Tax savvy for small business year round tax strategies to save you money 9th edition by attorney frederick w daily

9th edition

Tax Savvy for
Small Business
Year-Round Tax Strategies
to Save You Money
by Attorney Frederick W. Daily
edited by Bethany Laurence


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9th edition

Tax Savvy for
Small Business
Year-Round Tax Strategies
to Save You Money
by Attorney Frederick W. Daily
edited by Bethany Laurence


Ninth Edition

SEPTEMBER 2005

Editor

DIANA FITZPATRICK

Illustrations

MARI STEIN

Cover Design

SUSAN PUTNEY

Book Design

TERRI HEARSH

Production

SARAH HINMAN

Proofreading

ROBERT WELLS

Index

SONGBIRD INDEXING SERVICES

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CONSOLIDATED PRINTERS, INC.

Daily, Frederick W., 1942Tax savvy for small business : year-round tax strategies to save you money / by
Frederick W. Daily ; edited by Bethany Laurence..-- 9th ed.
p. cm.
Includes index.
ISBN 1-4133-0391-9 (alk. paper)
1. Small business--Taxation--Law and legislation--United States. 2. Tax
planning--United States. I. Laurence, Bethany K., 1968- II. Title.
KF6491.D35 2005
343.7305'268--dc22
2005051823

Copyright © 1995, 1996, 1997, 1998, 1999, 2001, 2002, 2003, 2004, and 2005 by Frederick W. Daily.

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Dedication
To my wife, Brenda, who has brought me everything that is good in life.

Acknowledgments

Trying to translate the tax code into plain English for the small business owner was a
challenge that all but overwhelmed me. Without the help of many others I could not
have done it.
Nolo has some of the most caring (and careful) editors on the face of this earth. First
and foremost in both categories is Mary Randolph. Other Nolo folks with a hand in the
project were Jake Warner, Robin Leonard, Lisa Goldoftas, and Steve Fishman. Stephanie
Harolde, Ely Newman, Robert Wells, and Susan Cornell made valuable contributions in
copyediting, proofreading, and production. Much thanks to Beth Laurence in updating
the new editions. Thank you one and all for putting up with me.
My peers in the tax community contributed immensely and without complaint. The
most helpful in making sure the things you need to know were covered: Chris
Kollaja, CPA; Dewey Watson, Tax Attorney (both in San Francisco); Lew Hurwitz, EA
(Oakland); Steven Mullenniex, EA (Berkeley); Malcolm Roberts, CPA, of Roberts
Schultz & Co. in Berkeley; and Gino Bianchini, Tax Attorney (Newport Beach). A special thanks to Richard L. Church, CPA (Southwest Harbor, Maine), and to Jeff Quinn,
CPA, of Incline Village, Nevada..
A special thanks in updating Chapter 15, Retirement Plans, goes out to Craig
Schiller, CPC, owner of Schiller’s Pension Consulting in Burlingame, California
(). Craig’s firm handles my retirement plan needs.



Table of Contents

I

Introduction
A. Taxes for Small Businesses and the Self-Employed ..................................... I/2
B. How Tax Law Is Made and Administered: The Short Course ...................... I/4
C. Sources of Tax Law .................................................................................... I/5
D. Marginal Tax Rate and Tax Brackets .......................................................... I/6

E. The Alternative Minimum Tax (AMT) ......................................................... I/6

Part 1: The Basics

1

Deductible Expenses
A. What Is a Deductible Business Expense? ................................................... 1/3
B. Is It a Current or Future Year Expense? ...................................................... 1/5
C. Top 25 Deductions for Businesses ............................................................ 1/5
D. Vehicle Expenses .................................................................................... 1/15
E. How and Where to Claim Expense Deductions ...................................... 1/19
F. What Is—And Isn’t—Income? ................................................................. 1/20

2

Writing Off Business Assets
A. When Various Expenses May Be Deducted .............................................. 2/3
B. Section 179: Expensing Business Assets .................................................... 2/5
C. Depreciating Business Assets .................................................................... 2/8
D. Tax Basis of Business Assets .................................................................... 2/15
E. Leasing Instead of Buying Assets ............................................................. 2/18
F. When You Dispose of Business Assets: Depreciation Recapture Tax ...... 2/20
G. Tax Errors in Depreciation ...................................................................... 2/21


3

Bookkeeping and Accounting
A. Why You Need a Bookkeeping System ..................................................... 3/2

B. Should You Hire a Bookkeeper? ............................................................... 3/3
C. Manual or Computer System? ................................................................... 3/3
D. What Kinds of Records to Keep ................................................................. 3/7
E. How Long Records Should Be Kept ........................................................ 3/11
F. Bookkeeping Methods of Tracking Income and Expenses ....................... 3/11
G. Timing Methods of Accounting: Cash and Accrual ................................. 3/12
H. Accounting Periods: Calendar Year or Fiscal Year .................................. 3/14

4

Business Losses and Failures
A. Unincorporated Business Losses ............................................................... 4/2
B. Incorporated Business Losses .................................................................... 4/4

5

Tax Concerns of Employers
A. Taxpayer Identification Numbers .............................................................. 5/2
B. Payroll Taxes............................................................................................. 5/3
C. Classifying Workers: Employee or Independent Contractor? ................... 5/10
D. Misclassifying Employees as Independent Contractors ............................ 5/13
E. IRS Filing and Payment Requirements for Employers .............................. 5/16
F. Record Keeping for Service Providers ..................................................... 5/17

Part 2: The Structure of Your Business

6

Sole Proprietorships
A. Business Expenses ..................................................................................... 6/2

B. Profits Left in the Business ......................................................................... 6/2
C. How Sole Proprietors Report Taxes ........................................................... 6/3
D. Estimated Tax Payments = Pay as You Go ................................................ 6/6
E. Employment Tax Rules .............................................................................. 6/7
F. Record Keeping ........................................................................................ 6/8
G. Outgrowing a Sole Proprietorship ............................................................. 6/8
H. Ending the Business .................................................................................. 6/9
I. Death and Taxes ....................................................................................... 6/9


7

C Corporations
A. Types of Corporations ............................................................................... 7/3
B. How C Corporations Are Taxed ................................................................ 7/5
C. Tax Benefits of C Corporations ................................................................ 7/10
D. Incorporating Your Business ................................................................... 7/11
E. The Importance of Issuing Section 1244 Stock ........................................ 7/15
F. Taking Money Out of a C Corporation .................................................... 7/17
G. Tax Pitfalls of C Corporations .................................................................. 7/20
H. Dissolving a C Corporation ..................................................................... 7/21

8

S Corporations
A. An Overview of S Corporations ................................................................ 8/2
B. Should You Choose S Corporation Status? ................................................ 8/3
C. Tax Reporting for S Corporations .............................................................. 8/5
D. How S Corporation Shareholders Are Taxed on Income ........................... 8/8
E. Social Security and Medicare Taxes .......................................................... 8/9

F. Electing S Corporation Status .................................................................... 8/9
G. Revoking S Corporation Status ................................................................ 8/11
H. Dissolving an S Corporation ................................................................... 8/11

9

Partnerships
A. Partnership Tax Status ............................................................................... 9/3
B. Tax Reporting by Partnerships ................................................................... 9/3
C. Tax Obligations of Partners ....................................................................... 9/4
D. Partnership Losses ..................................................................................... 9/9
E. Partnership Contributions ....................................................................... 9/10
F. Getting Money Out of a Partnership ....................................................... 9/12
G. Partnership Expenses ............................................................................... 9/13
H. Selling or Transferring a Partnership Interest ........................................... 9/13
I. Ending a Partnership ............................................................................... 9/15

10

Limited Liability Companies
A. Taxes ...................................................................................................... 10/2
B. Comparing LLCs With Other Entities ....................................................... 10/3
C. Forming and Operating a Limited Liability Company (LLC) .................... 10/4
D. Terminating a Limited Liability Company ............................................... 10/6


11

Personal Service Corporations
A. Personal Service Corporations ................................................................ 11/2

B. Taxes ...................................................................................................... 11/3
C. Fringe Benefits ........................................................................................ 11/4
D. Potential Tax Problems ........................................................................... 11/4
E. Transferring Shares .................................................................................. 11/5
F. Dissolving a Personal Service Corporation .............................................. 11/5

Part 3: Thinking Small

12

Family Businesses
A. The Legal Structure of a Family Business ................................................ 12/2
B. Income Splitting to Lower Taxes ............................................................. 12/2
C. A Spouse in the Business ......................................................................... 12/6
D. Preserving a Family Business After Death ............................................... 12/7

13

Microbusinesses and
Home-Based Businesses
A. Business Expenses Incurred at Home ...................................................... 13/2
B. Deducting Part of the Cost of Your Home ............................................... 13/2
C. Calculating Your Home Office Deduction .............................................. 13/6
D. Tax After Selling Your Home .................................................................. 13/9
E. A Microbusiness as a Tax Shelter ............................................................ 13/9

Part 4: Fringe Benefits

14

Fringe Benefits
A. How Fringe Benefits Save Taxes ............................................................. 14/3
B. Retirement Benefits ................................................................................. 14/4
C. Motor Vehicles ....................................................................................... 14/4
D. Meals ...................................................................................................... 14/5
E. Travel and Lodging ................................................................................. 14/5
F. Clubs and Athletic Facilities .................................................................... 14/8
G. Association Dues and Subscriptions ........................................................ 14/8
H. Health Benefits ....................................................................................... 14/8
I. Day Care Benefit ................................................................................... 14/10
J. Education Benefits ................................................................................ 14/11
K. Gifts, Rewards, Discounts, and Free Services for Employees ................. 14/11


L. Adoption Assistance .............................................................................. 14/12
M. Special Benefits for C Corporation Employees Only ............................. 14/13

15

Retirement Plans
A. Advantages of Retirement Plans .............................................................. 15/2
B. Overview of Retirement Plan Types ........................................................ 15/3
C. Details About Each Type of Retirement Plan ........................................... 15/4
D. Where to Go for a Retirement Plan ....................................................... 15/12
E. Potential Tax Problems With Retirement Plans ..................................... 15/13
F. Withdrawing Money From Retirement Plans ......................................... 15/14
G. Closing Your Business ........................................................................... 15/16

Part 5: Buying or Selling a Business

16

Buying a Business
A. Buying the Assets of a Business ............................................................... 16/2
B. Buying Shares of Stock ............................................................................ 16/3
C. Assigning a Price to Business Assets ........................................................ 16/6
D. State and Local Transfer Taxes ................................................................ 16/8

17

Selling a Sole Proprietorship
A. Selling Assets of a Sole Proprietorship ..................................................... 17/2
B. The Importance of an Arms-Length Deal ................................................ 17/4
C. How to Protect Yourself From IRS Challenges ......................................... 17/5

Part 6: Dealing With the IRS

18

When You Can’t Pay Your Taxes
A. If You Owe Less Than $25,000 ............................................................... 18/3
B. Getting More Time to Pay ....................................................................... 18/3
C. Paying in Installments ............................................................................. 18/3
D. What to Expect When the IRS Gets Serious ............................................. 18/5
E. Dealing With a Monster Tax Bill ............................................................. 18/7
F. When the IRS Can Take Your Assets ..................................................... 18/10

19

Audits

A. Who Gets Audited? ................................................................................. 19/3
B. How Long Do You Have to Worry About an Audit? ............................... 19/5
C. How the IRS Audits Small Businesses ...................................................... 19/6


D. The Auditor’s Powers .............................................................................. 19/7
E. Should You Get Audit Help? ................................................................... 19/8
F. Preparing for Your Audit ......................................................................... 19/9
G. What to Bring to an Audit ....................................................................... 19/9
H. Don’t Rush a Field Audit ....................................................................... 19/14
I. What Auditors Look for When Examining a Business ............................ 19/14
J. How to Behave at an Audit ................................................................... 19/16
K. How to Negotiate With an Auditor ....................................................... 19/18
L. Your Options After Getting an Audit Report .......................................... 19/20
M. When Your Audit Is Final ..................................................................... 19/21

20

Appealing IRS Audits
A. IRS Appeals ............................................................................................. 20/2
B. Contesting an Audit in Court ................................................................... 20/5

21

Penalties and Interest
A. Common Reasons for Penalties ............................................................... 21/2
B. Interest on Tax Bills ................................................................................. 21/3
C. Understanding Penalty and Interest Notices ............................................ 21/3
D. How to Get Penalties Reduced or Eliminated ......................................... 21/4
E. How to Get Interest Charges Removed ................................................... 21/6

F. Designating Payments on Delinquent Tax Bills ....................................... 21/6

22

Help Beyond the Book
A. Finding Answers to Tax Questions .......................................................... 22/2
B. Finding and Using a Tax Pro ................................................................... 22/7

23

Answers to 25 Frequently Asked Tax Questions


Glossary
Appendix
Form 2553, Election by a Small Business Corporation
Form 4506, Request for Copy of Tax Return
Form 4797, Sales of Business Property
Form 7018, Employer’s Order Blank for Forms
Form 8594, Asset Acquisition Statement
Form 8821, Tax Information Authorization
Form 8822, Change of Address
Form SS-4, Application for Employer Identification Number
Form W-4, Employee’s Withholding Allowance Certificate
Form W-9, Request for Taxpayer Identification Number and Certification
Form 1040, Schedule SE, Self-Employment Tax

Index

I
Introduction
A. Taxes for Small Businesses and the Self-Employed .............................................. I/2
1. The Typical Small Business ............................................................................. I/2
2. Knowing Your Taxes ....................................................................................... I/4
B. How Tax Law Is Made and Administered: The Short Course ............................... I/4
C. Sources of Tax Law ............................................................................................. I/5
D. Marginal Tax Rate and Tax Brackets ................................................................... I/6
E. The Alternative Minimum Tax (AMT) .................................................................. I/6


Introduction/2

TAX SAVVY FOR SMALL BUSINESS

I

f mastering the tax code were a prerequisite to
starting a business, no one would dare. Luckily,
the basics of federal taxes are right here in this
book. And once you grasp the fundamentals, you
can pick up the rest as you go along, perhaps with
the help of a tax adviser. As the well-worn phrase
goes, “It’s not brain surgery.”

The IRS does not require or issue business
licenses. Whether you need any kind of license
depends on your state and local authorities. For small
business start-up issues, see The Small Business StartUp Kit, by Peri Pakroo (Nolo).

Tax Advantages for Small-Time Operators

A. Taxes for Small Businesses
and the Self-Employed
Owning and operating a small business, full or part
time, has been called the little guy’s tax shelter. The
self-employed get tax benefits for any number of
expenditures not allowed to “wage slaves.” In effect, you are sharing expenses (as well as profits)
with Uncle Sam—and, in most cases, with your
state as well.
Small business or independent contractor? Selfemployed people often ask whether they are a
“business.” The answer is yes. Whether you run a
flower shop or freelance as a website designer, you’re
a small business. When we talk about small businesses
in this book, we’re talking about all kinds of self-employed people, from independent contractors, consultants, and freelancers to the guy who owns the pizza
parlor down the street.

1. The Typical Small Business
Everyone has their own idea of what a small business is. The typical small business in the United
States grosses less than $1 million and has fewer
than ten employees. That’s the type of venture this
book addresses, but most of the tax information
here applies to any size operation, except a publicly
traded company. As you might expect, when the
dollars or employees increase, so do the tax complexities. Still, the book in your hands covers all the
tax basics you need to know to get started.

1. Personal expenses can become partially deductible: your home, car, computer, meals,
education, and entertainment.

2. Retirement plans can shelter part of your
venture’s income from taxes, accumulate earnings tax-deferred, and provide for your
retirement at a reduced tax rate.
3. Family members—young and old—can be put
on the payroll to shift income to them and
reduce a family’s overall tax bill.
4. Travel and vacations can qualify in whole or in
part as deductible business expenses.
Sound interesting? With all of these possibilities, your business can earn less than if you were
working for someone else, and you still can come
out ahead. Of course, by going into business you
might be trading an 8-hour-a-day job for a 24hour one. But for many of us, it is worth it.

Our country has 45 million small businesses and
self-employed folks that the IRS knows about, and
probably many more. (Unhappily, U.S. Chamber of
Commerce statistics show that a venture has an 85%
chance of closing its doors within its first five years.
But our entrepreneurial spirit is strong, and many
who fail go back and try again.)
Four out of five of these brave souls are what the
tax code calls sole proprietors—one-person or mom
’n’ pop operations. The rest are either partnerships,
limited liability companies, or corporations. Ten
million small businesses provide jobs only for the
owners and their families—in other words, they
have no outside employees.


INTRODUCTION

Introduction/3

Don’t Forget About State and Local Taxes
While this book focuses on federal taxes, your business may also be taxed by your state and local tax
laws and agencies. Unfortunately, it can be even
more time-consuming to comply with state tax laws
than with federal tax laws. Especially if your enterprise is a multistate affair, you might find yourself
drowning in paperwork. At the very least, figure state
tax compliance into your cost of doing business, including hiring bookkeeping and accounting help.
State tax enforcement agencies are often more bureaucratic, tough, and downright frustrating to deal
with than the IRS. (For advice on dealing with state
tax agencies see Stand Up to the IRS, by Frederick W.
Daily (Nolo).) And many states have out-of-state
enforcement offices or use private collection agencies
to track you down anywhere in the U.S., so just because you live in Maryland, don’t think the state of
California can’t get you.
Here are some state tax issues to watch out for:
• Income taxes. All but seven states impose income taxes. See Chapter 7, Section B3, and
Chapter 8, Section C (corporate state income
tax and franchise tax information); Chapter 10,
Section A2 (LLC state income taxes); Chapter 9,
Section B1 (partnership state income tax reporting); and Chapter 15, Section F (retirement
plans).
• Sales taxes. Just about every state imposes a
sales tax. But each state has different rules for
collection and exemptions. Usually the seller is
responsible for collecting and paying state sales
tax whether it has been collected from the
buyer or not.

• Use taxes. This is a tax on goods that you
purchased out of state that were shipped into
your state without paying sales tax.
• Business transfer taxes. Whenever a business
changes hands, your state, county, or city may
impose a transfer tax on the buyer, the seller, or
both. (See Chapter 16, Section D.)
• Inventory and other property taxes. Some states
and local governments impose an annual tax
on the value of the personal (non–real estate)

•

•

•

•

•

•

property used in the business, such as vehicles
or equipment. And, most states or localities impose an annual tax on real estate, whether it is
used for business or personal purposes.
Internet taxes. There is a federal moratorium
on states’ imposing taxes on Internet transactions. However, some states impose a “use” tax
for out-of-state purchases, which is perfectly
legal.

Payroll taxes. All states with income taxes have
a payroll tax, deduction, and collection system
similar to the federal system.
Telecommuter taxes. New York is one of a
growing number of states that tax you if you
work from home in another state (for instance,
Connecticut), if the main business location is in
New York.
License fees. There are myriad state and local
licenses that a business must secure. Whatever
they are called, these fees are really just taxes.
Check with your local government agencies,
your chamber of commerce, or your attorney.
Out-of-state taxes. As an employer, you can be
responsible for withholding state income taxes
on your nonresident employees’ income for
their home states. Recently, a small incorporated consulting business owner came to me
with a plan to open satellite offices in two surrounding states. After learning that he would
have to learn and deal with three sets of state
payroll, corporate, and other tax rules, he decided not to expand.
Death taxes. Most states, as well as the federal
government, tax the value of all of your assets,
including your business, when the estate is
large enough, on your death. (See Chapter 12,
Section D.)

State and local agencies. To find your state
tax and licensing agencies, go to
www.statelocalgov.net for a listing of all the government agencies in your state, or look them up in your
local phone book.

Introduction/4

TAX SAVVY FOR SMALL BUSINESS

2. Knowing Your Taxes
No one likes paying taxes or dealing with the IRS,
but 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 tax side of the operation.
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.

What You’ll Get From Reading This Book
1. Information on how to deduct business expenses and write off purchases.
2. An explanation of the tax benefits of each main
type of ownership structure: sole proprietorship, partnership, limited liability company, or
corporation.
3. Ways to minimize taxes and stay out of IRS
trouble.
4. What to do if the IRS ever challenges your
business tax reporting or sends you a tax bill
you don’t agree with.

Four different federal taxes affect small business
owners:
• income taxes (everyone who makes a profit

owes these)
• self-employment taxes (Social Security and
Medicare taxes)
• payroll taxes (if your business has employees)
• excise taxes (only a few small businesses are
subject to these).
Thousands of federal tax laws, regulations, and
court decisions deal with these four categories. We
will look only at the relatively few rules most likely
to affect you, and translate them into plain English.

Do You Need a Tax Professional?
This is not a tax preparation manual. Because every small business’s tax situation is different, we
won’t walk you, line by line, through each and
every tax form you might have to file. Our goal is
to explain the IRS rules in plain English so you
will know how they apply to your business and
where you can go for help.
As good as we hope this book is, nothing takes
the place of a personal tax adviser. Everyone’s tax
situation is unique, and tax laws change annually.
But the more you know, the better you can work
with your accountant (referred to as a “tax pro”
throughout this book), and the less you will have
to pay him or her. (See Chapter 22 for tips on
finding and using a tax pro.) Also, take a look at
IRS Publication 1 for a summary of your rights as
a taxpayer in dealing with the IRS.

B. 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 threebranched 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 would like you
to believe, income tax law and the IRS are legal and
are not going to go away.
The code. Tax law begins with the Internal Revenue Code (referred to throughout this book as the


INTRODUCTION

tax code or IRC). Congress enacts and revises the
tax code. The president signs it (usually), and it becomes law. One major reworking of the IRC was
officially called the Tax Reform Act, but was known
to tax pros as the Accountants’ and Tax Attorneys’
Relief Act. The tax code is now over 8,500 pages of
exceedingly fine print.
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.

IRS tax administration policy is set in Washington,
but it is doubtful you will ever deal directly with
anyone there. The real work is done at IRS Service
Centers and local offices.
The courts. The United States Tax Court is an
arm of the federal court system that 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 20 for details.
See, that wasn’t all that bad, was it? Now, venture
forth into the rest of the book and into the entrepreneurial world, and may the small business gods
be with you.
The tax code changes frequently. While we
try our best to keep the material in this book up
to date, Congress is forever tinkering with the tax code.
Some changes are made retroactive, others become
law on the date they are signed by the president, and
some won’t be effective until the next year or further
into the future. Also, federal court decisions, which
interpret the tax code, are released throughout the year
and may change what is written here. Your best strat-

Introduction/5

egy is to make sure you have the most current edition
of this book (check Nolo’s website for updates to this
book) and check with your tax adviser to see if anything has changed in your tax world.

C. Sources of Tax Law
How to research tax law questions is covered in
Chapter 22, Help Beyond the Book, but 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
fill in the details of how the tax code is to be applied. The details are filled in by IRS publications,
such as Treasury Regulations. Treasury Regulations
or 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 and Regulations are available at most public libraries, larger
bookstores, and, of course, IRS offices. The IRC is
online at www4.law.cornell.edu/uscode/26 and the
regulations on the IRS’s website at www.irs.gov.
Court cases. When the IRS and taxpayers go to
court, a federal court may invalidate an IRS interpretation of the tax law. The judges’ written opinions
offer guidance on the correct interpretation of the tax
code. You can research 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
with a tax section.


Introduction/6

TAX SAVVY FOR SMALL BUSINESS

Tax Rates*
Bracket Married Filing Jointly** Single
10%

Up to $14,600

up to $7,300

15%

$14,601 to $59,400

$7,301 to $29,700

25%

$59,401 to $119,950

$29,701 to $71,950

28%

$119,951 to $182,800

$71,951 to $150,150

33%

$182,801 to $326,450

$150,151 to $326,450

35%

Over $326,451

over $326,451

* These dollar amounts for 2005 are subject to annual IRS adjustments for inflation.
** Tax brackets for heads of households and married
people filing separately are somewhat different.

D. Marginal Tax Rate and Tax
Brackets
In our graduated tax system, the more money you
make, the higher your marginal tax rate. Often referred to as your tax bracket, your marginal tax rate
is the rate at which the last dollar of income you
earn will be taxed.
For example, Janice is single, lives in New York,
and reports $100,000 in income on her 2005 tax return; her marginal tax rate, or tax bracket, is 28%.
(The first $71,950 of income will be taxed in increments at the 10%, 15%, and 25% tax rates, and the

remaining $28,050 will be taxed at 28%.) Every additional dollar Janice earns will be taxed at 28% until it reaches more than $150,150 in income, at
which point her marginal tax rate, or tax bracket,
will jump up to 33%.
If Janice factors in state and local income taxes
and Social Security and Medicare tax, her actual tax
rate may exceed 50%!
Use your marginal tax rate. The easiest way to
determine the effect of additional business income or deductions is to use your marginal tax rate.
For instance, if your marginal tax rate is 28%, 28¢ of
every new dollar you earn goes to Uncle Sam. Conversely, you save 28¢ in taxes on every additional dollar that qualifies as a deductible expense.

This table does not take into account itemized or
standard deductions or personal exemptions that
every taxpayer gets.

E. The Alternative Minimum Tax
(AMT)
As if the tax code weren’t diabolical enough, there
is something called the alternative minimum tax
(AMT). The AMT is really a second (alternative) set
of tax rates that potentially apply to everyone. The
theory of the AMT is that higher-income people
who take a lot of tax deductions or get a lot of tax
credits should still have to pay a minimum amount
of income taxes. About a quarter of taxpayers with
incomes between $100,000 and $200,000, as well as
40% of those earning more than $200,000, are subject to the AMT.
Everyone must figure their income tax liabilities
under both the regular (marginal) tax rates, and the
AMT rates—and pay whichever is the greater number. Ouch! Fortunately, tax software will figure the

tax, if any, for you. The AMT is reported on Form
6251, and filed with your individual tax return.
Without getting into details, the AMT works to
deny upper-income people many tax deductions
and credits otherwise allowed on their tax returns.


INTRODUCTION

AMT is figured by adding back to their 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 for self-employed
people to use a tax pro or a software program like
TurboTax (Intuit).

Introduction/7

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