This article has been excerpted from Small Business Legal Tool Kit, available from Entrepreneur Press.
One of the most common questions put before accountants and tax professionals is "What costs or expenses are deductible?" Generally, trade or business expenses are tax-deductible, which means they can be used to reduce your gross revenue (total revenue) to net income (profit) and thus reduce your taxable income. A good rule of thumb is that a cost or expense will generally be deductible if it has a legitimate business purpose, "legitimate" being the operative word here.
Just because something can be deducted on your tax return doesn't mean it's a good idea. Remember that in most cases to get the deduction you have to spend money. Therefore, taxes remain only part of the decision to incur a cost or expense in business.
Another common, but extremely complex, issue is that of depreciation. On a basic level, the question becomes "When can I deduct (write off) certain costs or expenses?" Usually a cost or expense will be written off in the year in which the business pays for the item. This is called expensing the cost. However, if an asset (or expense) has a useful life of more than one year, it will be considered a capital asset and will need to be written off over its useful life. This is called depreciating an asset or, in some cases, amortizing an asset.
Be aware that the IRS dictates the useful life of most assets by placing them into classes (e.g., carpeting has a class life of seven years). Capital assets do not include, for example, the case of paper purchased on December 23 that will be used by the business through the end of March; this cost should be expensed in the year it's purchased. Furthermore, the depreciation of assets should not apply to small, insignificant purchases; no one, including the IRS, expects you to depreciate the cost of a stapler. Many businesses will set a dollar limit for items that will be expensed rather than capitalized, or depreciated. For a small business, $100 to $300 is probably reasonable.
No discussion of capital assets and depreciation is complete without a mention of the useful tax tool known as Section 179. The Section 179 election allows a business to expense up to $112,000 of certain equipment and capital assets in the year of purchase rather than depreciating them over time. This is an important tax planning tool, especially for pass-through entities such as partnerships, S corporations and limited liability companies.
Because pass-through entities are deemed to take all the profits or net income out of the business each year, Section 179 can be used to reinvest in the business and avoid income taxes. It is wise to look at the potential income to owners and cash on hand in early December of each year to determine if a business should make an equipment or asset purchase before December 31 of each year to take advantage of the Section 179 election. Again, remember, while you may see a tax savings, both at the corporate level and the individual level, you still have to spend the money to purchase the equipment or asset.
Finally, a short discussion of startup and organizational expenses incurred by new businesses might be helpful. Startup expenses would usually include, but are not limited to: the cost of travel, trade shows, educational or training seminars, accounting and legal fees, consulting fees, building costs, and supplies or materials needed to get your business started (not inventory or raw materials). Organizational fees include the costs relating to forming or creating the business: fees paid to obtain licenses, and accounting or legal fees for formation of the entity.
Generally, a business can expense in the year purchased up to $5,000 for each of its startup costs and up to $5,000 of its organizational costs; any cost over that $5,000 maximum must be amortized over 15 years. Often startup costs and organizational costs are incurred prior to the actual formation and operation of the business. This will be important to know from day one, because it could affect when and how a business owner decides to incur a cost.
For example, a new business owner who wants to attend a trade show might form her business (i.e., incorporate) prior to paying for the trip and trade show fees ($8,000). That's because if she incurred those expenses before forming her business, they would be considered a startup expense; only $5,000 would be deductible in the first year and the remaining $3,000 would have to be written off (amortized) over 15 years. But if she pays the costs after forming her business, they will be considered a regular trade or business expense and will be expensed in their entirety in the first year.
A similar example might be legal fees--a new business may have several legal costs, such as incorporation (organizational cost), customer agreements and a lease review (startup cost). If the business incorporates first, the cost of incorporation will be an organizational expense and the first-year deduction will be limited to $5,000. The same goes for the customer agreement and a review of the lease. If the owner paid for them prior to forming his business, the costs may have to be treated as a startup expense, rather than expensed in full, as they would be if the fees were paid after the business was formed.
Federal Income Taxes
Income taxes for businesses are complex primarily because there are many ways to tax business income. Below is a brief summary of the way income taxes are assessed for the various entities. Sole proprietors file a Schedule C and pay income tax and self-employment tax (15.3 percent) on their net income or profits. An LLC may be taxed like a sole proprietorship if it has only one member or like a partnership (Form 1065) if it has two or more members. LLCs may also elect to be taxed as corporations (either an S corporation or a C corporation). LLCs' members, regardless of how they choose to be taxed, will pay income tax and self-employment tax (15.3 percent) on their net business income or profits that flow to their individual returns.
Like the LLC, partnerships file a partnership return (Form 1065) and pass the earnings on to the individual partners, who will pay both income tax and self-employment tax on those earnings. The S corporation also passes its earnings through to their individual shareholders, who will pay income tax, but self-employment taxes or payroll taxes may be avoided in certain cases. C corporations file a corporate return and pay income tax. Any distribution of dividends to shareholders will be taxed as part of their total income.
State Income Taxes
Every state has different rules and rates. You'll need to check with your state and local governments to be sure you understand them. Rates change frequently, in some states every year, so you'll want to make sure that you're staying up on any changes your state may make.
Theresa A. Pickner owns a law practice that specializes in business, taxation and estate planning law. She holds a J.D. and an LL.M. in taxation from the University of Denver. Ira Nottonson serves as a legal consultant and is a Law Review graduate of Boston College Law School. His past clients include House of Pies, IHOP, Orange Julius, PIP Printing and Quickprint.For more legal information, check out Small Business Legal Tool Kit, available from Entrepreneur Press.