A wealth of information on taxes and how they affect your business.
Small Business Guide
Don’t Lose Your Small Business Advantage
While your knowledge will make an important impact on the success of your business, you’re probably aware that creating the right circumstances for a prosperous operation includes many other elements. Business owners would do well to make it a priority to meet the criteria imposed by the IRS. This section will help you meet tax law requirements, highlights the pitfalls to be aware of, and provides some tips on how to overcome them.
Planning for Retirement
Planning for retirement as a self-employed individual or a business owner may sound overwhelming, but there are plenty of options available that made it easy. Read about some common solutions below, or give us a call! We’re happy to help you establish a plan for your retirement.
Self-Employed Pension Plan Contribution Limits
Tax laws provide for plans that allow self-employed individuals to establish retirement plans for themselves (and their employees, if they have any). One of the most common plans is the SEP (Simplified Employee Pension). Although the SEP does not qualify as an IRA, it does use an IRA account as the depository for plan contributions, which the employer’s administrative requirements.
Generally the compensation limits for an SEP plan is 25% of compensation. There are different limits for contributions for yourself (individual self-employed taxpayer or business owner) and contributions for your employees.
• Self-Employed Individual: The contribution limit is 25% of the net profits from self-employment, or 20% of the net profits before deducting the contribution itself.
• Employees: Generally limited to $50,000 or 25% of the employee’s compensation, whichever is less.
These limits may change year to year, so call our office to make sure you understand the current contribution limits.
Consider a Solo 401(k) Plan if you are an Owner-Only Business
The Solo 401(k) – also referred to as a Mini 401(k) or single-participant 401(k) – provides for larger contributions, includes the ability to borrow funds from the plan at reasonable rates and a Roth option for a portion of the contribution. Additionally, many plans allow you to roll over assets from other retirement plans.
A Solo 401(k) plan is a natural choice for those in two categories. The first group includes independent contractors, sole proprietors, and owner-only C or S corporations. The second group includes those who have dual incomes; those who are W-2 wage earners as employees of a company that offers a 401(k) plan and who also have income from freelance work or other income which requires them to file a Schedule C as a sole proprietor. Contribution limits apply to each individual (not the individual plan) for the year, so if the taxpayer has multiple 401(k) plans, he or she needs to make sure that their contributions do not exceed the annual limit.
Solo 401(k) plans are limited to the business owner and his or her spouse, and there are many benefits to having your spouse as your only employee. Because your spouse is on your payroll, you’ll have the ability to shelter some or all of your income by having your spouse make an elective deferral to a 401(k) plan.
However, as with most financial strategies, there is a potential downside. If your business grows and you need to hire employees, you’ll need to convert your single-participant 401(k) plan into a full 401(k) plan, which is subject to more complex requirements. If you have immediate expansion plans for your business, you should consider other options.
If you are considering a Solo 401(k) plan, be aware that you must set it up prior to the end of the year.
Keogh Plans VS SEP Plans
If you are a self-employed individual, the retirement plans available to you range from basic, simple-to-establish plans to very complex plans which require the assistance of professional pension plan administrators. Some of the more common plans are the Keogh, SEP, Defined Benefit, and Simple IRA plans. The Defined Benefit and Simple IRA plans are typically quite complex and have high administration costs. However, the Defined Benefit plans allow for larger retirement contributions which may justify the higher administration costs for older individuals.
About Keogh Plans: The overall annual contribution limit on this plan is 25% of the net profits less the retirement contribution made to the plan itself, which actually equates to 20% of the net profit.
Keogh plans must be established before the end of the year for which a contribution is made. Although the contributions for any year may be delayed, it must be made no later than the due date of the taxpayer’s individual return including extensions.
About SEP Plans: SEP plans are also referred to as SEP IRAs because they use IRA accounts as the depository for the plan contribution. Although the money is deposited into an IRA account, the SEP has the same contribution limits as the Keogh plan. The SEP plan has no annual reporting requirements like those that apply to Keogh plans. An SEP plan may be established after the close of the tax year, unlike the Keogh plan, but it must be established and funded by the due date of the taxpayer’s return including extensions.
Do you have employees? If you do, you may be required to include them in the plan you establish. While most plans require coverage once an employee attains age 21, there is some fine print. The Keogh plan requires employers to cover employees only after they’ve completed at least one year (or more in some cases) of work. An SEP plan requires employers to cover employees who have worked during three of the past five years.
Preparing for Tax Season
Federal Requirements for Employer Record Keeping
The IRS requires employers to maintain employment tax records for at least four years. These records must include the following information:
*Employer identification number (EIN)
*Amounts and dates of all wage, annuity, and pension payments
*Names, addresses, Social Security numbers, and occupations of employees and recipients
*Dates of employment
*Employee copies of Form W-2s that were returned as undeliverable
*Copies of employees’ and recipients’ income tax withholding allowance certificates (Forms W-4, W-4P, W-4S and W-4V)
*Amounts of tips reported
*Documentation for allocated tips
*Fair market value of in-kind wages paid
*Periods for which employees and recipients were paid while absent due to sickness or injury, and the amount and weekly rate of payments made to them by the employer or third-party payers
*Dates and amounts of tax deposits
*Copies of returns filed
*Documentation for fringe benefits provided, including substantiation
A willful failure to keep required records is a misdemeanor punishable by a fine of up to $25,000 ($100,000 for corporations) and/or imprisonment for up to one year.
Your Benefits and Compensation
There are two primary methods of withdrawing money from a corporation to compensate yourself and both have their own tax consequences. Salaries and bonuses are deductible by the corporation and taxable to the recipient employee, whereas dividends are not tax-deductible by the corporation but are taxable to the stockholder recipient. Thus, the dividends are taxed twice.
Unfortunately, this doesn’t mean you can avoid double taxation by only taking compensation and never paying dividends, since tax law states that compensation can be deducted only to the extent that it is reasonable.
This sounds vague, and it is. There is no formula for determining reasonable compensation, but the IRS generally considers specific circumstances and compares companies in the same industry, including the following factors:
*Employee’s abilities and accomplishments
*Employee’s duties and responsibilities
*Time spent to perform job duties
*Income of the company, both gross and net
*Employee salary policy
*Historical compensation history
There are several steps you can take to reduce the chances of having compensation deemed as “unreasonable” by the IRS:
1. Record the reasons for level of salary and/or why bonuses are being paid in the corporate minutes.
2. Record if the current year’s salary has been increased to make up for a salary that was too low in prior years in the corporate minutes.
3. Do not pay salaries in direct proportion to stock ownership because it gives the appearance of a disguised dividend.
4. Make sure your salary is comparable to others of similar position in your industry, and document your research.
5. If the business is profitable, pay out some dividends to avoid the appearance of trying to pay out all your profits as compensation.
The issue of reasonable compensation typically comes up several years after the payments are made, and the repercussions can last for multiple years. Therefore, advance planning is critical to avoid problems later.
Self-employed taxpayers have many options to consider when applying tax benefits for their own education expenses. Depending on your circumstances, one of the following methods may be most beneficial for you.
As a Business Expense
Generally, if your education meets certain qualifications, your education costs (including tuition, books, supplies, and allowable travel) can be taken as a business expense, which will offset both income taxes and self-employment tax. Education must either be to maintain or improve your skills or be required in your business in order to qualify as a business expense. However, you may not want to use the education’s costs as a business expense if doing so will limit your net profit and, thereby, your pension plan contribution, or if your Schedule C has only a small profit or shows a loss for the year.
As an Adjustment to Income
If your expense is tuition at an institution of higher education and you are under the AGI phase-out limit for this deduction, you may deduct up to $4,000 as an adjustment to your overall income for the year. This above-the-line education deduction can be taken regardless of whether the education maintains or improves the skills required for your business. You can still deduct other expenses, such as books and supplies, on your Schedule C as long as the education maintains or improves your skills required in your business.
As a Tax Credit
As with the option above, if your expense is tuition at an institution of higher education, you may qualify for the lifetime learning credit. The lifetime learning credit allows you a credit of 20% of the cost of your tuition (up to $10,000 of costs) as a tax credit. It, too, has an AGI phase-out limitation. This credit can be more beneficial than the business expense or AGI adjustment for the tuition portion of the expenses, especially if you are in a lower tax bracket or the business profits are low.
Employees and Tax Considerations and Tax Considerations
Employing a Family Member
Employing family members to work in your business reduces your tax bill by shifting income to them and providing them with employment benefits.
Spouses: Reasonable wages paid to your spouse entitles you to a business deduction. Although the wages are subject to both income and FICA taxes, your spouse may qualify for Social Security benefits and coverage under your retirement and health plans of your business. This allows you to increase your business deductions through contributions to your spouse’s retirement nest egg and health insurance premium payments.
Children: You may obtain a business deduction for their salary, thereby reducing your self-employment income and tax by shifting income to the child. Because their salary is considered earned income, it is not subject to the “Kiddie Tax” rules that apply to children under the age of 19. If your business is unincorporated, wages paid to your child under age 18 are not subject to social security taxes. In addition to these tax advantages, you may be able to provide your child with benefits such as life insurance and pension plan contributions.
Employee or Independent Contractor?
The amount of taxes you withhold from payroll checks and the types of taxes you pay depends on the status of the individual worker: independent contractor, or employee? This also affects how much additional cost your business must bear, what documents and information must be provided to you, and what tax documents must be given to the individuals you are hiring.
There is an obvious advantage to treating an individual as an independent contractor: business owners can avoid the expense of payroll taxes and employee benefits. But employers must be careful when making the decision, as the IRS focuses heavily on businesses who misclassify W-2 employees as contractors.
The 20-Factor Control Test
A worker’s status as an employee or independent contractor depends on the amount of control the employer has over the worker. The IRS has developed this test to help determine the extent of this control, although the results of this test may be up to interpretation by the IRS.
Your worker may be an employee if any of the following exist:
1. Instructions – They must comply with instructions about when, where, and how to work.
2. Training – You provide them training to enhance their skills and teach them how to do a job.
3. Integration – Their work is integrated into the business’ operations and the success of the business depends on the performance of those services.
4. Services rendered personally – A business which requires the worker to personally perform the services shows that the business is interested in the methods used to accomplish the tasks. This, then, shows control by the employer.
5. Hiring assistants – You hire, supervise, and pay assistants to help the worker.
6. Continuing relationship – There is an on-going relationship between you and the worker.
7. Set hours of work – They have set hours of work.
8. Full-time work – They work full-time for you, with restrictions on being able to work elsewhere.
9. Work done on the premises – You require them to work on the premises, especially if the work could be done elsewhere.
10. Order of sequence set – You set the order of their duties.
11. Reports – You require them to submit reports to account for his/her actions.
12. Payments – You pay the worker by the hour, week, etc.
13. Payments of expenses – You pay business or travel expenses for the worker.
14. Tools and materials – You furnish all the tools and materials to do the job.
15. Right to fire – You can fire the worker if he/she fails to perform services.
16. Right to quit – The worker may quit at any time without incurring liability.
Your worker might be an Independent Contractor ifany of the following exist:
17. Significant investment – They have a significant investment in facilities or equipment used to perform services for someone else.
18. Profit or loss – They can realize a profit or loss as a result of services performed.
19. (Working for more than one business at a time – The worker performs services for multiple firms at the same time.
20. Offers service to the general public – The worker regularly and consistently makes his/her services available to the general public.
Business owners will be better off classifying workers properly to begin with, instead of discovering later they have been misclassified and dealing with back payroll taxes and penalties.
Employee Incentive Rewards are Taxable Fringes
If you provide your employees with incentives in order to award top-performing employees for exceptional achievements, be aware that the IRS considers these taxable fringe benefits. Awards such as merchandise or vacation trips are non-cash fringe benefits that are taxable to the employee and deductible by you, as compensation. The fair market value of the award must be included in the wages on that employee’s W-2 and employers must withhold income, social security, and Medicare taxes for that supplemental compensation and deposit the withheld taxes along with employer matching amounts in the same deposit period they were treated as paid.
The rules regarding incentives do not apply to non-cash employee achievement awards of tangible personal property given for length of service or safety; these are deductible by the employer and excludible by the employee. Additionally, non-cash de minimis fringes (like birthday or holiday gifts of property with a low fair market value and gifts of theater or sporting event tickets) are deductible by the employer and tax-free to the employee.
Health Insurance for the Self-Employed
Unfortunately, being self-employed often means going without affordable health insurance. Below are some tips to help you navigate the process of obtaining health insurance as a small business owner.
Do your homework. Completing you due diligence on the company and policy before buying insurance can save you hundreds of dollars yearly.
Familiarize yourself with all the policies available.
Determine which companies offer the kind of policy fits your needs most closely. Then, research the agents that offer these policies.
Obtain what the policy will pay for and what it won’t in writing, including the total out-of-pocket expenses you will be liable for and the coinsurance limit. You should also request a detailed explanation of reimbursement of prescriptions, office visits, and ER visits.
Think carefully before agreeing to a policy that excludes pre-existing conditions.
Ask your agent if there are any service fees and discounts available if you make annual or semi-annual payments of premiums.
Consider changing to a higher deductible if your family is generally healthy, as a higher deductible could significantly reduce your premium.
Participate in an independent group plan. Many self-employed individuals join group health plans to help lower the overall cost of insurance premiums. You may consider creating a group health plan if one does not exist for your industry.
Consider applicable tax deductions. Self-employed taxpayers may deduct expenses for insurance that qualifies as medical care for themselves, their spouse, and/or their dependents, including any child of the taxpayer younger than 27 as of the end of the tax year.
Health Savings Accounts Offer Tax Breaks
Qualified taxpayers who have high deductible medical insurance plans can make tax-deductible contributions into a trust account called a Health Savings Account (HSA). Income earned on the HSA balance is tax-free, and the funds can be used to pay qualified medical expenses which aren’t covered by medical insurance. Unused funds are rolled over year to year.
Once the taxpayer turns 65, HSA funds may be used like a retirement plan or saved for future medical expenses. HSA contributions are considered above-the-line deductions, so taxpayers don’t need to itemize to itemize to take advantage of this tax break.
Eligible Individual – For HSA purposes, the law defines an eligible individual as anyone covered by a “high deductible plan” who, while covered by that plan, is not covered by another plan. Tax law specifies certain types of coverage, such as insurance for a specific condition, workers’ compensation, vision, dental care, and long-term care to be disregarded.
Qualified Medical Expenses – Typically any expenses that would be allowable as a medical deduction on your tax return can be paid with an HSA account.
Contribution Limits – Eligibility and contribution amounts for HSA accounts are determined on a monthly basis. That means that during any month in which you qualify, you are entitled to contribute up to one-twelfth of the annual limits to your HSA account.
If you are entitled to benefits under Medicare or are claimed as a dependent on someone else’s tax return, you are not allowed to contribute to a Health Savings Account.
Non-Qualified Distributions – Distributions are allowed at any time, but only they are used only on qualified medical expenses of the account beneficiary, his or her spouse, or dependents. HSA distributions are excludable from gross income. Funds not used to pay for qualified medical expenses are subject to a penalty unless they are used on account of the beneficiary’s turning 65, disability, or death.
Qualified Medical Expenses – These include unreimbursed expenses paid by the account beneficiary, his or her spouse, or dependents. These funds must be used for medical care that qualifies as itemized-deduction medical expenses and can only be used on expenses incurred after the HSA has been established.
Tax Credits for Small Employers Offering Health Coverage
The Patient Protection and Affordable Care Act provides a tax credit for an eligible small employer (ESE) for nonelective contributions to purchase health insurance for its employees. This means you can only claim a tax credit on contribution other than those pursuant to a salary reduction arrangement.
To qualify as an Eligible Small Employer, you must have 25 or fewer full-time equivalent employees employed during your tax year. The annual full-time equivalent wages of those employees must be an average of no more than $50,000.
Your number of full-time equivalent employees (FTEs) is determined by dividing the total hours for which you pay wages during the year (no more than 2,080 hours per employee) by 2,080.
Your average annual equivalent wages (AAEW) is determined by dividing the total FICA wages for the tax year by the number of full-time equivalent employees for the year.
Health insurance issues are always changing, particularly as new legislation comes into effect. Please call us today if we can help you navigate this complex issue.
Structuring Your Business for Success
Thinking About Incorporating?
The decision of whether or not to incorporate is a complex one, and though there are many benefits associated with corporations, there are also drawbacks. Let’s take a closer look at some of the major issues corporations deal with.
Administrative Costs – Starting and running a business can be costly. Ideally, a lawyer should handle filing of the Articles of Incorporation. Corporations have to pay yearly fees to maintain their charter and conduct their business. They must keep a list of all shareholders and hold at least one shareholder meeting every year, which of course adds to corporate expenses. However, a business running as an individual avoids these expenses.
Double Taxation – The only way money can be withdrawn from a corporation is through a reasonable salary, through dividends, or through reasonable interest on stockholder corporate debt. Because dividends are not deductible, there is a potential for double taxation. If an individual doing business takes a loss of the business’ overall gain or loss for the year on their personal return, there is no potential for double taxation.
Selling the Business – Selling an individual-owned business typically required putting the various pieces that constitute the business (such as equipment, real property, goodwill, etc.) up for sale, and being taxed on each piece. However, a corporation can be sold simply by selling shares of stock to a buyer. This results in a capital gain (or loss) to the seller. Many buyers prefer an asset purchase, providing better write-offs and avoiding assumption of any prior corporation liabilities. The sale of the assets in this way is taxed at the corporation level and will generally be taxed again at the personal level in the form of a dividend, salary, or liquidation.
Be cautious when structuring your business. Review your options and thoroughly educate yourself on considerations for various types of business, business partners, potential liabilities, investment required, etc.
Leave Your Business to Your Family, Not the Government
Most business owners don’t realize the importance of having a sound business succession plan, so passing the family business on to the family upon death of the owner can be a difficult task.
Without a succession plan, grieving loved ones may be forced into a business they know little about, which may adversely affect the financial stability of the business and the financial security of your family. In fact, only about 50% of all family businesses are transferred to the next generation.
Choosing a successor can be a challenge when creating a business succession plan. The needs of the business should be your primary concern, not the desires of family members. It’s vital to develop a plan as early as possible so that your successor can benefit from your experience and knowledge. Consider the individual’s strengths and weaknesses and ensure that the individual has the leadership skills and drive to meet the goals of the business.
Another important element of a good business succession plan is the transfer of ownership and estate planning. Each means of transfer (such as buy-sell agreements, trusts, will, and stock gifting) has specific legal and tax ramifications and should be considered in conjunction with proper estate planning.
Home Ownership and Your Business
Many entrepreneurs and professionals find that having a home office is convenient and cost-effective. Taxpayers may claim deductions related to their home office whether they are self-employed or employees.
Deductible home-office expenses include direct and indirect expenses of having a home office and are not related to how a business is structured legally.
Direct expenses relate only to the home office (like painting the walls or repairing a ceiling).
Indirect expenses relate to both the personal portion of the home and the portion that is used for business possibly including rent, utilities, home mortgage interest, real estate taxes, homeowners insurance, and repairs benefiting the entire property.
Home office expenses, both direct and indirect, are deductible only if a portion of the home is used regularly and exclusively as a principal place of business or as a place to meet clients in the ordinary course of business. If you are an employee, you must prove that use of your home office is for the convenience of your employer in order to claim a deduction.
Using Home Equity for Business Needs
Small business owners may have a tough time obtaining financing for their businesses without pledging personal assets. With interest rates at historic lows, tapping into your home equity is a tempting alternative, but you should carefully consider the tax ramifications of this choice.
You can usually deduct the interest on debt used to acquire and operate your business. However, this may depend on the structure of your loan.
The interest on a home mortgage is limited to the interest on $1 million of acquisition debt and $100,000 of equity debt secured by your primary residence and designated second home. Any interest on debts that qualify may be treated as home mortgage interest and is deductible as part of your itemized deductions. The excess may be deducted on your business, but only if the funds can be traced to your business use. However, this does raise a variety of problems:
Standard Deduction – If you fail to itemize your deductions, you won’t be able to deduct the interest on the first $100,000 of the equity debt, the portion that can’t be assigned to your business.
The AMT – If you are subject to the Alternative Minimum Tax (AMT), you will still be unable to deduct the first $100,000. It is not allowed as a deduction for AMT purposes.
Self-Employment (SE) Tax – Your self-employment tax (Social Security and Medicare) is based on the net profits from your business. Because not all of the interest is deductible by the business, your net profit may be higher, raising your SE tax.
One tax election allows you to treat any specified home loan as not secured by the home. Under this election, interest on the loan is non-deductible as home mortgage interest because it is a requirement that qualified home mortgage debt be secured by the home. However, this might be a smart move if the entire proceeds were used for business and all of the interest expense could be treated as business expense, by allowing the normal interest tracing rules to apply to that unsecured debt. However, if you have a mixed-use loan and part of it represents home debt, the part that represented the home debt would not be allocated back to the home, and the interest on that portion of the debt would become nondeductible, thus offering no tax benefit.
As you can see, using equity from your home often creates complex tax situations. It is wise to engage professional help when dealing with these issues.
Can You Write Off a Bad Debt?
Most small businesses have receivables that cannot be collected from providing services to customers, the sale of products, or both.
The bad debt deduction may or not apply, depending on what accounting method is used. We’ll take a closer look at both methods.
If the accrual accounting method is used, taxable income will include the uncollected income from your non-paying customers, because all of your billings must be treated as income, even if they haven’t been collected. In this case, these items will be considered a bad debt. With the accrual method, bad debts are deductible.
If the cash method of accounting is used, income is not reported until it is received, so a deduction cannot be taken if you are never paid for the goods or services you provided because the income was never reported. It should be noted that cash basis businesses don’t typically have bad debt deductions, though there are exceptions.
Keep Track of Meal and Entertainment Expenses
Meal and entertainment expenses are oft-overlooked deductions that many self-employed taxpayers could benefit from. In order to claim these deductions, the expenses must be ordinary and necessary to your business or trade and must be directly related to or associated with the active conduct of business. Additionally, the setting must be sensible for a business meeting, and conversations should relate to business.
Solid documentation is a must and needs to include the following items:
Amount of expense
Date, time and place
Names of guests
Business relationship to guests
If the purpose of the business is to conduct a specific business agenda, the IRS will allow you to take a 50% deduction on entertainment expenses. This also covers the cost of meals during away-from-home business travel.
Mixing Business with Pleasure
It’s no coincidence that most conventions are held in resort areas during spring, summer, and early fall. If planned properly, convention planners know that attendees can deduct some of their expenses while enjoying a mini-vacation. In fact, business travel can be combined with recreation while still providing a deduction. However, you need to make sure you know what expenses are deductible.
Business and Personal Travel
If the primary purpose of a trip is business-related, you may deduct all travel expenses, including meals, lodging, transportation, and incidentals, as long as they are not extravagant. If you take part in both business and personal activities while traveling, you may deduct the transportation expenses in their entirety if the main intent of the trip is business- related. If a spouse or other companion accompanies you on a business trip, their meals and travel expenses are non-deductible. Lodging expenses are only deductible at a single-occupancy rate.
Special rules apply to the deductibility of cruise ship conventions. The cruise ship must be a vessel registered in the US and all ports of call must be located in the U.S. or a US possession. In order to be deductible, the convention has to be directly related to the active conduct of your business or trade.
You’ll need to fulfill strict reporting requirements, including a written statement providing specific information by both the attendee and an officer of the sponsoring organization.
A higher standard is applied to deductions of expenses related to foreign conventions than to those within North America. Factors including the meeting’s purpose, the residence of the organization’s members, the locations of past and future seminars, and the sponsor’s purpose and activities are considered to determine the reasonableness of the location.
In order to deduct a foreign convention, the costs must directly-related to the active conduct of the taxpayer’s trade or business and be just as reasonable to hold the convention or seminar outside the US.
Start-Up and Organizational Costs
Small business owners can reap a big benefit from the tax law which allows them to deduct up to $5,000 of their start-up expenses in the first year of their operation.
To be eligible as a start-up expense, it must be something that would be deductible had it incurred after the business actually began. Taxes, interest, or research and experimental costs are non-deductible under this provision. Examples of qualified start-up costs include but are not limited to:
Advertisements related to opening the business
Wages paid to employees and their instructors while they are being trained.
Surveys/analyses of potential markets, labor supply, products, transportation facilities, etc.
Travel and other related costs to secure prospective customers, distributors, and suppliers.
Fees and salaries paid to consultants or others for professional services.
However, Congress put a cap on the amount of start-up expenses that can be claimed as a deduction. The amount may change from year to year, so we recommend talking to a professional.
If you are buying an active trade or business, you may only deduct investigative costs incurred while conducting a general search for or preliminary investigation of the business as start-up costs.
A Pension Plan
Offering a pension plan gives you a great way to defer income from your business and plan for your retirement. Different plans have different rules about contributions, reporting, coverage, etc. A Keogh plan is a good option for many business owners, but consult with your plan administrator to make sure you meet the specific requirements and limitations.
Independents vs. Employees
Workers you hire must either be classified as employees or independent contractors. The status of your workers is determined by the amount of control you have over the job they do; the more control you have the more likely that worker should be classified as an employee. If you have employees, you have to deal with employment taxes, withholding, payroll tax returns, and W-2 filing. Be careful not to classify someone who performs services for you as an independent contractor simply to avoid the administrative hassles and costs of treating the individual as an employee; doing so can lead to monetary penalties and cause you and your business serious problems.
Estimated Tax Payments
If your business is unincorporated, the income you earn from it is reported on your individual tax return and is subject to income and self-employment tax. Since no withholding is taken from self-employed income, you might consider paying estimated taxes to avoid a penalty. The due dates for estimated tax payments are April 15, June 15, September 15, and January 15. However, if a due date falls on a Saturday, Sunday or holiday, the due date will be the next business day.
Your Recordkeeping Routine
Establishing good recordkeeping practices for your business should be a high priority. Recordkeeping goes much farther than check writing, depositing income, and keeping receipts. Taking care of details like accounting methods, inventory management, computerization, and complying with regulatory tax requirements can be time-consuming and frustrating. Many of these details may be made simpler with the help of a financial or accounting professional.
When keeping your business records, though, try to follow a few basic “rules”:
1. Don’t Co-Mingle Business and Personal Bank Transactions.
From the start, open a separate bank account for your business in which you only deposit business gross receipts and from which you write checks for business expenses.
2. Keep Backup For Your Bank Deposits And Expenses.
Make sure you hold on to bank statements and supporting documents so that bank deposits, including those that aren’t income (such as loan documents for loan proceeds deposited, insurance reimbursement, etc.), can be easily traced.
Pay all business expenses by check if possible. Checks should be supported with invoices, sales slips, and other available documentation. Income and expenses should be recorded in an orderly manner, by either hand or computer, so that backup is readily available if needed.
3. Keep All Reports Filed With Government Agencies
It’s important to keep reports such as personal income tax returns, sales tax returns, payroll returns, W-2s, and 1099s filed for employees and contractors.
4. How Long To Keep Records
Federal tax authorities require you to keep books and records of your business for three years after the returns were due. However, in certain cases, the statute of limitations is longer. Therefore, we recommend keeping records at least six years. Keep any records that support cost basis of property, equipment, or any item that you are depreciating, for at least three years beyond the life shown on the depreciation schedule in your tax return.
5. “Ordinary and Necessary Expenses”
Tax law only allows taxpayers to deduct expenses that are “ordinary and necessary” for their business, but the meaning of this term is somewhat vague. The IRS defines an “ordinary” expense is one which is common and accepted in your industry. A “necessary” expense is one that is helpful and appropriate in your business, but necessarily indispensable. Do all you can to make your expenses are “ordinary and necessary” and are backed up with a solid paper trail.
6. Capital Expenses vs. Other Costs
Costs of assets that will be used in your business for more than a year and the costs of improvements that add to the value of those assets are referred to as “capital” expenditures. These expenses are generally deducted over a number of years. Operating expenses are deductible, as are most of the costs of starting your business. Keep records for capital expenses separate from those for general operating expenses.
7. Expensing Normally Depreciable Costs
In some cases, the costs of depreciable business assets can be deducted all in one year on your tax return. While this can offer certain tax advantages, it also has a negative side: if you dispose of the assets before the end of their normal depreciable life, you may have to “recapture” (or report additional income for) some of the costs you expensed.
8. Automobile Expenses
You may be unsure about what car expenses you are allowed to deduct. The expenses of traveling between business locations are deductible, but commuting expenses (such as travelling between your home and your office each day), are not. However, when you travel to temporary locations away from your regular business location, you may deduct the costs of those trips. Keep good records of your business driving by logging for each trip: where you went, your business purpose for going there, who you met with, and the number of business miles you traveled.
Only the business portion of your car expenses are deductible, but you can choose one of two ways to claim the deduction: You can deduct your expenses using actual cost of gas, oil, insurance, repairs, depreciation, etc., or you can multiply your business miles by a standard mileage rate to determine your expense.
“Material Participation” in Your Business
When Congress passed rules regarding “passive activities” in the late ’80s, “Material Participation” became a major issue for business owners and has remained one since. Material Participation means that the business owner’s activity in their business is substantial and continuous. There are several IRS uses to measure Material Participation; business owners who are unable to pass one of the tests is usually considered a Passive Investor in a company. Because deductible losses from Passive Activities may be limited to the amount of income from those activities, it becomes extremely important for business owners to show material participation.
Those who work full-time in their business will easily prove Material Participation. However, those that are employed at another job and operate their business on a part-time basis will need to prove Material participation by passing one of the tests the IRS uses for this purpose.
Your Profit Motive
If an activity consistently shows tax losses, the IRS may question the profit motive of the business owner. This is particularly common with activities that lend themselves to personal enjoyment or hobby. Business owners need to be prepared to show their intent to make a profit and that they are taking measures to do so.
If an activity consistently shows tax losses, the IRS may question the profit motive of the business owner. This is particularly common with activities that lend themselves to personal enjoyment or hobby. Business owners need to be prepared to show their intent to make a profit and that they are taking measures to do so.