Maybe a slight exaggeration, but everyone has to deal with them one way or another. The only interaction you might have with them is giving them your money when required. Sometimes more money than is required because you don’t know what you don’t know. Or it might be a more uncomfortable personal interaction through, say, an auditor. The IRS and their audits are not going to go away and it’s our job at Incite to protect you from them as much as possible. So, from our experience, it’s critical you know certain things as a small business owner and how the IRS views them. This is what the IRS doesn’t want you to know.
If you have a separate business, regardless of how much money it makes, it needs to be treated as a separate entity. What that means is that you have a separate business bank account and that you don’t pay for personal expenses out of the business account. We recommend having your business account and personal account at the same bank. As a business owner, you can take profits out of your business as a distribution (many people also call these owner draws or dividends).
You also may run into scenarios where you have to put money into the business in order to cover business expenses. Having your accounts at the same bank makes it easy and convenient to put money in and take money out as the business owner.
You likely actively participate in the business operations and doing so, you earn “ordinary income.” The IRS classification of this income is to let you know there is a self-employment tax (15.3%) that needs to be paid (self-employment tax, payroll tax, FICA, social security taxes are terms used by the general public to refer to this). Then you pay income tax on top of that. Because of the self-employment tax, you could be paying a 30% – 50% tax rate on your income. In our world, we define that situation as “no good.”
Proper entity structuring is at the top of the list of what the IRS doesn’t want you to know, because it can minimize how much income is subject to the self-employment tax. S Corps, LLCs, C Corps can all have a place in good entity structuring. For most small businesses we recommend an S Corporation.
That being said, because Uncle Sam is all up in your business, everything from if you have kids, how old they are, are you married, what industry are you in, do you have a lot of medical expenses, how involved are you or your spouse in the business, do you pay an assistant, etc. affect what type of overall structure you should get. Consult with a tax professional to get the best advice.
If you go through the effort to get the right structure, it’s even more imperative that you have a separate business bank account and that you keep personal and business crap separate. IRS loves to argue that a business is an “alter ego” of the individual. If they win their argument, then ALL the income becomes subject to the self-employment tax of 15.3%. Remember, that is “no good.”
You are supposed to keep records. This is a part of your bookkeeping. According to the IRS, a business that doesn’t keep records doesn’t have expenses. So, they disallow any expenses if they audit you. That results in paying more taxes. Unfortunately, they also expect you to be as detailed as an accountant. Every expense should have a receipt, every check should have a cleared check image, and every mile should have a log.
The IRS does have guidelines on how long you need to keep your records (http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/How-long-should-I-keep-records). If there are no issues with your tax return, you only need to keep records for three years. However, if they find issues, they can go back six years. So, we recommend just holding on to them for six years to be safe.
The IRS has led many to believe that they accept credit card statements and bank statements as proof of the expense. As a non-accountant, it’s easy for you to fall into the trap of blindly accepting that notion because it’s convenient. While statements can and should be used, it’s not the end all audit protection strategy. Keep your receipts! Stuff them in a big envelope instead of the trash can. But keep them. (A lot of our clients like to scan them or take a picture of them with their phone and then just save the image.) Without your receipts and cleared check images, the IRS will not allow those transactions, even if they’re on your bank statements and credit card statements.
The IRS only has three years from the date you file the return to audit you. It’s very hard for them to prove any major errors exist which would allow them to go back six years. What can happen though is that they audit a return three years old and if your record keeping is terrible, they can use that as a reason to open up audits back six years. Again, keep your receipts!
Get a good bookkeeping system in place. While you’re probably more than capable of keeping track of your expenses in Excel or QuickBooks or some other place, many business owners don’t ever make the time to do it. If you fall into that category, you can probably find data entry bookkeepers for $10 – $20 an hour. You do get what you pay for in the bookkeeping world, so if you want to have an even better system, with more accuracy and consistency, then budget the few hundred per month for more experienced bookkeepers.
Accountants have been blamed for helping companies lower their taxes, as if that’s a bad thing, by using loopholes… which are legal! The bottom line is that the IRS expects you to know that you should be happy to pay a lot of taxes. After all, how can you be a true American if you aren’t willing to fund entitlement programs that spend money without providing any lasting value in the Country (thick sarcasm).
Professionals do exist. And frankly, we know more about taxes than you do. In all cases we’ve been involved with, we even know more about taxes than IRS auditors. The tax code is 75,000 pages and is full of rules and exceptions. Businesses spend oodles of money with lobbyists to try and get favored tax rules for themselves. Government calls these loopholes, and they are legal. Loopholes are a perfect example of what the IRS doesn’t want you to know. Find a good tax professional that fits your style and attitude about taxes. A good tax professional will save you more money than their overall fees.
You are required to document your business expenses. If you don’t document them, then it isn’t a real expense. In addition, it’s only a business expense if it is “ordinary” and “necessary” in carrying on your business. An ordinary expense is one that is common and accepted in your trade and business. A necessary expense is one that is helpful and appropriate for your business. If you want to know what the IRS says about those two terms you can go to http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Deducting-Business-Expenses.
More of your expenses are probably business expenses than you realize. Two expenses for sure are not though. Personal groceries and your mortgage/rent expense for your primary residence (that’s the tax term for the place where you live). If you are spending money and you feel that it is common and helpful to your business, then you need to claim it as a business expense. If you are going to claim an expense on your business, make sure you are paying for it out of your business account. Business owners sometimes like to use credit cards as well. Whenever possible, if you are using a credit card in your personal name, designate one card and only use it for business. We promise it is easier to keep track of that way.
As you grow, you will pay more taxes. As your income increases and your lifestyle improves, you will pay more taxes. Basically, whatever good happens in your life, you will pay more taxes.
Businesses and individuals that make a lot of money have a higher chance of being audited. As your business grows, make sure you are being good about documenting expenses, saving receipts, and being compliant with things like payroll, sales tax, and all tax filings. Good record keeping makes audits less painful.
Chances are you are like a high percentage of small business owners that view accounting, bookkeeping, tax compliance, etc. as a necessary part of doing business, but a very unpleasant part. As humans, we tend to put off and procrastinate the things we find unpleasant. Face this part of your business with square shoulders. Take it on and be responsible. Your financials tell a story. Learn how to read them. Look at them often (at least monthly). If you utilize accounting as the language of business that it is, you will set yourself apart from your competitors and you will stand out in the marketplace.
The ultimate “what the IRS doesn’t want you to know” is if you don’t know something, they think you’re a criminal. We see this type of treatment and attitude from IRS employees and especially auditors all the time. It’s ironic that your tax dollars pay their wages, yet they treat you like you’re the criminal.
One thing is extremely important for you to understand. Based on tax code, the fact you have a business or receive 1099 income means all the tax codes that apply to big businesses apply to you.
If you feel like there are areas you want the assistance of a good tax and accounting professional, don’t hesitate to reach out to us. At Incite Tax we take a proactive approach to tax strategy and accounting so our clients can keep and grow their wealth.
Learn more at InciteTax.com
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