Small Business Taxes For Dummies. Eric Tyson
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Important Business Decisions
IN THIS CHAPTER
As a small business owner, you face many important decisions. This chapter deals with two big ones that come up in the early days, months, and years of your venture.
First is the type of business entity you’ll operate under — sole proprietor, C or S corporation, limited liability company (LLC), and so on. This decision impacts the liability exposure you have, tax-reporting requirements, and income taxes you and your business will owe.
The second is the benefits your business may consider for yourself and any employees.
Choosing Your Business Entity
Many small-business owners don’t fully consider (or aren’t even aware of) the options they have for the entity under which they conduct their business. Most entrepreneurs default into sole proprietor status for a variety of reasons. But you should be aware of all your choices — such as C corporations, S corporations, partnerships, and LLCs. That’s what I discuss in this section.
Sole proprietorships
If you’re interested in running your own business, odds are you’ll do so as a so-called sole proprietor. About 70 percent of self-employed folks operate their businesses as sole proprietors because setting up a business this way is easier and generally less costly than other options. In this section I discuss the advantages and disadvantages of operating your business as a sole proprietorship.
Understanding the “solo” advantages
The pros of operating as a sole proprietor (going solo) may or may not outweigh the cons for a given small business owner. Each business (and owner) is unique and should weigh the pros and cons. Consider the following advantages:
Simplest tax rules and record keeping compared with other business entity options: You report your business income and expenses on Schedule C of IRS Form 1040 (discussed in detail in Chapter 8), and the net income or loss carries over to your personal income tax return. Though no walk in the park itself, compared with corporate tax forms, Schedule C is easier to complete.
Low cost to establish or discontinue: Without incorporating, it’s a relative snap to get going or shut down such an entity from the perspective of state and local regulations and requirements.
High flexibility to switch to other entity forms: You can easily switch to any of the other entities (corporation, LLC, and so on) I discuss later in this chapter.
Good retirement plan options: You can stash away a large chunk of your business earnings in a tax-advantaged retirement account (discussed in Chapter 3).
So does this mean that running your small business as a sole proprietorship is the way to go for you and your company? Not necessarily — next up are the drawbacks, which you should weigh in your case.
SIDELINE BUSINESSES, TAX WRITE-OFFS, AND THE HOBBY LOSS RULES
Many supposed tax gurus state that you can slash your taxes simply by finding a product or service that you can sell on the side of your regular employment. The problem, they argue, is that as a regular wage earner who receives a paycheck from an employer, you can’t write off many of your other (personal) expenses. Open a sideline business, they say, and you can deduct your personal expenses as business expenses.
The pitch is enticing, but the reality is quite different. You have to spend money to get tax deductions, and the spending must be for legitimate purposes of your business in its efforts to generate income. If you think that taking tax deductions as a hobby is worth the risk because you won’t get caught unless you’re audited, the odds are stacked against you. The IRS audits an extraordinarily large portion of small businesses that show regular losses.
You need to operate a real business for the purpose of generating income and profits, not tax deductions. The IRS generally considers an activity a hobby (and not a business) if it shows a loss for three or more of the preceding five tax years. (Exception: The IRS considers horse racing and breeding a hobby if it shows a loss for at least six of the preceding seven tax years.)
Some years, a certain number of businesses lose money, but a real business can’t afford to do so year after year and remain in operation. The IRS commonly views these activities as hobbies, particularly when they generate little if any income: antique collecting, crafts, creating art, photography, stamp collecting, training and showing dogs or horses, and writing.
Even if your sideline business passes this hobby test as well as other IRS requirements, deducting any expenses that aren’t directly applicable to your business is illegal. Also, the Tax Cuts and Jobs Act that took effect in 2018 eliminated the ability for those engaged in a hobby to deduct their expenses as an itemized deduction up to the limit of the income from their hobby for the calendar year. Now, those engaged in a hobby are supposed to report their revenue for tax purposes but are no longer able to claim an itemized deduction for their hobby expenses.
Weighing the disadvantages of operating “solo”
Liability exposure: Unlike in a corporation, where you have some shielding from liability thanks to the corporate structure, a sole proprietorship offers no such protection. However, as I discuss in the later section “Investigating liability insurance,” you may be able to buy liability insurance, depending on the type of business you operate.
Only one owner is permitted: If you want to provide some small ownership stakes to key employees, you can’t do that in a solo business. One exception: You can share ownership with your spouse so long as your spouse “materially participates” (that is, works) in the business. If both you and your spouse are owners, you each need to file your own Schedule C (more work), and you each need to pay Social Security tax on your share of the earnings (more tax).
Estate issues: With some business entities, the business structure survives your passing, but not so with a sole proprietorship. This may have negative consequences on the tax front and if you want your survivors to be able to easily continue with the company. (Flip to Chapter 5 for an introduction to estate planning.)
You’re taxed on all profits, even if you don’t want to take them all out of the business: If you have a big year or two, don’t need all the money your business is generating, and want to leave some of it in the business, you still pay personal income tax on all those