Choice of Entity

Many businesses start out as sole proprietorships. An individual entrepreneur is automatically treated as a sole proprietor unless he or she chooses another business format. A sole proprietorship offers the advantage of simplicity business income and losses are reported on the business owner’s individual tax return. Moreover, losses from the business can be offset against income from other sources. However, a sole proprietorship has some drawbacks. For example, a sole proprietor bears unlimited liability for the debts of the business even if they exceed his or her investment in the business. Moreover, a sole proprietor is not protected from business lawsuits-a disgruntled client or customer may sue the business owner directly.

If a business is not a solo operation-if, for example, it is a mom-and-pop business or a business venture with another individual-it will automatically be classified as a partnership for tax purposes. Like a sole proprietorship, a partnership is not a tax-paying entity-income and losses pass through to the partners and are reported on their individual returns. However, a partnership must file an information return (Form 1065) with the IRS each year and send the information to the individual partners (Schedule K-1). In addition, like a sole proprietorship, a partnership generally does not shield the individual owners from personal liability for the partnership’s debts. (A limited partnership may shield some partners from personal liability, but it must have at least one general partner who is personally liable for debts of the partnership.)

As a result, business owners who want to draw a line between their personal and business finances may want to consider setting up a corporation or a limited liability company (LLC). Both corporate and LLC status protect a business owner from personal liability for business losses and debts.

Choice of a Tax Year

A business must figure taxable income and file tax returns on the basis on an annual accounting period called a tax year.

There are basically two types of tax years:

  • A calendar tax year is a period of 12 consecutive months beginning January 1 and ending December 31.
  • A fiscal tax year is a period of 12 consecutive months ending on the last day of a month other than December (or a 52-53 week period that always ends on the same day of the week).

Choice of Accounting Method

A business’s accounting method determines when and how income and expenses are reported for tax purposes.

Under the cash method, income is reported in the year it is received and expenses are generally deducted in the year they are paid. However, prepaid expenses must generally be deducted in the year to which the payment applies.

Under the accrual method, income is generally reported in the year it is earned, even if it not received until a later year. Expenses are deductible in the year that all events have occurred that that determine the fact of liability and the amount of the expense and economic performance has occurred [IRC Sec. 461(h)]. In the case of expenses for property or services, economic performance is deemed to have occurred when the property or services are provided. However, special rules apply to various types of income and expenses.

Small business exception: Despite the general requirement that a business must use the accrual method to account for inventory items, the IRS recently created a special exception for small businesses. Under that special break, businesses with average annual gross receipts of $1 million or less can use the cash method even if they produce, purchase or sell merchandise. Moreover, qualifying businesses can choose not to maintain inventories, even if they do not switch to the cash method. If a business chooses not to keep an inventory, it deducts the cost of items in the later of the year they are sold or the year they are paid for.

A more limited exception from the inventory and accrual accounting requirements applies to larger businesses (with average annual gross receipts of $10 million or less). The exception is generally available to businesses, such as electrical and plumbing contractors, that sell related products along with the services they provide.

Key Choice for Start-Up Costs

Starting a business doesn’t come cheap. And a new business owner may begin to rack up significant expenses even before the business is up and running. These start-up costs cannot be deducted as ordinary and necessary business expenses. Instead, the business has a choice: It can elect to amortize the start-up expenses over a period of time or it can capitalize the costs and add them to the tax basis of the business.

Start-up expenses include business investigatory expenses, expenses of setting up the business, and pre-opening costs to get the business up and running. For example, start-up costs for a typical business might include the costs of market surveys and analyses; salaries and fees for consultants and professional services; travel and other costs for locating distributors, suppliers, and customers; salaries and fees paid to employees-in-training prior to opening the business; and pre-opening advertising costs.

Tax Choice for Equipment Purchases

It’s a rare business that can operate without equipment. Therefore, a new business owner is likely to have significant expenses for equipment purchases. Here again, the business owner may have a choice: the costs can be recovered through annual depreciation deductions or the business owner can claim an up-front expensing deduction.

A new tax law change significantly expands the expensing deduction for 2003 through 2007. An expensing deduction can be claimed for up to $100,000 of eligible property (up from $25,000 for 2002). Moreover, the dollar limit is not reduced unless cost of eligible property exceeds $400,000 (up from $200,000 for 2002). Therefore, a business will be ineligible for an expensing deduction only if the cost of qualifying property exceeds $500,000.

However, new businesses face another limit on their ability to claim an expensing deduction. The total cost that can be expensed cannot exceed the taxable income from the active conduct of a trade or business during the year. As a result, a business that’s just getting off the ground may get little benefit from the expensing deduction in its first year of operation.

Backing Up Those Tax Choices

Making the right tax choices is only the beginning. A business owner must back up those choices with adequate tax records. And, here again, many new business owners take shortcuts. Commingling business and personal finances, failure to maintain proper receipts and other records, or inconsistent handling of business receipts can cost a business owner valuable tax write-offs or cause the IRS to challenge the accuracy of the income reported for the business. Therefore, new business owners should be encouraged to set up an audit-proof record-keeping system before they open their doors for business.