Business Entities – What are the Tax Implications?

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Deciding what business structure to establish is an important decision for you as a business owner.  The type of business entity you choose will determine which income tax form you file.  It will also determine how you are paid by your business.  Before forming your business entity check with an attorney and accountant.

SOLE PROPRIETOR

A sole proprietor is the easiest form of business to establish.  This is an unincorporated   business with only one owner.  You should check with your state to see if you need to register your business.  You may also need to register your DBA.  Some localities also require registration.

You will not receive a paycheck as a sole proprietor, instead you receive a draw.  These draws are not company expenses, rather they are a debit to an equity account commonly called Owner’s Draw.  This reduces the equity you have in the company.  You do not withhold any taxes on a draw, you pay a self-employment tax when filing your tax return.  The self-employment tax includes the company portion of social security and medicare.  An sole-proprietor does not pay federal unemployment tax, check with your state to see what their requirements are.  You may have to pay worker’s compensation, again check with your state.

A sole proprietor files a 1040 U. S. Individual Income Tax Return, a Schedule C Profit and Loss from Business and a Schedule SE – Self-Employment Tax.  You may also be required to pay quarterly estimated tax.

PARTNERSHIP

A partnership is a business owned by two or more persons (or other entities).  Each person contributes to the partnership with some kind of capital, labor or skill.  Each partner shares in the profit or loss of the business according to their percentage of ownership.

Partners do not receive payroll checks, instead they receive either a draw or a guaranteed payment, or both.  A draw does not reduce expenses, it reduces the equity the partner has in the business.  A guaranteed payment is an expense to the business.  Partners do not have any taxes withheld on the draws or guaranteed payment, however, like a sole proprietor they may have to pay quarterly estimated tax.

A partnership does not pay income tax, any profits or loss “passes through” to the partners.  A partnership files Form 1065 U. S. Return of Partnership Income.  Because a partner is not an employee they will not receive a W2, instead they receive a Schedule K-1 (Form 1065).  The K-1 is due to the partners by the due date of the 1065 Return.

CORPORATIONS

A corporation is a legal business structure chartered by the state.  Shareholders of the corporation contribute money, property or both.  A corporation can conduct business, realize a profit or loss, pay taxes and distribute profits to shareholders.

The profits of a corporation are taxable income to the corporation and the dividends to the shareholders are taxable income on their personal income tax return.  This creates double taxation.  The dividends to a shareholder are not a deduction for the corporation and a loss is not a deduction for the shareholder.

A corporation files a 1120 U. S. Corporation Income Tax Return.  If a shareholder has received any dividends during the year, they will receive a Form 1099-DIV in January of the following year.

S CORPORATIONS

A corporation can elect to be an S Corporation by submitting Form 2553 Election by a Small Business Corporation.  All the profits, loss, deductions and credits will  “flow through” to the shareholders.  The shareholders will report any income or loss on their personal tax return.  This will allow the S Corporation to avoid the double taxation on it’s income.  The S Corporation is still responsible for taxes on built-in gains and passive income.

Shareholders of an S Corporation receive a distribution of the profit.  The distributions reduces the equity in the company.  Shareholders who work for the company are also employees and  should be paid a “reasonable” salary which is an expense.  Your tax advisor can help you in determining how much the “reasonable” salary should be.  Shareholders do not pay a self-employment tax on distributions, however the normal payroll taxes apply to salaries.

The S Corporation files a Form 1120s U. S. Income Tax Return for an S Corporation.  A Form 1120s Schedule K-1 is distributed to the shareholder.  The shareholder may also receive a  W2 if they received wages throughout the year.

LIMITED LIABILITY COMPANY

A Limited Liability Company can be comprised of individuals, partnerships, other LLCs and foreign entities.  Check with your state to see what they allow.  Owners of an LLC are called members.  Some states allow “single member” LLCs.  Again, check with your state to see if that is allowed.

There is not a specific tax return an LLC will file.  The IRS treats an LLC as a partnership, corporation or disregard entity (part of the owner’s tax return).  If there are two member of the LLC the IRS treats it as a partnership, if there is only one member then the IRS treats the LLC as a disregarded entity.  If you want your LLC to be treated differently than the IRS default for taxes you can file Form 8832, Entity Classification Election.

As you can see, there are lots of things to consider when starting your business.  Discuss all this with your tax advisor so that the decision on what entity is best for your business will cost you the least amount of money in taxes.

 

 

Bartering and How to Enter in QuickBooks

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In these days and times, when budgets are tight, you may find that you can trade your service with another business to save on your cash flow.  This is called bartering and it is becoming more popular.  However, the fair market value of the property or services being bartered is taxable income to both parties.

The IRS has issued four facts on bartering:

  1. Organized bartered exchanges A barter exchange functions primarily as the organizer of a marketplace where members buy and sell products and services among themselves.  Whether this activity operates out of a physical office or is internet-based, a barter exchange is generally required to issue Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, annually to their clients or members and to the IRS.
  2. Barter income Barter dollars or trade dollars are identical to real dollars for tax reporting purposes.  If you conduct any direct barter – barter for another’s products or services – you must report the fair market value of the products or services you received on your tax return.
  3. Tax implications of bartering Income from bartering is taxable in the year it is performed.  Bartering may result in liabilities for income tax, self-employment tax, employment tax or excise tax.  Your barter activities may result in ordinary business income, capital gains or capital losses, or you may have a non deductible personal loss.
  4. How to report The rules for reporting barter transactions may vary depending on which form of bartering takes place.  Generally, you report this type of business income on Form 1040, Schedule C Profit or Loss from Business, or other business returns such as Form 1065 for Partnerships, Form 1120 for Corporations or form 1120-S for Small Business Corporations.”

So, now that we know what the IRS has to say, how do we record this in QuickBooks?  During my research on this I found a couple of different methods for recording barter transactions.  I’m going to giving the directions on the one I think is the best one to use.

Because you will be paying bills and invoicing and receiving payments from both a vendor and customer with the same name, you will have to distinguish them in QuickBooks since QuickBooks does not allow duplicate names in lists.  For vendors you could add -v after the name and for clients/customers you could add -c.

  1. Go to your chart of accounts and click on new.  Set up a new account called Bank and name the account Clearing Account (You can also call it Barter).  If you use account numbers enter an account number.  Click save and close.
  2. To record a barter transaction from the vendor go to the Vendor tab and Enter Bills and enter a bill for the vendor for the goods or service you are trading with from this vendor.  Click save and close.
  3. Next you will enter an invoice for this Vendor/Customer just as you would for any other customer.  Just don’t forget to use the Customer Name with the -c after it.  Click save and close
  4. Now you are ready to receive payment for the invoice.  Go to Receive Payment and enter the Customer Name, enter the amount, and mark the invoice to be paid.  In the Deposit to field click the drop down arrow and change from Use Undeposited Funds as a default deposit to account to Clearing Account (or Barter).  (If this file is not available to change you will need to go to Preferences > Payments and under the Company tab un-mark that box as the default).  Click save and close.
  5. To pay the bill, go the the Pay Bills and mark the Vendor and invoice you are going to pay.  At the bottom of the screen where is says Payment Account, click on the drop down arrow and change to Clearing Account (or Barter).  Click Pay Selected Bills.  On the next screen click done.

The clearing account can be reconciled just like any other bank account.  If the trades are equal in value the account will be zero.  If not, you may have to write a check or make a deposit to clear the account.

 

Independent Contractor or Employee?

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As a business owner you may hire individuals to help you with the running of the operations of your business.  Are the individuals working for you classified correctly? The IRS has rules on how a worker needs to be classified.  Misclassifying a worker can cause you, the employer, penalties.

The IRS has seven tips that an employer should know when classifying a worker.

  • There are three characteristics the IRS uses to determine whether a worker is an employee or independent.  They are:

Behavioral Control – do you, the business,  have the right to direct or control the     worker’s activity through training or instructions?

Financial Control – do you, the business, have the right to control the financial aspect of the worker’s financial status?

Type of Relationship – what do you, the business owner, and the worker perceive the relationship to be?

  • Your workers are most likely employees if you are controlling their activities, directing their activities and giving them deadlines on when the work needs to be completed.
  • If you are only controlling the result of the work, but not the means and methods or reaching the results, then they may be an independent contractor.
  • If you misclassify your workers you may be faced with high tax bills, along with failure to file penalties, late fees, etc.
  • If you are a worker, you could pay less taxes if you are being misclassified incorrectly as an independent contractor.  As an independent contractor you are subject to self-employment tax.  As an employee, the employer pays part of the social security and medicare tax.
  • If you are unsure of how to classify a worker you can request help from the IRS by filling Form SS-8.
  • You may qualify for relief under Section 530. which states that you are treating your workers as independent contractors because it is an industry standard for that worker, or you have relied upon advise from an attorney or accountant.  To qualify for this relief you will have to have mailed the required 1099 Misc. forms and treated all workers in the classification the same way.

More information can be found in the IRS Website by clicking on the Business link.

Sanity During Tax Season

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Now that tax season is in full swing, what are you doing to keep your sanity?  You have one week until corporate returns are due.  Of course you are still waiting for the last minute information to come rolling in from the procrastinators.  You just need that one little piece of information and their return will be done.  How many of these types of returns do you have?  But there is also the client who hasn’t brought you anything yet.  You wonder when they will be sending you their information.  But you know they always wait until the last minute, so you plan your schedule around them.  In the meantime you continue to work on individual and partnership returns.

You are working long hours every day, up and out the door while it is still dark.  You don’t get home until after dark.  You only see daylight if you go out to lunch or maybe on the weekend, if you aren’t working then.  You aren’t spending any time with your family or friends.  You have piles of files on your desk, your bookcase, your file cabinet, even your floor.  You know there is a light at the end of the tunnel, but until then, how do you keep your sanity?

Take a break from your work during the day to refresh.  Go out to lunch with others in your firm.  On a pretty day, go sit outside for a few minutes.  Run out and get an ice cream or milk shake.  It really doesn’t take that long and you will feel so much better and ready to get back to work.

If you have employees don’t forget about them.  Close your office for an hour on Saturday and take your employees out to lunch.  Keep food and drinks handy for snacking throughout the day.  Example of snacks would be individual size chips, fresh fruit, granola bars, veggies & dip, nuts, and popcorn.  Don’t forget the Tylenol and Advil for the occasional headache.  This will help keep employee morale up.

When tax season is finally over with, go out and celebrate, you deserve it!