Chapter 1
Tax Basics

Take it from one small business owner to another: Operating a business without tax savvy is like skydiving without a parachute—certain to end in calamity. Many business failures stem from ignoring the record keeping and taxes. Like it or not, the government is always your business partner.

Tax knowledge has powerful money-saving potential. It can give you a fatter bottom line than your competitors who don’t bother to learn. For instance, there are several ways to write off car expenses. The right choice can mean a few thousand more after-tax dollars in your pocket each year.

How Tax Law Is Made and Administered: The Short Course

Think of this section as a high school government lesson, only try to stay awake this time—it could mean money in your pocket.

The federal government. Visualize a three-branched tree. Congress, the legislative branch of the federal government, makes the tax law. The executive branch, which includes the Treasury Department, administers the tax law through the IRS. The judicial branch comprises all the federal courts, which interpret the tax laws and overrule the IRS when it goes beyond the law.

The power to tax incomes was granted by the 16th Amendment to the U.S. Constitution; the first Income Tax Act was passed in 1913. Contrary to what fringe groups and con artists contend, income tax law and the IRS are legal and are not going away.

The code. Tax law begins with the Internal Revenue Code (referred to throughout this book as the tax code or IRC). Congress enacts and revises the tax code. The president signs it (usually), and it becomes law. A major reworking of the IRC, the Tax Cuts and Jobs Act (TCJA), was passed in December 2017. The TCJA has provided the most substantial tax law overhaul seen in decades. The most significant changes affecting small businesses are covered in this book.

The IRS. The Internal Revenue Service (IRS) is a division of the Treasury Department. It is headed up by the commissioner of Internal Revenue, a presidential appointee. The IRS is charged with enforcing the tax code.

The IRS is headquartered in Washington, but it is doubtful you will ever deal directly with anyone there. The real work is done at IRS satellite offices.

The courts. The United States Tax Court decides disputes between the IRS and taxpayers and interprets the tax code. It is pretty easy to go to tax court in most cases, even without an attorney. Tax disputes are also decided in U.S. District Courts and the Federal Court of Claims, but these require payment of the disputed tax first, unlike in the tax court. All decisions in those courts, for or against you, may be reviewed by higher courts, meaning the various U.S. Courts of Appeal and the U.S. Supreme Court. The exception is small case tax court decisions (see Chapter 21 for details).

See, that wasn’t all that bad, was it? Now, venture forth into the rest of the book and may the small business gods be with you

Where to Find Tax Rules

How to research tax law questions is covered later in this book. Here’s a brief description of the main sources of federal tax law.

Federal statutes. Congress enacts tax laws, called codes, which make up the Internal Revenue Code. Each tax provision (called a code section) has its own number and title. For example, IRC § 183 refers to tax code Section 183, titled “Activities Not Engaged in for Profit.”

IRS publications. When Congress makes tax laws, it paints with a fairly broad brush. It’s then up to the Treasury Department (the IRS is a part of it) to determine how the tax code is to be applied. The details are filled in by IRS publications, such as Treasury Regulations. These “regs” are numbered in the same order as their related tax code sections, but preceded by the numeral “1.” For example, the regulation explaining IRC § 183 is Reg. 1.183. (Not all IRC sections have corresponding regulations.)

Both the IRC and IRS publications are available at most public libraries, larger bookstores, and, of course, IRS offices. The IRC is online at the IRS website (www.irs.gov) and www.law.cornell.edu (search for U.S. Code, Title 26, Internal Revenue Code). IRS regulations are available on the
IRS’s website.

Court cases. When the IRS and taxpayers go to court, a federal judge can reject the IRS interpretation of the tax law. Judges’ published opinions offer guidance on the correct interpretation of the tax code. Look up tax court opinions (from January 1, 1999 to the present) on the tax court’s website at www.ustaxcourt.gov or at a law library, courthouse, or law school.

Marginal Tax Rate and Tax Brackets

In our income tax system, the more money you make, the higher your tax rate. Often referred to as your marginal tax rate, it is the percentage at which the last dollar of income you earn will be taxed. You can find your tax rate in the annual federal income tax bracket tables published each year by the IRS. See www.irs.gov for current rates.

Example: Janice is single, lives in New York, and reports $100,000 in income in 2018. Her marginal tax rate, or tax bracket, is 24% after her personal exemptions and deductions. Janice’s income tax is figured like this: The first $82,500 of income will be taxed in increments at the 10%, 12%, and 22% tax rates, and the remaining $17,500 will be taxed at 24%. Every additional dollar Janice earns will be taxed at 24% until it reaches more than $157,500 in income, at which point her marginal tax rate, or tax bracket, will jump to 32%, and maybe as high as 35% or 37%.

If Janice factors in New York state and local income taxes and Social Security and Medicare tax, her true marginal tax rate may exceed 50%. Some types of income are taxed at different, lower rates, called capital gains.

What Is—And Isn’t—Income

“Except as otherwise provided … income means all income from whatever source derived.” That’s how the tax code defines income. (IRC § 61.) Not too helpful, is it? Paraphrased, it means, “You make it, we’ll tax it.” It can’t get much broader than that.

Things That Count as Taxable Income

For the most part, Uncle Sam doesn’t care whether your income is from self-employment, wages, investments, or organized crime. If it’s income, it is taxable.

First, anything of value received by you or your business is income unless it falls within the exclusions created by Congress. Here are some common noncash sources of taxable income.

Barter or trade. Goods and services received in a business deal are income unless they are consigned to you. When you barter (trade your goods or services), the fair market value of the item or service received is income.

Example: Marvin designs a brochure for Beeline Mortgage Brokers, for which he would normally charge $500. In return, Beeline gets Marvin a new home mortgage without charging its customary $500 fee. No money changed hands, but both Marvin and Beeline should report $500 income.

A lot of bartering goes on with small businesses and self-employed people, and the IRS is none the wiser. But getting away with something doesn’t make it legal, does it?

Side jobs. You can have business income even if you aren’t involved in a money-making activity on a regular or full-time basis. If you performed a service and got paid for it only once during the year, it’s still income and reportable to the IRS.

Constructive income. Constructive income is a legal doctrine that taxes things that you don’t actually have in your hands, but that you have a right to. Whether you grab it or not, it’s income the moment it’s available.

Example: On December 1, 2018, Raylene gets a $5,000 check from BigCo for her Web design services performed in November. Raylene looks at her books and sees she has already made so much that year that this $5,000 will be taxed at the highest individual tax rate (37%). Raylene is planning on taking a lot of time off traveling the following year, and her income will be drastically reduced. She would like to hold off cashing the check until after January 1, 2019 so that she can be taxed at a lower tax rate. Can she do it? No. The $5,000 was constructively received in 2018, and so is income in that year, regardless of when she cashes the check.

Illegal and off-the-books income. The tax law is morally neutral, not distinguishing between the fruits of your labor or ill-gotten gains, so even dirty money is taxable. As the IRS is fond of telling us, the legendary Al Capone wasn’t sent to jail for murder, bootlegging, or racketeering. He went to Alcatraz for not reporting income from all those activities.

Example: Rico is a hit man for the Soprano family. The cash, Cadillac, suits, and Cuban cigars he receives for his “work” are all taxable, and reportable, income.

Also in this category are kickbacks and bribes.

You don’t have to list the source of your illegal income for the IRS—you can claim your constitutional right against self-incrimination. If this sounds like something you might try, see a tax attorney first.

Foreign income. Income you earn from wages or self-employment or any source from anywhere in the world is taxable for American citizens and most residents, with two exceptions noted below.

Example: While traveling in Hong Kong, Juliana, an antique dealer from California, spotted a rare Ming vase. She paid $200 for it and sold it to another dealer in Hong Kong for $4,800. Result: Julia must report $4,600 of taxable income to the IRS. Silver lining: If the primary purpose of the trip was for business transactions like this one, Juliana should be able to deduct at least some of her travel expenses.

Exception One: An American residing out of the United States for most of the year can exclude $104,100 (2018) from his or her income taxes. To get this foreign tax exclusion, you must file a tax return in the United States every year claiming the exclusion.

Two additional key points:

• You must still pay Social Security tax on all your foreign earnings.
• You must pay income tax on any investment income you make while living outside the country.

Example: Charlene works as an English teacher in Spain for two years and earns $45,000 per year. She moves to Spain, not returning to her home in Vermont until three years later. Charlene pays Social Security tax but doesn’t owe any income tax in the United States as long as she files a return each year and claims the exclusion. (This doesn’t mean that Charlene doesn’t pay taxes in Spain, though.)

Exception Two: If you pay taxes in another country on income not covered by the foreign tax exclusion, you may get a tax credit in the United States for the taxes you paid abroad.

Example: Stanley, an independent contractor, goes to Norway for three months to extinguish an oil fire on an offshore rig in the North Sea. He is paid $100,000 for the job with $40,000 withheld and paid to the Norwegian government in income tax. Tax result: The $100,000 is taxable income that must be reported to the IRS, but Stanley gets a tax credit for the $40,000 he paid to Norway. He must file a U.S. tax return to get the credit.

For more information on these two exceptions, see IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

Finally, even if you renounce your U.S. citizenship and move abroad, you are still subject to U.S. tax law on income and gains for ten years. So much for offshore tax havens.

Exclusions: Things That Aren’t Income

Some income isn’t taxable because it falls into the “except as otherwise provided” section of the tax law. (IRC § 61.) Here are the main legal exclusions—things that don’t have to be reported to the IRS.

Gifts and inheritances. Income tax never has to be paid by the recipient of gifts or inheritances, no matter how much is received.

Example: Aunt Sophie leaves Ralphie, her favorite nephew, her mansion on Maui, her Kentucky Derby-winning horse, and $70 million. Tax result: Ralphie owes nothing to the IRS—but Aunt Sophie’s estate most likely paid a hefty estate tax.

Prizes and lottery winnings aren’t considered gifts and are taxable.

Example: The Publisher’s Clearing House Prize Patrol drops off a $10 million check at Mallory’s business. This windfall is not a gift, since Mallory had to do something for it: Fill in the form, place about a hundred different stickers on it, and mail it in. Uncle Sam is due his share of the $10 million.

Fringe benefits. Many fringe benefits provided by businesses to owners and employees are not taxable income, but a few are. (See Chapter 15.) Bonuses, vacation pay, and the like are always taxable.

Return of capital. Getting back what you put into a business doesn’t have any tax consequences.

Example: Elaine decides to move to New Zealand and sells her partnership interest in the Doggy Donut business to Marina for $15,000. She had owned a share of the business for only a few months and had $12,500 invested in it. Tax result: Elaine must report $2,500 of income (the gain on her investment in the partnership) on her tax return.

Loans. If the business has to pay it back, it’s not income.

Example: Roxanne pays $40,000 for the small warehouse building she uses to store and ship costume jewelry. She refinances the building and takes out a mortgage of $30,000. This is a tax-free way for Roxanne to take money out of her business.

Consignments. Goods held by your business that belong to others are neither income nor inventory.

For more details on exclusions from income, see IRS Publication 525, Taxable and Nontaxable Income.

A Word About Tax Shelters

A so-called tax shelter can be a perfectly legal way for a small business owner to reduce his or her income tax bill. One of the more common forms of tax shelters is to own rental property where the cash and noncash tax deductions, interest, depreciation, and insurance exceed the rental income. The owner/taxpayer may be able to use the loss from the rental property to offset income from other sources (such as a small business) on his or her tax return. Any appreciation in the property is not taxable until the property is sold.

This should not be confused, however, with the type of abusive tax shelters that the IRS is on the watch for. These deals, often marketed by self-styled financial experts or even some big-name accounting firms, involve transactions with tax reduction motives but minimal or no economic substance. They usually promise large tax deferrals, deductions, or write-offs beyond your investment cost—the tax equivalent of a free lunch. If you are audited, the IRS will demand that the proposal could stand on its own as a moneymaker, without the tax benefits.

The moral is, don’t buy into a tax savings scheme, whatever it is called, unless it has a reasonably good chance of making a profit—with tax savings as an added bonus. Many of these plans are so complicated that no one wants to admit they don’t understand them. If the promoter harps on the tax savings first, watch out. Don’t plunge in without checking with a trusted tax pro. If you get involved in a scheme that the IRS rules is abusive, you’ve got to give back any tax breaks, and pay penalties, interest, and any legal fees.

The Alternative Minimum Tax (AMT)

As if the tax code isn’t diabolical enough, there is something called the alternative minimum tax (AMT). The AMT is not a business tax but is really a second (alternative) set of tax rates that potentially can affect anyone with income of more than $70,300 (single) or $109,400 (married filing jointly) (2018). The theory of the AMT is that people who take a lot of tax deductions or tax credits should still have to pay a minimum amount of income taxes.

All taxpayers must figure their income tax under both the regular (marginal) tax rates, and the AMT rates—and pay whichever is the greater number. Ouch! Fortunately, all income tax preparation software automatically figures the tax both ways. The AMT is reported on Form 6251, and filed with your individual tax return.

The AMT effectively denies some tax deductions and credits otherwise allowed on a tax return. AMT is figured by adding back to taxpayers’ income many of the exemptions, deductions, and credits that lowered their taxable income in the regular system. The AMT is triggered by such things as:

• net operating loss deductions in a business
• interest deductions on home equity loans
• large itemized deductions for state and
  local taxes
• foreign tax credit
• passive income or loss
• certain installment sale income
• unreimbursed employee expenses
• exemptions for dependents
• child and education tax credits for
  Hope scholarships and Lifetime Learning
• interest income on certain tax-exempt bonds, and
• the exercise of incentive stock options.

The AMT is yet another reason to take every tax break possible and use the help of a tax pro and software programs like TurboTax (Intuit)
or Quicken.