The tax laws contain pitfalls for the unwary business owner. Knowledge is your best defense. Here are four key areas you should be aware of.

Independent contractors

For some kinds of work – part-time bookkeeping, for example – you may have a choice of hiring an employee or independent contractor. There can be advantages to going the independent contractor route.

For starters, you don’t have to withhold taxes from the worker’s check, and you don’t have to pay any Social Security tax. Your only responsibility is to complete a Form 1099-MISC if you pay the person $600 or more during the year.

Also, you save the expense of providing an office or other workspace, and the ongoing expenses of fringe benefits and insurance. All in all, opting for an independent contractor is often quite attractive – but not so fast. The IRS is looking over your shoulder.

If you treat someone as an independent contractor who is really an employee, you may have to pay the Social Security tax and the income tax you should have withheld. So who qualifies as an independent contractor and who doesn’t?

A true independent contractor controls both the outcome of a project and the means of accomplishing it. And an independent contractor typically offers his or her services to the public at large – not to just one company.

But it’s more complicated than that. The IRS weighs 20 factors in deciding if a person is an employee or a contractor. If you’re not sure how to classify someone, fill out IRS Form SS-8. If the IRS reviews the form and agrees that the worker is a contractor, you’re home free. For more information, download IRS Publication 15-A – “Employer’s Supplemental Tax Guide” – at www.IRS.gov.

Estimated taxes

The money you earn as a sole proprietor, a partner, a shareholder in an S corporation, or a member of a typical LLC isn’t subject to withholding – unless it’s paid in the form of salary. However, you’ll need to pay estimated taxes to the IRS.

You’ll need to ask your accountant how much to pay in estimated taxes based on your income. Then, you’ll make quarterly payments of estimated taxes during the year. What happens if you don’t send in enough tax money during the year? You’ll have to pay interest and penalties. For more details, get IRS Publication 505, “Tax Withholding and Estimated Taxes,” available at the IRS website.

Employee taxes

As an employer, you’ll be withholding income tax and Social Security tax from your employees’ paychecks. Make sure you remit those withholdings to the IRS on time. If you don’t, your business will owe substantial penalties. And that’s not all. If you own a small business and are personally involved in its management, you can be held personally liable for those taxes and penalties if your business lacks the funds to pay them.

Unreasonable compensation

Here’s a tax problem you may have to address if your business starts earning really big bucks. Suppose you set up your business as a corporation – not an S corporation, just a regular corporation. The corporation can pay salary and bonuses to you and deduct those payments as business expenses.

The net effect is that you pay income tax on this compensation, and the corporation pays no tax on those funds. That’s great – your income is taxed just once.

But if the corporation pays you dividends, something different happens. The corporation can’t deduct dividends when it computes its taxable income – and that’s bad. Why? Because the dividends get taxed twice: once when the corporate earnings are reported, and again when you pay personal income tax.

Usually, you can avoid this problem by having the corporation pay you no dividends – just salary and bonuses. The IRS will go along with this if your compensation is reasonable.

But if your corporation pays you salary and bonuses that are excessive, the IRS treats the excess as dividends, which are double-taxed. The IRS may conclude that an annual salary of $300,000 is peanuts for a major league baseball player, but out of line for the president of a small business.

So how do you protect yourself? Collect data on what other, similar executives are paid so you can justify your worth in the marketplace. Or see your accountant about shifting to S corporation status. No matter how much you earn from an S corporation, you’re only taxed once.