Our Taxing Times

A Hobby or For Profit-More Than an IRS Designation

Is your “business” for profit or a hobby? Now, don’t get riled up. I’m not trying to insult you. I’m not talking about what the business does but how you approach the business. Yes, we all want to make money but is that your main factor for starting the business? If it’s not, that is fine. Great businesses have developed from someone’s garage when they found a market for their passion.  They became a for-profit business. It doesn’t matter if they are making computers or doilies as long as they treat it as a for profit business. At the same time, there are owners who treat their business as a toy and it goes nowhere. How many restaurants or stores limp on because the owners are having too much fun being in business and not running the business enough. It’s up to you, the owner. Oh, yeah, and the IRS too.

The "Boss" Myth

Let’s clear up a misunderstanding when it comes to owning your own business especially at the start- You’re your own boss. I know you have heard that and that might be one of the reasons you want to start your own business. But do you understand it, really understand it? Yes, it means you can work from home in bunny slippers, run the business the way you want it run, fire a great employee because there is no work, fill out tons of paperwork, deal with the health inspectors or the unemployment department, clean up the overflowing toilet. Have I got your attention?

Being your own boss is not just the good stuff. It is also knowing everyone’s job and taking responsibility for it. Too often, a potential business owner looks at their boss and is sure they can do that job. They see what the boss does and it doesn’t look so hard. But what is the boss doing they don’t see? And what is the boss’s boss doing that affects their job and the business as a whole? And don’t forget all the support people off to the side. Or, have you thought about the work that happened years ago to develop relationships with vendors and customers. Even if you are hiring people to cover some jobs, you still have to know enough to be able to supervise them, to make sure they are doing what they are suppose to be doing.

Sally worked in the shoe department for a big department store for years. She worked her way up from sales clerk to buyer. Sally dreamed of her having her own shop and finally she got her chance. “Sally’s Shoes” was very successful and closed within 2 years. Why? It could have been that Sally didn’t know enough to see that the accounting student she hired to do the books wasn’t keeping her payroll deposits up to date. Or, that Sally didn’t really understand cost of goods and pricing. Or she didn’t pay her bills on time and her vendors dropped her.

Starting a business is fun. You can spend hours on picking a name, finding a location, writing ads, preparing for opening day. Running a business is great. But you also have to be the boss, too. You have to understand and do the not so fun stuff. Things like labor rules, tax filings, cash flow, missing employees, bounced checks … I could go on but I’m sure you get the idea.

The best business concept won’t be a long term success unless the owner is willing to be the boss. A real boss.

Now, For the Numbers

Numbers – you have a Social Security Number, a Driver’s License Numbers, credit card numbers, numbers, numbers… But to start a business, you will want new numbers; an Employee Identification Number (EIN) and state business numbers. It is possible to do without an EIN if you are a sole proprietorship that will not be subject to sales tax or payroll withholding. You can always get one later if you need it. But check into what you will need to set up a checking account for your business and what your state requires.

Getting and EIN is simple. You can get the form off the IRS Web Site (You need a SS-4) Once you have that filled out, you can mail or fax the SS-4 to the IRS, or immediately get a number by phone or online. You will receive a letter in a few weeks for your records. If you have questions, ask your preparer or call the IRS. Basically, the form wants info on the firm, what type of entity and who is in charge. It asks you to make an estimate of payroll and income for the first year. The payroll number gives the IRS an idea how often to set up you payroll tax deposits. Keep track of the number and how you named your business on the application.

Once you have your EIN, you can move on to the state numbers. This you will have to research since every state has a different set up. Check with the tax department to see what you need for payroll, sales, or use tax. Don’t forget specialty taxes. Kansas has special requirements if you are selling alcohol, tobacco products, or are running a dry cleaner. If there is a special state tax, I would make sure that there is not some Federal registration, too. Hopefully, your research has turned that up and you’re ahead of me on that.

If you haven’t done it before, this is the time to register with any other state department. In Kansas, partnerships, corporations, LLCs all register with the Secretary of State (and pay and annual fee) as part of setting up the business. Some states require sole proprietors to also register.

 

So now you are ready to start your business. This series was never meant to be a step by step guide to opening and running a business. My purpose is to keep you out of tax trouble and get you thinking as a business person. If you need more help or have more questions, look at the start up resources suggested in the “Homework” post or do more research. I want to focus on what I know best; bookkeeping and most importantly taxes.  There are a lot of tax issues that can get a business own into trouble and I will cover them. But please remember that some of these are very complex issues and I will only be doing overviews. I want you to know what is required and where to look for specifics.

State Tax Simplifcation

I’m on the AICPA’s (American Institute of CPSs) press release email list and occasionally something they send out interests me and it ends up here. (I’m sure that is why I’m on their list.) I just received a press release about their Congressional testimony at a hearing about a new tax law that may change how a non-resident’s income is taxed by the non-resident state where she is working.

The legislation is H.R. 1864, the “Mobile Workforce State Income Tax Simplification Act of 2011.” Its primary sponsor is Rep. Howard Coble (NC). The bill would give taxpayers 30 days of employment in a non-resident state before they would be responsible for state tax and withholding.The bill itself is short and as much of my understanding comes from the AICPA testimony and examples as from the bill. 

My understanding is that this will not apply to all non-resident employees. I have a few clients each year who live in Kansas but take a job at an Oklahoma casino. They work for a while then quit and move on to the next job. Even if they don’t work for 30 days, I don’t think see bill applying to them. I think it would apply to businesses that send work crews to short term assignments in states other than their home state. For example, a Kansas roofing business that takes jobs in Oklahoma. If an employee work for less than 30 days in OK, they would be covered by this bill. If the employee works 31 days, their OK taxable income begins and withholding starts. Everyone gets 30 days free. This would affect not just the construction business but also firms doing on site visited for inspections and audits. And don’t forget the athletes and performers who may only physically be in a state for a couple of days but still have to file a return for the income earned. The idea is to reduce the paperwork burden for small businesses that have a de minimis presence in non-resident state.

Sounds kinda good, but I want some clarification. First, am I right and this legislation doesn’t apply to my client working in the casino? What about the sole proprietor that takes jobs in more than their home state? It sounds like they might be covered if they are doing all the work, but I would want to make sure since I have a couple in that boat. Also, how will this other business entities like partnerships and S-Corps?

I don’t think passage of this bill is a slam dunk. I’m sure that the States will fight it. It would be bad enough to lose the taxes from Joe the roofer but losing the tax on the high salaries some athletes and performers earn would really hurt them. Also, the business owner now has to deal with 2 sets of rules and who qualifies for which.

But, it’s an interesting idea and I will keep an eye on H.R. 1864.

Tax Business - a Soap Opera?

Disclaimer: This post was written and published last August on another blog. My intention was to cross post it as a review of what was happening in the tax business. I had covered much of it as it happened. Today I was planning an update with a link to that Our Taxing Times post and I discovered that there was no prior overview post. This is a revised and updated version of original article I intended to post.

There is a new world coming, at least in the world of tax preparation. The last 2 years have shaken up the field with major changes unseen since e-filing was begun. Tax forums, blogs, and boards have filled with discussion of the changes and speculation of how the new world will work and how it will affect their own world. E-file mandates, income tax preparer registration, and the removal of the debt indicator are major changes in themselves but together they destroy the status quo. And they will trickle down and affect the general public too.

Business Entities - The Very Basics

You’re ready to go. You have a business you want to start. You have some money to begin with and plans are in place. Not so fast, you might want to think for a few minutes about the legal structure of your business-the entity. The dictionary defines an “entity” as: “That which is perceived or known to have its own distinct existence.” In business, it generally refers to how distinct the “owner” is from the business. This effects how the business is organized and taxed. The more distinct from the owner, the more rules there are to operating legally.

There are a lot of business structures. Some are unique to a type of business or investment. And someone regularly comes up with a new variation on an established form. For purposes of this post, I’m only going to deal with the five I see most.

• Sole Proprietorship (71% of all business tax returns*)
• General Partnerships (8.75% of all business tax returns*)
• C-Corporations (7.38% of all business tax returns*)
• S-Corporations (11.94% of all business tax returns*)
• Limited Liability Company ( taxed as one of the above)
• *IRS data for tax year 2004.

How do you decide? Look at your business right now and where you see yourself in the next 5 years. Then start with the structure that will best help you grow your business. The entity can always changed at a later date if you grow in a different direction. Factors that you need to look at are:

• Taxablity of profits
• Wages and Social security/Medicare treatment
• Bookkeeping requirements
• How losses are handled
• Fringe Benefits
• Personal Liability
• Organization and state reporting requirements
• Owner flexibility and transformation
• Vendor requirements

I have a chart you can download that overviews the 5 basic entities and how the main issues are handled. That should focus further research.

For almost 75% of us, being a sole proprietor is best option to start. But, more that one owner, liability concerns, or other issues may mean you need a more complex structure. If you are even thinking about going with something other than a sole proprietorship, talk to your attorney to make sure you understand the legal issues. Too often, the entity is chosen based on a misunderstanding of that entity. For example, a Limited Liability Company (LLC) is very popular but are you clear on what liability is limited? How does that differ from Corporate liability protection.? Or, what paperwork do you need to file with your state? (Even with a sole proprietor, there may be a registration with your state.) If you don’t want to spend money on a legal visit, please do your homework and make sure you understand the entity type and the registration documentation required.

Why do this now before you open the business? Because the next step is to get tax ID numbers and they will want to know what type of entity your business is. And you don’t want have to change the entity while you are working through other start up issues.

New Forms for Capital Assets

Back in 2008, The Energy Improvements and Extension Act of 2008 passed with a provision that required brokers to track the cost basis of stocks and mutual funds they purchase for clients beginning in 2011. This basis is then reported to the client (and the IRS) on a Form 1099B.

What is basis? For stocks and mutual funds it’s the purchase price plus commission. Then it depends on how I chose to handle the dividends and capital gains. If I take those in cash, my basis doesn’t change. However, if the dividends and capital gains (if a mutual fund) are reinvested in more shares of the fund or stock, then my basis changes to reflect the additional shares and their cost. When the stocks or funds are sold, I don’t pay tax on the actual selling price but the difference between the selling price and my cost basis. Let’s say I have $5000 to open a brokerage account and have the broker buy all the shares of MAC stock they can for that amount (say 250). My basis in MAC is $5000 or $20 a share. That won’t change if I have the dividends paid to me when they are issued. If I have the dividends reinvested, I add more shares and change the basis because I will report and pay tax on those dividends. For example, at the end of the year, my stock earns a $50 dividend. The price per share at that time is $23 so I now own 252.17 shares ($50/23 added to the original 250). My investment is $5000 + 50 = $5050 or $20.03 a share. This process is repeated every time there is a dividend or capital gain distribution for a mutual fund.

Too often, the preparer has to calculate the basis at the time of the sale basis on what statements, tax returns and company information the taxpayer and preparer can find. Part of the tax gap can be traced to incorrect basis reporting when the stock or fund is sold. (And out right lying about basis is part of that problem too). That is why the new rules about reporting the cost basis on the 1099B that reports the sale of the security. Actually, a lot of brokers already do part of this. I get 1099Bs that come with cost basis info in separate statements all the time. Currently, these are not reported to the IRS. But this year that changes. Technically, the new rules only apply to 2011 and beyond purchases but I expect to see the brokers who already provide the info to be using the new forms.

The new IRS forms for reporting stock and mutual fund sales have been released in draft form. (Thanks to Atticus and Doug L. for the heads up.) The big change is the new form 8949. This form is where the actual transactions will be reported. The totals will be carried from here to the revised Schedule D. Just like the Sch. D, Form 8949-Sales and Other Dispositions of Capital Assets breaks the sales into long and short term assets. But it also separates the assets by how the sale is reported; on 1099B with a cost basis, 1099B without a cost basis, and sales with no 1099B. One reporting type will be allowed per 8949. So, it will be possible to have 3 Form 8949s on a return carry to one Sch. D. (Can you say, Paperwork Reduction Act?)

It will take some time for the new reporting requirements to impact the tax gap significantly since it is not retroactive. It only has to cover 2011 and beyond purchases. As I said, I hope that brokers who already provide that info to their clients will adopt the new rules this year. One impact some investors might have already felt is an increase in broker fees to cover the additional record keeping. Hopefully, that will be offset by a reduction in tax return preparation fees for recreating a basis.

Links to download the draft forms:

8949

Schedule D

1099B

1099B Instructions.

Dear CPE Company

Dear (fill in company)

Please, do not call me again. I'm sorry I don't do business with telemarketers. I understand with the new licensing rules and mandatory continuing education (and not to mention classes for the actual test) you have a great opportunity to increase your business. However, you will not convince me to buy from you from a phone call. A bored marketer reading from a script they don't really understand is a waste of both of our time. And even worse is that no thought has really gone into that list. If you're soliciting new customers, then run the list against current customers. Or, pull EAs, CPAs and attorneys off your licensing test preparation course calling list. Dumb!

By this time of the year, I have already figured out my CPEs for the year. I know what I want to study or brush up on and ordered those materials or signed up for the classes. If you want me to seriously consider taking some CPE from you, send me a flyer/brochure or email me. If I have already bought for this year, I'll put it in a file or bookmark the URL. Simple! Oh, if you do email me don't send me something daily/weekly just because it's free. And I block graphics because of download times, so if all your content in in graphics, you've basically sent me a blank email.

So (fill in company), if you want me to consider doing business with you, have good, well presented content, give me a choice of methods of study (paper, online, PDF, live), don't gouge me with the price, and make sure you get the IRS's approval of the CPEs. And don't call me, I'm sure that list you bought has an email or snail mail address.

A Quick Word on Franchises.

I want to quickly cover buying a franchise instead of building your business from scratch. As a disclaimer, I have never owned a franchise but I have worked for people who did own one. Sometime they can work, sometimes they don’t.

Buying a franchise is basically buying a business kit. What you actually receive will depend on the franchise. Sometimes, all you are buying is the right to use their name and a set of basic instructions. Other times you’re buying a package that includes a detailed guidelines, marketing, materials and all you need to do is manage. In some cases, you aren’t really building a business; you are buying the chance to be the manager.

There are at least 2 types of costs with most franchises. The first is the actual cost to buy the franchise. This will depend on the franchise. A big name like HRB or McDonalds can cost a small fortune, if you can find one for sell. The other basic franchise fee is the royalties on your income. So if you decide to buy a “Merry Muffins” franchise, you will pay $X for the materials on how to run that business. Then you will be giving them X% for every muffin, coffee or whatever you sell. If you’re lucky, the fees will stop there but with most franchises you pay a marketing fee and you may have to buy your materials or services from them. (This is on top of the costs of the location and getting started.) All of the costs are outlined in the franchise’s Uniform Franchise Offering Circular (UFOC). The UFOC should outline all the fees and restrictions that will be part of the contract. Some franchise contracts will specify locations and/or hiring restrictions, and set rules on selling your franchise. And don’t forget non-compete clauses and confidentiality rules that can continue for years after you close the business.

My biggest concern about franchises is that you have no control about the main business. Your “Merry Muffin” store might be doing very well but if the main company is having problems these can trickle down to you. There are instances of the main company being gone but there are still a few former franchisees in operation but that doesn’t happen too often. Even if the main business is solid, that doesn’t mean that the corporate attitude won’t change. “Merry Muffin” may have started as a family business and franchisees had few contractual restrictions. However, a few years later you could be under pressure to change your business to fit into the new “Merry Muffin Lounge and Laundromat” format.

For the right owner and the right business plan, a franchise can be a good start into business if you understand that on top of business issues any start up will face, a franchise will bring problems unique to franchising. Do your homework.

The Money Question?

"Money, if you’ll pardon my expression. Money is like manure, it’s not worth a thing unless it’s spread around encouraging young things to grow."

                                 “Dolly Levi” from Thornton Wilder’s The Matchmaker

 

That’s one of my favorite quotes and pretty well sums up starting a business. You will need money. Not much for some. But with other start-ups you will need a considerable amount. No matter how much you need, you can easily spend a lot more if you are not careful. The money you need depends on the business and if you have other income for living expenses. If you’re starting your business as a side to your job, all you need to plan for are the business expenses. Otherwise, you have to plan on money to live on until the business starts producing.

Your research should have given you an idea of what types of expenses to expect but it’s up to you to decide what to spend on those expenses. Some will be fixed like licenses or starter kits. Some you can control by choice such as rent and advertising. Some expenses are a little of both like utilities. But realize that you have options. You may see your business in one of those nice building at an upscale office park but you don’t have to start there. Most customers won’t see that your stove is 10 years old as long as you are turning out good food. A decorator isn’t needed as long as you store/restaurant is clean and comfortable. You can upgrade later. You don’t need to spend a fortune on advertising if you are willing to think about alternatives. There are lots of long lived business that started with very little money.

Once you have an idea of how much you need you need to raise the money. If you’re lucky, you have enough saved or have family or friends who will loan or give you start up money. If you need to go to a bank, you will probably need a business plan to document your business and to show them your have thought about the venture seriously. For this, I can’t recommend too highly the Small Business Development Center near you.

No matter how big the business, you need to keep your money separate from that of the business. Spend a little money and set up a business checking account. All business income should be deposited into that account and all business expenses should come from that account. If you need to add personal funds to the business, write a check to the business and don’t pay business expenses from your account. Need to take income out of the business? Then write yourself a check as draw. And don’t pay personal expenses out of the business account either. If you mix funds, then you will have a harder time keeping track of how the business is doing day to day. Then there are tax and IRS issues we will discuss in a future post. For now, a separate checkbook is worth the slight expense and extra work.

You don’t have to spend a fortune to start a business but you do have to find out what expenses to expect and allocate money to them. But this can be a time where a little creativity or elbow grease/leg work is more effective than thousands of dollars to waste. And this goes for personal expenses also. If you’re counting on the business to support you, this is a good time to look at your living expenses and cut out the frills there too.

 

Years ago, I posted this article about keeping track of cash flow. But this is also a good tool for projecting income and expenses. I use one like this. Each year, I create a new one based on the previous year’s spreadsheet. As the new numbers come in, I change to actual expenses. That way I can play with “what ifs” like an increase in rent, a capital purchase or decrease in income.