Below is an article I wrote awhile back that is still relevant today:

If you own a small business or are planning to start one, you probably already know that there are plenty of things to consider both before you start and once you’ve opened your doors, literal or metaphorical. This applies to small record labels, t-shirt printers/designers, bands, basically any small DIY business. I’m here to stress the importance of and attempt to make clearer one of those considerations: taxes. Most people have a profound hatred of taxes, and this is understandable for a variety of reasons. Regardless of one’s feelings about the matter, they are not going away, and avoiding taxes can have devastating effects on your business. You don’t need to be a tax expert, you just need to know the basics. We can get into specifics (tax rates, tax benefits of various business types) in subsequent posts. In my next post, I will talk about how to pay yourself and if you have employees, how to navigate payroll taxes. For now, let’s start by talking about the underlying principles that will keep you in business. Two of the most important rules to learn are as follows:

File your returns
Keep good accounting records

To put it bluntly, the IRS loves small businesses. Not because they are the backbone of the American economy, and not because they are nicer people to deal with in an audit. They love small businesses because it is easy money for them. Why? The answer is simple: many small business owners do not file timely or correct returns and do not keep adequate records. This allows the IRS to charge small companies large filing penalties and gives them leverage to deny business expenses, even legitimate ones. That’s why the two rules above are so important. These rules apply whether you are set up as a C corporation, S corporation, single-member LLC, partnership or sole proprietor, but when we discuss keeping receipts later I think that is especially important for sole proprietors and single-member LLC’s, which are treated the same for Federal tax purposes.

These aspects of running the business are easy to put off and forget about because, well, you are busy trying to run and promote your business and these tasks are tedious. One major problem with putting these things off is that it often starts a downward spiral and suddenly it is so overwhelming that people will make every excuse under the sun not to do them. Others just can’t be bothered. Let’s start by looking at one of these excuses so we can dispel some of the myths surrounding small business taxation:

Part 1: Filing Your Returns

Excuse: “If I file my tax returns, the IRS will know where I am. I’d rather stay off their radar.”

I hear this one quite often. I like this excuse because it encompasses many of the other excuses people have used over the years. The truth is, unless your business is so small that you don’t have it registered with your state in any form and ONLY use cash to pay vendors and ONLY take cash receipts, it is virtually impossible to stay off the IRS’ radar. If your business is in fact that small, then you probably have a day job and consider your small business more of a hobby for the time being. Most businesses have paper trails. Somewhere, someone has your business name on a sheet of paper that the IRS has access to. That may seem like a risk worth taking, but there’s a catch: there is no time limit imposed on the IRS for coming after you if you don’t file. That means they can wait 10-15 years, which I have seen happen, when there is less chance of you still having the records to prove your expenses to offset income.

This may seem ridiculous to most people, but there actually is some rationale to it. U.S. tax law is almost on an honor system, like many train systems in Europe. You are expected to pay your fare, and people are inspected at random. If you don’t pay, you get fined. In a nutshell, that is how our tax system works. When we file our tax returns, we self-assess the taxes we owe. By law, the IRS has 3 years (in most cases) to accept our assessment or to question it by auditing us. The 3-year limit is known as a statute of limitations. One of my graduate professors liked to say that our tax returns were “an offer to the IRS.” However, if no return is filed, no offer has been made and the statute of limitations never begins.

In short, if you don’t file your tax returns, the IRS loves you. If they could form a band they would write you an emo song in the vein of Copeland or The Get Up Kids, or if they had a functioning budget they would probably send you one of those edible flower arrangements. Luckily, they have neither. What they do have is time. They can put all the non-filers on a back-burner and get around to them when they feel like it. If you do file your returns, yours will be piled up with hundreds of thousands of others and they must decide whether they want to accept your return within the statute of limitations. I cannot emphasize that point enough: if you file your returns,you impose a time limit on the IRS. If they have not audited you by the time that limitation expires, they are legally bound to accept the return as is and they cannot make any further changes.

To find out what returns you need to file, reach out to a CPA friend if you have one. If you don’t, you can search the internet and find articles for your business entity type. Just make sure it’s from a reputable source. Many law firms, CPA firms, and finance magazines such as Forbes will publish good articles online offering advice for small business owners.

Enter hardcore chorus: File. Your. Damn. Returns! Go!

Part 2: Keeping Accounting Records

There are several reasons to keep good records for your business. First, when it is time to file your tax returns, you won’t be scrambling at the last minute trying to put things together. It will also make the task less stressful. Most importantly, however, is that if you do get audited, good record keeping is your best defense against IRS adjustments. It can also help prevent mathematical errors that trigger computer generated adjustments in the IRS’ system. Here’s an example:

HC, LLC is a single-member LLC that repairs windmills for businesses. The owner of HC reported $100,000 in gross receipts on her 2016 individual tax return, Schedule C. Since the minimum charge for windmill repair exceeds $600, each client of HC is required to file Form 1099 to substantiate their own business deductions. HC picked up two new clients in 2016, and each reported the services rendered by HC to the IRS on Form 1099 for a total of $25,000. Due to a lack of adequate record keeping, the owner of HC neglected to report the new clients, whose windmills were serviced earlier in the year. Thus, the IRS made an automated adjustment to the correct amount of $125,000 and in addition to the taxes owed from the difference they assessed penalties and interest of $500.[i]

Now, a $500 penalty may not seem exorbitant, but when you couple that with the additional tax that the person in the example did not expect to pay ($6,250 if they are in the 25% tax bracket), you can see that the numbers start to stack up. Good record keeping not only allows you to look back easier and assess income and deductions, it can also allow you to look ahead and judge how much you should be setting aside for future expenses such as taxes, equipment purchases, or loan repayments.

So, what is considered good record keeping? It’s up to you to find the method that works best for your business, but here are a few guidelines:

Keep a Separate Business Checking Account

In my experience with small business audits, one of the things IRS Agents or Tax Compliance Officers (TCO) prey on are business owners who use their personal checking accounts to run their business. If you co-mingle funds, it makes it much more difficult to distinguish between business and personal expenses. The more expenses an Agent or TCO can reject, the greater their adjustment, which makes them look better to their bosses. If you set up a separate account for your business and only use it for business purposes, you’ve made your case that much stronger.

Only Use the Business Account for Business Expenses/Deposits

Now, this may seem redundant but it’s an important point. If you have personal expenses on your business checking account bank statements, for obvious things such as movies, clothing stores, etc. you pique the interest of any IRS agent looking at them. Again, co-mingling funds makes it difficult to prove the validity of business deductions. Various states and banks may differ in their requirements to set up a business checking account, so shop around. Very often small banks and credit unions give good deals to local businesses.

Use an accounting system or software that is convenient for you.

As far as accounting systems go, the most important thing is to find something that works for you. My personal recommendation is QuickBooks, but not everyone can afford to pay their fees. You may be able to find a desktop version which won’t make you pay a monthly fee, but you lose one of the biggest time savers, which is the ability to link your QuickBooks account to your bank accounts and download your activity automatically. Then all you need to do periodically is go through the list and make sure everything is categorized correctly. Regardless, you need some way of summarizing all your income, expenses and loans. Whether you do it in QuickBooks, Excel, or write it out the old-fashioned way is entirely up to you.

Keep receipts and find a way to pair them with invoices. (Especially for sole proprietors)

Another benefit to QuickBooks is it makes this last one, which is probably the most annoying, much easier because it gives you the option to add file attachments to your transactions. For instance, you can take a picture of a receipt with your phone, then once the transaction has posted you can pull up the app and add the picture to it for future reference. That cuts down on the need for paper filing and should you ever get audited all you need to do is print out the statements and all the receipts you attached to them. If you don’t have QuickBooks, again, no big deal, but you must find a way of pairing your receipts to the invoices you get from vendors. Bank statements alone may not be enough to prove you paid an invoice, depending on the circumstances. I have seen it go both ways, but it is always better to have actual receipts.

There are other ways, of course. Some people save all their receipts by month and then attach their bank statements and cancelled checks to them. That is an older but still very solid accounting system, if you make sure to keep all your receipts. Everyone forgets one now and then, it’s not going to kill you, just make sure your habits are working for you and not against you.

Conclusion

To summarize, before everyone reading this falls asleep, two of the most important things you can do to protect your business from potential IRS threats are to a) file your tax returns on time and correctly and b) keep adequate accounting records for your business. Small businesses can be hit hard if they don’t follow these two basic concepts. If you can do these two things, you will ease the tension that often arises from doing everything last minute and once you get into the habit you can spend less time on it and more time on the most important thing, running and promoting your business. I hope this has helped.

[i] $500 penalty used as an example, not an exact calculation. Penalties and interest depend on type of return filed and length of time the liability is outstanding.

2016 Tax and Financial Considerations for Same-Sex Couples

JANUARY 22, 2016LEAVE A COMMENT

The June 26, 2015 Supreme Court decision in Obergefell v. Hodges was a landmark case for civil rights. Legalizing same-sex marriage has a major impact on the lives of same-sex couples who have been disadvantaged both socially and financially. Socially, this legislation will ease the burden of same-sex couples who want to adopt children, it makes estates planning less complicated, and shows a growing national acceptance of the LGBT community as a whole. Filing a joint tax return is beneficial, in general. There are a large number of incentives in the U.S. legal code for married individuals. This, however, is not a blanket statement. As we enter the 2016 tax season, there are several things to keep in mind. There are both financial and tax advantages and disadvantages for people who consider marriage, which will be discussed below. The key fact is that same-sex couples are now on equal footing with and must take the same considerations on both the act and timing of marriage as their heterosexual counterparts.

Same-sex couples can now file joint tax returns and enjoy the same benefits the filing status provides that heterosexual couples have been granted throughout our nation’s history. The Obergefell case allows for a unique opportunity for gay couples, however. If the couple was married in a state that recognized gay marriage one year or more prior to the Supreme Court’s decision but resided in another state that did not recognize their marriage, they have the option to amend prior year returns to reflect their joint status and claim the refunds that would have been available to them if their marriage was legal at the time. The statute of limitations for individuals to amend their returns is 3 years. That means you have until April 15 to amend your 2012 return. Married couples also have an increased exclusion on the gain from the sale of their home, going from $250,000 to $500,000. Those are just two of the myriad assortment of tax advantages now available to them. However, it is very important to look at the disadvantages as well.

Although taxes and finances should not be the sole reason to get married or to hold off on the big ceremony, they are still important aspects to consider, especially with the commitment that marriage entails. In certain cases, some individuals might see adverse effects from walking down the aisle, or at least walking down too early. We see this most often with middle-class families. For example, filing jointly might cause couples to pay tax at a higher marginal rate that could have been avoided if they filed separately. While this is something that has been taken into consideration by heterosexual couples for decades, a rush to the alter in the second half of 2015 could cause a greater tax liability than if they had waited until the beginning of 2016.

There are also non-tax financial considerations when dealing with marriage. Many benefit programs use taxable income as a base to determine eligibility. For high net worth individuals this poses no problem, but it can be a serious issue for middle class families. Here is one example: A single parent has sole custody of his/her child. Based on the parent’s income, the child qualifies for decreased childcare fees and is eligible for a government-provided medical insurance. Because the parent is on the cusp of the income limits, the child could lose these benefits if the parent gets married to his/her partner. If the partner is in the same income position, the added expenses could be substantial. If one of the partners is planning on seeing an increase in income in the near future, it may be beneficial for the couple to wait until that increase is realized before getting married.

For high net worth individuals, trusts are another area of consideration. Prior to Obergefell, an individual could appoint his partner as the Independent Trustee to oversee the trust in the event of the death of the Trustor. Independent Trustees cannot be beneficiaries or spouses, so the legalization of same-sex marriage could have negative legal ramifications. If this sounds familiar, make sure to have a conversation with your estate attorney to see if the trust needs to be updated.

Two other potential disadvantages deal with real estate. The first is the home mortgage interest deduction. The second is the exclusion of the gain from a sale of a primary home. Section 163 of the Internal Revenue Code allows a taxpayer to deduct the mortgage interest on their primary and secondary residences. If each partner in a couple owns one home, then this is not a concern. If, however, at least one partner owns a third property, the couple would not be allowed to deduct the mortgage interest on that home unless it was turned into a rental property and reported on Schedule E of their Form 1040.

Section 121 governs the gain exclusion from the sale of a primary home. This exclusion is allowed once every two years. Using the example above, if the couple is already married and wishes to sell two of the three properties, they would have to wait two years between sales or recognize the gain from the sale of one. If, however, they are not yet married but are planning on becoming so, they can each sell a property while they are still legally single and can receive the exclusion on both homes.

The last disadvantage we will discuss involves the net investment income tax (NII). This is a major issue for wealthy clients with investment income over $200,000. If a partner has money invested in stocks and their gain from sales of stock are above $200,000 but still close to that number, they can gift stock to their partner with a basis up to $14,000 tax-free. Capital gains will still be recognized, but the NII tax may be avoided. This also applies for the gain on sale of other appreciated property, as well. If the couple is married, then a gift to the spouse is in substance a gift to themselves, so the amount might still be subject to the NII tax depending on the amount of gain (the exclusion for joint filers is $250,000).

As stated, there are great tax planning opportunities for same-sex couples who may now file jointly. There are also some pitfalls that need to be thoroughly considered before making such a big decision. Overall, the important thing to remember is that these considerations are welcome ones, not only because it makes the life of a tax practitioner easier, but because same-sex couples are now allowed the same benefits, stresses and securities that heterosexual couples have had for centuries.

Published on: 6 September

Posted by: douglasdscott

Small Business Tax 101: A Profound Hatred of Taxes