• Sole Proprietorship:  This is a business you operate yourself, in your own name or a trade name, with no partners or formal business entity.  You remain personally liable for business debts.  You report income and expenses on your personal tax return by filing a Schedule C.  You pay self-employment taxes (Medicare and social security) on your net profits.  Self employment taxes are 15.3% of your net income, in addition to regular income tax you pay.  Because of the higher taxes and total personal liability, a sole proprietorship is not the best choice for most businesses.

• Partnership:  This is an association of two or more partners.  General partners (GP’s) run the business and remain liable for partnership debts.  Limited partners (LP’s) invest capital, but don’t actively manage or participate in the business and are not liable for business debts.  The Partnership files an informational return (Form 1065) with the IRS and passes income and expenses through to each partner, via Form K-1, which is generated on the partnership tax return.  GP distributions are taxed as self employment income (the 15.3% mentioned above).  LP distributions are not subject to self employment taxes and are taxed as passive income. 

• “C” Corporation:  This is a separate legal entity organized under WA State law.  Your liability for business debt is generally limited to your investment in the corporation.  The Corporation files its own tax return (Form 1120), pays profits on its income at corporate tax rates.  If any of the profits are distributed to the shareholders (owners) they are also taxed as dividends at a 15% tax rate.  This double taxation makes a “C” Corporation a bad choice. 

• Limited Liability Company (LLC):  This is an association of one or more “members” organized under state law.  Your liability for business debts is limited to your investment in the company, and LLC’s offer the strongest asset protection of any entity.  Single-member LLC’s are taxed as sole proprietors, unless they elect to be treated as a corporation.  Multi-member LLC’s can choose to be taxed as a partnership or a corporation.  As an active member of the LLC, net income would be subject to self employment taxes of 15.3% as previously mentioned.   

• Subchapter “S” Corporation:  This is a corporation, formed under state law that makes an election with the IRS to be treated as a partnership and not pay taxes itself.  Instead, it files an informational tax return (Form 1120S) and passes all income and losses through to shareholders on Schedule K-1, generated on the Form 1120S.  Subchapter S owner employees must pay themselves a “reasonable” salary.  That salary is subject to the 15.3% self employment tax.  Any additional pass-through profits are not subject to self employment taxes.  This type of business entity is best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations.  In addition, there is an immediate tax savings, over other business entities, because most Subchapter S business owners pay themselves a salary of 40-60% of the business income.   The definition of a “reasonable salary” is subjective.  The IRS has not issued specific guidance on this subject. 

As you can see, there are several types of business entities to choose from.  The right choice depends on a number of factors and each business owner must carefully look at each before deciding on the right one.

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.