An activity qualifies as a business if its primary purpose is to generate profit and you are involved in it with continuity and regularity. A hobby does not qualify as a business.

MATERIAL PARTICIPATION

If the taxpayer does not materially participate, the activity is passive and the loss is limited by passive tax rules. However, if there is a profit, self-employment tax applies even to a passive activity.

AUDIT ISSUES WITH SCHEDULE C

IRS statistics show a higher rate of audit for returns with Schedule C. A few of the items often scrutinized are: hobby activity with no profit motive; improvements being expensed; treating employees as independent contractors; deducting personal insurance; no recordkeeping for business auto use; deposits per bank vs. sales (looking for unreported income); personal itemized deductions on Schedule C instead of on Schedule A; income on loan applications vs. the tax returns.

CHOOSING THE PROPER ENTITY

If you are a sole proprietor, you have unlimited liability. However, if you operate as a single-member LLC or as a corporation, you have a limited liability exposure.

If you decide to operate as a corporation, then you have choice between a C corporation and an S corporation.

C corporations can select a fiscal year-end and use a lower corporate tax rate. However, double taxation applies when earnings are distributed as dividends.

If you elect to be an S corporation, you can avoid FICA taxes by distributions; avoid double taxation; usually the calendar year is the fiscal year. In general, an S corporation does not pay any income tax. Instead, the corporation’s income and deductions are passed through to its shareholders. The shareholders must then report the income and deductions on their own income tax returns. You use Form 2553 to make an S election. The election of S corporation status must be made by a qualified corporation with the unanimous consent of all the shareholders on or before 15th day of the 3rd month of its tax year in order for the election to be effective beginning with the year when made.

ACCOUNTING METHOD

Initial choice of accounting method for tax purposes is critical in tax planning. Usually, there are two methods: accrual method and cash method. Generally, the most common method for small business is cash method. If the business involves inventory, inventory must be used to compute taxable income. Income includes all income actually or constructively received. If you receive a payment but could not deposit it in the bank, it is still income under the cash method. Expenses are deducted in the tax year you actually pay them. If a check is written before tax year-end with no money in the bank in anticipation of collecting a receivable, it is deductible if there is no restriction on presenting the check to the bank and the check is paid on presentation.

You can always find additional information on IRS website: www.irs.gov.

Parveen Maheshwari, C.P.A. has an office in Bur-lingame. (650) 340-1400. parveen@cpamax.com.

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