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With more entrepreneurs opening small and home-based businesses, questions about taxes and taxation are inevitable. This primer aims to provide some answers. However, you should consult your tax advisor on your specific situation.
There have to be some tax advantages to compensate for the risk of opening a home-based business, right? In addition, there are pitfalls to avoid, guidelines to follow and things to know in order to keep you out of the Internal Revenue Service's crosshairs.
(In addition, tax reform may be the horizon. But as of this writing, there are not enough details known to make any determination of the potential impacts.)
The big surprise: Self-employment tax
Depending on how your business is organized, if you are a sole proprietor, or LLC, then you are responsible for self-employment tax. Unlike those employed by others and paid as employees, the self-employed are responsible for what is in essence double FICA and Medicare taxes.
As an employee, you have likely noticed the 7.65 percent that is deducted from your paycheck: 6.2 percent for Social Security and 1.45 percent for Medicare, which maxes out at $7,886.40 in 2017 on earnings of $127,200. Your employer pays the same amount on your behalf. The self-employed, however are both the employee and employer, and pay both halves, for a maximum of $19,461.60.
Those caught unaware of this can be whipsawed at tax time. Since many self-employed do not draw an actual paycheck, and thus taxes are not withheld, it is easy to lose sight of this liability until tax-filing season, which can make for an awful shock to the wallet.
For example, if your business earns $100,000 and you are considered self-employed, the self-employment tax alone would be $15,200. That does not include income taxes. The remedy, especially if you don't want a negative tax-time surprise, and potential IRS underpayment penalties, is to include the amount of self-employed tax owed in your quarterly estimated tax payments.
Some of this double taxation can be offset due to the fact that the self-employed are able to deduct 50 percent of the self-employed tax they pay from their income. In the 25 percent income tax bracket in the above example, that would equate to a $1,900 reduction in federal income tax -- better than nothing.
Other deductions: Health insurance
As a self-employed business owner, if you don't have access to a spouse's health insurance plan, you're on your own to obtain coverage. Health insurance markets have changed dramatically in the last decade. With the advent of the Affordable Care Act in 2010, private insurance as we once knew it no longer exists.
The bad news: Insurance plans -- which no longer allow consumers to pick and choose what is covered (such as maternity care, mental health or a "free" preventative visit) -- can be much more expensive. Here's what hasn't changed: The self-employed still can deduct their health insurance premiums, much like the self-employment tax deduction.
Retirement savings: Best kept secret for the solo self-employed
One of the issues we all face is saving for retirement. One of the many risks for the self-employed comes with leaving the sometimes comfortable confines of the corporate world, where you are able to contribute $18,000 to your company's 401K plan (plus $6,000 if over age 50), and more than likely have a portion of that matched by the employer.
There are several options open to small businesses. Perhaps the best and most flexible is the Self Employed 401K Plan, also known as the Solo 401K. This option is for employers with no additional employees other than the owner and spouse. It is not subject to the rather stringent requirement that traditional 401K plans must adhere to and are easy to set up.
Many providers have a very streamlined process making it easy to start such a plan. From there, the business owner wears two hats:
- As an employee, you can contribute up to $18,000 per year of earned income and an extra $6,000 catch-up contribution if over age 50.
- As an "employer," you can contribute up to 25 percent of the company's net profits.
Total maximum contribution, including "employee" and "employer" contribution for 2017, is $54,000 for those under age 50, and $60,000 for those 50 and over.
The record keeping and administrative burdens of such a plan are light. Once the plan's assets reach $250,000, form 5500-EZ must be filed with the IRS. However, just like the rest of this, it is a "simple" form to fill out, and should not take more than 10 minutes.
Last but not least, the Solo 401K plan is available in both ROTH and traditional tax-deductible forms.
What else can I deduct?
The truth is, there's quite a bit that you can deduct as a small business owner. If you're a sole proprietor, or have formed a limited liability company (or LLC), you or your tax professional will likely file a Schedule C (Profit or Loss From Business-Sole Proprietorship). If your total business expenses are less than $5,000, you can use schedule C-EZ.
Here, you will list your revenue and expenses, which can run the gamut from advertising to office expenses, supplies, repairs and maintenance, travel, deductible meals and entertainment, legal and professional services, utilities, taxes and licenses, and rent, among other categories. There's also an "other category" where small business owners will expense items such as subscriptions, telephone and internet expenses, and perhaps additional items, depending on the nature of their business.
There's quite a bit of speculation and often questions among small business owners as to what they can and cannot deduct. In a nutshell, legitimate business expenses must be:
- Both ordinary (considered common in your type of business) and necessary (appropriate for your type of business or industry) in operating your small business.
- Should not be personal in nature: Schedule C is for your business; personal expenses, such as mortgage interest (unless you are eligible for home office deduction, in which case a portion would still be taken here), state and local income taxes, casualty or theft losses, tax preparation fees, medical expenses or others if deductible at all, would be reflected elsewhere on your tax return, most likely Schedule A (Itemized Deductions).
What else can I expense?
Depending on the type of business you operate, you will likely have to purchase equipment. This could include everything from a computer, monitors, laptop, printer, desks, tables, chairs and the list goes on. While larger businesses typically depreciate these assets over time, essentially claiming a small piece of the cost each year based on the useful life of the asset, small businesses can essentially expense these assets for tax purposes in the year they're purchased.
Termed "Section 179" depreciation, there is a generous limit, up to $500,000 per year. So if you purchase a laptop for $2,000 that is used solely for business purposes, rather than depreciating it over its useful life (determined by the IRS to be five years), which itself would allow a $400 deduction, you can deduct the entire $2,000 in the year of purchase. This provides a tax incentive for small businesses to purchase equipment. The tax savings can be considerable; remember the 15.2 percent self-employment tax mentioned previously? That's calculated after expenses.
What about assets not solely used for business purposes?
Not to worry: If there are assets used for both business and personal reasons -- called "mixed-use assets" -- you can still take a partial deduction, based on the percentage of business use. These can include that laptop that you use half the time for business, as well as a portion of your internet and phone bills.
In addition, that can include expenses for the business use of your car, via a standard mileage rate (currently $0.535 per mile), or the actual expenses of repairs, gasoline, maintenance and repairs, even if it is used primarily for personal use (deductions will be prorated). As in all aspects of running a small business, maintaining impeccable records is an absolute must. For example, for deductible mileage, you need to maintain a record of the odometer reading at start and finish, date, place and purpose of the trip. Commuting miles if applicable are not deductible.
The home office
This is one of the trickier areas in terms of small business taxation, and subject to considerable scrutiny. The bottom line is that if an area of your home is used exclusively for your business, you may be eligible for the home office deduction. However, unlike other assets (the PC described earlier, half used for business, half personal) this designated space -- to qualify for the deduction -- cannot be of mixed-use.
Even if you are using a small space -- for example, what used to be a spare 12-foot by 12-foot bedroom -- exclusively for your business, you can get some tax benefits by writing it off. From there, you will have another decision: whether to use the Regular Method or Simplified Option.
This allows you to use the actual expenses associated with using the office, including mortgage interest, utilities, insurance, repairs and other costs, as well as depreciation. Essentially, all of the costs are prorated based on the square footage of the office relative to that of the entire home. In the case of items such as mortgage interest and real estate taxes, the amount associated with the rest of your home (all but the business space) are still reported on Schedule A (Itemized Deductions).
As the name suggests, calculations are much simpler in figuring the deduction; $5 per square foot up to maximum of 300 square feet or $1,500 deduction. There's no need to do any other calculations, unless you want to determine which method provides the higher deduction.
Here's another thing to be aware of that many small home-based business owners may not know: If you use the regular method, and take depreciation, the total amount will be recaptured when you sell the home, which will reduce your cost basis, and could result in capital gains, depending on the sales price relative to the cost basis. Generous exclusions of capital gains on the sale of a qualifying primary home ($250,000 single, $500,000 married) may provide adequate cover for this, but all situations are different.
Travel for business
You can expense the cost of transportation including airfare, car rental, parking and so on, plus hotel and lodging costs, and other associated expenses. If a trip is personal and business, be careful; you can only deduct what is attributable to business.
Meals and entertainment
Just 50 percent of qualifying meal and entertainment costs are deductible. You can deduct the cost of business-related meals and entertainment with clients, as well as your meals while attending conferences, or on business-related trips. Maintain accurate, detailed records -- for meals with clients, keep dates, who attended and location. It is always wise to keep receipts.
Putting it all together
Accurate record-keeping is a must in all aspects of running your business. Maintain a receipt file, and err on the side of caution when it comes to keeping or ditching receipts, or other records. In addition, it is wise to consider using accounting software (such as QuickBooks), or hiring someone to manage your books.
Finally, consider working with a tax professional who knows the ins and outs of small businesses and personal taxes. When you own a small business, your personal and business taxes are likely intertwined. While accurate tax preparation is extremely important, it is a backward-looking event. Tax planning, which should begin each year on Jan. 1, is forward-looking, and can help you make the most out of your personal and business tax situation.