Tax Talk Issues for Small Business Owners
IT’S TAX TIME . . . THAT TIME OF YEAR WHEN MANY CONTRACTORS look at their tax bills and wonder if they could have done anything differently. The smart ones do more than wonder. They seek professional advice.
For many green industry entrepreneurs, the first few years in business are an exciting and memorable time. When things go right and business keeps coming, it’s hard to think of anything besides doing more of the same. But no matter what size business you have, taking time for serious tax planning is always a good investment.
Ironically, even the most cost-conscious business owners often overlook tax planning, according to Judith E. Dacey, a nationally recognized small business consultant and CPA with J. D. Sumter & Associates, Inc., Summerfield, Florida. “Business owners are usually well aware of the need to keep expenses down,” she says. “They often try to cut costs with vendors, for example, but they forget about Uncle Sam, the silent partner, who’s always there taking his piece.”
She recommends a new attitude. “If you really want to cut expenses, think of Uncle Sam as one of your vendors. Of course you have to pay him, but you don’t have to give him more than his share.”
What’s the best way to trim your taxes? If you ask successful contractors, most will say that finding a trusted accountant was one of the smartest things they ever did. They know that leaning on professional consultants, like tax and legal advisors, is a way to expand their team without adding staff. Good CPAs can be loyal partners in your business efforts. Their role is to use their expertise to help you meet your goals.
Separating myth from fact is one part of that role. “People tell you about this tax break and that tax break, but there’s a lot of misinformation out there,” says Barbara C. Kogen, CPA, J.D. Kogen is a partner with NSBN, LLP, a top Los Angeles-area CPA and business consulting firm. “You need someone to give you accurate advice,” she says. “Saying, ‘My friend who knows an accountant told me to do this,’ isn’t going to hold up if you get audited.” Dacey says tight budgets may tempt some small business owners to go it alone on taxes. “Some say, ‘Why should I pay to have my taxes done when I can do it myself?’ The answer is the same one you give to your landscaping clients. Can homeowners do their own landscaping? Yes. Can you do it better? Yes.”
Using a trusted advisor to cut through tax confusion means you can spend more of your time doing what you do best.
One area of confusion for many small businesses continues to center around home offices. If you work at home and don’t write off your home office expenses, you’ve probably heard mixed advice. It usually ranges from “That deduction will save you big money,” to “Don’t bother; it’s a big red flag to the IRS.”
Neither statement is entirely true. Will it save big money? The answer is yes for some, no for others. Does it trigger an audit? There is some debate about this, but most agree that fear of an audit shouldn’t prevent you from taking this deduction if you qualify and it can save you money.
To qualify, your office must meet strict criteria. In brief, you must use the office: 1) exclusively and regularly and 2) as your principal place of business. (Details and exceptions are found in IRS Publication 587, Business Use of Your Home.) If you are a full-time, self-employed contractor and use your home office to conduct your administrative activities, you probably meet the definitions for “regular use” and “principal place of business.” However, the “exclusively” part disqualifies many home offices.
“It’s very important to set aside a separate area,” says Kogen. “It can’t just be the TV room or another room used for other purposes. When you use that space for personal reasons, that’s when you get into difficulty.” That doesn’t mean you need to set aside an entire room; you can use part of a room as long as it is clearly defined. “It must be a separate identifiable space,” says Dacey. “But it doesn’t have to have a permanent partition. Setting it apart can be as simple as moving a bookcase.”
“We also advise people to take a photo of the space,” she continues. “You might move or stop using the office some day. If you’re ever audited, a photo will provide documentation.”
Allowable deductions include a percentage of home expenses like real estate taxes, mortgage interest, rent, utilities and insurance. The size of the deduction is based on the percentage of your home dedicated to your office.
The actual impact this deduction has on taxes varies greatly depending on the type of business you have, the home and mortgage you have, the size of your office in relation to your home, and other variables. For example, if your office represents a very small percentage of your home, or if your expenses are relatively low to begin with (maybe you have a small office in a small home and have paid off your mortgage), then the impact may be modest.
“The economic benefit may not be all you think it is,” says Kogen. “Many people assume that it’s always a great thing to do, but for some, the ultimate benefit may not be worth the extra hassle.” Your employment status (whether you are considered self employed or an employee of your company) also plays a role in the impact of a home office deduction. Your status may depend on the type of business you own (see below).
If you’re self employed, your deduction is reported on a Schedule C, where it reduces your business income. This impacts your income tax and the amount of self-employment tax you owe. If you are considered an employee, however (as is the case if your business is incorporated), your deduction is reported as a miscellaneous itemized deduction. As an employee, your office also has to meet additional requirements to qualify for the deduction.
A home office deduction may be a great option for you. But before you decide to kick everyone out of the TV room, it’s best to do some homework. IRS Publication 587 is a good place to start. Better yet, sit down with a professional to determine whether you qualify and what impact it will have on your taxes.
What kind of entity are you?
Another area of confusion centers around business entities. Because many tax and legal issues depend on the type of business entity you have, it’s important to understand the differences early on. The following is only a brief summary. If you haven’t yet examined this issue, be sure to consult with legal and tax advisors for details on the most beneficial structure for your enterprise.
Businesses are typically identified as proprietorships, partnerships, corporations, or limited liability companies. Many businesses start as proprietorships. (If you own the business yourself and have done nothing to establish another identity, this is what you are.) As a sole proprietor, you and your business are considered one and the same. Business income is reported on your personal tax return and business losses are deducted against other income.
The primary advantage of a proprietorship is simplicity. The major disadvantage is liability. Because you and your business are one and the same, you have unlimited personal liability for all debts of the business. (Think lawsuit or bankruptcy to imagine the implications.)
General partnerships are similar but involve two or more owners. Each general partner has unlimited personal liability for all partnership debts, including those incurred by other partners. (Again, think of the implications.) There can also be limited partnerships. In these, some members (general partners) accept more of the management and liability for a business while others (limited partners) serve as investors with no active involvement.
Unlike a proprietorship or partnership, a corporation is considered a separate entity from those who own and operate it. A major advantage of this is liability protection. Owners/operators are considered employees of the corporation and are not personally responsible for its debts. Business income is taxed to the corporation. If it is distributed as dividends, it is taxed again to the individuals who own stock.
To avoid “double taxation,” some corporations identify themselves for tax purposes as “S-corporations” (as opposed to regular corporations or “C-corporations”). An S-corporation offers the liability protection of a corporation but its owners pay taxes in the manner of a sole proprietor or partner and can deduct business losses from income.
A limited liability company (LLC) is a newer business entity that has become a popular choice for small businesses. It provides liability protection like a corporation but with a simpler and more flexible structure. When it comes to taxes, owners can choose to be treated like a proprietorship or like a corporation.
Depending on the unique situation of your business, there may be tax and legal advantages and disadvantages to each entity. Because the issues can be quite complex, it’s unwise to choose a business structure without professional guidance.
However, it can be equally unwise to do nothing. Many owners default to sole proprietorships or partnerships without thinking about the liability exposure. “Often, small business owners don’t know about the pros and cons of each entity,” says Dacey. “They’re uncomfortable with the unknown and because they want to keep costs down, they do nothing about it.”
Burying your head in the sand about this issue can be an extremely costly mistake. Make sure you have all of the tax and legal advice you need to make an active, informed choice about the best structure for your business.
Another area where good advice can cut through confusion revolves around business expenses. “If you’re in business, you should be getting tax advice all year, not just at tax time,” says Dacey. “If you have a CPA working with you on your taxes, you also have someone who knows you and the ins and outs of your business,” says Dacey. With this knowledge, they can help find deductions you may not think of on your own. Dacey says commonly overlooked expenses include small costs that add up. For example, the cost of providing water to workers on a jobsite, subscriptions to the daily newspaper where you do your advertising, even the costs of the checks you purchase and bank fees.
Food provided on the jobsite is another commonly overlooked expense, says Dacey. “If you’re providing food for ‘the convenience of the employer’ (for example, if you need to provide lunch to keep your employees at the jobsite), it is deductible. It should not be reported under meals and entertainment, because those are only 50% deductible.”
These are just a few examples of deductible expenses that are easy to miss. A professional who knows your business will help make sure nothing slips through the cracks.
You can’t deduct expenses unless you track them. Unfortunately, poor record-keeping is notoriously common. “Whether it’s on the expense side or the income side, you need to base things around well-documented records,” says Kogen. “When people try to estimate, that’s where these things become a problem.”
It doesn’t have to be hard. A separate bank account for your business, along with monthly expense reports to identify possible deductions while they’re still fresh are two simple record-keeping methods.
“If you have a business, treat it like a business,” says Kogen. A professional approach to record keeping and tax planning will help keep your new business growing.
“I’m very interested in my entrepreneurial clients,” says Dacey. “I think most CPAs feel that way. There’s so much value in becoming your own boss and having the freedom to work on the projects you choose. I love watching that happen for people.”