Sonja Krivokapic

 Taxes For Small Businesses LLC Sole Proprietorship Startup Taxes and Everything In-Between Contents Introduction3 Chapter 1: Types of Small Businesses4 Chapter 2: Types of Small Business Tax11 Chapter 3: How to Calculate your Tax Deductible Business Expenses17 Chapter 4: Capital Expenses and Depreciation22 Chapter 5: Claiming previous years' tax deductions26 Chapter 6: Keeping Accurate Records29 Chapter 7: How to avoid problems with the IRS35 Conclusion40 Introduction One of the hardest, most challenging endeavors that one can undertake is opening their own business. Most of the time, business owners are expected to be experts in all aspects of their business, from marketing and management to customer service and human resources management. However, when starting a business, one of the things that many people ignore is taxes, and how to pay them. What many people do not realize is that this is one of the most important steps to take when starting a business. This is not only because paying taxes is a necessary evil, but also because it can mean that they end up paying the wrong amount at the end of the year, which could cause major problems in the future. That is one of the reasons this book has been written. As a small business owner, you probably have someone, or have outsourced a firm, who helps you to file your business’ annual returns. However, as the buck ultimately rests with you, you still need to provide them with all the information they need to be able to file the said returns. Within the pages of this book, you will find all the information you need to ensure that you produce the proper records and documents to file the right tax returns. This will help save you hours of sorting through all your receipts and notes looking for the right expenses and costs. However, it is important that you still go through all your options with your tax professional to ensure that you have a concrete plan that is specific to your business’ structure and situation. Chapter 1: Types of Small Businesses Before we even begin to discuss what you need to do to ensure that you are filing the proper tax returns, it is important that you know the different structures for small businesses that exist right now. There are many different structures that one can choose when setting up their business, but it is important that you know the difference between all of them, as they will affect your trading status and therefore, the taxes that you pay. Listed below are the most common business structures for small businesses: 1. Sole Proprietorships Many people wrongly believe that owning a sole proprietorship, or single proprietorship as it's also called, means that you have to work on your own. However, this could not be further from the truth, as there are thousands of sole proprietorships out there that hire people to help with the workload. Being the owner of a sole proprietorship only means that you are the only owner of the company. Managing and controlling of the business is solely in the hands of the individual owner, although a sole proprietor can employ a manager or other person for the said purpose. These are usually the simplest companies to set up, as they require very little paperwork and can be set up at the drop of a dime. Obtaining a permit from various local authorities and administration is often enough so start a business. The start- up of the sole proprietorship is also very cheap compared to other business' start – up costs. The benefit of a sole proprietorship is also the lack of governmental interference with the business' activities, although, of course, there are general rules and laws which would have to be obeyed by the sole proprietor. This only means that the business should be conducted according to the law. However, unlike the other company structures on this list, in a sole proprietorship, the owner takes full, personal responsibility for the running of the business. If the proprietor decides to hire a manager in order to acquire help for controlling the business, the manager's activities also become the owner responsibility. This can be a very good idea, especially if the business is very small. This is because as the owner of a sole proprietorship, you will be able to take home all the profits from your business once you have paid the appropriate taxes on them. The relationship between the working effort and the reward are direct and clear, which makes the motivation to work even bigger. Since all the decisions are made by the owner, this type of business is ideal for realizing the goal of securing the livelihoods of the proprietor's family members. These types of businesses are usually maintained and supported by family members. In the cases of non- involvement of the family, the sense of freedom associated with the ability of sole decision making is very liberating and potentially profitable. That also means that decision - making process may stay secret if the proprietor wants it to be so. The operations which the proprietor decides on can be conducted or terminated in a very simple way. The same goes for reports, and they are often not required since the obligation to hire a secretary doesn't exist. Sole proprietorships may also get concessions from the government. For example, they could get water supply and electricity at very affordable price. However, one big downside to sole proprietorships is that under law, you and your company are one and the same thing. This means that should the company make any losses, you will be personally responsible for ensuring that those losses are covered and that any debts that the business incurs are paid off. It also means that if you are unable to pay any of your business’ debts, your business’ creditors are legally allowed to seize your personal assets in an attempt to recover their money. This is also true should your business happen to get sued for any reason, should you be unable to pay a settlement, your personal property, including things like your house and your car, can be seized to help settle the lawsuit. Therefore, this is a business structure for those who are willing to take risks and are confident that their product or service will turn a profit at the end of every fiscal year. The other downside of this type of business is that the owner may not possess all the necessary skills related to various aspects of their business, which can prevent it from growing, always keeping it small. The inability to raise sufficient capital is also something that can make the business growth significantly difficult because they have often put all the money they had into setting up their business. The small number of people may also cause a business to slow down. If a proprietor is ill, for example, there are very few people that can replace them in order to keep the continuity of the business growing. Very long working hours may also become a constant fixture due to the lack of people. Many sole proprietors often work double, and sometimes even triple shifts within a day. 2. Partnerships If you are planning to open a business with more than one person, then you can choose to start a partnership. There are two basic types of partnerships, limited and general partnerships. Usually, people enter into partnerships in order to avoid limitations on business growth which is characteristic of a sole proprietorship. Since a person wanting to enter a partnership doesn't possess a large amount of capital, same as a sole proprietor, they will partner -up in order to enhance the growth of their business. That means that the desire for expansion of business is the main reason and the primary motive for a formation of partnerships. The rules for general partnerships are very similar to the rules of sole proprietorships, except in this case all the partners share equal responsibility for the company. This means that all profits must be shared equally among all partners, however, it also means that they also share equal risk. This means that should the company face a lawsuit, or go into the red, then everyone in the company can lose all of their personal assets. However, it's up to partners' agreement how the profits and losses ought to be distributed and shared, and this agreement is determined on the basis of suggestions which are voiced equally among partners. This may provide some sense of comfort when compared with the concept of a sole proprietorship, because the sole owner cannot distribute risks among people. Since by default every partner is equal in general partnerships, the partnership is terminated if one of the partners withdraws from the agreement. This doesn't lead to the termination of the business, though, since the withdrawing partner's share can be purchased and shared among the remaining partners. No person can become a partner if the remaining partners don't voice an agreement for that decision to be made. General partners are agents of a business, which means they are liable to make decisions, use the partnership property and obtain management control. Registration of a partnership is not very complicated and expensive. In some countries there are no consequences for failing to register your partnership, but in others there are. Like with sole proprietorships, it's better to fill out the forms for the purpose of registering the business in order to avoid complications with the law. Of course, the first step for setting up a partnership is an agreement between partners. As in cases of a sole proprietorship, the process of partnership business registration is not very expensive. Maintaining a partnership is not demanding and complicated, as there is usually very little governmental regulation involved. Unlike a sole proprietorship, a partnership is an ideal arrangement for managing a business in which various skills have to be utilized, since partners can bring their different specific knowledge, skills and contacts to the table. However, this conjures up the possibility of disagreements and disputes to be materialized, which can potentially slow down the business and make certain operations inefficient. With setting up a partnership, the goal of accumulating larger amounts of capital is much more accessible than in cases of sole proprietorships. This is due to the formation of partners, which means there are several people working together to ensure that the capital pool becomes larger. However, when compared to corporations, partnerships are not as effective when it comes to accumulating capital. The fact that this type of business is not subject to business tax, however, somewhat makes up for the difficulties of profit accumulation when compared to a corporate form of ownership. All the profit and losses count as personal income or debt, meaning the tax the partners have to pay is an income tax, not a business one. Limited partnerships are a little different. In limited partnerships, one or more of the partners can be limited partners, meaning that they have limited liability. However, every other partner in the company will be a general partner, meaning that they will have unlimited personal liability. With limited liability partnerships, partners that have limited liability will only be legally liable for the total amount that they contributed to the company. However, most limited liability partners may find themselves at a disadvantage because they are also not allowed to take any part in the routine management of the company. If they do, they could find their limited liability status revoked. Should this happen, all the protections that they enjoyed as limited partners will also be revoked, and they will revert to being general partners. Unlike general partnerships, limited partnership can be taxed as corporations instead as a partnership in certain circumstances. For example, if a partnership has perpetuity and consolidated management, then the limited partnership will be taxed as a corporation. It is important to note that not all partnerships are run the same, and there are various approaches that can be made when setting them up. For instance, a partnership does not necessarily have to be between two individuals, as you can enter a partnership with another company or even a corporation. The benefit of this is an increase in productivity and a larger accumulation of capital, which makes them more competitive in the market. This is, however, not the only reason. Companies engage in partnerships because they think they can bring something new to the market. The problems that could potentially occur with this arrangement are the emergence of disagreements between partners because they became larger in number. 3. Limited Liability Companies The limited liability partnership/company or LLC is some sort of a hybrid company; it shares some characteristics with the general partnership, and it shares the others with a sole proprietorship. When you create a limited liability company, you are basically creating a separate organization specifically to run your business. This effectively frees you from any personal liability for the company, and separates your personal finances from the finances of your business. That's why this type of organization is has a term „limited liability “in its name. This means that all profits will belong to the company, and must be shared out equally between all the shareholders. Shareholders in LLCs do not have to be part of the routine management of the company, as this is handled by a board of directors. This usually refers to the persons who have invested in the partnership but don't engage in management, such as family members of the owners. However, in many LLCs, the members of the board are also shareholders, usually to ensure that they are also liable for any losses that the company incurs. The owners can name a member to take the responsibility for managing the partnership, and they can even appoint an outsider to do the job. The limited liability partnership start –up is more complicated than setting up a sole proprietorship or a general partnership. Paperwork is required, sometimes called „articles of organization“, which is then filed with a state agency. A person starting up this company would have to pay a filing fee, which can range from $100 to $800. The limited company agreement contains the rules for business operation, which may include data referring to percent interest per member, voting power, rules for voting and meetings, rights and responsibilities members need to undertake and data about profit and loss. Limited liability partnership members do not have the right of transferring their ownership. In the case of retirement or death of a shareholder, the continuity dissolves. When LLC loses one owner, the remaining ones are compelled to fill in the forms for closing of their business. If they wish to continue doing business, they are obliged to open a new and separate company in order to do so. Limited companies are also similar to corporations in many ways. Despite the fact that they cannot be deemed as individuals under federal law in the same way that corporations are, they can still be subject to some of the same rules that corporations are expected to follow. For instance, they can choose to be run as S-Corporations, which means that they can have a limit of 100 shareholders, and those shareholders must prove that they are US citizens. If the LLC is owned by just one person, then the owner can choose to be treated as a sole proprietor for the purposes of filing their income tax returns. Business income is passed through the business to the owner or owners, on the basis of which they write a report containing data on the share of profits and losses, which is then sent to the IRS. This is also called a pass – through taxation, which enables the non – owners to avoid double taxation. Like sole proprietorship and general and limited partnerships, LLC also has a limit on business growth. Although it stands a better chance than sole proprietor when it comes to capital accumulation, there are some things that are inaccessible to LLC, such as issuing shares of stock in order to attract investors. As a sole proprietor, creating a limited company may actually be a good idea, as it allows you to enjoy some of the perks of having a sole proprietorship, while simultaneously enjoying limited liability. Despite the slightly complicated application process, LLC is considered a simple business when it comes to structure. 4. Corporations As most people know by now, corporations are considered as separate legal persons under federal law. This is what makes corporations different from a sole proprietorship and a partnership alike. In addition, because they are separate legal persons, the owners and shareholders in the corporation are rarely held financially responsible for any financial or legal claims that may arise against the corporation. That means that the shareholders of the corporation can't lose more than they have invested, and they are not obligated to pay their debts if the corporation as such doesn't have enough money to pay it. However, corporations are traditionally large companies, so why would you want to create a small corporation? Well, the main advantage of a corporation is that they allow you to expand your business a lot faster than any other companies on this list. This is because they allow you to raise huge amounts of capital by issuing stock. The percentage of stock determines the portion of the corporation which is owned by shareholders. Board of directors is often appointed by the shareholders. The board usually consists of people from outside the corporation who are responsible for managing and governing. It inspects policies made by the corporation, outlines goals, hires executives and approves dividends to shareholders. The corporation has another advantage over other forms of business organization, and that's the ability to get bank loans relatively easily. Their ability to get loans depends on the corporation's size and strength, but it's important to note that if the corporation is large enough, the bank won't request a guarantee by its owners in order to issue a loan, which is not the case with small businesses. The fact that they are large contributes to the fact that they are able to attract people with various kinds of skills, and they can usually afford to hire high trained professionals. There is a low risk of shutting down a certain operation segment because of the lack of skilled workers, which can easily happen to a sole proprietor or a partnership. Another thing that sets a corporation apart from other types of organizations is the continuity. Since a corporation is a separate legal life, it doesn't have to end when an owner retires or dies. In these cases, the ownership can be transferred through stock which is sold to other persons. Some corporation founders, however, impose a restriction on the transferability of the stock, turning the corporation into a privately – held organization that way. This consequently means that only a small number of people is allowed to hold the stock, and aren’t allowed to sell it to anyone. The transferability also, however, means that the double taxation is obligatory – it must pay extra taxes because of its status as a separate legal life. That means that the dividends received are paid first at the corporate tax rate and then as an individual tax rate. The problem that might occur within a corporation is the existence of different goals set by people that have different positions within a corporation. For example, managers, who usually don't own stock, would be more interested in their careers than in profitability of a corporation, while stockholders who often don't work for the company would be more interested in profit and would devote less energy in trying to improve the working conditions of their employees. This kind of a complex human structure doesn't exist in smaller business organizations, making them much easier to manage. Corporations are ideal organizations for raising capital. This type of a business organization is the most effective for a large amount of capital accumulation. However, the costs of starting a corporation are high and it requires a lot of paperwork. This process requires paying the licensing, filing, accounting and attorney fees, which can cost up to several thousand dollars. Companies like Facebook and Yahoo were able to grow to their current sizes because they are corporations. However, if you are not sure about how large your company can become, you can always choose to incorporate it at a later date. Now that you know a little bit about the different company structures that you can choose from, we can now delve into the world of taxes. In the next chapter, we shall look at the different types of tax that small companies are expected to pay, and begin to take a look at how you can organize your records so that you are filing the correct returns. Chapter 2: Types of Small Business Tax One of the most boring things you can do is go through all 74,000+ pages of the federal tax code to see which taxes you need to file and when. Therefore, this practice is not very high on anyone’s priorities list, especially if they have both business and a home to run. However, if you are running a business, there are certain sections of the federal tax code that you just have to be familiar with. There are quite a few things that will dictate what you have to pay in taxes apart from the type of company that you are running, mainly the income you receive from that business. In general, the more you make, the more you get taxed. However, your expenditure is just as important as your income, and it can actually help to reduce the amount of tax you pay. So how does the IRS determine how much of your income they can tax? Well, just as with your personal taxes, there is a myriad of forms that you will have to fill in order to file your tax returns. Every form is unique in both name and purpose. Some of them are meant to report deductions, while others are designed to help you take advantage of tax credits that can ultimately place you in a lower tax bracket. So, rather than looking at all those forms like they are the enemy the next time you receive them, you should actually welcome them as a friend that will help you ensure that you only pay what you owe, and not a penny more. It is important to note that all tax returns (at both the federal and state level) for small businesses in the US need to be handed in by the 15th of March every year. If you would like an extension for whatever reason, the deadline to apply for it is the same. However, it must be noted that the extension only gives you 6 months to get your house in order, meaning that by September 15 all your returns for the previous year have to have been filed with the IRS. Failure to do so could result in heavy fines, and even jail time if you are convicted of tax evasion. Before you even begin to contemplate how your year has gone, and therefore how much tax you need to pay, you need to first get all your records in order. However, before you can even get those in order, you need to remember that unlike your individual tax returns, businesses are required to submit forms for four different taxes, all of which cover different aspects of the business. These taxes are listed below. 1. Income Tax Before engaging in analysis of an income tax, the first thing you should know is how the income is defined. There are roughly two kinds of profit – business profit, the profit used for business expenses, and net profit that's not injected back into business. The latter type of profit is income, and when this profit is taxed, that taxation is called an income tax. However, income for businesses and income for individuals are defined differently. Generally, income includes any type of enrichment that taxpayer receives, which includes profit gained by businesses, rents, interests, dividends, pensions, annuities, etc. Most tax systems don't consider health care benefits to be income and thus subject to income tax. An income tax is a tax imposed on taxpaying individuals and entities on the basis of income as it's here defined. Individuals are taxed at different rates than companies. “Individuals” means only human beings. The tax rates among individuals may also vary from country to country. However, many countries share similar tax systems when it comes to income taxation. Residents and nonresidents will also be taxed differently, and residents will generally be taxed on all worldwide income. Sole proprietorships and independent contractors are subjected to a self- employment tax, which will be discussed in the next chapter. Partnerships are not directly taxed by federal government or the state, but the individual partners are taxed based on their income. Partnerships are obliged to file an annual report on their income, deductions, gains, and losses, but they are not obligated to pay an income tax. This means that partnerships are not regarded as businesses that need to be subjected to taxation on an entity level, but their members are, because the individuals are directly taxable, as are corporations. The character of an individual partner's share of income is calculated on a partnership level. As for Limited liability companies, they could be treated either as a partnership, or as a corporation. If they are defined as partnerships, then they aren't directly taxable, however, is they are defined as a corporation, then they will be subject to taxation at the entity level. Many tax systems regard an income tax imposed on corporations as a corporate tax. This is a direct tax, which is imposed on corporation's income or capital, in most cases on the national level. The corporation is taxed as an entity level, unlike partnerships or sometimes limited liability companies. In the United States, all companies other than partnerships are expected to file income tax returns annually. There are various ways this can be done. For instance, if you own a business that uses the withholding method of paying taxes, then you should be able to pay your taxes as you earn your income. You could also choose to pay estimated taxes, which means that you will be able to pay the taxes due when you file a federal income tax return. The estimated taxes are taxes that are not subject to any type of withholding. This type of tax has to be paid by individuals, sole proprietorships, S corporations and partners if they owe more than $1000 when they file their return. However, as estimated income tax returns are just that, estimates, then the amount that you need to pay in taxes will be pegged on your previous year’s earnings. For instance, if you paid at least $2,000 in taxes last year, then your taxes for this year will equals 100% of the $2000, or 90% of what you expect to owe in the current tax year. This works well for those who have just opened their businesses, as paying 100% of the previous year’s taxes may actually work in their favor. It's important to note that not all states in the US employ the federal tax. However, if you have been in business for just one year, and therefore do not have a benchmark to use to estimate the amount that you owe, then you could choose to use the estimated tax worksheet that the IRS provides on form 1040 ES. This form is the most common form used to figure estimated tax. This helps you calculate how much you would owe based on your quarterly income, however, it does mean that you are going to have to calculate your estimated tax returns every quarter to calculate how much you need to pay. In order to figure the estimated tax, many factors need to be considered, such as taxable income, gross income, deductions and other factors. It's important that these figures are estimated accurately to avoid penalties. 2. Self-Employment Tax The IRS describes a self-employed person as “one who carries on a trade or business as a sole proprietor or independent contractor, a member of a partnership that carries on a trade or business, or a person who is otherwise in business for themselves.” Self-employment tax is usually paid by sole proprietors, and is used to contribute to their social security and Medicare. A self – employed person is obliged to file an annual tax return and to pay an estimated tax. They are required to pay a self – employment tax as well as an income tax. This tax is similar to Social Security and Medicare employers pay for their employees, except in this case the employer and the employee are the same person. In order to calculate your earnings as a self- employed person for tax purposes, you would have to subtract your business expenses from your business income. If the amount shows that your expenses are lower than your earnings, then you have a net profit. If, however, the situation is reversed, then you have a net loss. The income tax return has to be filed if a self- employed person's net profit is more than $400. To be able to pay self- employment tax, you have to have a Social security number, which can be obtained by applying with a Form SS-5. The other solution is obtaining the individual taxpayer identification number, which you can also apply for using a Form W- 7. The self- employed person has to file their estimated taxes quarterly. To be able to figure out estimated tax, a person would have to use Form 1040 ES to do it. The year is divided into for different periods within which payment is expected when it comes to paying estimated taxes. Every period has a set due date, which has to be respected in order to avoid penalty charges. Some home – based self – employed persons are required to pay a self – employed tax. Workers who are employed at somebody's home are subjected to a self- employed tax. If a person is taking care of the elderly or disabled individuals, then they are classified as caregivers and thus have to pay the self- employed tax. Many tax payers willingly pay this tax as it ensures that they will have access to some form of retirement and disability benefits, as well as hospital insurance. The tax also goes towards benefits for survivors in case of an untimely death. At the moment, the self-employment tax rate is 15.3%, 12.4% of which goes towards social security. However, this percentage is only paid on the first $106,800 that the person pays the tax makes. What's important to note is that self- employment tax rules apply to people of any age. All that matters is that a person is receiving Social security or Medicare. 3. Employment Taxes These are usually levied against those that employ individuals, and are used to cover social security and Medicare taxes. They are also used to cover federal income tax withholding, and federal unemployment tax (FUTA). However, the federal unemployment tax is the responsibility of the business and cannot be deducted from the employee’s paycheck. In most cases, the company will pay half of the Medicare and social security tax from its own coffers, while the other is deducted from the employee’s paycheck. The employment tax is usually calculated by an accountant, or in some cases by an employer. The person doing the calculating estimates the gross pay for the employees and then based on the employee's gross pay deducts an amount for a federal tax based on a W- 4 form which the employee has filled. The person then deducts an amount for Social Security and Medicare, sometimes called FICA („Federal insurance contributions act“). The amount that needs to be taken from company's own coffers and paid for FICA taxes then needs to be calculated, after which payments to the IRS are made. Additional Medicare tax may be imposed on employees who earn higher wages. Employment taxes may vary depending on the type of the business, its location, size and other factors. These taxes can be paid monthly, quarterly or annually. Only employers pay the employment taxes, except in the cases of self- employment. They can pay it through withholding or by direct payment, or they can choose to combine the two methods. The employment tax is sometimes called payroll tax. There are voluntary payroll deductions which can be withheld from the employee's paycheck only if the employee gives its permission for the deductions to be withheld. These can be paid with pre- tax dollars or after – tax dollars, depending on the type of the benefit the employee has chosen. The purpose of those is to pay all kinds of benefits for employees. These include various health insurance premiums, life insurance premiums, employee stock purchase plans, retirement plans and certain work – related equipment, such as uniforms. These deductions can also include union dues if the employee had decided to join a union, and it can include meals and other job- related expenses. The employee tax rate for social security is 6.2%, and the same amount is also the rate for the employer tax. For Medicare, the employee tax is 1.45%, the same as for the employer rate. In the year 2013, an additional Medicare tax, as it's already mention above, was imposed on the persons with higher wages. This means that persons whose income is above $200,000 per yeah, the tax for this would be 0.9%. However, all wages are subject to Medicare tax, and there aren't any exceptions to this rule. There are a number of states that also require businesses to pay state employment taxes as well. These taxes are usually used by the state to cover workers’ compensation insurance, as well as state unemployment insurance, and temporary disability insurance. 4. Excise Tax The excise tax or just excise, sometimes called a special excise duty, is a tax that is usually charged to certain businesses depending on a variety of factors including: -The type of business -The equipment and/or products that the business utilizes -The payments that the business receives for providing certain services -The products that the business sells and/or manufactures Excise taxes usually include environmental, communication, air transportation, and fuel taxes. They are also levied on the first retail sale of heavy trucks, tractors and trailers. This tax has to be distinguished from custom duties, which are solely taxes on importation and don't fall under the category of excise tax. The excise tax is also called an inland tax, which means that goods and activities subject to it have to be materialized within a country, while the custom duties are called border tax, which means they can happen outside a country's borders. The excise tax is an indirect tax, which means that the taxpayer who produces these goods has to recover the tax by raising the price which is paid by the buyer of the good or goods. The EU has prompted legislation on excise in the middle 1990's since tax borders between Member states were abolished and new rules had to be brought on. Tobacco, gasoline, and alcohol are now subject to taxation in almost every country worldwide. Tobacco and alcohol are subject to it because, since they are recognized as legal drugs, cause many illnesses, and because they are considered to be addictive. The other reason for imposing the excise duty for the EU has been a tendency to prevent trade distortions and to ensure fair competition between companies. Excise tax for alcohol included the rates and structure, rules for alcohol that's not intended to human consumption and provisions for locally produced alcoholic products in many states. When it comes to tobacco, EU imposes the tax for the same reason – to ensure fair trade opportunities for different businesses. Gasoline is subject to taxation because it pollutes the environment. The same goes for other types of fuels, like diesel. The taxation of gasoline and other fuels fall under the category of energy when it comes to excise taxations. This category also included electricity and other products that are used for heating and transport Some countries, like U.S., impose a tax on transactions of illegal drugs, and gambling licenses are subject to excise tax today in many countries. In Canada and the U.S. state of Nevada, prostitution is proposed to be subject to excise tax, on the grounds that an extra funding for police services is required because of its existence. It is important to note that all businesses need to pay these taxes, though they have to file using specific forms depending on their business structure. If you feel that you are good enough at doing your taxes, you could do them yourself, however, if not, it is always better to get a professional to do them for you. Chapter 3: How to Calculate your Tax Deductible Business Expenses Running a business can be very expensive. You have to ensure that you pay all your employees, pay all your overhead costs, and try to ensure that you turn a profit while doing all of this. However, many of the costs that businesses incur can actually help them when it comes time to file their taxes. This is because they can be turned into deductions, depreciation amounts, and credits by yourself or your CPA. As a business owner, one of the most important questions you can ask yourself is, should I make certain expenses tax deductible? The answer to this question is more complicated than you may think, as different businesses are run in completely different ways. Therefore, the way that your CPA will report your expenses to the IRS is going to be different from the way your competitor’s CPA will report their expenses. In short, the expenses that you can make tax deductible will depend on the type of business that you own and operate. It is important to note that the IRS has various rules and regulations in place to ensure that business owners do not abuse the fact that they can create tax deductible expenses. For instance, if you took a trip to the Bahamas in the last year, then unless you are an hotelier or restaurateur scouting for new locations to open your next branch or business, then you are not going to be able to claim the costs of the trip as business expenses. This means that when the time comes to make any tax deductions for your business, you have to fight the urge to include all the purchases you made or expenses you incurred and state that it was for your business. However, just because you should not include all the expenses you incurred in the last year does not mean that you should understate your expenses just so that you do not get into trouble with the IRS. The majority of the money that you use to start and operate your business can be considered either a business expense or a capital expense. These are two very different things, and we shall cover capital expenses in more detail in the next chapter. For a deduction to be made at any expense, the business owner has to prove that they are both ordinary and necessary expenses. Ordinary expenses are usually the most common and accepted expenses that your business incurs, while necessary expenses are expenses that you incur in order to help your business, and that are deemed appropriate to be deducted from your taxes. For example, a restaurateur cannot claim the purchase of a new pair of ski boots as a business expense. This is because skiing has nothing to do with running a restaurant and therefore is not a necessary expense, and ski boots are definitely not a common or usual expense for a restaurateur to incur. However, the same cannot be said for a ski instructor, who will definitely need ski boots in order to continue conducting their business. The criteria that are used to define necessary expenses is quite broad, as the expense does not have to be absolutely necessary, i.e. it does not have to be an expense that the business cannot live without. However, the business owner does have to prove that by incurring the expense, it benefited their business in one way or another. For instance, if you are a CPA, you could claim that the rent that you pay for your office is a necessary expense, as it provides you with a place for you to meet with your clients. However, this is not an entirely necessary expense, as many CPAs work from home, or provide their services from their clients’ premises. Some claims may seem rather trivial, but if it can be shown that they are both ordinary and necessary then they can be tax deductible. For instance, bodybuilders have been known to claim that body oil as a business expense, while some models have been able to claim that the plastic surgery that they have had done counts as a prop for their job. It is important to remember that the burden of proving whether a business expense is tax deductible rests on you as the business owner. You have to prove that the expenses that you claim were necessary and that they have benefitted your business in a particular way. As you can see from some of the examples above, these can range from the ordinary to the outright absurd. However, for many businesses, there are a couple of things that are standard across the board. Office expenses Office expenses are one of the most commonly deducted business expenses since there are so many businesses that have an office. Before you deduct any office expenses, there are certain firm rules that need to be followed. The most important thing, as it’s already noted, is that you prove to the IRS that you are in business. It may seem trivial to say that, much less repeat it, but if you look carefully at what it means to have a business that has an office, it does require additional clarifications. That means, first and foremost, that your business must not operate as a hobby. If your office works full time, that means that the IRS will recognize your office as a business. This applies to businesses that function only as offices, for example, if you are a freelance writer or if your apartment serves the purpose of being a store in which you sell certain goods. You have to be registered as a business, no matter if your business has an office, or your business is only an office that serves certain office purposes. This, of course, goes for sole proprietorships, partnerships and LLS's as well as for C corporations. Many people conduct businesses in their homes, and many of those businesses are offices. If you want your office to function as a business, another important thing to do is to turn an entire room or an entire space into an office space. The private and the business space must not mix together, as that would potentially cause problems with deducting your business expenses, that is, you won't be able to do it. Although separating the space you use for business from the space you use for private purposes is not something that IRS will explicitly require, it will make things a lot easier for you to claim that the space in question is only for business purposes. If you run a business that has an office, one of the things you can claim for can be office supplies. These include things like printer and copy paper, pens, staplers, and printer ink cartridges. For those that are running a transportation business, the cost of gas and maintenance can also be tax deductible, as well as any repairs and upgrades that need to be made to your vehicles. However, despite the fact that there are no clear definitions for what can be claimed as ordinary and necessary expenses, there are some things that should never be claimed. This is of course, unless you would like to find yourself in front of a tax auditor and facing fines, interest and additional taxes. For instance, you cannot claim your first office landline as a tax deductible expense. However, you can claim any long distance phone calls you make on that phone as a business expense, and, you can claim the full cost of any subsequent landlines that you purchase. Travel expenses As office supplies have to be used for business purposes in order to be deductible, the same goes for travel expenses. Transportation expenses are, as are office expenses, the most common business expenses that people want to deduct, so more attention to them needs to be paid. A business trip can be considered a business trip if you go away for business. To a business travel to be classified as such, the destination you are heading to must be either an office, bank, some temporary job site, the store where you buy your supplies or the place where you keep inventory. However, what's important to note is that business travel is not just going from one place to another. When you travel from your home to your place of business, that's considered commuting and these expenses are nondeductible. Hauling your tools or supplies from your home to your office or another location is also commuting. For a business trip to be just that, a business person has to travel away from home and stay overnight for business purposes, in a location that's outside the city limits in which their business is registered. They don't even have to stay overnight – they can stay long enough to require a stop in order to rest or sleep. Also, napping in your car isn't something that falls under the category of business travel. So, for example, if you travel to another city or country for business purposes and stay there for one or several nights, these expenses can be deducted as business expenses. Transportation costs are deductible only if they are necessary for your profession, business or trade. It should be noted that it doesn't matter which type of transportation you use – whether it's a car, taxi, bus, van or any other means of transportation, the means itself doesn't matter. What matters is if the transportation costs can be deductible. When it comes to mileage that you have traveled, you can use standard mileage rate or you can check what your actual expenses were. Both calculations can be categorized as deductible travel business expenses. However, there are certain rules when it comes to the usage of standard mileage rate. First, you have to be in business for over a year, meaning that you have to use your business transportation device for business purposes only for a year. Second, if you have more than five cars that you use simultaneously, you can't use standard mileage rate. If you are a small business owner, the latter probably shouldn't concern you. You must, of course, be careful while noting your travel expenses if you want those deducted. This means you have to keep track of your car washing if you use a car, your gas and oil expenses, insurance, parking fees, tolls, repairs and maintenance, registration fees, etc. Also, travel expenses that occur on your first and last day of your job cannot be deducted. Business entertainment expenses We've all heard of people going to a business lunch or a business dinner. Since many people cheat when it comes to these types of events, there is a tendency to think of all entertainment expenses as something that IRS frowns upon. But this is not the case – some entertainment expenses do qualify as business expenses and thus can be deductible. Of course, there are rules to this. First of, we need to define entertainment. Again, this may also seem trivial, but gathering all information is your friend when it comes to deducting taxes. So, the entertainment involves activities that are considered to be fun, such as having a dinner in a restaurant, going to a club, to a movie, the theater, doing sports activities or attending some sporting event. What you already suspect by now, even these activities have to be business related in order to be deductible. For example, if you are on a business trip and you go to a movie that has nothing to do with business, these costs won't be deductible. Also, entertainment business costs can't involve any type of entertainment. For instance, paying for a hotel room or buying your employee lunch is not considered entertainment business expense. For you to prove that the entertainment in question was indeed for business purposes, you will have to prove so. In order to do that, you have to provide information that the dinner you had with clients, for example, was business related only and that you talked about business. That doesn't mean that you can't say anything that's not business related – it simply means that the purpose for going to dinner was business related. Some events automatically qualify as events that are entertaining, but that are primarily set up for business purposes. For instance, conventions where you meet your clients may fall under that category. To be able to deduct expenses from a convention or something similar you attended, you simply have to save the program. Socializing after a convention is considered an entertainment, but not a business event, because going for a drink after a convention is considered to be a rest from business activities. Lastly, these costs shouldn't extravagant or lavish. They have to be reasonable. It is not clear what exactly is meant by this. But at least you can conclude what is an unreasonable spending. For instance, if you have only a few things to talk about as business partners and you have a 3- hour lunch, this might be going too far. Extravagant or lavish is anything that too extreme and thus inappropriate for the occasion in question. Additional expenses Additional expenses are those that occur during normal business operations. These include advertising, education expenses, giveaway items, clothing, dues, and subscriptions, etc. These can be deductible as long as they are ordinary, necessary and reasonable. Almost anything related to advertising can be deductible. This covers business cards, brochures, catalogs, billboards, display racks, publications, newspaper advertisements, radio and television advertisements, etc. Items that you give away to customers for the purpose of promoting your business, such as coffee cups, pens, T-shirt and other things can also be deductible. However, if they cost too much, you won't be able to deduct them. If they cost over 4 dollars, the IRS won't treat them as deductible items. Bad debts that are business- related can also be deductible. This includes lending money, selling inventory on credit and such. You must prove you have suffered economically as a result of this debt. You can deduct clothing that is essential for a type of business activity. That means that the clothing suitable for deduction has to be worn only for business purposes and must not be suitable for everyday ordinary street wear. If you pay dues to professional, civic or business organizations, then these are considered business expenses which can be deducted. Note that the IRS doesn't like the word due when it comes in this context because it suspects that this due is paid out of personal impulses. It's advisable to use the word „fee“ instead. Educational expenses can be deductible business expenses, as long as they serve the purpose of improving skills and knowledge necessary to the business. This, however, doesn't apply to educational requirements that are considered to be at a basic level. For example, you can't deduct expenses of going to art school. Chapter 4: Capital Expenses and Depreciation As mentioned in the previous chapter, most businesses will have two different types of expenses, business expenses, and capital expenses. Both business and capital expenses benefit the company, however, they do share significant differences. Whereas business expenses are usually related to the day to day workings of the business, capital expenses are related to the assets that a business owns. To find out if any of your purchases over the last year should fall under business or capital expenses, there are a couple of questions you need to ask yourself: Do you own or lease the equipment in question? Will you utilize the equipment for business at least half the time? Will the equipment that you purchased contribute to the generation of income for your business? Will you begin to use the equipment during this fiscal year? Will the equipment have a “usable life” that is longer than a year? If the answer to all of these questions is yes, then you should treat the purchase as an asset. For instance, if you bought your office a brand new Xerox copy machine, that should be considered an asset because not only do you own it, it will last for longer than a year, and it will help to bring in business. In addition, the copier will definitely be used more than 50% of the time, as offices do have a lot of copying to do, even in this day and age when computers and the internet seem to be phasing out the need for paper. The IRS is very clear on this particular subject, and states that every business must capitalize their assets, especially if they are meant for long term use, and will help to bring in an income. Capitalization in the traditional sense is the ability to take advantage of a situation in order to benefit from it. However, in tax terms, capitalization is an accounting method that is used to suspend the recognition of a particular expense in order to make incremental payments on it as a long - term asset. The ability to suspend certain payments until a later date can actually be very beneficial for your business in the long term. For instance, if you are a farmer and you spent $70,000 on tractors and other equipment that you then used to clear your fields and sow your crops, then it would make very little sense to deduct the full amount of the equipment in the same fiscal year. This is because your farm’s income will most likely be very low compared to previous years. So rather than deducting the full amount in that year, you can choose to spread the deductions over a longer period of time so that they have a greater impact on your income in the coming years. Some of the most common capital expenses include expenses for machinery, vehicles, buildings, office furnishings, property improvements and repairs, additional inventory, and copyrights and patents. The depreciated value of all your assets are usually deducted from your gross income for a set number of years. There are some things that can be claimed as both business and capital expenses, such as your inventory and property repairs. For things such as inventory, the deductible business expenses include all the inventory that was used or consumed by the end of the business year, while the deductible capital expenses include all the inventory that remained at the end of the same year. With property repairs and improvements, business expenses will include things like repairs and improvements that help to maintain, restore or protect the property so that it is in pristine working condition. However, any improvements that are made to improve, extend, or otherwise upgrade the value, size, strength, or capacity of the property will fall under capital expenses. When you are calculating your capital expenses, you need to keep in mind that there is a capitalization limit. This limit is usually decided by the business owner or partners, and their accountant, and is used to set a minimum cost requirement that any piece of equipment must meet before it can be deemed a capital expense. In most cases, if the equipment in question does not meet the set criteria, it will then be considered a business expense. How to Determine the Depreciation Value One of the most important things you can do is determine the depreciation value of your assets, because as stated before, your deductions will ultimately reduce the amount of tax you have to pay to Uncle Sam. For this reason, the IRS takes the depreciation into account when it is trying to figure out how much you can claim when you file our tax returns. It is common knowledge that almost every purchase you make depreciates as soon as you have paid for it. Even the farmer who spent $70,000 on his farm equipment will make losses on his equipment 5 years from now if he decides to sell, and the IRS takes this into account when you are filing your tax returns. To calculate your assets’ depreciated value, you’re CPA is going to need a couple of things such as: The name of the asset A short description of how you use it The purchase price of the asset (this includes all additional expenses or fees tied to the purchase, such as sales tax) The date the purchase was made The estimated amount of time the asset will be useful to the company The estimated resale price at the end of the asset’s usable lifecycle, otherwise known as its salvage value The depreciated value will then be equal to the purchase price minus the salvage value. There are three different ways that the IRS allows small business owners to claim capital expenses. These are: Section 179 Modified Accelerated Cost Recovery System (MACRS) Straight Line Depreciation Declining Balance Method Section 179 This is basically the only system that is in place that allows for small businesses to make deductions on the total cost of their capital expenses in the same year that they were purchased. For example, if you purchase a computer for $30,000, the normal depreciation will require you to stretch that cost over 3, maybe even 5 years, but the Section 179 deduction allows you to keep that amount in your current tax year. This means that Section 179 allows small business owners’ assets to be exempt from depreciation, which is a very good thing in the long run. Congress signed the PATH (Protecting Americans from Tax Hikes Act) in December 2015, and in the process, set a maximum capital expense deduction limit of $500,000, which allows small business owners to actually make savings in the long run. Assets that qualify under Section 179 include things like tangible general property, business vehicles, gasoline tanks and pumps, office furniture and equipment including computers, livestock, testing equipment, and even signs. Modified Accelerated Cost Recovery System (MACRS) This is only applicable to energy companies, farms, and “non-typical” business types. The system is usually used to determine land depreciation costs, and comes with a host of complex rules and regulations that are outlined in a 119 - page document that you can find on the IRS website. If you are new to doing taxes, dealing with MACRS is something that you should consider handing over to a tax professional, at least until you understand the intricacies of the system. Straight Line Depreciation This is the simplest and most popular method used to calculate depreciation, as it applies deductions uniformly over an assets usable lifecycle. To calculate your depreciation using this method, you must first find the depreciable base value (depreciated value) and divide that value by the number of years that you feel the asset will be useful to find the annual depreciation expense. Once you have figured out your annual depreciation expense, you can then fine-tune the amount claimed in one year to show the duration the asset was useful during that year. For example, if you buy a computer that costs $30,000. You expect your computer to last for about 4 years, and after that period you will sell it for $5,000. So, this means that depreciable amount of this computer is $25,000, that it, $30,000 minus $5,000 salvage value. You will be using it for 4 years, which means that the computer has 4 years of useful life. If you divide your $25,000 with 4, you will get the amount of $6,250, which will be your depreciation expense. This depreciation expense will remain the same over the course of the useful life of the computer. That means that the amount of $6,250 will be the depreciation expense for all four years. As you can see, it's pretty simple to calculate. It shouldn't be a problem even for those people who don't use math operations on a daily basis and who don't like math. The Declining Balance Method This is the least used method to calculate your depreciation value, and it involves applying the depreciation rate to the non-depreciated balance. Therefore, rather than spreading the cost of the deductions evenly over the life of the asset, the cost of the deductions is flat during the asset’s lifetime. One reason this method is not used as much as all the others is because it decreases the income of a business more early in the asset’s life. For instance, instead of depreciating 20% of the asset value, you will expense 40%. The main idea behind this is that something that's not used in a straight line method, and that is the fact that an asset becomes less productive towards the end of its life. That's why when the asset's value decreases, that is, when its value decreases in accounting books, the depreciation expense decreases as well until the asset is written off. Chapter 5: Claiming previous years' tax deductions If you are in business for a while and you haven't deducted your expenses, not all is lost. There are several reasons why this happens to people who run businesses. You might have simply forgotten to take a deduction, and these things can be mended. Taxpayers make these kinds of mistakes quite frequently. There are other reasons why people want to amend a tax return – they have net losses and want to apply them to previous years, they gave incorrect information about their returns, or they want retroactive changes because of the new changes in tax laws that have occurred. The time limit for tax return Of course, you won't be able to wait forever to do a tax return. Usually, the IRS applies the three- year period, that is, if three years pass from your original return, you won't be able to claim the return from previous years. Retroactive tax laws Sometimes the law might play in your favor even when you don't yet realize you are in need of some benefit. For example, the Congress or the IRS can change laws in a way that the change is more favorable to you than it was when you deducted your expenses. If that's the case, you will be able to file another tax deduction and get e refund for previous years. Sometimes these things happen automatically. For example, the law was changed for assets after 9/11, and it allowed businesses to take an additional 30%. In cases like that, you will get the bonus without asking. If, however, this doesn't suit you, you can always notify the IRS about it and request a change. Although it doesn't seem logical why you would complain if something like this happens, this bonus can actually result in your having to pay more taxes if you sell your assets that are purchased after the law concerning bonuses is made. It's important to be up to date about these things, so you don't suffer economic losses. Net losses Many people, especially if they have recently started a business, experience more amounts of losses than gains. Although that may be discouraging, you can benefit from this by reducing your taxable income from other sources; investment income, your spouse's income on other sources. You can even apply some portions of the losses to future years. You can carry the loss for two years prior to the year when the loss occurred. This is advisable, because the IRS gives you a quick refund for this. You can claim previous year's taxes by filling out a Form 1040X, which is a form for amending individual income tax return. You can file a Form 1045, which enables you to get a quick refund. If you file a Form 1040X, you can end up waiting for a year for a refund. Casualty losses Casualty losses are those losses which occur when some external forces damage your business assets. Earthquakes, fire, floods, and vandalism all fall into this category. If this happens, you can deduct these losses from prior year's taxes by filing an amended tax return and deducting the loss amount from that year. The IRS will then send you a refund because this calculation will result in a certain difference. Bad debts The term „bad debt“ stands for a debt that is worthless. That's what the word „bad“ means. It sometimes takes years for the debt to become bad. First of all, it's important to recognize which debts can be deducted. If your bad debt falls into the category of deductible debts and you forgot to file a tax return the year your debt became worthless, you have up to seven years to file an amended return on that debt. However, if the debt is only partially worthless, then you have a period of three years to amend it, the three – period limit above mentioned. If your debt has become completely worthless, then the seven year period applies. Steps to amend your tax return The IRS form 1040X is all you need. Since it's not difficult at all, you probably won't need any extra help in order to file it. It has three columns – A, B and C. The first column is for the original tax return information, and the new, corrected information has to be in the column C. In the column B you have to write down the differences between the information from the other two columns. The form is then sent by mail, and not by e-mail. If you are amending your tax returns for more than one year, you would have to use several forms and put them in different envelopes, with each form containing information for each year. If you want a refund related to the net loss, an extra form will be needed – the Form 1045. The other option is to use the latter form alone, without the Form 1040X. The IRS reviewing process Since the IRS doesn't like paying money back, the claims for returns will be examined with special attention. After that's done, the IRS employee will then conclude if you are entitled to a refund and if you are, it will bring a conclusion regarding the amount which you will receive. Claims can be accepted, denied or audited. The trouble is that if your claim is audited, the IRS is allowed to audit your entire tax return. So that means that the amended tax return actually increases your chances of an audit. But, this should be not something you need to worry about. If everything you did was done according to the law, the IRS employee won't discover anything out of order, even if they select you for an audit. If your claim is accepted, you should get your refund in about 12 weeks. However, if you have additional debts, you may receive a refund smaller the one you have expected because the IRS might use your refund money to repay the debt for you. If your claim is denied, the IRS has to give you an explanation why it has decided to do so. If you don't agree with their conclusion, you can appeal a denial. Chapter 6: Keeping Accurate Records The only way you will be able to file accurate tax returns is if you keep an accurate record of your income and your expenses. It doesn't make sense to deduct if the records you keep are incorrect, incomplete and inaccurate. This usually sounds easier than it seems, as there are quite a few records that you will need if you should hope to file accurate returns. Many businesses that encounter problems with the IRS do so because they do not have accurate records, and therefore, cannot calculate their income or expenses accurately. However, it is important to note that keeping accurate records is not just something that will help you in file accurate tax returns, it is also a legal requirement that the IRS takes very seriously. The consequences of not keeping accurate records may be losing your money and suffering additional costs, which is something you want to avoid. If you are a small business owner, some of the most important things that you need to keep are your receipts and tax records. Not only does the IRS require you to keep them, they will also provide you with a means to track your income, deductions and any credit that is shown on your tax returns. They will help prove that you earned what you claim you earned, and that you bought the things that you claimed you bought. However, it's not that hard to keep records of your expenses. With clear direction, it shouldn't be something you would have to worry about too much. Depending on the taxes that you are going to have to pay, you are going to need to keep certain documents and supply these to your CPA when the time comes for you to file your tax returns. Some of the documents that you will need include: 1.General documents These include your previous year’s tax returns, and your Federal Tax Identification Number 2.For Business Income Taxes You will need to keep quite a few records for these including •All accounting journals and ledgers; basically all reports that contain records of business transactions that you may have carried out, and all the funds that left or entered your account •All documents that show your transactions in detail. Journals and ledges tend to provide an overview of your transactions •All invoices that you received and paid •All bank deposit slips •Bank statements •Your business checkbook, including cancelled checks •Credit card statements •All vehicle and mileage logs 3.Business-Related Expenses You will need to provide a detailed, itemized breakdown of all you expenses if you hope to reduce your taxable income, and hopefully, drop to a lower tax bracket. Ensure that all your receipts have their purchase dates. If it's too hard for you to decide what your categories should be, there is an IRS Schedule C, a form that helps you list your business – related expenses. These are not carved in stone, but the form helps you gain a general orientation when it comes to your categories, which helps you organize your business in a good way. Some of the categories included by an IRS Schedule C are: •Supplies: general office supplies •Regular operation costs such as rent, utilities, and subscription based services. You can also include repairs and maintenance in this category • Taxes and licenses • Depletion • Interest • Bad debts •Entertainment and travel (meals, car expenses) •Marketing and advertising costs •Expert fees and commissions for people such as attorneys, accountants and consultants •Insurance policies, such as individual and group policies, company vehicle policies, and other policies that cover your assets •Equipment and assets, ensuring that you include any applicable depreciation schedules. You can divide this by two categories – equipment, machinery and vehicles, and other business – related property. The employment taxes listed below is also included in the IRS Schedule C form. You can put them all together, or you can separate employment taxes from other business expenses, as it's done here. As it's already been said, this list is not carved in stone. The Schedule C is here just to give you an idea of how to put all your business – related expenses on paper. It all depends mainly because different businesses will have different categories; some will keep all of these and add more, and some might replace a few categories from this list with another ones. For example, a writer may include agent fees and writing supplies on the list. What's also important is to put a miscellaneous category for those expenses you do not have a category name for. 4.For Employment Taxes You will need •Employee forms •W-9 forms •I-9 forms •W-2 forms •Records of subcontractors and professional services •1099: non-employee tax forms •1099-misc forms •Payroll reports •Monthly or quarterly reports for the total time each employee has worked •Monthly or quarterly reports for the wages paid to each employee •The gross monthly payroll •The total deductions held back from employee wages 5.For Self-Employment Taxes You will need to provide a calculated percentage of your net income as follows •Social security tax: 12.9% •Medicare tax: 2.9% It is important to note that there are some expenses where you will not necessarily have to keep a receipt. For instance, if you are travelling, you will not have to keep any receipts other than the receipts for your lodgings. In addition, you are not expected to keep receipts for entertainment, transportation or gifts, as long as the following conditions apply: •The cost of the exemptions is less than $75 •The exemption is transportation and you cannot readily obtain a receipt Despite these exemptions, you must still keep in mind that should you ever be subject to an audit, all your expenses will be called into question, including the expenses under $75. For the IRS to uphold any deductions for expenses under $75 during an audit, you are going to have to provide them with the following information: •The amount of the expense •The date the expense was incurred •The location the expense was incurred •The purpose for the expense If the expenses are entertainment expenses, then you are going to have to provide the names of the people that were entertained. To make this easier, it is always advisable to write these things on the back of any receipt you receive, in your diary, or even on your calendar. It's important to note that the IRS pays great attention to entertainment business expenses, because it always suspects these could be abused, meaning it suspects that these expenses were made only while entertaining, without the business element attached to it. If you want to avoid being scrutinized and even closely scrutinized if you get selected for an audit, you will have to treat these expenses with more care. That means you will have to keep closer track of these expenses more than for any others. To be able to do this, it helps to categorize them separately. After you have written information on the back of the receipts you received, it's advisable to make your records as clear as possible afterward, when coming to the place you work. You should include the date, the amount spent, place where the expense occurred, the business purpose and the business relationship. The latter will contain names of people which you encountered during the event in question. Rewrite the data from the receipt, a calendar or a diary to keep track of them more easily. Although you will have all this information on the receipt, as it's mentioned, it's well advised to keep track of these expenses more carefully. Still, you don't have to be too diligent about it – the IRS doesn't require you to keep credit card slips, canceled checks or other documents that closely detail the event in question. However, having these five categories listed above in mind will help you have a clear head, but it will also help you to avoid any trouble with the IRS. In general, it is advised that you keep your records for at least 3 years from the day that the tax return was filed, or from the date the tax return was due, depending on which one was later. Therefore, if you decided to pay your taxes on February 13, 2016, rather than keep your records until the same date in 2019, you will have to keep them until April 15, 2019. This is because the due date to file your taxes is April 15. This three year period is called the Period of Limitations, and allows taxpayers to amend their tax returns. It also allows the IRS to conduct audits if it feels it needs to. After the three year period, you are not required to keep any of your tax returns, or their supporting documentation. However, there are a few exceptions to this rule. For instance, if you made a deduction on a bad debt or a worthless security, you will need to keep you records for 7 years. Also, if you do not report any income that you need to report, and it is more than 25% of your gross income, then you need to keep your records for 6 years. For those businesses that have employees, they will need to keep their records for at least four years, while any records that are related to property should be kept for at least 3 years after the property has been disposed of. If you are hoping to try and get away with tax fraud, it is important to note that there is no Period of Limitations on unpaid taxes and therefore, you could be under the IRS radar forever. Accounting methods Accounting methods are something also worth mentioning. They represent a set of rules which determine how and when your expenses and income are reported. It can come across as something tedious and difficult, but it’s not necessary for a person to become an accounting expert in order to do their accounting for taxes. Basics are enough, but should be taken seriously for multiple reasons. First of all, you need to keep track of your business activities in order to make sure your business is running smoothly. Second, the IRS has somewhat strict rules when it comes to accounting as well. For example, you have to choose a method which you used when you filed your first tax return, otherwise, you would have to ask the IRS for approval if you want to change your method. To do this, you would have to use the IRS Form 3115 and to pay a fee. Also, some types of businesses have to use strictly required methods. For example, the IRS will require certain businesses to use only the accrual method. Sole proprietorships, for example, are not required to use the accruing method; these are required for bigger businesses only. Sole proprietorships and partnerships frequently use cash method, but they can use accruing method as well. The IRS states that the most important thing is to stick to one accounting method once you decide on it. There are two main types of accounting methods you can use. These are: • the cash method – this is the simplest of methods. It's perfect for small businesses and for the simplest accounting procedures. However, if you sell, purchase and keep an inventory, it's advised to use the accrual method. This method includes recording money as it's received and recording expenses as they are paid. The downside of this is perhaps the fact that you can’t hold checks or other payments from one tax year to another. In short, you cannot postpone your income, because you have to report everything you receive that year you received the payment. • the accrual method – this method is somewhat more complicated, as you don't just record your account changes as they happen. Instead of just reporting received money and expenses when they are collected or paid, you report them when they are earned and incurred. If you have a C corporation, you would have to use this method. However, even some partnerships are obliged to use it, although partnerships, like sole proprietorships, generally use cash method. If you have a partnership whose annual gross receipts exceed $5 million, you would be required to use the accrual method. It's difficult to say which method is better since they both have advantages and disadvantages. Moreover, if you have to use a particular one, it doesn't help to think about pros and cons. However, if you own a type of business that allows you to choose which accounting method you can use, then the cash method is probably the better option. However, accrual method, although complicated, is a much more precise and detailed accounting method, because this method accurately matches your earned income in one period to the expense in that same period. Computer financial programs Computer financial programs are designed to help you in keeping track of your finances. There are simple and more complex programs. However, even the simplest of programs is more complicated than handwritten record tracking. So it's better to investigate the nature of these programs in order to decide if you want to invest time in figuring them out, which would be a necessary task if you want to use these programs properly. The Internet is full of information – you can check each of the programs' individual properties just by using Google's search engine, or you can talk to people who have used it or are using it. If you decide you do want to utilize a certain program, be prepared to invest some time in it. These programs may turn out to be very helpful for you in the long run. The simplest programs are Quicken and MS Money. They function like computerized checkbooks. They already come with categories, which may not be adequate for some businesses, but the program allows you to create your own categories. These programs can create profit and loss statements, income and expense reports, etc. If you are already familiar with these and are in need of more sophisticated programs, QuickBooks Pro and MYOB might be the right programs for you. They deal with more complex tasks, such as tracking inventory, invoicing, double – entry bookkeeping, etc. Amending your improper tax records It sometimes happens that you forget to keep track of all the records you are required to keep track of, and that’s something that’s quite normal. It’s also amendable. It’s covered by a so - called Cohan rule, named after the Broadway entertainer George Cohan, who was involved in a tax case back in the 1930’s. Basically, the rule states that businesses have to spend a certain amount of money to stay in business and thus have to have certain deductible expenses, regardless if they keep the records that prove that. So the IRS may apply this rule, which is used to estimate how much you must have spent, and it will allow you to deduct that amount on the basis of these expenses. You would, however, have to provide some evidence to the IRS. It’s important to note that this rule doesn’t apply to meals, travel, entertainment, gifts or property. It’s not the best deal because you will probably get only half of the deductions you will claim, and maybe even less than that. But it is important to be aware that there is a rule which you can call upon should any problems like this occur. Chapter 7: How to avoid problems with the IRS As it's already clear by now, taxes are vital when opening up and maintaining a business. Since you are going to be dealing with some kind of a tax agency, it's best that you learn everything you need to know about it to avoid trouble. Tax systems are tricky – they aren't simple or easy, they don't come with a manual, and the instructions often given by tax agencies are written in a stern bureaucratic style that only few understand. Not all the businesses will be opened in the United States, where the IRS is the agency you need to send your tax reports too, but it is very important to know something about it because it will help you grasp other systems as well, at least to some extent. So this chapter will be dedicated to avoiding having problems with the IRS, in hopes that the information will come in handy for the reader when dealing with their business activities. Audits Simply said, audits are situations in which the IRS performs a review of a certain business. It's the IRS' s job to examine the individual's information or the information given by businesses and compare it with tax law to make sure everything is done properly. The audits occur if the IRS perceives a problem with your report. There are three ways in which the IRS can do this – by e-mail, in an office and in a field. Audits handled by e-mail are the simplest and shortest ones. The IRS sends you a short e-mail in which it notices a problem with your report and may request documentation or additional information that it views as necessary. The most common reason the IRS sends e-mails is the unreported income. Since it has information about the income you gain, it has access to information about the unreported or underreported income as well. Office audits are done face to face. The IRS invites a person to an office audit because of a problem that's more complex in nature. Also, if there is more than one problem with your report, the IRS might invite you to your office in that case. The field office is the most difficult one and you are likely to face a more diligent scrutiny. That's because an IRS auditor comes in your office and examine your documents, finances, tax returns and all of your records. These audits are the most common in cases of businesses who earn a lot of money and who have a more complex organizational structure, and thus require more paperwork than businesses that are more simple in terms of organization. How the IRS selects individuals and businesses for an audit There are two ways that selection for audit can happen. The first one is benign – sometimes the IRS randomly selects you via computer, so the request for an audit doesn't always indicate that there is a problem. The other way is related to the recognition of a certain problem. Sometimes the IRS finds a problem or problems in their own computers, but in other cases, they may contact you if they get a referral from a government agency. Also, the IRS is well known to receive tips from former business partners, siblings or other private citizens that claim have an important information about the individual or business in question. In either way, if the IRS doesn't specify its reasons for contacting you, you always have the right to inquire and the right to get an answer from the IRS. Nowadays, the IRS initiates all contacts with individuals and businesses via e-mail. If you are selected for an audit, your telephone won't ring. This is somewhat reassuring for people who find the IRS intimidating since the e-mail communication allows you to gather your thoughts and respond when you feel comfortable enough to do so, unlike with telephone communication, in which you are required to give an answer immediately. Factors that are taken into consideration When the random selection is out of the question, the IRS uses a complex formula which it calls DIF, or the discriminate function score. On the basis of factors that make this formula the IRS then decides who to audit. The exact factors are a closely guarded secret, although certain information about what the IRS takes into account are known. 1. High income These IRS usually looks closely at businesses that make a lot of money. As said before, these are likely to be scrutinized via a field audit, but this doesn't always have to be the case. What's most important for individuals and businesses to know is that the IRS usually takes these businesses into consideration and that they are most likely to be selected for an audit. However, keep in mind that not all businesses that gain large amounts of profit get to be selected for an audit, it's just that there is a higher risk for them. There are individuals and businesses like that who are never selected for an audit. 2. Loss of money and irregular income Similarly, the IRS will pay closer attention to those organizations that are reportedly losing a lot of money. The reason for this is simple – the IRS is interested in the correct reporting, and if your business is losing a lot of money but still exists, it might suspect you are earning more money than you are reporting. This doesn't always happen with well - established businesses that suddenly started losing money – most commonly, if the IRS considers your business a hobby, they might review your taxes. Photography, arts, crafts and other activities that typically don't earn profits regularly will probably be under scrutiny. Businesses who earn small amounts of money but on a regular basis are the least likely to be selected for an audit. 3. Place of residence Some reports say the place where you live has something to do with why the IRS can select you for an audit. Since the IRS doesn't release information on audit rates by state and doesn't reveal the reasons why in some states audits happen more frequently than others, no real information can be given about a potential pattern. Nevertheless, it does help to know where the audits occur more. In 2000, individuals and businesses in Southern California were five times more likely to be selected for audits than, for example, individuals and businesses in Georgia. States with highest audit rate are also Nevada, Alaska, and Colorado. However, businesses and individuals that were not audited frequently were the ones living in Illinois, Indiana, Maryland, Massachusetts, Michigan, Ohio, West Virginia, Pennsylvania, and Iowa. 4. Type of business The type of business you run is also a factor that the IRS takes into consideration. For example, sole proprietors are more likely to be selected for an audit than partnerships, as well as large corporations. Partnerships and small C corporations are the least likely candidates for an audit selection. The IRS doesn't always target private businesses since those are not the only ones who have to pay taxes. Reportedly, the IRS is likely to consider lawyers, dentists, doctors and salespeople for an audit selection. Also, the IRS likes to target people which use any kind of tax shelter or who have offshore bank accounts. Also, any kinds of extra payments are carefully monitored by the IRS. If you have a client that paid extra for your services, those must be reported to the IRS via For 1099. The IRS is extra keen on scrutinizing these kinds of activities, and if they note any discrepancies, the business owner is extremely likely to be selected for an audit. Conclusion of an audit If, however, you get to be selected for an audit, it doesn't automatically mean a prison sentence. There are three ways in which an audit can be concluded in. When you submit all information and documentation that's requested, the IRS may recognize that there wasn't any problem that needed to be solved. In other cases, when the problem is detected and the IRS proposes changes, you may agree and comply in order to realize those changes. The third way which an audit can be concluded in is if you disagree with the changes proposed by the IRS. In cases in which you agree with the changes that the IRS proposes, then you will have to sign a document which will allow the IRS to further examine the audit findings. For owing money, separate documents need to be filed, which are available on the Internet. When you disagree with the audit findings, you have the right to a consultation with an IRS manager, and you can also file an appeal. How to avoid problems There are several things that you can do to make sure you don't have troubles with the IRS. Since being selected for an audit is a means of which you can come under the IRS's radar as a potential problem, the solutions that are about to be selected can also be regarded as advice on how to avoid being selected for an audit. 1. Be professional and don't file early If you don't want to be suspected by the IRS, your e-mail by which you would have to submit your report has to look professional. There are numerous instructions on the Internet that show how to write a professional e-mail, so it's well advised to look over them. Don't speculate on numbers, as this will look suspicious. Instead, be thorough and exact in order to avoid problems. Don't hesitate to ask for help if you feel you are unable to achieve this alone, because the extra effort will pay off in terms of IRS leaving you alone. If you do your own taxes, there are computer programs that will help you do just that. You will come across as more professional if you don't list general expenses and give out vague categories. Being specific is what the IRS wants, because that looks more honest. If you think that the IRS will ask for an explanation for certain items on your report, beat them to it; the more questions the IRS feels it has to ask, the more likely it is it will consider you to be selected for an audit. The other important thing has to do with tax deductions – check what is deductible and what's not. If you try to report an item that's not deductible, the IRS will suspect you. Also, large amounts of deductions will potentially increase your chances to be audited. What's large and what's is not easy do determine, since it all depends on the nature and the size of your business, but it shouldn't be that hard to find out the statistics and compare it with your own numbers. Again, if help is needed in this area, don't hesitate to seek it, because avoiding an audit is worth it. Also, don't file your taxes early. This will give the IRS more time to consider you as a candidate for an audit. If you file early, the IRS might think you are trying to evade something and that you are not paying too much attention to your report, which will make you suspicious. 2. Report everything That's obviously the most important thing. Trying to evade something will not go well with the IRS, and even a successful income tax evasion only lasts so long. The IRS will figure things out eventually, and when it does, that information will only get you into trouble. As it's already been said, sole proprietors are more likely to be spotted by the IRS and to be viewed as more suspicious. In fact, the IRS is convinced that sole proprietors don't report all of their income, so it's important to prove it wrong. 3. Partner up This is a tricky advice since it might look like being a sole proprietorship is a bad thing when it comes to the IRS. Although it considers sole proprietors high risk when it comes to tax evasion, this isn't always the case. If you follow the above - noted instructions, if you are thorough, honest, if you don't rush with filing a report and if you offer an explanation when you think it's needed you won't become an IRS target immediately, just because you are a sole proprietor. This advice is for people who are already considering partnering up because the fact that IRS is less suspicious of partnerships will only serve as an additional reason to partner up. Moreover, when it comes to the U.S., in some states partnerships and LLC's are obliged to pay additional taxes. So this advice has to be examined with a great care before it's taken. However, certain things have to be taken into consideration, just to have all your information – in 2006, 3,78% of sole proprietors that were earning less than $250,000 were audited. There is no rule that says you have to be a sole proprietor forever, and taxes are not a mundaine reason why people change the type of business they are running. So if you think that this is a sufficient enough reason to stop being a sole proprietor, form a partnership with someone. After all, only 0,40 % of partherships were selected for an audit the same year 3,78 % of sole proprietors were selected, so it's good to keep this information in mind too before making any decisions. Conclusion Taxes are a hassle for everyone, despite the fact that most of the federal and state services that we enjoy are funded by them, including education, healthcare, infrastructure development and social security initiatives. However, despite the hassle of paying your taxes, the good use that the money is put to makes it worthwhile in the end. Besides, there is no point in fighting it – taxes are here to stay, and turning them into your advantage is something that should be in everyone’s interest. Filing the proper tax returns is one of the most important things you can do as a business owner. However, one of the only ways you will be able to do this is if you can keep accurate records all year round. Keeping accurate records also makes good business sense, as you will be able to keep track on your business’ successes and failures, and be able to see the impact of your expenditure, or lack thereof, on your future income. Regardless of whether this is your first business, or you have been in business for years, as a small business owner, you need to protect your business so that you can see it grow. One of the best ways to do this is to ensure that you have properly prepared your taxes.