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Weekly UpdatesSo you are done with the rat race and are finally going to open that surf shop down by the beach. Of course, you'll want to set up your business in the most tax-advantageous way possible. The first step in that process is deciding whether to establish your business as a sole proprietorship or as a corporation.
Sole proprietors prepare their taxes using an IRS Form 1040, specifically on a Schedule C. Most sole proprietors file under their own name. Yes, you can name it, "Petey Pirate's Pet Store." Just file a "doing business as" (DBA) form with your local tax assessment office or municipal documents office.
Your tax bill will be based on the income your business earns. For example, if "Petey Pirate's Pet Store" has a great year and makes $50,000, Peter Parker is going to be paying taxes based upon that $50,000. But don't forget you'll be able to claim $60,000 in deductions for Amazonian Piranhas and Rhesus monkeys you bought during the year.
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If your business is starting out on larger scale than, say, a pirate pet store, and you already have a good number of employees, corporation status may be a better option for its limited liability advantages. In other words, were the corporation to fail, its owners--i.e., shareholders--would only lose their investment. They would not be personally liable for the remaining debts of the corporation.
Be forewarned about corporations, though--they are a lot more complicated than sole proprietorships, and are also subject to twice the amount of taxation. That's because the corporation's income is taxed two times, the second being on dividends paid out of earnings.
Fraud Watch
There is a difference between tax avoidance and tax evasion. Tax avoidance is generally the legal epxloitation of the tax regime to one's own advantage. Tax evasion is the general term for efforts by people or businesses to evade the payment of taxes by illegal means. The following is a list of the most common types of self-employed fraud the IRS is likely to investigate:
| Common Types of Self-Employment Tax Fraud | |
| Type | Example |
| Not Reporting Substantial Amounts of Income | Video rental store owner's failure to report a portion of the daily business receipts |
| Phony Deductions on a Tax Return | Obvious overstatement of travel expenses, or a large deduction for charitable donations to an organization that does not actually exist |
| Accounting Discrepancies | Computer technician's failure to keep adequate records |
So What Tax Breaks Am I Entitled to?
From a tax standpoint, being self-employed is a pretty sweet deal, because there is no shortage of deductions for self-employed people to use.
Just look at the numbers: every $100 worth of deductible expenses trims $28 off your income tax bill, assuming you are in the 28 percent bracket. Even better, because you are self-employed, you qualify for the self-employment tax deduction, which provides an additional $15.30 of savings from every $100 of taxable income. It is well worth your while to find every business deduction available to you.
Below is a list of some of the more common expenses self-employed taxpayers deduct each year:
- Rent/lease property (office, studio, etc.)
- Home office
- Office supplies/equipment (computers, pencils, furniture, telephones, etc.)
- Insurance (health, disability, liability, automobile, etc.)
- Utilities (telephone and internet service, etc.)
- Automobile expenses (i.e. fuel, maintenance, etc.)
- Taxes (self-employment, state, local, etc.)
- Travel expenses (hotels, airfare, etc.)
- Meals and entertainment
- Material/inventory purchased
- Gross wages/salary paid
- Professional services paid (legal, accounting, etc.)
- Professional dues and licenses
- Subscriptions
- Postage and delivery charges
Now, let's look at some tax-planning strategies you might want to think about
as a self-employed business owner.
Expensing
Any self-employed person would love to deduct $250,000 worth of business
property right from the get-go. And thanks to the expensing provision of the tax
law, he or she can.
This provision enables you to write off immediately up to the above figure of otherwise depreciable property used by your business. Even if it is something you did not put into service until late in the tax year, you can still deduct the full cost of up to $250,000 of qualifying items.
For example, say you buy $100,000 of business property with a five-year tax life. Under the tax law's midyear convention provision, your first-year depreciation deduction would be a $20,000--certainly not chump change. But if you choose expensing, you can write off the entire purchase price on the current year's return.
Alternatively, if you are thinking of deducting the entire cost of your new Chevrolet Silverado, expensing will not let you deduct $24,000 of the full cost of a car all at once. Under the "luxury car" rules, in the most recent tax year, the luxury depreciation deduction was as follows:
| Year | Deductible Amount |
| 1 | $3,050 |
| 2 | $4,900 |
| 3 | $2,850 |
| 4 | $1,775 |
| 5 | $1,775 |
Bear in mind that this expense is a one-time opportunity. There is no carry-over into the following year if you do not take full advantage of the deduction in the year of ownership. In addition, all of these figures are based on 100 percent business use. If the car is used for personal purposes, the limits will decrease.
SUV 1; Other Cars 0
An exception to the luxury car rules allows you to use expensing if your new business vehicle is heavier than 6,000 pounds. For a car, that means 6,000 pounds empty, which disqualifies almost everyone right off the bat. But for a sports utility vehicle, it is 6,000 pounds including the maximum for passengers and cargo, so many SUVs can qualify.
Social Security
Believe it or not, there is a way to trim your taxable business income and create double savings. Here is how: In addition to cutting your income tax bill for the year, you can also save on Social Security and Medicare taxes. Self-employment income is subject to a 15.3 percent of Social Security and Medicare taxes. The full tax applies to the first $102,000 of earnings from salary, wages and net self-employment income in 2008. Every $1,000 of extra business deductions can save $153 in Social Security and Medicare taxes, as well as saving on income taxes.
Hobby Expenses
If you are not making a profit on your business in at least three years out of every five, the IRS may consider your fledgling enterprise just a hobby. That distinction prevents you from claiming a loss in your taxes, because your deductions are limited to the amount of income you report and the completion of a Schedule A, itemized deductions.
Consequently, your year-end planning needs to consider both where you stand on the profit-or-loss front and how you are doing on the three-out-of-five-year test. If you need to show a profit this year to avoid having your activity fall into the hobby category, your strategy may be the opposite of that outlined above. You may want to press for collection of any income you are due and delay paying expenses or buying new equipment until the following year.
Income Deferral
The idea here is pretty straightforward: income you do not receive until after midnight on New Year's Eve is not taxed until the following year. Regardless of whether you wind up in the same tax bracket, you win simply by delaying the tax bill an entire year.
If you are self-employed or have a part-time freelance or consulting gig in addition to you job, you have more leeway than a wage earner--assuming you use the cash basis of accounting. By delaying your billings until the end of December, for example, you are ensuring you will not receive those payments until the following year. Therefore, if you are dealing with a delinquent client, it might make sense to call off the dogs--at least until January. Of course, business considerations always come first. But if you have the flexibility to put off payments, doing so will save you the trouble of paying tax on them until the next year.
On the other hand, it pays more to hurry up with expenses. Remember, you get a deduction in the year that you pay for your purchases. If you office is looking a bit bare, load up on supplies before the end of the year so you can lock those deductions in by paying for them with Visa or American Express cards before Dec.31.
Next: Wake Up, Junior, You're Hired
Roni Deutch is the founder and owner of the nation's largest tax resolution law firm, Roni Lynn Deutch, A Professional Tax Corp. She is also founder and owner of Roni Deutch Tax Center, one of the fastest-growing tax preparation franchises in the U.S.
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