Form of Doing Business
An initial consideration, depending on the nature of the business and legal protection required, is the choice of the form of business entity. The options include a sole proprietorship, partnership, corporation, or limited liability entity. If a corporation is the preferred method then a further decision is necessary as to whether to elect S Corporation status or remain as a conventional corporation. For the limited liability situation either a limited liability corporation (LLC) or limited partnership is available.

In any case, each and every form selected carries with it certain advantages and disadvantages including special tax treatments.

Self Employment Income
When an individual's self employment income is $400 or more, then they must file Schedule SE with their individual income tax return and compute and pay the related Social Security and/or Medicare tax. Self employment income results when either the sole proprietorship or partnership form of business operation is in effect. Undistributed earnings from an S Corporation are not subject to the self employment tax. But wages paid by any corporation to its sole shareholder/owner are subject to all appropriate payroll taxes including withholding (both Federal and local), FICA, unemployment tax, etc. Guaranteed payments received from a partnership, however, are not considered wages or salary for withholding and other taxes.

Accounting Method
Generally, the small business can select its method of accounting on the initial tax return filed. The cash basis, accrual basis, and modified accrual basis are the most common generally accepted accounting methods used also for tax reporting purposes. But when inventories are present - as in a retail operation - then the accrual method of accounting must be used. Typically, service industries like lawyers, accountants, consultants and physicians use the cash method. Finally, there are special rules in effect for accounting methods available to corporate entities.

Selection of Fiscal Year End
Although there are some exceptions, most sole proprietorships, general partnerships, and S Corporations must use a calendar year (Jan. 1 through Dec. 31) when filing their annual income tax return. A conventional - or C Corporation - may select any fiscal year it wishes and is not necessarily limited to using a calendar year.

Insurance
Depending on the form of business operations, certain types of business insurance are treated differently. In most states, for example, workers' compensation insurance is not available or required for the owner of a sole proprietorship. Health insurance premiums are not deductible as a business expense for the owner or his family operating as a proprietorship or an S Corporation. For other business entities, the insurance benefits may be further limited under the effect of the top heavy tests applied by the IRS when employees are excluded from the plan.

Office In Home
To be eligible to deduct office in home expenses, the self-employed person must use the allocated portion of the residence to regularly conduct business, as the principal place of business, or to meet clients or patients there. The amount deductible may then be limited by the operating income of the business before the office in home deduction is considered.

Retirement Plans
A variety of retirement plans are available for the self employed or small business owner. Determination of the specific type of plan to implement is often governed by whether the company has family employees only, other employees, union workers, and top heavy requirements as previously mentioned. This particular deduction is attractive to the owner as contributions to a qualified plan are immediately deductible as a business expense but not taxable to the beneficiary until the account is withdrawn generally after retirement.

First Year Depreciation
A tax deduction of up to $20,000 for 2000 can be taken when the business places into service qualified personal property. This deduction - called a Section 179 deduction - allows immediate expensing of business assets instead of depreciating them over lives of three to twenty years. Like the office in home deduction, this deduction is also limited to operating income before computing the depreciation.

Vehicle Expenses
All taxpayers may compute their deduction for business use vehicles by using the IRS computed per mile rate instead of the actual expenses of depreciation, repairs, gas, oil, washes, license tags, lease payments, insurance, etc. For 2000, the allowable rate is 32.5 cents per allowable business miles. Take note, however, that the law still requires written substantiation of applicable business use.

Disposal of Business Use Property
An item that often goes unnoticed is that any sale or other disposal of depreciable business property is treated as ordinary income - not favorable capital gains - to the extent depreciation deductions have been previously taken.  These transactions are separately reported on the returns and often can result in heavy tax bills when the actual cash available from the sale is not sufficient to pay the liability.

Tax Forms
For each issue discussed above, different tax forms and/or schedules are required. In addition, the actual responsible taxpayer may differ and so can the due date of the tax return.

Summary
In conclusion, tax considerations are numerous and significant for the small business person. Proper selections and elections are critical to establish the minimum tax liability annually and help insure future success of the business entity itself as well as the owner.

Originally published Dec. 11, 2000