This blog post is going to discuss the ways small business owners get in trouble with the IRS and how they can correct those mistakes.
Deadly Sin #1: Commingling Personal and Business Funds
Many small business owners are in the habit of commingling both their personal and business funds.
Examples of commingling funds are:
-Depositing business checks into your personal bank account.
-Using the same bank account for business and personal use.
-Using your business credit card because you forgot your
personal card.
While the IRS doesn’t require separate bank accounts, not having them exposes you to legal issues (such as piercing the corporate veil) and makes bookkeeping exponentially more difficult. If you have an S-corp or C-corp and you commingle funds, the IRS will most likely deny many of the deductions something that can be solved by setting up an accountable plan for all employees.
Have you already been running your business through your personal bank account? That’s ok, just get a separate one now (put it on a must-do list for this week). Start depositing your business income into it and start expensing through it. Separate your business and personal expenses up to the point of opening your business account and summarize your business expenses into categories.
Deadly Sin #2: Not Planning for all types of taxes and annual compliance.
This is a short but very important sin. Most business owners only think about their federal income tax but they should also consider:
- State income taxes
- Franchise tax
- Excise tax
- Payroll tax
- Self-employment tax
- Sales & use tax
- Property tax on Business Property, etc.
You should also be prepared to document annual compliance annual reports, meeting minutes, paying annual filing fees, etc. If you’re not sure of your annual requirements, consult your tax advisor or attorney.
Deadly Sin #3: Not paying quarterly estimated tax payments.
If you expect to owe $1,000 or more when you file your return, you most likely need to make estimated tax payments - 100%/110% of prior year tax liability or 90% of estimated current year tax liability. Most people think these payments are optional however, if you don’t do them you’ll be penalized.
I always recommend to my clients who have self employment income and unearned income from investments to, at minimum, run a yearend tax projection before the end of the year to eliminate surprises and allow time to do some tax planning to lower their tax liability before year end.
Deadly Sin #4: Inaccurate Bookkeeping (or No Bookkeeping at all)
A big mistake many small business owners make is waiting until tax time to catch up on record keeping. To avoid missing out on deductions and other benefits, try to organize your record keeping by making it as easy and as automatic as possible.
Online apps, bank and credit card downloads, for example, can improve accuracy and make record keeping easier. Save yourself and your tax advisor the headache and save on your tax preparation fees by having accurate bookkeeping in place.
Bookkeeping options include platforms like Xero, Wave, Freshbooks, or my personal favorite, QuickBooks Online. Transactions easily download from your bank and credit card accounts and there are tons of tutorials online. However, if you are not accounting inclined, please save yourself the headache and hire a professional so you can concentrate on building your business and wealth.
Deadly Sin #5: Missing out on tax deductions or not tracking them accurately
Not tracking deductions accurately or missing out on them altogether can cost a small business owner not only time but also money. Let’s take a look at some common mistakes:
Deducting startup expenses incorrectly- The IRS will allow up to $10,000 in deductions from startup costs in your first year ($5,000 for startup and $5,000 in organizational costs) if your total expenses did not exceed $50,000.
Not tracking business mileage- Keep a small notebook in your glovebox or download an app like MileIQ to help track your business mileage over time
Not keeping receipts- The IRS will disallow deductions without a receipt for proof. Typically the IRS will not approve of credit card statements as a receipt.
Try to find legitimate ways to move personal expenses to your business. For example, Section 105 plans can be used to write off medical expenses. Consult a tax professional to learn more about what kinds of personal expenses can be moved into business.
It’s important not to exaggerate your deductions. You can’t write off things like clothing or makeup without a business purpose. For example, I work with a professional opera singer and she has special stage makeup for her performances that would be deductible. The suit you wear to work is not deductible because you can wear it outside of your place of employment.
Deadly Sin #6: Classifying an Employee as an Independent Contractor
Some small businesses make the mistake of classifying what should be an employee as an Independent Contractor. As a result, the business would need to pay back taxes as well as penalties for income taxes, Social Security, Medicare, and unemployment taxes.
Let’s take a look at what makes an employee vs. an independent contractor:
Behavioral Control - the degree the employer exercises control over the worker’s time & tools. If the employer trains the worker and directs the work, sets specific hours, and dictates how the work will be completed, the individual is an employee.
Financial Control - If the worker is paid on salary or by the hour, they are likely to be designated as an employee. If the worker is paid a flat fee per job or project, they’re more likely to be an independent contractor.
Type of Relationship - If the work being done is directly related to the company’s core work, then the worker is probably an employee. Alternatively, if the worker is providing a service that is on the periphery of the business, they could be designated as an independent contractor.
Deadly Sin #7: Wrong Entity
There are 5 main types of businesses: Sole Prop, SMLLC, Partnership, S-Corp, and C-Corp.
Lets see how choosing a business entity classification can affect small business taxes.
I see most businesses open an LLC or a C-corp without consulting an advisor. An LLC is great for asset protection but, generally, won’t save you any additional tax unless you elect it to be taxed as an S-corp or C-corp for tax purposes. With a C-corp you are generally subject to double taxation (once at the corporate level and then dividends are taxed at the individual level).
Of course, there are times when these entities are advantageous, such as taking advantage of the Ccorps lower 21% tax rate if your personal tax rate is in the 37% bracket.
Sometimes it’s best to stay a sole proprietorship until your business is viable and you have enough profit to make a change in entity worthwhile.
Just because your small doesn’t mean you don’t need the liability protection of a formal entity check with your trusted attorney for your state’s laws.
The right entity sometimes depends on your state. In Tennessee we a have Hall Tax of 3% on interest and dividends meaning S-corp owners are subject to the Hall tax for distributions above their reasonable compensation. There are a handful of states, such as Texas, Illinois, and Missouri, that allow Series LLC which are great for real estate investors. They allow one LLC filing fee for multiple LLC’s formed within the Series.
Some entities allow for the deduction of certain expenses that others don’t. For example, the C-corp enjoys a wide range of fringe benefits for employee owners not available to S-corp owners, such as life insurance and disability insurance.
So now that we’ve looked at the 7 biggest mistakes, how can you move forward with avoiding them? Start educating yourself through reputable sources online. You should also hire a reputable and competent tax advisor who will proactively work with you and your other wealth advisors. Yes, it may cost an additional amount to hire the experts but, remember, don’t step over a dollar to pick up a nickel! These experts will SAVE you money!