Small Business Tax
| Author | Jeffrey Wilson |
| Pages | 1321-1326 |
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There are several important tax issues that arise for owners and managers of small businesses. These issues occur at the federal, state, and local levels. Because the state and local issues vary so widely, this entry focuses primarily on federal tax issues.
To understand the many tax issues that arise for small businesses, one must first know the different types of business entities one may create. The Internal Revenue Service (IRS) and the U. S. tax laws—codified in the Internal Revenue Code (IRC)—treats each of these entities in significantly different ways. The four basic forms of businesses are:
Sole proprietorships
Partnerships (general and limited)
Corporations and S)
Limited liability companies
Generally, taxpayers who own their businesses alone can form any one of these types of businesses except partnerships. Multiple owners of a business may form any type of business except a sole proprietorship.
Most of the many kinds of business income are taxable. The Internal Revenue Service (IRS) taxes the income generated by a business the same as it does an individual's income. Similarly, businesses can minimize their tax liabilities through deductions and credits the same way individuals can.
Regarding the topic of small business taxes, it is necessary to understand the IRS definition of "income" before turning to a discussion of deductions, credits, or other aspects of small business taxes. It may actually be better to understand the concept of "gross income." In section 61 of the Internal Revenue Code (IRC), the phrase is defined thus: "Except as otherwise provided … gross income means all income from whatever source derived." Obviously, this is a very broad definition.
Section 162 of the IRC is the section of the Tax Code used to determine the deductibility of business expenditures. This is a lengthy section, but the first sections contain the most important language. Here are the principal provisions:
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(a) In general, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including:
(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business;
(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
Apparently, the IRC can be quite vague at times. For example, the IRC does not go on to define "ordinary" or "necessary," even though these terms are very important concepts in small business taxation. In the most general sense, a business's net income is the product of "ordinary and necessary expenses" subtracted from "gross receipts." In an effort to define these important concepts, the federal courts have held "ordinary" to mean "normal, common and accepted under the circumstances by the business community." And according to the courts, "necessary" means "appropriate and helpful." Thus, the two terms generally mean the purpose for which an expense is made.
Basically, gross receipts are all the money earned by the small business entity. And although "ordinary and necessary" expenses are left up to the courts to define, they are not particularly abstract or unusual concepts. Practically every expense that a small business owner reasonably needs to run a business qualifies as "ordinary and necessary." Rent, wages, marketing, and office supplies are some typical examples. But other expenses such as interest on business-related loans and insurance premiums can also qualify.
For tax purposes, income can take many forms. It need not be just cash. Services, good, and other types of property received in exchange for goods or services may qualify as income. If the business owner exchanges goods or services for someone else's goods or services (a process also known as bartering) the owner needs to report the fair market value of the goods or services received. Basically, anything of value the owner or the business receives is income, unless it specifically falls within one of the following IRS exclusions such as gifts and inheritances and some "fringe benefits" provided by businesses to owners and employees.
It is particularly important to owners and investors of businesses that the return of a capital investment is not taxed as income. If a business owner sells a business or an asset and receives money for the asset, the business has not earned any taxable income. Only the profit, if there is any, will be taxed.
When the IRS audits business deductions, one of its primary concerns is that personal expenses are claimed as business expenses. Because these tactics are so common among taxpayers, the IRS...
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