Death by Taxes: Here's how to avoid some common tax preparation errors and the harsh penalties they may incur

Pool & Spa News, Feb 14, 2005 by Alan Naditz

 

 

It's that time of year again--the trade show circuit is winding down and the busy season is around the comer. But guess what else is only a couple of months away?

 

Yes, tax time looms--time to sharpen the pencils, pull out the calculator and go over the numbers for the past three months or year.

 

It seems like a simple enough process. Still, every year small-business owners get caught up in the "error trap," according to Michael D. Savage, author of Don't Let the IRS Destroy Your Business: 76 Mistakes to Avoid (Perseus Books). The small mistakes they make can cause them big problems.

 

"Small businesses are audited by the IRS more than any other group of Americans and they get into more trouble than any other," says Savage, tax expert and partner at New York law firm Gersten, Savage, Kaplowitz, Wolf & Marcus, LLP. "Small-business owners are no less honest than most people; on the contrary, they are even more honest."

 

Yet small-business owners often lack the resources to get the professional help they need to decipher IRS regulations--a fact that gets them in trouble, Savage says.

 

"It sounds unfair, and it is," he says. "In many cases, a successful businessperson gets into trouble without knowing it. And it's not because of bad advice. In many cases, they didn't seek out advice, or even know they had to."

 

He offers a quick list of common pitfalls to be avoided as you prepare your company's taxes this year:

 

1 Understanding the cost of errors

 

There was a time when you actually could make money by underpaying your taxes, Savage says. The IRS used to charge about 6 percent interest as a penalty for underpayment of taxes; meanwhile, almost any stockbroker could earn you more than 8 percent on the market. Or, if you needed money for your business, "it was a lot easier to 'borrow' it from the IRS than from your bank," Savage says. But the IRS has wised up and now charges interest at market rates, plus a 3 percent processing fee. It also now compounds interest daily instead of annually or monthly, and it can assess an accuracy-related penalty of 20 percent of the underpaid tax.

 

Bottom line: Make every effort to pay the correct amount, on time. "Today, when you make a mistake on your taxes, the cost can be unacceptably high," Savage says.

 

2 Using withheld payroll taxes to run your business

 

Even a company with only a few employees can incur a huge payroll tax. This money--accumulated from your employees and your company each month--is supposed to go to the IRS within three days of the payroll.

 

But a cash-strapped company may try to withhold the money, figuring it can make up the difference at the next payroll. As a result, the firm risks eventually owing the IRS more than it can ever pay.

 

"The bad news is that if your business cannot pay the withheld portion of the taxes, the IRS can collect the money from you personally," Savage says.

 

If someone in your organization is responsible for making the payroll tax payments, don't try the "I didn't know; it's not my fault" defense, Savage warns. "Often there is more than one person the IRS considers to be a responsible party when it comes to paying taxes," he says. "The owner of the company is certainly a responsible person when he is running the business on a day-to-day basis."

 

3 Forgetting to review the number of withholding exemptions claimed by your employees

 

If an employee submits a W-4 form claiming more than 10 exemptions, you as a business owner must get approval from the IRS to withhold such a small tax amount. If you don't, and it later turns out that the employee intentionally underwithheld taxes, your firm is liable for the difference between what was withheld and what should have been--per paycheck.

 

Remember, too, that you can't get the underwithheld money back from your employees. "You are obligated to make sure your employees don't seriously underwithhold," Savage says. "If you fail to do so, you are stuck with the bill."

 

4 Treating an employee as an independent contractor

 

After failing to pay the proper amount of taxes, this is probably the second most common error that small-business owners make, Savage says. One reason is that the line between employee and independent contractor often is unclear. But in general, a worker qualifies as an employee if:

 

* you regularly instruct and train the person in their job duties

 

* you pay the worker by the hour, day or week

 

* you provide the person with the tools needed to do the job

 

* the person works exclusively for you

 

In contrast, an independent contractor works for many people and chooses to perform services for you, supplies the necessary equipment, and runs a business of his or her own.

 

"Perhaps the best rule to follow when it comes to independent contractors is to not make obvious mistakes," Savage says. "If you hire an in-house accountant, pay him a monthly salary, give him an office and expect him to come to work from 9 to 5 every day, you can't treat him as an independent contractor just because you could have hired an outside firm instead."

 

5 Treating yourself as an independent contractor

 

Savage advises keeping this rule in mind: If you own your company and work for it, you are also an employee of it. This seems obvious, but many small-business owners try to pass themselves off as independent contractors because they want to deduct pension plan contributions or home-office expenses.

 

Falsely classifying someone as an independent contractor can result in hefty fines. Typically, you end up paying that person's income and Social Security taxes; then, if the IRS can find the person, you'll get a tax credit. But that's a big if, Savage says. He adds, "If you're going to treat someone as an independent contractor, try to obtain proof from him--such as copies of his tax returns and cancelled checks--that he paid his Social Security and income taxes."

 

6 Failing to document your "reasonable" salary

 

When you are a business owner, you can pay yourself whatever you feel you're worth. Just remember that you have to pay tax on your income. While you can deduct some of the tax because you're a company employee, the IRS has limits on what's considered "reasonable."

 

To prove you earn a "reasonable" salary, you must cite your qualifications, and compare your paycheck to what others in your field make. Also, demonstrate how hard you work--how many hours per day and days per week you put in, and the number of jobs you perform. If possible, you should offer a comparison of your salary with that of your employees.

 

"If your business pays generous salaries to everyone, yours may look more reasonable," Savage says. "If your salary seems out of line, be able to justify it."

 

7 Failing to charge yourself adequate interest for a loan from your company

 

Writing yourself a loan from your business can work as a nice tax deduction, as long as you follow all the rules. The IRS permits you to charge yourself adequate interest--basically the same as private lending institutions--and deduct it on your income tax.

 

But many small-company owners get carried away, assessing 25 percent or 30 percent interest. Or they don't produce the proper paperwork, such as a contract requiring repayment in a specific amount of time. The IRS can then disregard the transaction as a loan and treat it more as a source of personal income, subject to taxes.

 

8 Failing to substantiate business or entertainment

 

If you reimburse employees for business or entertainment purposes, you must ask for documentation in the form of receipts, credit card statements, phone bills and the like. When substantiating such expenses, the IRS requires you to justify the amount of each travel expense above $75: The business purpose must be established, the period of travel noted and the place of business listed.

 

This isn't hard, but it can become a problem if you don't stay on top of it. "What's easy to do the day after a business trip becomes a real chore several weeks later, and may not get done at all," Savage says.

 

The same goes for cash advances given to employees for business trips, he adds. If they have any left when they get back, it must be returned. Otherwise, the IRS can consider it as general wages, subject to taxes and a possible fine for you.

 

Online tax help

 

* The Internal Revenue Service's home page at www.irs.ustreas.gov offers electronic forms and answers to frequently asked questions.

 

* "Small Business Taxes & Management" is the electronic version of The Small Business Tax Review, which offers articles on financial planning, management and tax-cutting tips for small- and medium-sized business. Visit www.smbiz.com.

 

* The small business tax section of the Nolo Press Web site at www.nolo.com provides answers to basic small-business tax questions.

 

* TaxSites at www.taxsites.com offers a wide variety of accounting, legal, government and general information links.

 

--A.N.

 

A few tax-cutting tips

 

In addition to finding ways to avoid run-ins with the IRS, consider the following ideas for reducing the amount of taxes you pay:

 

Consider a major overhaul.

 

With the new year under way, it's a good time to examine major steps, such as a corporate restructuring, that could benefit your business in the years to come. For example, changing your company to a C corporation might allow you to avoid paying some taxes on its inventory, which might be considered personal property if you're not incorporated.

 

Deduct professional expenses.

 

If you're self-employed and regularly file a Schedule C form, you can deduct business costs such as:

 

* the cost of subscriptions to business and professional publications

 

* trade association dues

 

* business supplies

 

* office-space rent

 

* employee salaries

 

* tax preparation fees

 

* business-related travel deductions, including transportation, lodging, meals, dry cleaning, fax machine charges, passport fees, taxi fares, telephone charges, Internet service connections, and bagging and shipping fees.

 

Think SIMPLE.

 

The Savings Incentive Match Plan for Employees, better known as SIMPLE, is a pension plan available to employers with 100 or fewer employees. Under this plan, a business owner can set aside up to 56,000 a year for pension purposes and deduct that amount on the company's tax return. Eligible businesses include sole proprietors, partnerships, subchapter S corporations, incorporated businesses and limited liability corporations. Eligible employees must have earned at least $5,000 in 2004 or 2003 and may participate if they expect to earn at least $5,000 in 2005.

 

Use the expensing provision now.

 

In 2004, you can deduct up to $19,000 for equipment bought that year. The alternative--depreciating it over a longer time period, typically three to five years--makes for a smaller deduction.

 

Look for losses.

 

Did you have a bad business year in 2004? The IRS lets you take the portion of loss that exceeds your income, "back it up" one or more years (up to three, total) and apply it to your previous income tax. This could result in a refund. For example, if you earned $100,000 in 2004, but incurred $120,000 in expenses, the $20,000 excess toss can be applied to another year, such as 2002, when you may have earned $80,000 and spent only $50,000. The tax paid on the $30,000 you made that year may be reduced--and refunded--after you apply all or part of your $20,000 loss from 2004.

 

Or, if you prefer, you can carry your most recent loss forward up to 15 years, which might result in future tax savings.

 

Throw a party.

 

Company parties and picnics are 100 percent deductible, but they must be infrequent and everyone at work must be invited.

 

Gifts for employees, if small, are deductible for the employer and not taxable for the employee. Be careful about giving cash as a gift, however; employees must declare it as income and pay tax on it. Don't forget your clients--client gifts of $25 or less also are deductible.

 

Delay shipping.

 

When the end of the year rolls around, if you know of customers who aren't in a hurry for the goods they bought, consider putting off their shipments into the next year. This works for many pool and spa firms because they use the accrual accounting method, under which sales don't become taxable (and expenses deductible) until the product is in the customer's hands. The IRS requires this method of companies that maintain inventory.

 

Businesses without inventory have another option: Delay invoicing. The IRS permits these firms to use the cash accounting system, under which income is taxed when received and expenses are deductible when paid--that is, when you actually have your customer's check in hand. Putting off invoicing ensures that the taxes will be paid the following year.

 

Make sure you pay any outstanding bills before the end of the year, however, or you won't be able to deduct them for another year.

 

--A.N.

 

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