In these uncertain economic times, I find a very high number of clients and people I talk to about taxes are either starting or considering starting a small business. For most, this takes the form of something in addition to a regular job, often a hobby that they would like to turn into something profitable. Sometimes in response to a lay-off, individuals decide to strike out on their own, either because they’ve been wanting to or it’s simply a necessity in the current job market. For those individuals, here’s some important tax considerations for your new business.
One side note just for those who have found themselves working as “contractors” in a position similar to what they did for their previous company. As contractors, you are now “self-employed” and for tax purposes you have your own business…that is, assuming you are actually a “contractor”, not an “employee”. What’s the difference? you might ask. Well, there are a number of defining characteristics, that the IRS defines here. However, for practical purposes, being a contractor means you pay more taxes and have fewer legal protections and benefits (no workman’s comp, no unemployment insurance, etc.). If you’ve been hired back by a previous employer to do something similar to your previous job, but as a “contractor” rather than an “employee”, this may well be an illegal attempt by the employer to get out of their legal obligations as an employer. Just a heads-up for people in that situation. If you think you may be in this situation, the IRS provides guidance and procedures for handling this situation.
So, on to the tips for new small business owners…
1) Make sure you have a business, not a hobby. There is no hard and fast rule for what constitutes a business, but the IRS does have some guidelines for determining whether you have a business or a hobby. In short, you need to demonstrate you have a plan for being profitable within a specific time frame. If the IRS doesn’t think you legitimately have a business, you may lose all the deductions while still having to pay tax on the income you did receive. Example: “I like detailing cars and I’m pretty good at it. I’d like to start my own detailing business someday. Can I deduct the car shows I go to as a business expense?” Probably not. If you’re incurring more expenses than you have income, make sure you can demonstrate a clear business plan and intent to ultimately profit.
2) Document, document, document. Keeping records is always a good idea for any business regardless of tax implications. Having a separate business bank account & credit card should be one of your first steps when establishing a business. For tax purposes, you must be able to substantiate all business expenses–and sometimes a bank statement is not good enough, the IRS may require a receipt. Documentation is especially important when it comes to travel expenses, meals, and entertainment. Anything spent on these three items should have not only a receipt, but a record of what business was discussed at the event. In addition, if you want to deduct expenses for using your personal vehicle for business, you must keep a contemporaneous mileage log documenting the date, destination, where you travelled, and what the business purpose was. Mileage logs constructed long after the fact from estimates have been disallowed by the IRS in many audits and court cases.
3) Deduct your health insurance premiums. Large businesses don’t pay taxes on the health insurance they provide for employees; as a small business owner, you don’t have to pay income tax on your health insurance. If you have a health insurance plan established under your business–and the IRS has consistently held that for sole proprietors this includes a health insurance plan in your name–you may deduct the entire cost of your premiums under the Self Employed Health Insurance deduction (Line 29 on Form 1040). Long-term care insurance can also be deducted under this rule.
4) Know the rules for home office deduction. Many people are afraid to take the home office deduction because at various times the IRS has carefully scrutinized this deduction. Other people think they can take this deduction because they sometimes work on their laptop while watching TV in their living room. To deduct home office expenses, you need to have an area of your home set aside for exclusive, regular use by your business. By IRS rules, a spare bedroom that you sometimes let company stay in would not count–it must be exclusively for business use. On the other hand, the IRS does not require an entire room be used for business purposes, so if you only use half of a storage space as your office while the other half stores personal items, you may still take the home office deduction (as long as the business space is clearly delineated). It’s a good idea to review the IRS website for specific details if claiming this.
5) Know how to categorize your expenses. You do NOT have to be concerned about whether a particular item is categorized as “Supplies,” “Office Expense,” or “Other.” Generally speaking, if you have a system for categorizing your expenses that makes sense to you, use it. When filling out tax forms, it’s perfectly legal to put all your expenses under “Other” and then use whatever category names makes sense to you…with certain exceptions. It’s a good idea to always categorize meals and entertainment as a separate expense. The reason is meals and entertainment are only 50% deductible as a business expense. The second, and more important, exception is the costs incurred in purchasing “assets”. Assets are items with an expected useful life of more than a year. For example, computers are considered to have a five-year class life. These items should be categorized separate from normal expenses because they are usually deducted ratably over the length of their class life. There are ways to deduct the entire cost of an asset in the first year, but special rules apply. Always keep asset purchases in a separate category and your tax preparer can discuss your deduction options with you.
6) Take advantage of more favorable retirement plan rules. Individuals who don’t participate in a 401k through work usually have very limited options for contributing to a tax-favored retirement plan. The maximum amount that can be contributed to a Traditional or Roth IRA is $5000 ($6000 if over age 50). However, if you are self-employed, you may choose to establish retirement plans under your business such as a SIMPLE IRA or a SEP-IRA. SEP-IRA’s allow you to contribute up to 20% of your business income to a tax-favored account, up to a maximum contribution of $46,000. If your business is not very profitable yet, you could establish a SIMPLE IRA which would allow you to contribute up to $10,500 ($13,000 if over age 50) to the plan without having to worry about the 20% cap. The rules for these plans vary, consult your tax advisor.
7) Finally, make estimated payments to avoid a nasty surprise during tax season. You may not have to worry about making estimated payments at first, but once your business is making more than a few thousand dollars, you’ll need to consider making quarterly estimated payments of tax based on your expected income at the end of the year. By not making payments through the year, you can get hit with a large unexpected bill at the end, plus penalties from the IRS for not making timely estimates. Many married couples with one spouse self-employed and the other working a traditional job find it easier to simply increase the withholding for the spouse receiving a regular paycheck.Again, consult a tax advisor about your specific situation to find out whether you need to make estimated payments and how best to make them.