by Todd Unger
Starting a business involves establishing new processes and systems that will ensure a strong foundation from which to grow.
Here are a few simple tax tips all new businesses should put into place, before they officially hit the ground running:
Establish the appropriate structure for your business.
Because there can be different tax implications associated with different business structures, it’s important that you have the appropriate legal entity established before you officially open for business.
If you start a business without a partner, then the default entity is a sole proprietorship. A sole proprietorship is often the easiest business type to establish, but the tax savings opportunities are limited. To make matters worse, a sole proprietorship can expose the owner’s non-business assets to creditors. Finally, a sole proprietorship would report its income on Schedule C of the Form 1040. Schedule C is the most highly audited schedule. Therefore, at a minimum, you should explore all business entities with a tax attorney to ensure efficient tax savings, asset protection, and reduced tax audit risk.
Choose a proper accounting method.
The two primary accounting methods under which a business reports financial transactions are cash-basis accounting and accrual method accounting. Under the cash method, income is not counted until money is actually received and expenditures are not counted, i.e. deducted, until paid. Under the accrual method, a company records revenue when the transaction is completed, not when it receives the proceeds. Expenses are similarly handled. The business reports the expenditure when it is incurred, not when the expenditure is paid. Therefore, each method is about the timing of income and expenditures.
Recently, I was involved in an audit whereby the taxpayer was utilizing cash basis accounting. When I was reviewing the taxpayer’s transactions, I discovered that the accrual method was more advantageous than cash method. During the audit the IRS agent stated that the taxpayer’s business had adopted a method of accounting because the corporation filed more than one return utilizing the cash method. I argued that the business made a mistake and, therefore, did not adopt its accounting method. If the IRS concludes that the taxpayer adopted a method that accurately reflects income, then you must receive permission from the IRS to change your method on the Form 3115 prospectively.
Establish business-only financial accounts.
Before you officially open for business, establish an EIN (employer identification number) for your business. Although an EIN is not required for all businesses, I like utilizing an EIN because it shields your social security number from identity theft exposure and creates a distinct entity. Once you have the EIN, open a business checking account dedicated to business-related income and expenses. If your financial institution issues business credit cards or lines of credit, apply for one (even if you don’t intend to take out loans), to build a business credit history separate from your personal financial history. You must remember that you and your business are separate from each other. The commingling of personal and business accounts will make life difficult when preparing your taxes or understanding the businesses cash flow.
Commingling business and personal records is the biggest problem that I see in both examinations and collections. If you business is selected for audit and a revenue agent reviews your bank records, then any cash deposits will be considered income. The burden will then shift to you to prove non-income deposits. Furthermore, owning a small business requires that you pay estimated taxes if you expect to owe $1,000 ($500 if you are filing as a corporation) when you file your tax return. Many of my business clients have tax problems because they are not adequately withholding taxes. Typically, inadequate withholding results from not being able to stay organized and analyze cash flow. There are so many things to focus on when running a business. Make life easy by opening a business account and using it for business exclusively.
Keep cohesive records of start up costs.
Another mistake that I see during tax audits is when a business misclassifies start-up expenditures. Before a business begins any startup and organizational costs of $5,000 or less (of each type of expense) can be deducted the year a business begins. However, expense amounts over $5,000 must be capitalized and amortized over 180 months starting with the month a business is “open.” Additionally, you may be able to take depreciation deductions on tangible property placed into service (which can include computer hardware and software).
It’s important to maintain receipts and records of expenses that are related to the opening of your new business to ascertain what, if any, can be deducted versus what must be capitalized.
Collect the tax related information for workers and contractors.
The IRS is focusing on worker classification audits to close the tax gap. During the height of the recession, businesses would cut corners by labeling workers as independent contractors and not as employees. When you have employees on payroll you must abide by additional payroll tax laws, including withholding a certain amount of funds from employee paychecks for Medicare, Social Security, unemployment and any “fringe benefits” you may offer.
The IRS realized that many independent contractors were in substance employees. The IRS saw this as an opportunity to audit for the collection of back payroll taxes. You should consult with a tax attorney before hiring workers to ensure that you are properly classifying them and meeting all of your employer state and federal obligations.
Make expense records mobile.
The biggest audit challenge that I’m confronted with is representing businesses that have lost records. Generally speaking the IRS has three years to audit a return and six years if there is a substantial understatement of income (25% omission of gross income) from the date the return is filed. Practically speaking, you should maintain records for at least 6-7 years from the date of filing. I highly recommend purchasing a good scanner to maintain a digital file of your records, in particular, receipts. Once downloaded to your computer, you should purchase an offsite, back-up server such as Carbonite, Drop box, or iCloud. Congress codified a strict record retention standard when it comes to charitable deductions, auto expenditures, and entertainment expenses. As a business owner, you are required to maintain records and with today’s technology, it has never been easier.
Because taxes take on a whole new meaning when you own a business, preparing for how you’ll tackle the tax implications can minimize the amount of time you spend managing your financials on a daily basis.
Todd Unger has a J.D. degree from Nova Southeastern University and an LL.M in Taxation from Georgetown University Law Center. He is a tax attorney whose practice is focused on helping new businesses resolve their IRS tax problems.