New tax laws give little firms a break

Associated Press

NEW YORK — This year promises to be easier for small businesses from the standpoint of income taxes — a variety of changes in the tax laws are giving smaller companies a little relief.

But tax professionals say that doesn’t mean the IRS is getting soft — in fact, they warn that a policy shift at the agency means greater scrutiny of companies known as S corporations.

Perhaps the biggest change taking effect in 2002 results from the tax cut that became law last year. Because many small company owners file their business taxes as part of their individual returns (for example, by including Schedule C along with their 1040 forms), the taxes they pay on the business will be lower, and that means more money that can be returned to the company or paid out as profit.

Changes this year in the laws affecting retirement plans — including higher contribution limits for 401(k)s and some employer-sponsored Individual Retirement Accounts — make these more attractive employee benefits.

According to Barbara Weltman, an attorney in Millwood, N.Y., "The first thing to consider is that small businesses can claim a tax credit for starting up a qualified (retirement) plan if it doesn’t already have one."

A company can get a $500 credit for each of the first three years of a new plan, said Weltman, author of "J.K. Lasser’s New Rules for Small Business Taxes." The credit is limited to businesses with less than 100 employees.

Other changes include an adjustment upward in the standard mileage rate for vehicles used for business, which rises to 36.5 cents from 34.5 cents in 2001, Weltman said. And self-employed people can now deduct 70 percent of their health insurance costs, up from 60 percent.

One hoped-for change that isn’t happening is an increase in what’s known as the Section 179 deduction. This deduction, named for an Internal Revenue Code provision, allows a small company to deduct up front the costs of equipment bought and put into service during the calendar year.

The deduction remains at $24,000 in 2002. Weltman said it’s possible Congress might pass an increase this year, but cautioned businesses against counting on one.

Besides the changes in tax code provisions, accountants report that the IRS has undertaken a policy shift affecting S corporations.

An S corporation — also named for a part of the Internal Revenue Code — differs from more traditional companies known as C corporations in the way earnings are taxed.

In a C corporation, the company itself is taxed for what it earns. When those earnings are paid to shareholders in the form of dividends, the money is considered income to the individual shareholders and therefore it is taxed again.

In an S corporation, the company’s earnings are not taxed, but are instead "passed through" to shareholders, who list the income on their individual returns.

Accountants say some S corporation owners have sought to lower their employment tax bills — including Social Security and Medicare taxes — by taking minimal salaries and treating the rest of their income from the company as pass-through earnings.

Tax officials, well aware of this practice, are focusing on ending it, according to Gordon Spoor, a certified public accountant with Spoor, Doyle &Associates in St. Petersburg, Fla.

For example, Spoor said, a business owner cannot pay himself or herself $10,000 when a reasonable salary for the work done is $50,000. But he said some owners have taken the $10,000 as salary, and treated the rest as pass-through income to avoid the employment taxes.

"The IRS says that’s unreasonable compensation," Spoor said. "They’ll make you defend the reasonableness of your compensation."

Spoor said the IRS will enforce the policy shift by more closely scrutinizing how salaries and pass-through income are allocated on Schedule K-1, the tax form filed by S corporations.

If the IRS disagrees with how you’ve made that allocation, Spoor said, you’ll find yourself in the same position as with any other tax dispute. You’ll have to decide whether to fight it, and in the end, you might find yourself paying hefty penalties and interest on taxes that should have been paid.