Dealing with Uncle Sam

Whether you're a veteran manufacturer or a novice retailer, income tax time can bring on the willies. But a little proactive planning will go a long way to calming your nerves.

By J. Tol Broome Jr. -- Gifts and Dec, 1/1/2002 12:00:00 AM

Most gift industry business owners would rather undergo root canal therapy than have to even think about income taxes. Yet while the subject of dealing with income taxes can make you feel down in the mouth, there are a number of things you can do to make the process less painful, and save money. It requires proactive planning, according to Pete Pulliam, a CPA for 42 years and a partner in Pulliam & Jones in Greensboro, North Carolina. The firm's client list consists exclusively of small businesses and professionals.

"You need to get off on the right track with income taxes," he advises. "You need to make sure you have the right election for the legal entity of your business, choose an appropriate fiscal year, establish a plan for taking legal expenditures and tax credits, and set up a good record-keeping system. If you do these things, you should be able to take advantage of the tax laws rather than having them take advantage of you."

Here are a number of useful ideas to get you moving in the right direction when dealing with Uncle Sam.

The Professional Touch

The first step you should take is to seek input from a professional. Depending on your financial acumen, you may ultimately choose to do most of the day-to-day income tax work on your own. And that's fine. However, every business owner should seek some professional assistance in the tax planning process.

The reason is simple. No matter how financially astute you might be, you can't possibly keep up with all the tax laws on your own. And if you try to save a few dollars on tax preparation by doing all the work yourself, it could wind up costing you many times over what you've saved — in lost deductions, forfeited credits, and even severe penalties.

"We lean toward letting our clients do whatever they can on their own," explains Pulliam. "We just want to make sure they know what they are doing. I have one big client who has us do everything on financial reporting and income taxes. On the other hand, we have many small clients who do nearly everything themselves. But we meet periodically with them to make sure that what they are doing is on target, and won't cause any surprises come tax time."

Richard Burke of Richard J. Burke MBA Inc., a consulting, taxation, and business services company in San Francisco, concurs with Pulliam. "My job is to keep my clients from having a heart attack in April," he says. "I like to keep up with my clients all year to make sure this doesn't happen. Some I meet as little as a couple of times a year. First, we get together in September or so to see where we stand. And then we follow up in February or March to make sure we are ready for filing in April."

Some Cost-Effective Resources

In addition to seeking professional input, there are a number of free or inexpensive resources that can assist you in the income tax planning process. If you don't already have a good accounting software system, you should consider purchasing one for financial record keeping. Most cost less than $500, including M.Y.O.B. Premier 1.0, Peachtree for Windows 6.0, QuickBooks Pro 6.0, and One Write Plus 7.0.

If you choose to undertake the tax form preparation process on your own, there are a number of inexpensive (generally under $40) and easy-to-use software packages available, such as TurboTax (for IBM compatibles) and MacInTax (for Macintosh computers), that will save you time. As far as the "good old" paper forms go, you should find everything you need at your local municipal government office.

Finally — and this is no kidding — one of the best resources available for tax planning is the Internal Revenue Service. The IRS is eager to help you in your tax planning process, and despite what some people believe, calling for help will not increase your chances of being audited. Check out the IRS Web site at www.irs.gov or call (800) 829-1040 to obtain advice from an IRS representative, information about Small Business Workshops and Small Business Tax Education (STEP) Programs, or to order free publications such as Tax Guide for Small Business (Publication #334) and Business Expenses (#535).

Start With the Basics

There are a few key areas that are essential to any good tax plan. First, you must select a legal entity structure for your business. There are four legal designations from which to choose: proprietorship, partnership or limited liability company, C-Corporation, or S-Corporation. While there are myriad legal ramifications for each structure that an attorney can help you understand, here are some basic tax filing considerations for each one:

Proprietorship: A sole proprietor files his or her business tax return as a Schedule C (Profit or Loss from Business) attachment to the personal 1040 tax return, along with a Schedule SE (Self Employment Tax) attachment for computation of Medicare and Social Security Taxes. According to the IRS, "if you expect to owe less than $1,000 in income and self-employment taxes, you can pay them when you file your income tax return [at the end of the year]. If you expect to owe $1,000 or more in income and self-employment taxes, you will need to make estimated tax payments [quarterly]."

A sole proprietor is required to make quarterly estimated tax payments that must be at least 90 percent of the current year's tax liability or 100 percent of the liability from the prior year, whichever is less. The estimated taxes are paid in equal installments in April, June, September, and January.

Partnerships and Limited Liability Companies (LLC): Companies set up with this legal structure must file Form 1065 (U.S. Partnership Return of Income), and provide copies of Schedule K-1 (Partner's Share of Income, Credits, Deductions) to the partners or LLC members by the filing date for Form 1065.

C-Corporations: Form 1120 (U.S. Corporation Tax Return) is filed for C-Corporations on the 15th day of the third month after the end of the corporation's tax year (which is March 15 for most companies). The earnings of a C-Corporation are taxed separately from the personal incomes of the shareholders.

S-Corporations: An S-Corporation owner must file Form 1120S (U.S. Income Tax Return for an S Corporation). A copy of the K-1 schedule (see Partnerships) must also be furnished by the same due dates as those for C-Corporations. The earnings of an S-Corporation flow through to the personal tax return, and are taxed accordingly.

One basic consideration is the tax year: Depending on the legal structure (an S-Corporation must have a December 31 tax-year end, for example), a business can choose any month end to conclude its tax year. This can prove beneficial for a company seeking to reduce its first quarter workload. Some CPA firms even offer discounted rates for companies with a tax year-end other than December 31. You may want to consider changing your tax year-end, but make sure you are happy with the new one. In most cases, the IRS allows the tax year to be changed only once every ten years.

You have to have an Employer Identification Number (EIN) if your gift business has employees or if your legal entity is a corporation, a partnership, or a limited liability company. You can obtain an EIN simply by calling (800) 829-3676.

Cash vs. Accrual Accounting

There are two basic methods of accounting for any business: cash or accrual. Under the cash basis accounting, income is recorded when it is received in the bank account, and expenses are recorded when they are paid out. While this sounds like a simple method, most businesses nevertheless are set up under the accrual basis of accounting. In fact, the IRS requires accrual accounting for businesses with annual sales in excess of $5 million, C-Corporations, and businesses that maintain an inventory.

"While the cash method is quick and easy, the accrual method gives you a much more accurate picture of your financial situation," says Alice Magos, the online columnist for the Commerce Clearing House (CCH) publication Business Owner's Toolkit. "Because you record income on the books when it is truly earned, and you record expenses when they are truly incurred, the income earned in one period is accurately matched against the expenses that correspond to that exact period."

With inventory being one of the key determinants of cash versus accrual accounting, gift businesses are required to account on an accrual basis. Sales are recorded when invoiced (or at the point-of-sale in a retail business) and cost of goods sold (primarily inventory) is recorded at the same time. An important point here is that inventory is not recorded as an expense until it is sold.

However, for a business with under $5 million in annual sales, some operating expenses can be accounted for on a cash basis. This hybrid cash/accrual accounting method can result in tax savings in a given year. Here's an example: You receive an insurance premium bill for $2,000 and a rent notice for $5,000 on December 20 for the following month, and your tax year ends December 31. Even though those are prepaid expenses for the following year, you can pay them before December 31 and deduct them in that tax year, thereby reducing your net income by $7,000 and your federal tax bill by over $2,500.

Deductible Expenses

One of the most confusing areas of income tax preparation is the eligibility of deductible expenses. Many a business owner has flunked an audit because he or she took improper deductions. On the other hand, many legally deductible expenses go unrecorded due to misunderstanding or poor record keeping.

The IRS has three standards that are part of its deductibility litmus test. First, the expense must be "ordinary and necessary." An expense is ordinary if it is "common and accepted in a field of business," and necessary if it is "helpful and appropriate to a business."

Second, the expense must be reasonable. Here's an example. If, while traveling on business, you stay at a Holiday Inn and eat lunch at an Applebee's and dinner at an Outback Steakhouse, these expenses will be considered "reasonable." However, if you stay at a Ritz Carlton and eat at five-star restaurants during the trip, the IRS will disallow many of these deductions as "unreasonable."

Third, you must be able to prove that the expense was actually incurred. You must have a good record-keeping system to document all expenses. Of course, you should have good records (receipts, expense logs, paid invoices, etc.) for all expenses taken, but there are some expenses that receive particular scrutiny by the IRS. They are travel, meal, entertainment, business gift, cellular phone, and computer expenses, as well as others that can be incurred for both business and recreation purposes. For these expenses, the IRS requires a receipt for any expense over $75, and for any lodging cost regardless of the amount. In addition to the amount, you must document time, place, and business purpose of the expense. A mileage log is strongly recommended for vehicle expenses.

"You must have a good record-keeping system," advises Richard Burke. "Some people miss quite a lot of deductions because they don't keep up with expenses by collecting receipts. If you incur an expense personally, you should actually reimburse yourself by filing a detailed expense report and writing yourself a check out of the business account."

Fixed Assets

Another frequently misunderstood area is the accounting of fixed asset purchases (also called capital expenditures). A capital expenditure is one incurred for the purchase of an asset that will benefit your business for more than a year. The distinction is critical for income tax purposes, because most capital expenditures must be depreciated over the useful life of the asset (as defined by the IRS) rather then being expensed in the year incurred. The reason for this tax law is tied to accrual-based accounting, which seeks to match expenses to the period in which corresponding revenues are generated. For instance, if you buy a new truck and drive it for five years, you are getting five years' worth of revenue generation out of the truck. Expensing it all in the year it was purchased would overstate your expenses for that year. Of course, this would understate your income and the amount of taxes owed. Suffice it to say the federal revenue coffers would be greatly reduced if not for capital expenditure depreciation laws!

Examples of fixed asset purchases include equipment, vehicles, computers, office furniture, and real estate (buildings only, land cannot be depreciated). Additionally, any expense that adds to the useful life of the asset (e.g. adding onto a building or a major computer system upgrade) is considered a capital expenditure to be depreciated over the remaining useful life of the asset. This is in contrast to ongoing repairs and maintenance, which are expensed in the year they are incurred.

Section 179 of the tax law governs the depreciation of fixed assets. While most capital expenditures must be depreciated over the useful life of the asset, Pete Pulliam notes out that the IRS provides one exception that particularly benefits a truly small business. "In 2001, the IRS will allow you to deduct up to $24,000 in equipment expenditures incurred in the tax year regardless of useful life," says Pulliam.

For more on capital expenditures and depreciation laws, consult a tax advisor and get a copy of IRS Publication 534.

T&E Per Diems

There are two systems the IRS allows for tracking and deducting travel and entertainment expenses. The first is by recording the actual expenses incurred and deducting those that are ordinary and necessary and reasonable. The second is by using per diem rates as designated by the federal government.

Using the per diem system not only can reduce your tax bill, but it also simplifies record keeping. By recording the number of days and nights in each city you stay, you can write off the allowable amounts for lodging, meals, and incidentals, along with actual expenses incurred for airfare, mileage, car rental, etc.

Allowable per diem rates can be found at www.policyworks.gov/org/main/mt/homepage/mtt/perdiem. The Web site provides maximum rates allowed for both lodging and M&IE (meals and incidental expenses) for all U.S. cities. Rates vary significantly based on individual cities. For instance, Manhattan has maximum rates for lodging of $198 and M&IE of $46, while Buffalo's maximum rates are $78 and $42, respectively.

"This is a big deal for anyone who does a lot of trade shows," notes Burke.

Medical Spending Accounts

In 1997 Congress passed a law that allows certain small businesses to set up Medical Spending Accounts (MSAs). An MSA is available to self-employed individuals and to companies with 50 or fewer employees. The MSA allows employees to fund their medical expenses by contributing pre-tax dollars to a medical "savings" account. Disbursements are made on a tax-free basis. The eligible amounts that can be contributed to an MSA are based on the level of the deductible in the major medical insurance plan provided by the company. All the rules that govern MSAs are available from the IRS.

"I wish they had called it a Medical Savings IRA, because Medical Spending Accounts sounds negative, and a lot of small businesses don't take advantage of it," says Richard Burke. "The balances can be carried forward from year to year earning tax-free interest, and employees can save a substantial amount of money on medical expenses by using pre-tax dollars."

Retirement Accounts

Burke also advises clients to start retirement plans. "So many small-business owners put off retirement plans," cautions Burke. "Entrepreneurs are famous for saying, 'I'm growing my business. I'll start saving for retirement next year.' But there is a point where you have to say, 'Next year is here.' "

According to Burke, a small business owner can use a number of different savings plans to start saving on a tax-deferred basis. He recommends the SEP-IRA as a great place to start. "A self-employed business owner can put up to 20 percent of his self-employment income into a SEP-IRA," he says. "And you can wait and pay into the IRA until you actually file your return, including extensions. On $50,000 income, you can put away close to $7,500."

Other Write-Offs

The IRS imposes heavy penalties for tax evasion, but there are many legal options, besides taking off all your deductible expenses, to help lower your bill. Here are five of the most common:

Use Your Credit Cards: Richard Burke points out that credit cards can be used in November and December to incur expenses for that tax year even if the credit card bill won't be paid until the following year. "I don't advise my clients to jack up expenses just for the sake of the tax write-off," he says. "But for expenses that will be taken anyway, you can pay with the credit card and write them off in that tax year."

Shift Income to a Lower-Bracket Taxpayer: If you have children over the age of 14 and your legal form is anything other than a C-Corporation, you might be able to reduce your tax bill by making them part owners of your business. Your tax advisor can help you determine whether or not you are eligible and if it makes good business sense to make this change in ownership structure.

Expense Bonuses One Year and Pay Out the Next: In some cases the IRS allows you to expense bonuses in one year and pay them in the next, as long as you pay them within two and a half months of the tax year-end.

Hold Invoices Until After Tax Year Ends: This is often overdone, but if some of your sales are on account, you can hold invoices and mail after year-end to defer revenue. This is not advisable for companies with tight cash flow. However, if your cash flow is solid, you can defer a significant amount of your tax bill until the following year by invoicing late December orders in early January.

Take Advantage of Tax Credits: Tax credits are different than deductions in that they allow you to take a direct credit against the amount of tax owed. Pete Pulliam points to the North Carolina Lee Tax Act as an example. "The Lee Act offers tax credits for certain machinery and equipment purchases and for certain training and hiring expenses," he explains. "You have to plan ahead to take advantage of tax credits that are available, but there are a lot of credits out there if you know where to look."

To find out more about tax credits available in your state, consult your tax advisor or contact the federal Department of Commerce and/or your home state's commerce department.

Avoiding Penalties

It is imperative that you follow all of the rules and deadlines for filing and payment of taxes. Failure to do so can result in often devastating penalties. "The small business owner will pay 40 to 50 percent of his profit in income taxes and self-employment taxes," says Pulliam. "You will save yourself a huge amount of money by paying these on time."

There are two components of the tax bill that must be paid in a timely manner: income taxes and self-employment tax.

Income Taxes: You must file your return or an extension by the due date, along with the actual or estimated tax owed. The penalty for failure to file the return at all is 5 percent of the unpaid tax for each month it is unpaid up to a maximum of 25 percent of the tax due. You could also be subject to more serious consequences (such as criminal charges) if a pattern and practice of tax evasion is evident.

Even if you don't have funds available to pay your tax bill, always file the return or an extension by the due date (see chart, page 38). If you don't have the funds available, partial payments will reduce your penalty and interest due to the IRS. The penalty for non-payment is 0.5 percent of the unpaid tax for each month up to 25 percent of the tax due. Additionally, the IRS will charge you interest on the late tax payment until paid. This rate varies based on short-term Treasury bill rates and typically runs in the 10 percent range.

Self-Employment Taxes: These taxes cover Medicare and Social Security tax payments for self-employed business owners. If you have filed before as a self-employed business owner, then you know that you pay both the employer and employee portion of Medicare and FICA taxes on the first $72,600 (1999 figure) of income. The actual calculation for self-employment tax is provided by the IRS or in most tax preparation software packages. As with your income taxes, it is critical that you pay these taxes on time.

"Many small business owners will pay income taxes and forget about self-employment taxes," warns Pulliam. "The penalties for non-payment are severe and it puts you in a hole that is hard to get out of."

Estimated Taxes: Establishing the right formula for quarterly estimates is critical for most small businesses. A sole proprietorship is required to make quarterly estimates in April, July, October, and January to avoid interest and possible penalties. These estimates should be based on the net income level from the prior year. However, Richard Burke advises that quarterly estimates should be adjusted during the year if revenue levels change significantly.

"If you see more money coming in, pay attention," says Burke. "If sales are higher than last year, you may want to consider increasing your quarterly estimates. Otherwise you might be in for a surprise when it is time to file your return."

Just as proper dental care will help you avoid the ordeal of a root canal, paying income taxes is an inevitable maintenance expense of being in business. But if you plan proactively, you can make the system work for you rather than against you. "Small business owners who set up a system for taxes and follow it almost never get into trouble," concludes Pulliam. "If you plan early and follow all of the rules and deadlines for reporting and filing, you should be able to minimize your tax bill and eliminate the problems that many small business owners face when they fail to set up a good tax plan."

Due Dates For Tax Returns

Return Type	Original Due Date	1st Extension Due Date	2nd Extension Due Date
* For a calendar year. If the tax year is a fiscal year-end other than December 31, then the original due date is the 15th day, fourth month for Proprietorships, Partnerships, and LLCs, and the 15th day, third month for Corporations. The first extension due date is four months following the original due date for a Proprietorship, three months following for a Partnership or LLC, and six months following for a Corporation. The second extension due date is two months following the first extension due date for a Proprietorship and three months following for a Partnership or LLC.
Individual, Sole Proprietor (Form #1040)	April 15	August 15 (#4868)	October 15 (#2688)
Partnership or LLC (Form #1065)	April 15	July 15 (#8736)	October 15 (#8800)
Corporations, C or S (Form1120)*	March 15	September 15 (#7004)	N/A