Tax Question

[SoutherDem]

Over the last 3 years (about the time since Obama won) I have been hearing news coverage on raising taxes or more specifically ending the Bush tax cuts. In general they remind us all that many "small businesses" file personal taxes, so ending the Bush tax cuts will hurt small business, they make this argument no matter where the beginning line is drawn, $300K, $500K, $750K or $1M. But I keep hearing different explanations as to how those taxes are calculated. I have heard 3 common methods, all may be wrong. Does anyone know which, if any is true. I will use a small restaurant with $400K in revenue and $40K in profit as the example.

Method 1) Taxes will be based on the $400K in revenue.

Method 2) Taxes will be based on the $40K in profit.

Method 3) Taxes will be based on the $400K in revenue minus cost of goods sold, minus various deductions including capital improvements thus the taxes may be paid on more than the profit or less than the profit.

Which if any is true?

[Warpy]

1. All business expenses are fully deductible

If the net profit is $40,000, that is the figure that is taxed. However, the IRS is going to need proof of $360,000 of operating expenses.

[joeglow3]

2. A little of both

First, I am a corporate tax accountant in a Fortune 500 company.

The answer is primarily number 2 - i.e. you don't owe income taxes on gross revenue, as expenses paid reduce your income. However, there are certain expenses that disallowed for income tax purposes (i.e. 50% of meals and entertainment, penalties paid to a government body, lobbying expenses, etc.). Additionally, you can fully expenses capital expenses if you only place in service a certain amount of assests. If you place in service more than that amount, you must capitalize the costs and can depreciate it over its tax life.

Edit to state that this is for taxpayers on a cash basis of accounting, which is most small businesses. They can also use an accrual method of accounting for book and tax, but I could spend all day explaining that...

[SoutherDem]

8. Thanks for the reply, if I could ask,

In my example of a business making a 10% profit wouldn't that mean the small business would need to have $3M in revenue to even have profits over $300K ( not counting the exceptions you noted), and if so use some of that profit invested in the business eliminate the additional 4% in taxes the Bush tax cuts ending would cause? Also, can a $3M company be considered a small business?

[jmowreader]

3. It isn't that simple

There are sole proprietorships, partnerships, limited-liability corporations, Subchapter S corporations and Subchapter C corporations. The "corporate income tax rate" applies to Subchapter C corporations. The other four business forms are "pass-through" entities--the revenues of the business "pass through" to the owner's personal tax return.

To figure out a business's taxes, you need to get a corporate income tax form (C corporations) or a Schedule C (any of the others) and go through the numbers.

BTW, if you've got a restaurant throwing off 10 percent profit, I'd be shocked--actual profit margins in that business are around four percent.

[joeglow3]

5. What type of business it is does not matter

There are different rules around who pays the taxes (C corporation versus flow through), but taxable income is calculated essentially the same for all. That said, no intelligent person with a small business would have anything other than an LLC (which, BTW, is a check-the-box entity that can elect to file as any type of entity. Again, though, no intelligent person would pick anything other than a partnership).

[SoutherDem]

7. 10% kept the math simple

[Trekologer]

4. Additionally employee salaries are deductible as well

Modestly raising taxes on the "job creators" actually is stimulative because it gives incentive to hire additional employees and/or invest in capital expenditures.

[joeglow3]

6. Really?

Of all the years I was in public accounting, not a single business owner based a hiring decision on taxes. It was based solely on if they needed additional employees or not. They never hired an employee they did not need because of taxes and never decided to not hire an employee they needed because of taxes.

[jmowreader]

10. The "or make capital expenditures" line comes into play there

I've worked for a few places that based their capital planning around tax avoidance. I have never, however, worked for anyone who used hiring to dodge taxes.

[SoutherDem]

9. I don't know if I would hire an employee which isn't needed, but

if I were debating hiring someone it may make me do so, or invest in my company.