Small Business
The biggest challenge for most small businesses is separating business expenses from personal. It looks easy at first, but many tend to forgo allowed deductions by failing to properly record them. Another group of business owners does completely the opposite by recording almost everything...business related or not. This is not a bad habit by itself but you cannot deduct groceries and, most of the times, collecting receipts from gas stations is just a waste of time.
Auto deductions
The biggest advantage of small business taxation is per mile auto expense deduction. Many small business owners maintain a primary business location at home; so any trip with a business purpose, whether it is to purchase supplies at Home Depot, to visit a contractor’s site or meet an accountant, are automatically deductible at a generous rate of 48.5 cents per mile. If the primary business location is not at your home, the only miles you’ll be able to deduct are the ones originating from the office.
The IRS allows the taxpayers to choose their preferred auto expense deduction method in the fist year of vehicle business use. It is important to make the right choice which will affect your business for the years to come.
If you chose to depreciate your car, the deduction will be restricted to a very limited amount per year and you will have to keep records of all expenditures related to it. In addition to that, the car will have to be maintained mostly in business use and the complications arise if it is used as a personal vehicle or sold.
Choosing standard miles allowance usually dramatically simplifies record keeping, although you still need to record the trips. Many choose to keep a log at the car, but an alternative record keeping might be done by calculating the distance from your office to other business locations using Google maps and keeping records that will prove that you visited these business destinations (invoices, receipts, etc). For mixed business and personal vehicle use, the standard per mile deduction is usually the best choice.
Equipment
Most of the small business equipment can be deducted in the year of purchase. However, even if you can deduct everything in the current year, it might be more beneficial to depreciate keeping in mind future income brackets.
Labor: Contractors vs. Employees
Overall, most small businesses prefer using contractors instead of hiring employees. Having employees immediately adds additional regulations burden including unemployment taxes, employer portion of Social security and Medicare, mandatory quarterly transfers of estimated payroll taxes, to name just few. On the other hand, having employees might qualify you for business tax credits and retirement plan deductions.
If you have contractors, please remember - they should have their own tools, determine their own schedule and choose the manner they perform. Contractors might even have all the contracts from you, but these three conditions have to be maintained in order to keep their contractor status.
Cash basis vs. Accrual
Cash basis is generally preferred to accrual just because of the simplicity of record keeping. You won’t have to pay tax on the revenue not physically received. On the other hand, you cannot deduct anything that was not paid for either (which is often the case with accrual method).
The Accrual method provides less flexibility and might result in situations when you have to pay tax on the receivables. The difference between the two methods is especially important at the end of the year.
The Cash method is driven by dates of the invoices, checks and receipts, while accrual method takes into consideration what work was performed before the end of the year and any financial obligations you had on the 31st of December.
Self-employment tax and entity choice
The biggest disadvantage of being a contractor and having your own business is the 15.3% self-employment tax. Basically, it is the Social Security and Medicare taxes paid by the employers and the employees at the same time (remember, you are your own boss, after all). The good news is that one half of the tax is deductible and it is limited by $97'500 total personal income at least for the social security part (12.4%).
Self-employed, one-member LLC and general partners are the main victims of SE tax.
C-corporations are exempt, but are subject to double income taxation: first on the corporate level, and second on the owner level as dividends. IRS discourage use of C-corps by personal service providers and put such companies to 35% brackets right away skipping all lower tax brackets available for everybody else.
Limited Liability Corporations have a choice of being taxed as a corporation or partnership (for one member LLC - as a sole proprietor). The main benefit of LLC is limiting personal liability. Sole proprietors and general partners are personally liable for all business debts, while LLC owners are only liable to the extent of their investments. The Personal Service company rule does apply in case LLC chooses to be taxed as a corporation and mostly delivers owner's personal services.
The only way to reduce self-employment tax (other than making less money and deducting all allowed expenses) is by conducting business as an S-corporation, which are taxed similar to partnerships but are exempt from Self-employment tax. However, S-corporations are obligated to pay "reasonable" compensation to their employee-owners, which might result in higher taxes than conducting business as an LLC. Another drawback is that only legal US residents are allowed to incorporate S-corp; there should be no more than 100 owners and only one class of stock. For personal service providers, such forms of business entities start to be attractive as soon as the owner's income after all the deductions becomes higher than the average salary for the industry and loses its attractiveness after the owner's annual personal income reaches $97.5K social security tax limit.
Small things which can save a lot of money
More often than not, business owners skip recording small expenditures. It might be the purchase of small tools or supplies, restaurant bills for meetings with clients or phone bills. Remeber, if you don’t have a set place of conducting business and meet during lunch in the restaurant or entertain clients in the night clubs – most of the bill is deductible as long as business purpose overwhelms personal benefits. You can qualify for deductions for meals and lodging allowances during overnight stays as well as expenses for meals served for “the convenience of employer”. IRS has a set of standard meals and travel allowances and sometimes it is not even necessary to keep the receipts of some expenses up to a certain amount. Construction contractors are allowed to deduct their work-related laundry expenses, which are almost impossible to record due to the nature of this expenses, but it adds a good deduction at the end of the year.