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HEALTHY WEALTHY & WISE
Discussion of Small Business Tax Issues
Prepared for Seminars on October 22, 2008

 

Small Business Tax Issues

Inherent in our service to so many clients within the small business arena, we see many problems and scenarios that require our attention.  We have decided to utilize our experience in providing some general guidance to you as the small business owner as you approach the fourth quarter and the pending tax preparation season early next year.

Recordkeeping

IRS has taken a new stance to enforce compliance with the introduction of its new commissioner this past year.  So, in recent meetings with you we have stressed the importance of keeping records and documenting your deductions, especially for your very helpful mileage deductions.  Without a properly documented mileage diary or log, IRS will disallow your deduction in the event of an audit.

Shareholder Compensation

This is something we have discussed with our clients for years, and it is an issue that has been heavy on the IRS radar for two years running.  With S-Corporation shareholders eligible to take dividends from their corporations which escape FICA taxes, IRS is vigilant in watching shareholder compensation on the corporate tax returns.  There is no magic number on this, only an explanation that a shareholder’s salary must be reasonable. We approach this in meetings with clients and make an assessment when we review your records.  If you have questions on this issue, please let us know and we can discuss it.

Entity Choice

New clients that come to us before the selection of an entity choice for their new business have benefited from our experience in entity choice consultation.  We have the answers for you on the best tax strategy for your new business, and anytime we have questions that are better answered by an attorney we can find one for you or speak with your attorney.  This is critical to the tax treatment of your income so never hesitate to discuss it with us.  If you already have an LLC in place, remember that you can elect to be taxed as any entity in the tax system if you aren’t happy with your current choice.

Payroll Taxes

As you know, employers are required to withhold taxes from their employees’ paychecks and remit the withholdings along with a FICA match to the IRS, and the state withholdings to SC.  I have had the experience of working with clients who treat those withholdings as a short term loan and use those funds for working capital instead of pursuing a bank loan.  Please understand that IRS is deadly serious in this area and if you find yourself behind in payroll tax deposits, you could be in serious trouble.  IRS treats the misuse of withheld employee taxes as tax fraud and seeks to punish businesses which do this by applying steep penalties and interest to unpaid taxes.  If your business is behind in its payroll tax deposits, we need to talk about immediate action to remedy it and deal with the pending penalties.

Shareholder Loans

As with any arm’s length loan within a business, IRS expects a corporation to charge interest on or receive interest from shareholder loans.  If you as the shareholder have loaned your corporation money for working capital or other reasons, you must execute a loan document and account for interest.  If your corporation has loaned you money, first of all we need to discuss repayment terms and then discuss an applicable interest rate that you will pay the corporation for the funds.

Retirement Plan Contributions

Please make sure you see us before year end to discuss opportunities for retirement plan contributions through your business.  If you already have a plan in place, we can work with your financial planner and talk about contributions.  If you don’t have a plan in place, let us know and we can recommend a financial planner to you and recommend the correct type of plan for your small business.

Financial Statement Education

My firm has always been interested in educating clients so they understand the financial statements that we prepare for them.  I say to clients all the time that accounting shouldn’t be smoke and mirrors.  In order to make educated, accurate, rational business decisions you need to be able to read the financial statements and understand what they represent to you.  You can’t budget without understanding them; you can’t make decisions on hiring new employees or expanding your range of services if you don’t know your true profit on current operations; and banks certainly won’t entertain loaning you money if they feel you can’t understand the numbers behind your business.  If you have questions about your financial statements or if you need a little refresher course from us, please make that known so we can address it.

Small Business Pension Plans

With the state of the economy, I have had a surprising number of clients interested in setting up and funding retirement and pension plans through their businesses.  I am of course in favor of these plans due to the fact that they serve a dual purpose – helping clients plan for retirement as the obvious one, and they also provide a good tax deduction.  For instance, did you know that a taxpayer with adequate profit from a sole proprietorship or adequate compensation from a corporation can fund a SEP up to $46,000 for 2008 (and $49,000 for 2009) and receive an income reduction for the entire amount?  Funding usually takes place in smaller increments for my clients, but I have had some clients who had stellar years who did contribute large amounts.  It sure beats the amount you can contribute to a traditional IRA!  There are other plans available as well, such as the Simple IRA and the Solo 401(k).  The proper fit for your business can be determined with a meeting, so if you are interested please let us know.

DEPRECIATION CHANGES FOR 2008 PURCHASES ONLY

The economic stimulus package passed earlier this year contained a tax law change for depreciation of certain assets.  The bonus depreciation granted in this package is very similar to the law in place in 2003.

  • The bonus depreciation is equal to 50% of the total cost of the asset placed in service during 2008.  To qualify, the property must satisfy four key requirements.
  • The property must meet one of the following four definitions:
    1. It must be MACRS property with a cost recovery period of 20 years or less; or
    2. It must be water utility property as defined in MACRS; or
    3. Computer software property; or
    4. Qualified leasehold property
  • Original use must commence with the taxpayer after December 31, 2007 – In other words, this must be a 2008 purchase of a new asset.  In the case of an automobile, it must not be used.
  • The property must be placed in service in 2008 – In other words, you cannot purchase a new computer system on December 31, 2008 and deduct it if you don’t put the system in service until January 2009.
  • The property must be acquired after December 31, 2007 and before January 1, 2009.

For automobiles (sedans and other autos that weigh less than 6,000 pounds), the bonus rules don’t apply per se.  However, expanded depreciation amounts are in place in the following manner:

  • Automobiles are depreciated at $10,960 in 2008; $4,800 in 2009; $2,850 in 2010; and $1,775 in 2011 and thereafter.
  • Light trucks and vans are depreciated at $11,160 in 2008; $5,100 in 2009; $3,050 in 2010; and $1,875 in 2011 and thereafter.

Remember that certain SUVs weighing more than 6,000 pounds are eligible for a $25,000 Section 179 deduction before bonus depreciation is applied.  Those rules are still in place for 2008.

SELF-EMPLOYED HEALTH INSURANCE DEDUCTIONS

Health insurance is so expensive for individuals and certainly for small groups.  In the cases of self-employed individuals (including shareholders of S-Corporations), the deduction for health insurance “above the line” still exists.  The deduction directly reduces income and is reported on page 1 of the Form 1040.  For S-Corporation shareholders, wages must exist for the individual attempting to deduct the premiums.  If no wages exist, the health insurance is deductible on Schedule A with all other medical expenses.  Of course, that expense is limited to any amount over 7.5% of adjusted gross income and is therefore extremely difficult to deduct. 

We still feel this is a huge benefit to shareholders and self-employed individuals.  A health insurance premium of $1,000 per month, which is not out of the ordinary, will save a taxpayer in the 15% bracket approximately $2,500 in Federal and state taxes.

INDEPENDENT CONTRACTOR VERSUS EMPLOYEE

Payroll taxes are a complicated issue for employers and workers’ compensation insurance is usually pretty expensive.  However, IRS mandates that workers be classified as employees if the employer can exercise any element of control over an employee whether they actually exert control or not.  The abuse in this area is out of control and IRS will not hesitate to levy intense penalties on the employer who flagrantly violates the law on this issue.

There is a 20 point test that IRS follows in determining if control exists, and speaking from experience, they rely heavily on this test.  While they do rely somewhat on the normal practices of the industry in question, they do not place heavy reliance on it.  For example, if you have a worker in an industry that usually treats that person as a contractor, but you know for sure that you exert control over this worker then industry precedent makes no difference in this case.  You should do what you know to be correct.  In cases where we see a potential problem, we will bring it to your attention and make sure that the proper steps are taken to remedy the situation.

AUTOMOBILE DEDUCTIONS – MILEAGE OR ACTUAL EXPENSES?

This is a question that comes up so often in my practice, as my clients often purchase automobiles through their respective businesses or use their personal vehicles for business travel.  Here is a quick primer on mileage versus actual expenses:

  • If your corporation owns your vehicle and business use is deemed to be at 100%, then you are required to use actual expenses.  I do advise clients to watch the business use, since there would be an element of income recapture if business use falls below a certain percentage.
  • If you own your vehicle personally and use it for business, then you have an option in the first year of use to determine the method you will use.  With mileage reimbursement rates at an all-time high, it’s amazing how little business use it actually takes to amount to a large mileage deduction.  In some cases, however it still makes sense to use actual expenses rather than mileage.  Beware of this one fact – if you choose to use actual expenses, then you are required to use it until the automobile is disposed of. 
  • If you lease your vehicle (I don’t have many clients who lease these days) then we can deduct the business-use percentage of the lease payments and other expenses.  We find this by dividing the business miles by the total number of miles and applying that ratio to the expenses incurred during the year.

With the automobile depreciation changes that have taken effect this year, we will be running comparisons for clients who purchase new vehicles in 2008 to make sure that we choose the optimal method for you.  If you are thinking of purchasing a new vehicle this year, or trading an old model for a new one, please let us know.  The rules on how much you can deduct depend heavily on the cost of the new vehicle and the book value of the vehicle you are trading. It can become a complicated calculation.