Starting a Business

When you start a small business, you put all your time and energy into making sure it succeeds; taxes may be the farthest thing from your mind. But there are plenty of tax considerations that go along with your new venture. We’ve made a list of some important tax-related issues you need to be aware of as you’re getting started and going through your first year.

Accounting Methods

Businesses must figure their taxable income and file a return for a tax year or annual accounting period. You’ll need to select an accounting method, which is a set of rules that determines when and how you report your business income and expenses:

Cash: When you use the cash method of accounting, you count income or expenses at the time you actually receive a payment or pay a bill. A cash-basis report shows income only if you have received it, and expenses only if you have paid them. This method is used by most sole proprietors and other self-employed individuals with no inventory.

Accrual: Under the accrual method, you record income when you earn it and expenses when you incur them. Thus the point where you enter a transaction on your books and when you actually pay or receive cash may be two separate events.

Estimated Tax Payments

As a small business owner, you’ll need to make estimated tax payments during the year to cover your federal income tax liability, unless you expect to owe less than $1,000. Generally, estimated tax is due in four quarterly installments. For the 2007 tax year, the four dates are: April 17, June 15, and Sept. 17, 2007, and Jan. 15, 2008. For the 2008 tax year, the four dates are: April 15, June 16, and Sept. 15, 2008 and Jan. 15, 2009.

If you’re mailing payments to the IRS, use Form 1040-ES. Or, you can pay electronically by enrolling in the Electronic Federal Tax Payment System (EFTPS). When you start up your business and request an employer identification number from IRS (see below under “Employment Taxes”) the IRS automatically enrolls you in EFTPS.

Employment Taxes

If you have employees, you must pay the employer share of their Social Security and Medicare tax liability, and withhold their share of those taxes from their wages. For 2007, you and your employee each must pay 7.65% on the first $97,500 of the worker’s wages. For income above that level, you and your employee must keep paying only the Medicare portion of the tax, which is 1.45% for each of you. The taxes must be deposited with IRS periodically; how often you send in these funds depends on how large the deposits are. You can deduct the employer share of these employment taxes as a business expense on Schedule C.

What about your own employment tax liability? If you’re a sole proprietor, partner, independent contractor or are otherwise self-employed, you must pay the full freight—15.3% in 2007 on the first $97,500 of your net earnings from self-employment, which you calculate on Schedule C. For net earnings above that amount, you’ll still owe Medicare tax of 2.9%. You can deduct half of your self-employment tax when figuring adjusted gross income on your 1040. That’s not as good as paying half the liability—as employees do—but it’s better than nothing.

Employer ID Number

When you’re starting out, you’ll need to apply to the IRS for an employer identification number or EIN, which must be on your return and other documents you file with the IRS. (If you’re a sole proprietor with no employees or you have a single-owner limited liability company, you’ll use your Social Security number instead.) To get an EIN, you can apply with the IRS online or call the IRS at (800) 829-4933.

Employee vs. Independent Contractor

It’s important to distinguish between workers you hire as employees and contract labor, because your tax liability and reporting are different depending on which type of worker you use. You don’t pay or withhold employment tax for independent contractors as you would your employees. At year-end, you’ll report payroll information for employees using Forms W-2 and W-3, while you’ll use Form 1099-MISC for anyone who is a contractor.

The IRS monitors employers to make sure they aren’t avoiding employment tax liability by classifying workers as contractors when they really are employees. IRS looks to see how much control the employer has over the details of a worker’s performance and whether the employer also exerts financial control. If, for example, you pay your workers an hourly wage, reimburse all their work-related expenses, dictate where they do their work, train them and provide them with equipment, you’ll have a hard time making a case for classifying them as contractors.

For more information, review IRS Publication 15-A, Employer’s Supplemental Tax Guide.

Buying Assets

In general, you can deduct the costs of running your business in the same year that you pay them. But the tax treatment is different for assets you buy that are expected to last more than one year. You must depreciate these assets, or spread their cost over several years.

But IRS has a special rule known as the Section 179 deduction that is designed to allow small businesses to deduct the full cost of assets in the year they are purchased. This is also known as “expensing,” because you get to deduct the cost of new assets just as you do current expenses. Property that is eligible for this special first-year expensing includes machinery, tools, fixtures, computers, software and vehicles used in your business. For assets placed in service in 2007, you can expense a maximum of $125,000. (For 2008, the limit is $128,000.) But that amount is reduced if you purchase more than $500,000 in eligible property during the year. (For 2008, the ceiling is $512,000.)

Keeping Track of Expenses

To make sure you get all the tax deductions you’re entitled to, you need to maintain good records of your company’s expenses. And because you can’t deduct any personal expenses, it’s important to keep them separate. For example, you may want to have a bank account just for your business and a credit card for business purchases. If you incur an expense that combines personal and business use, you must divide up the total cost and take the deduction only for the business use.

Two types of business expenses that require special record keeping are:

Business Meals and Entertainment

You must identify the business purpose of any meal or entertainment expense for it to be deductible. Don’t forget that 50% of the total expense is deductible. Keep these in mind, too:

• A deductible meal is usually with a business contact.
• An entertainment event usually follows a business meeting.
• Write on your receipts with whom you met, as well as the business purpose of the meeting. Save these receipts with the rest of your tax records.

Autos Used in Your Business

When figuring your expenses, you can choose between taking the standard mileage rate (which is 48.5 cents per mile for 2007) or deducting your actual expenses. These include items such as gas, oil changes, tires, repairs, preventive maintenance, insurance and registration fees. Using the standard mileage rate is much easier, but depending on the type of vehicle you drive and the number of expenses you have, recording your actual expenses may be a better deal. If you’re self-employed you can also deduct the business part of interest on your car loan, state and local property tax, parking fees and tolls even if you claim the standard mileage rate.

Home Offices for Sole Proprietors

If you are running your business out of your home, you may qualify for the home-office deduction. To get this deduction, the IRS requires that you use your home office “exclusively and regularly” for your business. It has to be a separate area in your home where you don’t mix business with other activities.

Here are some things to keep in mind:

• You can take the home-office deduction even if you perform your main work elsewhere, if you use the home office for all your administrative and management activities, including billing customers, ordering supplies, and setting appointments. For example, if you’re an electrician and perform your work in other people’s homes, doing all your paperwork in your home office can qualify you for the home-office deduction.
• You can claim the deduction if you store inventory or product samples there, or you operate a daycare facility.
• The size of your deduction depends on the percentage of your home that is used for business. If your total business expenses exceed gross income from business use of your home, your deduction will be limited.

For more information, see IRS Publication 587 - Business Use of Your Home or Publication 334 - Tax Guide for Small Businesses.

Updated for tax year 2007