We’ve done some research and talked to some smart people that do this tax stuff for a living in order to provide Performance Business readers with some small business tax tips. The information collected here is in no way comprehensive, and it is designed to provide ideas and talking points for further discussion with your accountant, tax advisor, financial advisor and/or business attorney because each business is unique. I’ve also boiled this information down into simple layman’s terms. For more information direct from the IRS, visit http://www.irs.gov/businesses/index.html.
Small business owners find themselves in a unique tax category with some special considerations at tax time. The federal government requires that we pay something annually called the “Self Employment Tax” as a portion of our tax bill, and it’s a hefty sum. I call this “The Pajama Tax” because for me, it’s the price I pay to go to work in my pajamas most days. My first year in business, I didn’t realize the “The Pajama Tax” would be quite so costly. Early on, I did not receive good advice on how to calculate this tax, or how to offset that tax payment with smart business practices, income protection strategies, long range planning and detailed record keeping that could truly have saved me a bundle getting started.
State and federal tax guidelines undergo massive changes each year. The burden for gathering and knowing this information is on the small business owner. It is crucial that small business owners create consistent mental and professional habits born from a basic awareness of allowable deductions, credits, tax savings and income protection mechanisms and the requirements for them so we can set ourselves up for success. It’s up to us to learn all we can about what the government has provided for us legally and to inject that knowledge into our daily business thinking and practices.
Every tax and financial advisor we spoke to said that the most important foundation for this stuff is to create a habit of keeping detailed, accurate records-that’s the trick-to create a habit. Make sure that you save every receipt (yes, you can use a shoe box), maintain detailed logs (yes, you can use a notebook), and route expenses through either your business checking and/or business credit account, because they create an automatic record of business transactions that includes date and location. Then, implement tax strategies throughout the business year that will yield the highest benefit for your unique business.
Did You Know That You Can:
Amortize Your Start-Up Costs
There are many costs associated with the launch of a small business, and a portion of them are referred to as start-up costs. Although not deductible, these costs can be amortized over a period of NOT LESS THAN 60 months.
To qualify as a start-up cost, the expense must be one that you could deduct if you were already in business. For example, costs for computers, phone service, Internet service, travel to suppliers, training for your new employees, uniforms, office supplies and utilities all fall under this category. Costs associated with the purchase of a specific business are considered capital expenses and are not considered start-up costs. Check with your tax advisor for the most recent tax code on this issue to identify the maximum start-up costs that can be claimed and amortized.
Deduct Health Insurance Costs at 100%
As a self-employed taxpayer, you are allowed to deduct 100 percent of the cost of the health insurance policy from your adjusted gross income. This also applies if you provide health insurance coverage for your employees. Whatever portion you pay is deductible as a business expense. Although this may not save you money in terms of the amount of self-employment tax you pay, the deduction will reduce your overall tax liability.
You can title the policy in your name or in the name of your business. The tax treatment is slightly different if your business is incorporated, so you will want to review this information carefully with your tax advisor to make sure that you are listing the maximum deduction allowed by law.
From what we found, it seems that the most important thing to remember is how to title the insurance policy. As a self-employed taxpayer, you can title the policy in your name, or in the name of your business. As a corporate taxpayer, you must title the policy in the name of your business, even if you are a sole proprietor and have no employees. If you are providing insurance coverage for your spouse and dependents, these costs are deductible as well.
Establish a Health Savings Account-An HSA is Not Subject to Federal Income Tax at the Time of Deposit
A Health Savings Account (HSA) is a tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a High Deductible Health Plan (HDHP). The funds contributed to the account are not subject to federal income tax at the time of deposit.
“I think a Health Savings Account is a gift from the government because you can use the money that is in your HSA for any qualified medical expense, including things that may not be covered by your regular health insurance,” said Bonnie Victor, Senior Advisor for The Victor Group. “For example, the IRS states that you can even include contacts and eyeglasses if they are needed for medical reasons. It also says you can use this account to pay for dental X-rays, extractions, braces, fillings and dentures if they are medically necessary.”
Funds collected in your Health Savings Account can only be used to pay for qualified medical expenses, but the money in this account is protected from being taxed. Withdrawals for non-medical expenses incur rather stiff penalties, so you’ll want to make sure that you use this account only for medical expenses. These expenses can include payment for doctor visits, hospital care, testing, prescriptions and more.
Through an HSA, you are encouraged to save money for future health care expenses, while simultaneously protecting that money from being taxed. Many high-deductible plans allow you to choose a Health Savings Account as part of your health insurance program. Check with your insurance advisor and get the details on what might be available in your geographical area, and the requirements for getting started.
Start a Tax-Deferred Retirement Plan
Since 1978, the option of setting up a tax-deferred retirement plan has been available to the small business owner. The money put into the tax deferred retirement account is not taxed until you take it out.
“A 401K or an IRA would fall into this tax-deferred retirement plan category,” said Victor. “The cool thing about this kind of account is that the money is not taxed until you take it out at retirement time-thus the name tax-deferred. It’s a great way to protect your income from taxes during your earning years. This is like getting a double bonus, because the money is protected from tax at the time that it’s earned, and you also earn interest on the money you put in and that interest continues to be compounded over time.”
“If you have several 401K or IRA accounts in different places because you left money in an account you established with a previous employer, for example, I highly recommend that you consolidate them into one primary account,” continued Victor. “When you lump your money together, it gives you a greater total sum which earns you a higher rate of return. It’s also important for record keeping purposes.”
Consider these issues carefully with your tax advisor and attorney to see which option provides the greatest tax benefit to you at your current stage of business development.
Deduct Appropriate Vehicle Expenses
If your business owns a vehicle that is available for employee business use, the vehicle and related expenses are deductible to the extent that the vehicle is used for business purposes. For example, if the vehicle is used 100% for business purposes, then the costs and expenses associated with that vehicle are 100% deductible, but you must keep accurate, detailed, vehicle-expense records in order to claim this deduction. Keep in mind that there are generally two ways of reporting your vehicle expenses. Both require a mileage log of some kind.
“Keep in mind that there are two primary ways that you can report your vehicle expenses, but you have to select one method, and make sure you don’t go back and forth between the two,” said Victor. “You’ve either got to take the deduction for the vehicle and related costs, or take the standard mileage deduction, but you can’t do both.”
If you’ve got a vehicle that you purchased specifically for the business, and it is used almost completely for business purposes, then you may want to take the deduction for the vehicle and related expenses, but this will require very accurate record keeping. You’ll have to keep a mileage log of every trip you take, and earmark those trips that are specifically for business.
At the end of the year, you’ll tally up the total and figure out what percentage of vehicle use applies to business only. For example, if you’ve used your vehicle for business about 80% of the time, you can also deduct 80% of the cost associated with owning the vehicle including lease payment, repairs, gas, oil, insurance, supplies and then figure in depreciation (Your tax advisor can help you with the formula here.) That “daily log” thing can be daunting, but the government allows you a little-known shortcut here. If your mileage is typically the same over any 90-day period, you are allowed to keep a detailed 90-day log, and then multiply it by four to get your year-end total.
For folks who have a personal vehicle that they occasionally use for business purposes, taking the mileage deduction is the way to go. For example, if you only use your personal vehicle for the occasional delivery, business meeting, out of town event or trip to the post office or office supplies store, simply keep a mileage log for those business-specific trips, and at the end of the year, total the number of miles and take the mileage deduction. For 2007, the mileage deduction is 48.5 cents per mile. The government increases this amount each year, and the amount is meant to cover your cost for fuel with a little more built in for maintenance fees and vehicle depreciation.
“The key is to make sure that you keep a painstakingly accurate mileage log, as well as accurate maintenance records,” said Ronald Elwood, CPA, Elwood Financial. “If you know that you are going to be using your business vehicle almost 100 percent for business purposes, then it’s also helpful to have all associated costs paid directly from your business account or business credit card. This makes it easier for you to keep the kind of detailed records the government requires.”
Business Entertainment Expense Deductions Come in at 50 Percent-That Includes Meals
Many people do not realize that business-related entertainment expenses, including meals, can only be deducted at 50 percent of the total spent, and they must meet specific documentation standards in order to be considered for deduction purposes.
“As it relates to entertainment expenses, the documentation standard is much higher for this type of deduction, and this standard has been established because of tax abuse or perceived abuse,” said Elwood. “The notion that all expenses are deductible is now gone, especially as it relates to food and entertainment expenses. Expenses in this category must be considered ordinary and necessary to your profession in order to be considered for the deduction. The word “AND” is very important here. In addition, you must be able to document the day, date, time, location, purpose and persons in attendance. Even when you meet all these qualifications, the maximum deduction is 50 percent of what was spent.”
For example, for the deduction of a meal expense for business purposes, the documentation must include the date, time, purpose and attendees. You must also be able to show that it was ordinary and necessary for your profession. When the meal expense meets these qualifications, you can deduct 50 percent. You will apply the same formula to entertainment expenses.
You Can Hire Your Children
According to the information we found, if your children are under the age of 18 and you hire them to work for you, you are not required to withhold Social Security and Medicare from their wages, nor are you required to pay in the employer’s share. And, you are not required to pay federal unemployment tax on their wages until they reach the age of 21. You also save yourself some payroll taxes.
“If you are going to hire your child, they must be able to perform the work assigned-in other words, the work must be appropriate to their age and skill level-and you must log their hours, and pay them an appropriate wage,” said Victor. “This is a great strategy you can use to help them save money for college. You are taking a portion of the business income to pay them for work that you would have hired someone else to do anyway, and the money they earn can go right into their savings account.”
You May Be Eligible for the R&D Tax Credit
“In the simplest terms, to the extent that you are trying to improve your product through research and development, the IRS has made available a specific tax credit for this purpose. Not only does it cover what is manufactured, but it can also apply to the process that is used to make the product,” said Greg Knarr, Principal Advisor, Meridian Tax Advisors. “This tax credit is one of the most overlooked tax credits available, and it has rather important ramifications for manufacturers who are continually trying to enhance the performance of the product, or process, that they offer. In a majority of the states, the R&D tax credit is available at the state level also.”
In order to find out if you are eligible for the R&D tax credit, examine the evolutionary process of the improvement of your particular product or process. To be eligible, you must be able to show the government that you are engaged in improving your product or process consistently over time. There are four major qualifications that you must meet in order to be eligible, and you can get the details from your tax advisor.
Calculate Several Types of Deductions Related to a Building Owned and Used for Business Purposes
Whether you buy an existing building for business or you choose to build a new space, keep in mind that for tax purposes, there are many components of this building that are broken out into separate categories in order to calculate deductions including depreciation. To make it easier, think about your building as being broken into four major categories.
For tax purposes, the building itself is called a real property asset or fixed asset, and that’s number one. Within the building are all the things you need to run your business-from furniture to computers-and these things are called personal assets, and that’s number two. Then, there are expenses associated with owning and maintaining the building: replacing light fixtures, repairing torn shingles after a storm, lawn care, and these things are referred to as incidental expenses or current expenses, and that’s number three. Then, there are major improvements such as a new roof, siding, a driveway or other extensive renovation, and these things are called capital improvement and that’s number four.
The rules for allowable deductions and the formulas used to calculate depreciation (which is also a type of deduction) are specific to each one of these categories.
“Things like incidental expenses can simply be totaled up at the end of the year to calculate the deduction related to this category,” said Knarr. “But, for the fixed or real asset (the building structure) and the capital improvements (significant repairs, improvements and renovations), depreciation has to be calculated. Depreciation is calculated using a formula based upon what the government perceives as the average life span of these things, so make sure your tax advisor and preparer pay close attention to these important deduction categories.”
If your building is very large, you may want to invest in what’s called a Cost Segregation Study. Cost segregation is a detailed and expensive process of identifying personal property assets that are grouped with real property assets and separating out personal assets for tax reporting purposes. The goal of such a study is to identify and reclassify personal property assets to shorten the depreciation time for taxation purposes, thereby saving you money.
A Few Final Thoughts
As I said in the introduction of this article, the information collected here is in no way comprehensive, and it is designed to provide ideas and talking points for further discussion with your accountant, tax advisor, financial advisor and/or business attorney because each business is unique.
In addition, I want to point out that there is often a big difference between a tax or financial advisor (someone who is well versed in tax law, tax savings strategies and long range financial planning), and a tax preparer (an accountant whose primary skill set is specific to plugging in the information provided to them in order to accurately complete your tax return).
As a small business owner, it is very important that you have both. Sometimes both of those skill sets reside within the same person, and sometimes they don’t. Make sure you know the difference and that you have the right people to help and advise you. For more information direct from the IRS, visit http://www.irs.gov/businesses/index.html.