TO DO TAX PLANNING

TAKE ALL THE LEGITIMATE

BUSINESS EXPENSES YOU CAN

Some might say that the list of potential business expenses is limited only to what the mind can perceive. That would be a big stretch.   Believe it or not, the IRS knows your business better than you do.  That is to say, they know what expenses are ordinary and acceptable for your type of business.  After all, they have audited millions of businesses over the years.  So, when it comes to deciding what business expenses you can legitimately take, why not start with IRS publications and other documents to find out what the IRS will allow.  You may even find some expenses you never thought of taking. 

To be deductable, expenses must be “ordinary” and “necessary.”  That is, to be deductable, the expense must be normal, usual and customary for the type of business you are in (that’s the ordinary part) and it must be necessary for your specific business. 

I have created a generic list for you to use as you prepare to do your taxes.  Use this as a checklist to make sure you have not forgotten anything.  I will be updating the list from time to time to insure it is as complete as possible although I’m not trying to cover every niche business.  I’m sure there are some unique expense items that I haven’t even thought of, but this list will be a good starting point for all of you to review to ensure you don’t miss any of the big ticket items.  If any of you want to add to the list, send me an e-mail and I’ll be glad to do so. 

Sometimes, depending on your business entity, expenses are handled differently, that is to say, they might do on a different part of your return.  Feel free to contact me if you have any questions. 

Let me start by giving you links to some IRS publications that you might find useful:

1. Pub 538 – Accounting Periods and Methods – http://www.irs.gov/pub/irs-pdf/p538.pdf
2. Pub 535 – Business Expenses – http://www.irs.gov/pub/irs-pdf/p535.pdf
3. Pub 587 – Business Use of Your Home – http://www.irs.gov/pub/irs-pdf/p587.pdf
4. Pub 463 – Travel, Entertainment, Gift and Car Expenses – http://www.irs.gov/pub/irs-pdf/p463.pdf
5. Pub 334 – Tax Guide for Small Businesses – http://www.irs.gov/pub/irs-pdf/p334.pdf
6. Pub 583 – Starting a Business & Keeping Records – http://www.irs.gov/pub/irs-pdf/p583.pdf

So here’s the list: 

 Cost of Goods Sold (generally for those who make or build something)

            Cost of products or raw materials

            Storage

            Direct labor – labor involved in manufacturing the product

            Factory overhead – the costs of running the factory

            Capitalization of direct costs for certain production activities

            Inventory

            Freight in

Dump fees

Employees pay including certain fringe benefits

Owner’s salary – only if the business entity is a corporation or subchapter S corporation.

Owner’s draws, per se, are not a deductible expense

Independent Contractor fees

Consultant fees

Advertising

Commissions and fees

Generally, penalties are not deductible

Professional services

            Bookkeeping

            Accounting

            Tax preparation

            Legal

            Professional photographer

            Web designer

Partnership guaranteed payments (only in partnership returns)

Rent

Taxes on leased property

Cost of getting a lease

Improvements by lessee (generally amortized)

Equipment rental

Interest

            Mortgage interest (for business real estate)

            Vehicle loan interest (business vehicles; to extent used in the business)

            Capitalization of interest

            Prepaid interest

            Credit line and business loan interest

Taxes & licenses

            Real estate taxes (business assets)

            Employment taxes

            Other business related taxes

            Business licenses

            Building permits and fees

Insurance

            Business insurance (for example, E&O insurance)

            Auto insurance (prorated for business use)

            Self employed health insurance                                 

Capitalized expenses (amortizing or depreciating them over a proscribed period of time)

            Business start-up costs

            Business organizational costs

            Business assets

            Improvements

                        Capital vs. Deductible expenses

Amortization

            Intangibles such as Goodwill

Business bad debts are handled differently depending on the accounting method you use

             Cash basis – not deductible – income is not recognized until money received

            Accrual basis – deductible because income recognized when earned

Repairs (vs. capital improvements) and maintenance

Repairs keep the property in good working condition without materially adding to the properties’ value.  Examples include painting, fixing a leak, replacing broken items, etc. 

Personal vs. business expenses – be very careful not to intermingle the two.

Personal expenses are never deductable as business expenses, although many people try

Charitable expenses

With the exception of a C Corporation, charitable expenses will carry to your Schedule A.

Depreciation

            MACRS

            ADS

            Assets to be depreciated

                        Software

                        Office equipment

                        Furniture

                        Automobile

                        Manufacturing equipment

                        Buildings

                        Capital improvements

Bonus depreciation – only used when allowed by IRS

Section 179 depreciation

            Allows full amount to be taken in current year – subject to limits

Depletion

Pension & profit sharing plans – treatment depends on business entity

            SEP

            IRA

            401K

            SIMPLE

Employee benefit programs – treatment depends on business entity

            Insurance

            Health and welfare programs

Reimbursable business expenses through a formal reimbursement plan

Domestic production activities credit

Business credits – there are many types of business credits

Travel (must be for a business purpose)

            Airline tickets

            Rental car       

            Hotel/motel

            Taxi

Meals and Entertainment (generally limited to 50% of actual expenses)

            Travel

            Entertaining customers or meeting with colleagues

Office in home (OIH) expense

Business must be profitable before you can take OIH expenses in current year

Special rules apply See my blog http://www.professionaltaxservicesinc.net/2009/08/office-home-expense/

Automobile and truck expenses

            Mileage vs. actual (allowable expenses to maintain and operate vehicle)

                        Actual almost always exceed mileage but you must keep good records

                        You must keep written records either way

            Auto loan interest

            Leasing expenses

Parking fees and tolls 

Miscellaneous Expenses         

Bank charges

Business start-up expenses (if under $5000 and not amortized)

Business Bond

Consulting fees

Credit and collection costs

Credit card processing fees

Damages

Delivery (Freight out)

Discounts

Documents

Dues and subscriptions

Dump fees

Exposition (show) fees and expenses

Equipment rental

Federal (FUTA) and State (SUTA) unemployment taxes

Ferry fees

Gifts

Limited to $25 per client or customer

Internet fees

Janitorial

Labor & Industry taxes

Laundry & dry cleaning

            Only for specialized clothing

Maintenance

Marketing

Meeting expenses

Miscellaneous

Office expenses

Organizational expenses (if not amortized)

Pay pal fees

PO Box

Postage and delivery

Printing

Professional memberships (special rules apply)

Professional education (Continuing professional education)

Professional supplies and publications

Real estate agent fees

Sales & promotion expenses

Security

Small tools & equipment

Staging costs

Storage

Supplies

Surety bond

Telephone

            Cell phone

            Second phone in home for business

            Fax line

Training & professional education

Utilities

Waste disposal

Web hosting

Website costs

Work clothing (special rules apply)

So Far, So Good!

Have you heard the one about a man who jumped out off the 20^th floor of a building?  As he was falling past the 10^th floor, someone yelled out to him, “How’s it going?”  He replied “so far, so good.”

A few days ago I just had a conversation with a new client.  By the way, I’m an Enrolled Agent, which means I am a tax professional and, in addition to doing taxes and consulting, I represent taxpayers who are in trouble with the IRS.  When the owner told me about her company, I’ll call it XYZ, all I could say is wow, what a great idea for a business.  The money was flowing in and customers were waiting in line for their highly specialized services.  How in the world could a company only a few years old be in so much trouble with the IRS?

It’s a sad story, but one I hear all too often.  The business is a Sole Proprietorship (a subject of another article).  The money is flowing in but on a sporadic basis.  XYZ has a couple of employees and takes draws out for the husband and wife owners’ personal expenses every month.  After all, it’s their hard earned money, right?  And they have to live, don’t they?  One thing XYZ did right was to hire a bookkeeping company to help them with their payroll reporting.   At this point, it’s still “so far, so good.” 

Let me tell you the rest of the story.  Quarterly, the bookkeeping company prepared and sent the payroll forms to XYZ, told them where to sign, how much and how to pay.  Trouble is, after paying wages and draws for the owners and other expenses of the business, there wasn’t enough money left over to pay the payroll taxes.  So, instead of paying withholding taxes in full, XYZ paid a very small portion of what was owed.  They were sure they could catch up next month or next quarter.  This became the modus operandi each quarter.  To compound the problem, since they could not pay what they owed, they incorrectly believed they should not file the quarterly Federal Payroll Tax returns, Form 941, until they could.  Also, because they did not have any money in the bank, they did not pay any estimated taxes to the IRS, in anticipation of the taxes they would eventually owe on their profit in XYZ.

Believe it or not, still a perception of “so far, so good”, or so it seemed to XYZ.  Since the IRS had not received the 941 Forms, the IRS did not know that the company owed payroll taxes and, therefore, did not take any action against XYZ.  In addition, since the income tax return for the year did not have to be filed until April of the following year, the IRS had no idea how well XYZ was doing, so, in the eyes of the IRS, there were no estimated taxes due. 

Fast forward to first quarter of the next year; tax season.  The bookkeeping company prepared the W-2/W-3, 941 and 940 in January.  The IRS received the W-2/W-3s and 940, but once again, the 941 was not sent in. 

Still with a feeling of “so far, so good” the owners of XYZ took their records to a tax professional to have their personal tax return prepared.  When the tax professional asked to see the Payroll Tax returns, he was told that they had not been filed.  They were advised to file immediately, even though they didn’t have the money to pay, and did so.

The owners of XYZ soon learned that they owed the IRS approximately 35% of their net profit in XYZ.  XYZ had a net income of over $250,000, which meant a tax bill of approximately $87,500.  The social security and Medicare portion of those taxes for the two owners amounted to over $38,000 alone. 

Oh, and did I mention that the payroll taxes had not been paid? 

Still so far, so good?  Not!  When the IRS received the W-2/W-3 and the newly filed Forms 941, it became aware of the unpaid payroll taxes which immediately activated the Automated Collection System (ACS) process.  Threatening IRS letters soon started arriving in the mail.  When you have employees, and withhold social security, Medicare and federal taxes from their wages, this is no longer money that belongs to your business, it is what the IRS terms “Trust Fund” money.  It needs to be set aside and paid to the IRS on time.  XYZ’s salaries to the two employees totaled $200,000.  Withholding from the employees’ wages amounted to over $35,000 for the year.  In addition, the company must match Medicare and social security which is another $15,300.  

With penalties and interest, at the time of the initial IRS collection activity, the company owed the IRS over $45,000 in Trust Fund money and the amount was going up each day.  XYZ also owed another $15,300 in matching social security and Medicare.  And remember the $87,500 the owners personally owe on the net profit of XYZ.  Wow, that’s taxes totaling $147,800 and going up!  And, surprise, surprise, XYZ did not have enough money in the bank to pay the taxes.  Using my analogy, XYZ has hit the ground.  And by the way, there is another penalty the IRS could assess, called the Trust Fund penalty.  It doubles the amount of Trust Fund liability.  Fortunately for XYZ, that has not been applied. 

I know that was a long story, but I wanted to make a point.  You can’t ignore the IRS.  Sooner or later it will catch up with you.  Ignorance of the tax code is not an excuse.  So, what should you do to avoid these mistakes?

1. If you hire employees, I highly recommend you hire a bookkeeper or professional payroll company to help you with state and federal forms. Follow their instructions to the letter.
2. If you decide to do it on your own get advice from a professional before you start.
3. Set aside money for taxes each time you earn income in your business.  I recommend you have a separate account and that you sweep a percentage of your income into that account.  Depending on your business entity and your personal situation, 30-35% might be a good starting point.  Your tax professional can help you do some tax planning.  It’s better to over-estimate rather than under.
4. Always file state and IRS tax and other returns on time.  Even if you can’t afford to pay everything you owe, file the return to avoid a late filing penalty.
5. Pay what you owe, on time if you can.  If you can’t afford to pay on time, go on an IRS installment plan, or better yet, borrow the money and pay off the IRS. 
6. When you are self-employed you will owe taxes on the net profit of the business.   Those taxes include social security, Medicare, federal income taxes and state taxes, depending on where you live.  You must plan ahead and forecast what you owe and make estimated payments to the IRS or be penalized for not doing so. 

Now for those of you contemplating jumping out of the 20^th floor, the economy is not that bad.  However, if you want to avoid the mistakes make by XYZ Company, one of the best ways to protect yourself is to set up an advisory team for your company, or a Board of advisors.  A good tax professional can help you avoid these kinds of mistakes.  Remember, you get what you pay for, so be prepared to pay him/her on an hourly basis if you don’t engage him to do your taxes and tax planning.

First some definitions from the IRS:  In order to claim a deduction for OIH, the part of the home used for the business must be used “exclusively” and “regularly” as your principle place of business.

• “Exclusive use” means a specific area of the home is used only for the business.  To pass this test, you cannot do any personal business in that space.  For example, having a TV in the room might disqualify it, unless the TV is required for the business. 
• “Regular use” means the area is used regularly for the business.  Incidental or occasional use is not regular use. 
• If you have more than one location for your business, your home can still qualify as an OIH if it is the “Principle Place of Business.”  Your OIH will qualify as the principle place of business if:
  • You use is exclusively and regularly for administrative and management activities of the business, and
  • You have no other location where these significant administrative and management activities can take place.

To summarize, you must set aside the space for the business and only use it for the business.  Non-business profit seeking endeavors such as investment activities do not qualify for an OIH, nor do not-for-profit activities such as hobbies.  If you carry on any personal activities in the area, you are not allowed the OIH deduction.

So let’s discuss how you compute the amount of Home Office Deduction you can take:  Generally, the amount of the deduction depends on the percentage of the home that is used for business.

A taxpayer can use any reasonable method to compute business percentage, but the most common methods are to:

• Divide the area of the home used for business by the total area of the home, or
• Divide the number of rooms used for business by the total number of rooms in the home if all rooms in the home are about the same size.

Taxpayers may not deduct expenses for any portion of the year during which there was no business use of the home.

Example:  Your home is 1800 square feet and your home office uses one room which is 120 square feet.  Your business use of home is 6.7%

You may deduct expenses that are directly and indirectly related to your office.  Expenses that are directly related to the office, for example, painting or re-carpeting the office are deductible in full.  Other, indirect expenses are deductible based on the percentage use of the home.  Examples of these kinds of expenses are rent, insurance, utilities, general repairs and security systems. 

Example:  Let’s say your rent is $1,200 per month, $14,400 per year.  The deduction for OIH would be $14,400 X 6.7% or $964.80. 

Some expenses are not deductible at all.  For example, lawn services would not be deductible unless you meet clients at your home office.  Painting another room in the house would not be deductible.

For those of you business owners who own your home, the same business use percentage is applied to your real estate taxes and mortgage interest; however, these are also deductible on Schedule A, Itemized Deductions.  So, they would be deductible regardless.

Finally, you can take a depreciation deduction for the business use of a home you own.  You cannot take depreciation if you rent.  Depreciation is an allowance for “wear and tear” for the part of the home used in the business. 

Caution:  When you do depreciate your home, and later sell it, you must pay tax on the amount of depreciation you took.  This portion of profit you make on the sale is recaptured as ordinary income, even though the home might otherwise qualify for the home sale exclusion. 

Other than real estate taxes and mortgage interest if you own your home, OIH can only be taken to the extent you have a profit in your business.  In other words, the OIH deduction cannot cause a loss in your business.

One last point; when you are self employed and take the OIH deduction, your home becomes your base and all mileage to and from business meetings becomes deductible.  Of course, you must document that mileage.  I’ll talk about that in another blog post.

 Federal taxes: income and self employment taxes

          Impact on personal income tax.  When you own and operate your own business, in almost all cases [the exception is a C Corporation], the income or (loss) from the business passes through to your individual income tax return (Form 1040).  Business income increases the total taxable income on your individual income tax return while, in most cases, a loss will offset other income, or, if the loss exceeds your income for the year, it can create a Net Operating Loss which can then be carried back or held for future years and used to offset income in those years.

Assuming your business is making a profit (that’s everyone’s objective, right), I highly recommend you do some tax planning and determine your estimated taxes you need to pay the IRS throughout the year.  The IRS expects you to pay taxes as you earn the income.  This is done either through withholding taxes or by paying estimated taxes.  If you don’t pay as you earn and end up owing money when you file, the IRS will penalize you.

For those of you still working for someone else, you are paid a salary or wages and receive a W-2 at the end of the year.  Through that process, you have Social Security, Medicare and income taxes withheld from your pay each pay period.  The company matches the amount of social security and Medicare withheld from your wages.  Combining what is withheld from your paycheck with the company matching, the total amount paid to the IRS is 15.3% of your taxable wages [there is a threshold on Social Security taxes that changes each year].  If, when you are working for someone else, you have had enough income taxes withheld then you will owe no additional taxes when you file your tax return.

          Impact of being self-employed:  As a self-employed business person, you have just become the employee and the employer for the purposes of paying your payroll (self-employment) taxes.  Even though, in most cases, you do not pay yourself wages or issue a W-2, you still must pay the same Social Security, Medicare and income taxes you would if you were working for someone else.  These taxes for the self-employed are called Self Employment Taxes, surprise, surprise.  As a self employed business person you must pay both halves of Social Security and Medicare taxes; the full 15.3% on the net income of the business.  That is paid when you file your individual income tax return, Form 1040, and is in addition to whatever income taxes you owe. 

So, for your tax planning, you must take into consideration what your total income tax will be for the year, based on your projected business income and other income you receive, minus the various deductions you are allowed.  As a self employed business owner, there is a new deduction you can take; ½ of the Social Security and Medicare taxes you pay can be taken as an above the line deduction in the Adjustments portion of your Form 1040.  To your income taxes you project you will owe, you need to add Social Security and Medicare (that 15.3% I just talked about) to determine your total tax liability.  Assuming your income is earned evenly during the year and also assuming you are not having taxes withheld by an employer, you will divide your tax liability by 4 and pay estimated taxes each quarter.  Estimated taxes are due April 15^th, June 15^th, Sept 15^th and Jan 15^th of the following year.  You will use Form 1040-ES to pay your estimated taxes.

If you are working for someone else while you start your business, not a bad idea, by the way, you need to account for the income taxes withheld from your salary or wages to determine what you should be paying in estimated taxes. 

I highly recommend you set up a second business bank account, or use the savings account portion of the account you already have open to set aside money for tax payments.  Your tax planning will tell you what percentage of your business income should be set aside for income and self-employment taxes.  Do not take the money out of the account until all taxes are paid.  Remember, you will not know the full impact of taxes until you file your annual tax returns in the following year. 

In a future blog I will discuss payroll taxes when you have employees.

                        I love doing what everyone else hates to do