Introduction

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.

Small business or independent contractor? Self-employed people often ask whether they are a "business." The IRS says "yes." Whether you run a flower shop or work at home as a website designer, you're a small business. This includes all kinds of self-employed people, from independent contractors, consultants, and freelancers, to the guy who owns the pizza parlor down the street.

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 Start-Up Kit, by Peri Pakroo (Nolo).

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 to go 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. 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.

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 interprets the tax laws and 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.

Tax laws are ever-changing. While we try our best to keep 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 strategy 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.

Where to Find Tax Rules

How to research tax law questions is covered in Chapter 23. 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 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 judge can reject the IRS interpretation of the tax law. The 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 tax bracket, or marginal tax rate, it is the percentage 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 2007 tax return; her marginal tax rate, or tax bracket, is 28%. Janice's income tax is figured like this: The first $77,100 of income will be taxed in increments at the 10%, 15%, and 25% tax rates, and the remaining $22,900 will be taxed at 28%. Every additional dollar Janice earns will be taxed at 28% until it reaches more than $160,851 in income, at which point her marginal tax rate, or tax bracket, will jump up to 33%.

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%!

What's your marginal tax rate? Determine the effect of additional business income or deductions by applying 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 federal income taxes on every additional dollar that qualifies as a deductible expense.

[2007 Federal Personal Income Tax Brackets chart] omitted for online sample chapter.

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 not a business tax but 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 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 under both the regular (marginal) tax rates, and the AMT rates -- and pay whichever is the greater number. Ouch! Fortunately, tax software automatically figures the tax both ways. The AMT is reported on Form 6251, and filed with your individual tax return.

The AMT works to deny upper-income people many tax deductions and credits otherwise allowed on their tax returns. 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 to use a tax pro or a software program like TurboTax (Intuit).

Don't understand tax terms? Check out the glossary at the back of this book for a plain English explanation of the taxese used in this book.