Since our income tax system in the U.S. is a voluntary one, the IRS wants us to believe they are watching our every move and will come knocking on your door if you make even the smallest error on your tax return.  They want the image as the Big Bad Wolf.  Does it work?  For the most part, you betcha! 

Let’s look more closely at how the IRS operates and some of the statistics to see if you have good reason to be afraid.  The IRS sends millions of letters to taxpayers every year.  Many of the letters they send out are straight forward and are administrative in nature.  They may be correcting a math error, advising that you left something off the return and giving you a chance to fix it.  Or they may be more serious, assessing a penalty if you filed late or notifying you that your tax return is being audited.  Unfortunately, they never send you a letter saying you are doing great, keep up the good work.

So, what are your chances of being audited?  Actually they are very small.  On average, a little over1% of filed tax returns get audited each year, however that number has been going up in the past decade and as you will see a little later, the odds increase depending on the type of return you file.  Several years ago an IRS research study showed that there is an underpayment of taxes of about $300B (B as in Billion) per year, known as the “Tax Gap.”  About $250B of that comes from underreporting income and/or overstating expenses. 

Congress has asked the IRS to aggressively try to close the “Tax Gap.”  One way they are doing it is by hiring more employees and conducting more audits.  Let me analyze this a little bit further.  Financially, most taxpayers lead rather uncomplicated lives.  They work for someone else, get paid by W-2, earn interest from their bank or brokerage, buy and sell a few stocks, put some money in a 401K or similar plan, pay their mortgage or are retired drawing a pension and social security.  Virtually everything financially in their lives is reported to the individual and to the IRS on one form or another.  For this large segment of taxpayers, it is a simple matter for the IRS to know who has filed and accurately reported their income and deductions.  In many cases, if a taxpayer does not file a return, the IRS will file a substitute tax return for the taxpayer.  This will only occur only if they taxpayer owes money.  If the taxpayer is due a refund, the taxpayer will probably never hear from the IRS.  Why?  By law, after three years the IRS no longer has to refund the money. 

So, how does the IRS know who to audit?  The IRS scores every tax return filed; known as the DIF score.  Through research, the IRS knows what types and how much a taxpayer should be taking in deductions based on his/her Adjusted Gross Income.  If the computer review of the tax return finds some of the numbers outside the norm, it assigns a higher DIF score to the return.  The higher the DIF score the more likely the return will be audited. 

I’ll give you one guess where the majority of the $250B shortfall comes from.  It comes from small businesses and self employed folks; that’s you and me.  Research and IRS experience from past audits have shown that there is a significant underreporting of income as well as overstating of expenses on many business returns.  This is especially the case with sole proprietorships and single member LLC’s that report their business income on Schedule C on their 1040 return.

As a self employed taxpayer, you are about 10 times more likely to have your Schedule C audited than you would be if you filed a Form 1065 (partnership or LLC return) or 1120/1120S (corporation or subchapter S return).    Based on years of audits the IRS knows that those small businesses who file on Schedule C probably don’t keep sufficient records and frequently can’t prove the income and expenses claimed.  On the other hand, small businesses who file Form 1065, 1120 or 1120S generally keep better records and frequently use a bookkeeper or accountant and a tax professional.   As a result, the IRS knows that the “low hanging fruit”, so to speak, is in Schedule C businesses.  So take the hint.  For those of you who are filing on Schedule C, you might want to consider another type of business entity. 

The IRS uses education of the public and audits to keep people in compliance.  Lately the IRS has been putting most of its emphasis on audits and is expanding its audit force.  Audits are the subject of another article, but, briefly, there are three types of audits,   Correspondence, Office and Field, with a Field audit being the most comprehensive one.  The IRS makes sure it gets a lot of publicity on its high profile audits and criminal actions. 

So, how do you protect yourself from the Big Bad Wolf? 

• First of all, keep excellent records.  If you are not good at recordkeeping, hire a bookkeeper or accountant to help you or at least be on your team of advisors.  See:  (http://biznik.com/articles/ive-got-your-six).  Use a software program like QuickBooks to track income and expenses so you can create financial statements.  This will not only help you at tax time, it will help you immensely if you are audited.  These reports are also essential to understanding and managing your business.
• Keep your personal and business finances separate.  Always!  Have separate bank accounts and credit cards for the business and for you personally.  By the way, if you are one of those people who does not believe cash is money (in other words, not reportable to the IRS as income), the IRS has ways to determine when you are not reporting income.  In a Field audit, they always do this analysis and sometimes in an Office audit as well. 
• Have documentation to back up expenses you claim.  Cancelled checks are not considered adequate proof, although they are better than nothing; it’s always best to have a receipt for each item you claim.
• Keep good automobile records if you use your car for your business.  I know it’s a pain, but keep a log in your car and annotate every business trip you take with the miles you drive and the reason for the trip.  This only takes a minute or two and it is well worth the effort.  If you are seeing a client, note who that client is.  If you are constantly going to the same place, for example you are in construction, you can use Map Quest to determine the mileage, but you still need to keep a log of the number of trips to that location.
• File your tax return(s) on time.  On time includes an extension if you file for it.  Remember, the extension is to file your return, not to pay what you owe.  If you owe money, the IRS expects it all to be paid no later than April 15th. 
• Lastly, if you get that dreaded letter from the IRS, open it immediately!  Not dealing with it quickly will only lead to more trouble later.  IRS letters can be long and difficult to understand.  If you used a tax professional to do your tax return, contact him/her immediately for their help.   If you did not use a tax professional and the issue seems serious, contact an Enrolled Agent (http://www.professionaltaxservicesinc.net/enrolled-agent/) or CPA who has experience dealing with the IRS.  I would not recommend contacting a tax lawyer unless you suspect the IRS is after you for fraud or you are under criminal investigation.  If agents show up at your door with a badge, it’s usually very serious.  That is when a tax lawyer should be consulted. 

Should you be afraid of the Big Bad Wolf?  Absolutely not!  If you follow the simple guidelines I laid out above, you really should have nothing to worry about.  That doesn’t mean you won’t get an IRS letter or be audited, but if you are you will be prepared.  Adding a tax professional to your team of advisors will give you extra peace of mind as well.

So, why in the world would I be talking about flying in combat in a multi-aircraft formation when I should be talking about business? Whether you know it or not, as a business person you are in a type of combat, because you are in stiff competition with others, everyone competing for the same customers and dollars. A recent article in the Wall Street Journal, “With Lobster Prices Low, Things Get Ugly in Maine,” by Simmi Aujla, points out the hazards of competition. Lobster prices are so low the fishermen are actually fighting one another. This is certainly an extreme situation, but we in small business are fighting for our survival, against our competition while dealing with a myriad of other factors. For example, we fight on a daily basis to keep up with local, state and federal regulations. So why are you going it alone? Just like fighters going off to combat, you need to arm yourself with a team of advisors. A good team of advisors can be “checking your six”, so to speak, and keeping you and your business out of trouble.

How do you go about forming a team of advisors and how should you use them? Each business and business owner is unique. The first thing you should do is assess your strengths and weaknesses and in any area you rate yourself as weak or even average, I would consider having an advisor.

What kind of advisor should you look for? You should look for a professional who has experience in small business and is at least familiar with your business.

I assume you are an expert at what you do or you would not be in your business. But perhaps you have decided to branch off into a new field. In that case I would definitely find someone, in the same field, who is not a direct competitor, to use as a resource. Pick that person’s brain to find out as much as you can about your business.

If you are strong in recordkeeping and enjoy doing it, that’s great. If not, bring a bookkeeper on board to do your bookkeeping for you, review your books periodically or, if not that, at least be available to give you advice how your books should be set up and kept. Good bookkeeping is critical to a successful business. Why would you want to cut yourself short here?

The same thing goes for taxes. Perhaps you have been operating your business long enough to know what you need to file and how to plan for your taxes, but if this is an area of weakness, bring a tax professional on your team to be there when you have a question. A tax professional experienced in small business can provide invaluable advice. For example, are you in the right business entity? Are you doing proper tax planning? Are you taking all the deductions you can legally take and does the business entity you have chosen help to minimize your taxes? You may be surprised what you learn.

If you are in a business that requires capital, get to know a banker or other source of capital. Even if your business does not require a lot of capital, you need to make sure you have a line of credit, a credit card or some other source of money to get you through the low income, high expense periods.

What about your E&O or similar insurance. Do you have someone you can call to give you straight forward advice and who will shop around for the best price for you?

The same thing could be said for: Marketing, legal, website development, retirement plans and other benefits for you and your employees.

Speaking of employees, that brings up one final consideration. Dealing with payroll is complicated and can get you in a lot of trouble with both the state and IRS if not done properly. (see my article, “So Far, So Good” http://biznik.com/articles/so-far-so-good ) Don’t be afraid of payroll. My advice, hire a professional to do your payroll for you or at least to get you set up properly. This could be your bookkeeper or a professional payroll service. If you do it yourself, make sure you know what you are doing and/or follow the advice of the advisor to the letter. Remember, if you are a Subchapter S Corporation, you are an employee of the Corporation and must pay yourself a reasonable salary, assuming you are making a profit in the business.

I could go on and on, but I think you get the picture.

Take a few minutes and do a self assessment. Try to think of everything you need to do to make your business successful, including the not-so-fun stuff like bookkeeping and taxes. Look at your list to see where you have rated yourself as weak or average, then try to think of someone you could call on as a resource in that area. Perhaps it’s a friend, perhaps an acquaintance or someone you have met through Biznik.

You will use some of your advisors more frequently than others. In those areas where you know you need help and will need frequent advice and assistance, consider an arrangement where you negotiate with the professional to pay an hourly rate, an annual amount for continuous advice, or hire that person to do everything and get their advice with it. For example, if you hire me to do your taxes, you get my advice free for the year. If you don’t want me to do your taxes, you could hire me for an annual fee or pay me by the hour. There are lots of choices. Remember, you get what you pay for, so if you want advice from an expert, expect to pay for it.

Depending on your business, you could also have your team of advisors set up so that you can refer a client to them if he/she needs that type of professional advice or service. It’s great when a group of professionals refers clients to one another. Clients who trust you will tend to take your referral.

Fly safe, your team of advisors has your six!

 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