only to investors, not small businesses and their owners 8 | Tax Savvy for Small Business don’t understand them If the promoter harps on the tax savings first, watch... choice would reduce the tax bite Business and personal tax work Small business owners’ personal and business tax concerns are almost always inseparable, so one tax pro can handle an owner’s personal and business issues These fees, whether business- or personal-related, are always deductible, but different rules apply The accountant’s or tax pro’s bill should always split out the business and personal... 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... Medicare taxes You take the deduction on the first page of your Form 1040 tax return The form lists this as an “adjustment” to income, but it works like a deduction Real estate taxes Regular state and local taxes on real estate used for business are deductible business expenses However, if your business is home based, you must list this expense on Form 8829, which is filed with your individual tax return... ordinary business expenses as part of the cost of the item For instance, $25 of office supplies with $2 sales tax is deductible as $27; you don’t deduct the sales tax separately However, you must deduct sales taxes on assets you purchase for the business over the life of the asset or by using Section 179 (See Tax Basis of Business Assets” in Chapter 3.) Sales taxes a seller takes in for a state or local tax . 4 Where to Find Tax Rules 5 Marginal Tax Rate and Tax Brackets 5 A Word About Tax Shelters 7 The Alternative Minimum Tax (AMT) 8 4 | TAX SAVVY FOR SMALL BUSINESS T ake it from one small business owner. | TAX 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,. if “In America there are two tax systems; one for the informed and one for the uninformed. Both systems are legal.” —Judge Learned Hand 2 | TAX SAVVY FOR SMALL BUSINESS We know you put your