I am going to use my industry as an example because I know it well, but it works the same in every industry. Why is the $15 hr Min Wage a problem for small business? In my business the customer wants our office open year around in case they want to discuss a change in their life, receive a letter or even an audit. In order for that to happen we need a clerical person full time. $15 per hour x 2,080 equals annual wage of $31,200. Add another 10% for Workman Comp, Unemployment, Employer portion of Social Security and Medicare and you are spending $34,320 for front desk support. We need about $15,000 in software, cyber insurance, professional liability insurance, technology equipment and supplies just to get the season started (probably low). So, just to start I need $49,320 to begin work (34,320 + 15,000). In my industry the normal workload for a CPA/EA is 400 returns. Our base rate starts at $130 and goes up from there. If every return cost $130 and 400 is a normal workload, then revenue is $52,000. Subtract the Clerical Support and Supplies of $49,320 and you are left with $2,680 to pay utilities, real estate taxes and building insurance. At these rates the accountant has yet to make a dime for preparation of 400 returns. The math doesn’t work and it is why the cost of a meal at a restaurant or the cost of a tax return or even a hair cut will increase. Small businesses are especially being hit hard. Its either go big or go home as the economies of scale are killing the small mom and pop business. Unfortunately the same people that beat the drum for higher wages are also the ones that complain the most about fees. So, the next time you are thinking about ripping into a small business owner over their pricing, make sure you know what you are talking about. Small business owners have had enough of the hypocrisy of the left. We are entitled to make a living without continually justifying it.
What happens in a tax audit is a topic discussed throughout tax season. Let me start with who is responsible. Too often taxpayers think the accountant is responsible.
Example: The accountant has a question as part of the due diligence responsibility. The relationships between the numbers look unreasonable. Upon making adjustments for error, the return has a balance due. The accountant discovers the error occurred in the prior year and amends it. Client is not happy and refuses to pay the bill. Comment goes something like “if those returns are wrong it is your fault”, then further in the discussion “aren’t you suppose to take my numbers and not question them?”. Yes, there are clients that think accountants must take the numbers without question and then be responsible for those numbers when they are wrong. We are only responsible for applying the law correctly and pointing out issues that come to our attention. The taxpayer is responsible for the final results.
So, how does an audit happen? Some are based on statistical analysis by IRS computers, some based on a specific project, one audit can bringing attention to a second audit and some by random sample.
Do you wonder what the NAICS Code is used for? These codes identify the type of business, for example Trucking, Farming, Restaurants and so forth. This tells the IRS computer systems which statistical ratio to use when comparing your return to the norm. Fuel usually is a percentage of gross income for a trucker, input cost (Fertilizer/Chemical/Seed) as a percent of grain sales and food cost a percentage of sales for a restaurant. We believe when the return hits the system, it is scored based on a top secret scoring system (confirmed by a former IRS employee many years ago). Fall outside a certain score and the return gets looked at by a human. What happens next is a matter of human decisions.
In my more than 30 years in the business, computers have become a HUGE part of the industry. When the PDF file format was created in 1993 we began seeing more changes. Today, it is very common for an audit to be performed without ever meeting the auditor. Many set in offices and expect documents be delivered to them using technology. This was not the case when I started. We developed an understanding and professional relationship with the auditors from the local offices. They got to know our work and we got familiar with their methods. This connection is being lost.
It is typical for a taxpayer to ask, “How are they going to find it?” when discussing the possibility of leaving something off a return. This is a conversation that should never take place with your accountant. We are not afforded “attorney client privilege”. If you wish to engage in criminal activity, keep it to yourself or hire an attorney. If we are summoned to testify, we must testify or risk jail. While we may really like you, we are not going to jail for you.
So, “How are they going to find it”? Understand the code begins with “All Income is Taxable” and “All Expenses are Not Deductible”. They are going to have an Initial Interview designed to set the stage for what’s about to follow. Then they are going to assess your life style, drive past your home, search Google, Facebook and probably run a Credit Report. They might even visit the court house for property records and other legal filings. Certainly they will look for FINCEN (foreign bank account), Crypto Currency Transaction and Large Cash reports filed by the bank. They will determine, based on statistical averages, what it cost to house, feed, clothe, entertain, transport and educate a family your size. This gets compared to the return and then they have a variance, usually called the Pre T-Account Understatement (or Overstatement) of income.
Now the fun begins. They will ask for bank statements (including deposit slips and cancelled checks), brokerage statements, loan activity, purchase agreements (especially large purchases), rental agreements and other proof of living cost such as utilities, clothing, vacation and insurance receipts (to name a few). From this they adjust the Pre T Analysis to come up with a Post T Analysis (Pre and Post refer to Pre Audit and Post Audit, the T references T- accounts used in accounting). At this point they will generally have an idea of the accuracy of the income tax return that you filed “under penalties of perjury”.
During the process there will be questions regarding large cash purchases, proof of gifts (often requiring a statement from the donor), proof of inheritance, proof of basis in sold assets. They are trying to count all income taxable and disallow all expenses. Remember how the code begins? All income is presumed taxable and all expenses are presumed not deductible. This should be committed to memory by every taxpayer. This does not begin in your favor!
The explanation above is basic, there is far more to it. The bottom line, you might be able to get away with an immaterial amount missed on the return, but if you are trying to hide large amounts of income, it can be found. Big Crime Syndicates’ understand this, which is why they “lauder money”, a process that exposes the illegal income to TAXES thus making it legit. Probably the opposite of what the average taxpayer believes.
Usually only 3 years are available for audit. That goes to 6 years in the case of “a gross understatement” and all years are open if the IRS can prove "fraud". What a taxpayer says and does during an audit could be evidence of “fraud”. Agents take their job seriously. Joking comments about “bribes or cash” are not laughing matters, even if they are jokes. This is one reason we do not recommend a client represent themselves in an audit. It’s also the reason we do not want to know anymore than we need to know.
While your risk of audit is approximately 1% each year, that equates to once in a 100 years. You could say 1 out of 2 people during a 50 year period will be audited. Putting it this way, this is a 50/50 chance over your 50 year working life you will be audited. Don’t look so good now, does it.
It is very common for a taxpayer to walk into a tax office and proudly proclaim “I have a lease, therefore I get to deduct it” and our answer is always “MAYBE”. A lease doesn’t translate in to more or less deductions than had the asset been purchased. It depends on many things. After Sept 11th, 2001, the immediate write-off of assets (Code Section 179) was greatly increased and Bonus Depreciation was introduced, making leases less favorable. The entire point of a lease, under the old law, was to get the deductions faster. With Section 179 election at $500,000, most clients find a true lease a restriction, not a help. Over the years, the IRS and the courts have been clear regarding leases. There are two basic categories:
1) A True Lease (think rent) where you are gaining no ownership, no equity, no credit toward purchase, you are ONLY paying to the use of the property for a period of time and then you’re done. Some describe this as “throwing your money away”.
2) A Capital Lease (think loan) which looks more like a financing agreement. Payments go toward ownership and the longer you “lease” the less you pay in the end to own the asset. Often the IRS will reference the existence of a “Bargain Purchase Option” (BPO). An example of a BPO is “after ten years of lease you pay $5 and you own it”. Any predefined value and transfer of ownership would make the lease a Capital Lease (treated as a loan), with or without a BPO.
What is the tax difference? In the case of a True Lease, the payments are deducted when paid, just like any rental arrangement.
A Capital Lease gets setup on the Depreciation Schedule just like buying any other asset with a loan. The applicable depreciation elections may be utilized, Sec 179 and/or Bonus Depreciation. By declaring “I have a lease and therefore I get to deduct my payments” you are really saying “forgo the immediate write-off of up to $500,000 and take my deduction over time”. This may not be what you want or need. In general, leases just are not as beneficial as they were 20 years ago.
Our advice: Seek a qualified tax accountant before entering into any lease and let the accountant read the lease document. Sales people are not tax accountants, they are sales people and some will tell you anything to make a sale. Caveat Emptor!
Some taxpayers want to deduct expenses for questionable businesses. As tax accountants, we must determine if they have a business or a hobby. Hobby losses are not deductible. These discussions don’t last long as the taxpayer is often convinced they have a business with deductible expenses. I love the response that "someone" told them they could. The problem is that "someone" is not signing the return. So, when does one have a business?
A business, by definition, is the pursuit of profit. Pursuit does not mean you arrive at your destination. Some businesses lose money for years. So what makes a business a business? Intent of the owner is a lot of it. When a taxpayer says they are trying to make a profit we have to take it at face value. Only their future actions will expose the true intent.
If taxpayers want to show they are pursuing profit, then monitor profit. This means separate books and records and reviewing financial statements periodically. In the early years of a business, it is important to have projections of when profit is expected. IRS Audit Guides usually have some blurb about a businesses showing profit one out of last five years or seven years or something like that. The myth I hear a lot is “if we show a profit this year they won’t audit me”. That is just not true since the illusion of profit is not really profit. The Audit Guides are simply guides, no more. There are other factors to consider.
Other factors: the amount of hours spent in the activity, previous expertise and success, time spent learning the business and honing skills to name a few. How reasonable are the expectations? The amount of pleasure is important. Example: being in the business of bass fishing is a lot more pleasurable than someone in the business of digging ditches. Losses from the business of bass fishing will be scrutinized more than losses from ditch digging. We usually find in the world of sporting events (like fishing), the main source of revenue is from sponsorship. If the bass fisherman isn’t knocking on doors for sponsor money, then how will it ever be profitable?
The best advice I can provide for all businesses: Keep separate books and records (including hours spent), comply with all normal business regulations like issuing W-2 and 1099 Forms and file Sales Tax Returns when necessary. Register with all Federal, State and local agencies as well as obtain proper licensing. Join associations and industry groups to expand your knowledge of the industry. Carry the proper insurance. In the end, it will be the actions of the owners that will determine the nature of the activity. Sometimes it is hard to explain, you just know it when you see it.
The best advice for those trying to turn a weekend hobby into a business: If you don’t reasonably expect to make a profit and can’t reasonably forecast one, forget it, you don’t have a business. If you still think you have a business, then follow the advice above and be prepared to shut it down if you find you can not reach profitability.
Gee, what can go wrong here?
Businesses usually ask "Do I have to issue those 1099s?" Let me provide the warning and from this point I am tired of discussing 1099 reporting.
A little history:
2011 - IRS added to business income tax returns the questions regarding requirement to issue 1099 and subsequent compliance. This falls under the penalty of perjury statement of the tax return and under the tax accountants due diligence responsibilities. What does that mean? Taxpayers can be charged for perjury and the accountant can be banned from practice for noncompliance..
2016 - IRS greatly increased fines for non-compliance with 1099 information reporting and moved up the due date up for the Non-Employee Compensation portion.
2019 - Earlier this year IRS announced that they will bring back the 1099-NEC for Non-Employee Compensation in 2020, thus moving the Non-Employee Compensation off the 1099-MISC and back to its own form, as it was in 1982. Why are they doing this? The answer is that they are having difficulty in separating 1099-Misc for Non-Employee Compensation from other items on the 1099 that have different due dates. The separation will provide an easier path to assess penalties for late filing these documents.
Clearly the IRS is concerned about 1099 Forms. The new 1099-NEC for 2020 will first be issue in 2021, five years after penalty increase and 10 years after setting the compliance trap. Clearly a 10 year plan in place to go after noncompliance. Our advice is to file all information returns that are required by their respective due dates. For this office, we want all 1099/W-2 work done before February 1st. By this time, we are into income tax season.
Think about this, IF the "check the box" on the tax return is marked "compliant" they can cross check to see if they really were issued. No cross match, then someone is in trouble. IF the "check the box" marked not compliant, could be an automatic audit. The issuance of late 1099-NEC will be automatic penalty. You have been warned, it can not be any more clear.
BASIS IN STOCK
Stock Basis (especially for S-Corp) has been a big deal for many taxpayers, especially in light of the Schedule E changes in 2018. The point of basis calculation is to limit losses to the amount of investment in the S-Corp. For example $100 paid for stock should never have deductions or tax free distributions greater than $100 unless there is a profit to distribute. A question I get many, many times, “if we had a sole proprietorship or a partnership would we get the loss?” and the answer is usually yes.
WHY CORPORATE LOANS DON"T COUNT
A sole proprietor and the individual are considered one. When the sole proprietor takes a business loan, they are personally responsible for the debt. When the corporation borrows money, the debtor is the corporation, not the shareholder. Even when the shareholder co-signs, they are not responsible until default. Without default, there is no basis in the stock. Think of it this way: A shareholder has $100,000 gain in Ford Motor Company. Can the shareholder simply co-sign a loan for Ford for $100,000 and avoid paying taxes on the gain? After all, Ford is very unlikely to default on such loan. When the loan is paid off the shareholder is free of obligation and tax? It makes absolutely no sense to allow a co-signer to count the loan as basis until they become personally liable, otherwise no investor ever would have a gain on a stock sale.
UNDERLYING SYSTEMIC PROBLEM
In an S-Corp, when the owner takes more out of the business than it can support, it becomes the tax accountant’s job to stop it (or tax it) through basis limitation rules. In a sole proprietor and partnership it becomes the banker’s job to stop it with a foreclosure notice. In the end, the path is the same. Any successful business, regardless of structure, should always pursue profit and retain enough funds necessary for operational needs, asset replacement and/or expansion. When properly managed, there should not be a basis issue. A healthy balance sheet is often said to have less than 50% of the assets financed, A/K/A the Debt to Asset Ratio. Financial advisers might consider this an early warning and a potential benefit of an S-Corp, not a disadvantage.
WHY THE S-CORP IN THE FIRST PLACE
One benefit of an S-Corp is setting the owners wages below the profit level and the excess amount saves Social Security and Medicare tax when compared to a sole proprietor. The wages need to be “reasonable” and the excess (if any) can be distributed via a dividend. Technically there are no available dividends if there is no profit. If the wages create a loss, then the owner has over paid taxes and created something I call “Phantom Income”. This should be avoided in the S-Corp structure. The IRS position is that an S-Corp should not be structured solely for tax benefits, but for “business reasons”. What is a “business reason”? That would be separation of liability from the shareholders assets, which I will leave to the attorneys to explain. This separation of liability benefit is also the reason corporate debt doesn't increase shareholder basis. They really are trade offs or different sides of the same coin.
So, when COULD an S-Corp be appropriate?
1) When a business is pursuing profit
YOUR ADVISER DID NOT FAIL YOU
If someone said they are going to have losses for many years and will be heavily leveraged by banks, then a different structure would be in order. It is rare that anyone goes into a business with the intention of losing money for years and using bank loans to sustain themselves. In over 30 years of being involved in finance, I can say that I don't recall anyone ever telling me they are committing 100% of their future and their family's future to a business that will lose money. They usually have very high expectations of profits, they usually like the idea of separating liabilities (especially product liability and employee disputes), usually favor saving payroll taxes and sometimes they like the idea of being eligible for Unemployment Benefits when they have no work.
It is not the banker's job to tell you when your business is poorly managed. I don't think it's the tax accountants job unless the taxpayer ask for such analysis, but when it limits the deductions on the tax return the elephant in the room must be addressed.
How Real Estate rules work
The S-Corp Stock Basis issue is not only a situation of losses, but an issue with the Code Section 179 write-off of up to $500,000 of equipment purchase, If the Corporation borrows $500,000 to purchase assets and then elects to write-off the full amount in order to reduce a $500,000 profit, then the Corporate bank account can be cash rich yet no tax profit in which to declare a dividend. A distribution then translates into a return of capital until exhausted and then a gain on the stock. At this point should the corporation have a loss, the shareholder has no stock basis to declare the loss as described in the article below. The S-Corp can not be managed solely by the bank balance.