This article addresses the top five small business tax pitfalls observed by the author in his tax and business law practice. Each issue is followed by suggestions and techniques to help the reader manage the problem area appropriately.
Poor Bookkeeping Practices
Business owners run into major problems when they do not track business income and expenses on a regular basis. A business should have a system for tracking income and expenses by category. This system should be reconciled to the business’s bank statements each month. Each transaction should be categorized using categories that (a) will be useful to help the owner to manage and evaluate the company’s progress, and (b) match up reasonably well to deduction categories on the business’s tax return. [Note: This is one of the primary functions of specialized business accounting software such as Quickbooks, Peachtree, Xero, or GnuCash (www.gnucash.org, which is open-source (i.e., “free”).] When these items are not tracked, the owner will not have timely financial information to make good management decisions. In addition, the tax return preparation process becomes much more difficult, overwhelming, and expensive. In extreme cases, business owners become so overwhelmed that they may fail to file returns for a number of years.
Commingling Business and Personal Bank & Credit Card Accounts
One of the most prevalent problems observed in small businesses is a commingling of business and personal bank and credit card accounts. This creates a number of issues. First, if the business is incorporated or set up as a limited liability company, the liability protection offered by the entity is jeopardized when funds are commingled and the business is treated as the owner’s “alter ego” instead of respected as a separate legal entity. Second, this practice often results in deductible expenses being understated or overstated on tax returns because business expenses are forgotten and omitted or personal expenses are improperly included. Third, it becomes more difficult to accurately include all income and expenses in the business’s regular financial reports, so the owner does not have correct, timely information to gauge the business’s progress and identify opportunities or make course corrections. The proper way to address this problem is to run all business income and expenses through the business’s bank accounts and business credit card accounts (or credit card accounts that are used only for business expenses). These are the only statements that need to be included in the monthly bookkeeping. Any expenses that are paid personally or on a personal credit card should be reimbursed from the business account, categorized appropriately, and the receipt for the business expense should be kept on file by the business. Similarly, any personal expenses that are paid from a business account should be reimbursed by the owner or categorized as a distribution to the owner. This should not happen with regularity. Generally, checks should be written to the owner who will then pay his or her own personal expenses out of personal funds.
Failing to Handle Employment Taxes & Sales Taxes Appropriately
Falling behind on employment taxes and sales taxes is a significant problem that often precedes the failure of a small business. These taxes should be highly feared and respected by every owner of a business with employees and/or retail sales subject to sales tax. The penalties for failing to meet required deadlines are severe and can accumulate very rapidly. In addition, many of these taxes can be fully or partly assessed against the owners and officers of the business even if the business shuts down. Unfortunately, many business owners view the payment of these taxes as a last priority compared to other creditors. For the reasons listed above, these taxes should be considered a top priority. In fact, the moment a business hires employees, a critical decision should be made concerning whether the business will hire a payroll company or a professional to administer its payroll. Due to the potential penalties and personal liability involved, obtaining this assistance is highly advisable and in most cases, should be considered an additional implicit cost of hiring employees from day one. If a business owner intends to tackle this on his own, an exceptionally high level of organization and discipline is required. One final note on this point: care should be taken to make sure that (a) the business correctly reports payments to independent contractors, and that ( b ) employees are not mischaracterized as independent contractors. If persons who would be considered employees under applicable law are treated as independent contractors, a significant potential liability is created for the business, particularly if the relationship sours and the “non-employee” challenges the way the business handled its payroll.
Failure to Pay Reasonable Wages to an S-Corporation Shareholder
This can be a tricky one. For all of the sole proprietorship filers out there (Form 1040, Schedule C), feel free to skip ahead to Issue 5 below. But for all S corporation owners and LLC owners who have elected S corporation status, this is an important issue. If the S corporation owner-shareholder is actively involved in operating the business, which is almost always the case, the corporation should pay a certain amount of wages (reported on Form W-2) to the shareholder that is “reasonable” in light of a number of factors. A tax professional can be very helpful in assisting with determining reasonable wages for a specific business. If the S corporation fails to pay reasonable wages to an active shareholder, particularly if the business was profitable and non-wage distributions were made to the shareholder, this can create substantial additional tax liability exposure in the event that the tax return is selected for examination.
Missing Out on Valid Tax Deductions
Under the Internal Revenue Code, a business may deduct “ordinary and necessary” business expenses. The costs a business incurs in its efforts to earn a profit are generally tax deductible. Business expenses are deductible in the tax year incurred; however, “capital expenses” are treated differently. Capital expenses are the costs of purchasing assets with a useful life exceeding one year, such as property or equipment. These assets are generally depreciated over a certain number of years and care should be taken to distinguish between ordinary business expenses and capital expenses and to report them properly. There are a number of ordinary business expenses that business owners occasionally forget to include at tax time. The following is a list of some of these expenses. Remember, these are not all “ordinary” and “necessary” for every business. It is the business owner’s responsibility to ensure that only valid business expenses are deducted on the business’s tax returns:
- a. Advertising and marketing
- b. Bank charges (account fees and credit card merchant charges)
- c. Charitable donations (cash or non-cash donation of goods)
- d. Computer and Internet Expenses
- e. Contract labor (non-employee labor) – report on Form 1099-MISC if necessary
- f. Dues and subscriptions
- g. Education, business-related (such as continuing education classes, etc.)
- h. Home-office Expenses (if you do not have another office outside of the home)
- i. Interest (business loans and business credit cards — not personal debt)
- j. Laundry and cleaning (including business dry cleaning)
- k. Licenses and permits
- l. Meals and entertainment (documented as business-related – 50% deduction)
- m. Mileage reimbursement for business-related travel
- n. Organizational expenses (start-up expenses before business technically opens)
- o. Parking and tolls
- p. Postage
- q. Printing
- r. Rent (on real property and personal property such as equipment)
- s. Repairs and maintenance
- t. Security
- u. State annual registration fees (a/k/a “franchise taxes”) for an LLC or corporation
- v. Taxes – Employment and Sales taxes (if included in gross receipts)
- w. Telephone
- x. Travel
- y. Utilities
- z. Website design, hosting, and development fees
As far as capturing all of a business’s tax deductions goes, a business owner who fails to plan, as they say, “plans to fail.” If a business is able to appropriately handle Issues 1, 2, and 3 listed earlier in this Article, its accuracy with respect to this Issue 5 will be greatly enhanced. Please refer to IRS Publication 535 entitled “Business Expenses” located at http://www.irs.gov/pub/irs-pdf/p535.pdf or consult a professional tax preparer if you have questions about whether any of the above expenses are deductible for your particular business. Many of these expense categories have additional rules, requirements, and limitations which must be observed before deductions can be taken.