Taxolutions
RECORDKEEPING FOR TAX PURPOSES
Keeping thorough and accurate financial records is one of the less exciting tasks that business owners face, but it is a necessary one. In addition to enabling you to monitor the progress of your business and make informed decisions on a daily basis, keeping good records is essential when it comes time to prepare your tax returns. While the smallest businesses may be able to get by with the “shoebox method,” having in place a reliable and comprehensive recordkeeping system for your business finances is crucial if you want your business
to grow.
The types of financial records you must keep are not mandated by law, but the Internal Revenue Service (IRS) demands that your recordkeeping system clearly shows your business’ income and expenses. A failure to keep good records of finances could result in underpayment or overpayment of taxes, penalties for filing late or for underpayment, and additional fees for tax preparation. Incomplete accounting records can also present problems if your return is audited by the IRS.
Rather than relying on handwritten journals or ledgers, many businesses now use small business accounting software to keep track of their revenues and expenses. Relatively easy to use and generally affordable, a basic accounting software application will help you generate balance sheets, categorize transactions, track sales, record cash disbursements, manage payroll, create invoices, set up budgets, conduct your banking, and monitor tax liabilities. Your tax professional may be able to recommend an accounting soft-ware program that provides the level of functionality appropriate for your business.
But even the best electronic bookkeeping system does not eliminate the need for filing and storing paper receipts that may be necessary to substantiate deductions. In addition to recording transactions electronically, keep any printed documents that show the amounts and sources of gross income, such as invoices, cash register tapes, and credit card charge slips. The IRS may also want to see documents that show the amounts paid for purchases, such as canceled checks, credit card sales slips, and invoices.
It is especially important to have a paper trail when claiming deductions for certain types of expenses, such as business related gifts, entertainment, travel, and meal expenses. In addition to keeping paper receipts, maintain a diary or calendar to record details of business meetings, including who was in attendance and what was discussed. While you are not required to keep receipts for entertainment and meal expenses of less than $75, you should still maintain written records of any meetings for which expenses are deducted. If you use your personal car for business part of the time, keep a log in the car that records mileage, tolls, and parking fees incurred in the course of business usage.
TAX TIPS FROM THE IRS
Even with the best intentions, filing taxes often becomes an event that is put off until the very last minute. For those who are not accountants, tax laws can be confusing, leaving many unsure of what they may deduct and how they should file. However, according to the Internal Revenue Service (IRS)¹, the process can be simpler than you may think. Here are some tax tips direct from the IRS de-signed to make your filing easier than ever:
Organize. Take time throughout the year to store and organize your records and receipts in one place. Remember to include the income, deduction, or tax credit items that you reported the previous year. Organizing and maintaining a filing system will keep everything in one place, and make filling out forms that much simpler.
Avoid Procrastination. Procrastination is often tempting. However, doing your taxes sooner rather than later will allow you extra time to sort out potential problems or questions that might arise. Also, with time on your side, you will be more likely to avoid mistakes, as well as have the opportunity to discover all applicable tax savings.
Look up the IRS Online. At www.irs.gov, you will discover many sources of information. You will be able to download and print tax forms, access tax law information, and find a list of answers to frequently asked questions.
Double-check. When you have finished with your forms, take a couple of extra minutes to double-check your information, especially your Social Security number. Also check spelling and math. If your forms are hand-written, make sure they are legible.
Use Direct Deposit. If you are to receive a refund, the direct deposit option will allow for a faster return, and it may decrease chances of theft. When you enter information for this option, take the time to double-check your bank account number to avoid errors.
Stay Calm. If you owe the IRS money but can’t afford to pay, stay calm. Options for paying with a credit card—or even in monthly installments— do exist. Filing your return on time, or requesting an extension on time, can save you from possible late filing fees. For more information, go to www.officialpayments.com or www.pay1040.com.
Apply for an Extension. If your time is up and your forms aren’t ready, you can request an extension deadline of August 15. If you owe money on your taxes, you will still be subject to payment due on April 15. Failure to do so may subject you to late charges with interest. These easy-to-follow steps will help to prevent any unnecessary tax apprehension, and they can help to make the process that much smoother. Starting early and organizing throughout the year will greatly reduce chances of error and stress. Who knows? Your next tax return may just be the easiest yet!
¹IRS. “IRS Suggests Ten Ways to Avoid Problems at Tax Time.” http://www.irs.gov/newsroom/article/0,,id=108508,00.html (accessed September, 2006).
TURNING A HOBBY INTO A BUSINESS
Many Americans dream of turning their favorite free time activities into money-making ventures. Creating a successful and profitable business is seldom easy, but the federal government offers tax incentives to business owners that could make converting an avocation into a business start-up an effective part of your overall tax planning strategy.
In determining whether your activities can be defined as a business for tax purposes, the IRS will want to see evidence that the amount of time and effort you are putting into the venture indicate an intention to make a profit. You may also be asked to show you have earned a profit from conducting similar activities in the past and prove that you or your advisors have the knowledge necessary to carry on the activity as a successful business. While many start-ups incur losses in the early stages, the IRS may require you to demonstrate that these losses are due to circumstances beyond your control and to provide evidence of a willingness to change your methods of operation to improve profitability. To qualify for tax purposes as a for-profit business over time, the IRS may wish to see that the activity has generated a profit during at least three out of the last five tax years.
You can establish a profit motive by taking relatively inexpensive steps to market your products or services, such as running advertisements online, buying a Yellow Pages listing, or placing ads in the local newspaper.
Best of all, many of these expenses become deductible once you have established a business. Provided they are directly related to your business activities, you may be able to write-off entertainment and transportation expenses. You may also be able to hire your children to work for the business, thus shifting income to a minor child subject to lower tax rates. If you have a home office and equipment that are used exclusively and regularly for business, you could qualify for deductions for the business portion of property taxes, mortgage interest, rent, utilities, insurance, depreciation, maintenance, and repairs.
Depending upon the type and scale of your business, you may have to file papers with state and local authorities to register for sales and other business taxes, and to obtain any relevant licenses or permits. As a self-employed individual, you will have to pay income and self-employment taxes as estimated installments on a quarterly basis. If you have employees or are operating as a partnership, you will have to obtain an employer identification number (EIN) from the IRS. Your accountant can help you with these tasks and advise you on selecting the business entity that best suits your needs.
TIPS FOR STEERING CLEAR OF THE DREADED AMT
Originally designed to apply only to rich Americans who were attempting to shelter their wealth from the taxman, the alternative minimum tax (AMT) is increasingly ensnaring families whose earnings fall in the middle- to upper-middle income range. Taxpayers who have two or more dependents, live in high-tax states, itemize deductions, or exercise incentive stock options are especially likely to fall into the AMT trap. Until debate in Congress about modifying or abolishing this unpopular “stealth” tax translates into action, the best approaches for coping with the AMT threat include managing your tax burden so that the chances of triggering the AMT are minimized and finding ways to reduce the amount owed when the AMT cannot be avoided.
The AMT eliminates all standard and many of the itemized deductions available under the regular tax system. Itemized deductions for state and property taxes, unreimbursed employee business expenses, investment and home equity loan interest, and medical expenses that do not exceed 10% of adjusted gross income are examples of the deductions that are not permitted when the AMT applies.
Under the AMT formula, all disallowed deductions are added back in, and a single AMT exemption is used to reduce your taxable income before the tax is calculated. Due to the passage of The Tax Increase Prevention Act of 2007, the exemption amounts for 2007 are $43,350 for single filers and $66,250 for married couples filing jointly. Any income above these exemption levels is then taxed at flat rates of 26% up to $175,000 (or $87,500 for married filing separately) and of 28% in excess of this amount.
If there is a chance you will be subject to the AMT, you must calculate your tax liability under the rules of both the regular tax code and the AMT, and pay the higher amount. In some cases, the difference in the amounts owed under the AMT and the regular tax system can be substantial. Families may find themselves having to pay the AMT in a given tax year because they have claimed a large number of itemized deductions on top of claiming a large number of standard deductions. Planning away personal exemptions for dependent children is hardly feasible, but there may be ways you can organize your other expenses to avoid entering the AMT zone, or to minimize the amount you owe if you are liable to pay the AMT.
Planning for the AMT means turning the conventional tax planning strategy on its head: Instead of accelerating deductions and deferring income, attempt to accelerate your income and defer deductions. Examine all the itemized deductions you expect to claim in this or the coming year, and think about whether it makes sense to try to defer or accelerate those expenses. If you are likely to face the AMT this year, consider deferring payment on state and local taxes, provided any penalties incurred would be lower than the additional taxes owed.
It is not always possible to control when potentially deductible medical expenses are incurred, but it may be possible to control when the bills are paid. If your employer offers a cafeteria plan, consider using this option to pay medical expenses in advance on a pre-tax basis, rather than claiming an itemized deduction on your tax return. Whenever possible, schedule the payment of any items not deductible under AMT rules, such as business or investment expenses, for years when you are not likely to be subject to the AMT. If you are employed and claim unreimbursed business expenses on your personal income tax return, consider asking your employer to reimburse you directly for these expenses.
Similarly, consider the potential AMT consequences of selling long-term investments, and time those sales accordingly. While long-term capital gains are taxed at the same rate under the AMT as under the regular income tax system, adding a large capital gain to your income can serve to reduce or eliminate the AMT exemption.
Accelerating income may be advisable if the AMT’s flat rates of 26% and 28% are lower than the tax brackets you would be subject to under the regular tax system. Ways to accelerate your income include asking for prepayments of salary or bonus, cashing in certificates of deposit or savings bonds, taking a short-term capital gain, or withdrawing funds from taxable retirement accounts.
It is especially important for AMT planning purposes to take care when exercising employer-provided incentive stock options (ISOs). The difference between the fair market value of the stock at the time of purchase and the amount paid for the stock is considered taxable under the AMT. If you fail to sell the shares in the same year the ISOs were exercised, you could end up with a very large AMT liability. If the stock declines in value during the holding period, you may actually lose money on the transaction. Because of the risks involved, you should always consult your tax professional before exercising ISOs
Tax Strategy Favors Your Financial Future
Lowering your tax bill starts with planning for both the short and long term. By aligning your tax strategies with your financial strategies, the money you do not pay to the government can help fund your financial future.
Like your financial strategy, your tax strategy operates in two time frames—now and later. “Now” covers the 12 months of the current tax year. A misstep of a month in selling an appreciated stock, and paying the higher short-term capital gains tax versus the lower long-term rate, could result in a significantly higher tax bill. “Later” covers long-range moves, such as maximizing the long-term tax benefits offered by a qualified retirement plan such as a 401(k). Either way, timing is critical. Every year, the tax laws change in large and small ways, and time and attention are required to stay current.
In fact, there’s hardly an aspect of your financial situation—savings, education, real estate, home office use, retirement funding, and estate planning—that isn’t touched by tax law changes. For example, the Tax Increase Prevention and Reconciliation Act, passed in May 2006, ex-tended through 2010 the reduced long-term capital gains and qualified dividends rates set up by tax reform in 2003. Later in 2006, the Pension Protection Act made permanent many of the retirement and education tax breaks temporarily established by tax laws in 2001. And before the year was out, the Tax Relief and Health Care Act renewed through 2008 certain tax incentives for energy efficiency set up by reform in 2005.
Your life experiences should take center stage in planning your tax strategies. Take a stroll down the front of Form 1040. Near the top of the form you must declare your filing status (single, married filing jointly, married filing separately, or head of household), which determines your marginal tax rate (the rate at which your last dollar of income is taxed). The number of exemptions you claim, or dependents you support, comes next, followed by more than a dozen types of income. At the bottom of the form are the possible deductions that reduce your total income to adjusted gross income (AGI).
Retaining as much of your gross income as possible should be an ongoing objective, not something that happens only at tax time. Some portion of household-related expenses may be deductible if you maintain a home office. Ongoing childcare and dependent care expenses may provide you with special tax advantages, helping to reduce your tax obligation. Furthermore, you may be able to gift assets, including investment income, to your children over age 18, who are likely to be in a lower tax bracket.
Tax regulations can be complex, but a tax professional can help you. Developing and implementing a tax strategy early on can help you achieve your long-term financial goals.