Mom & Pop's

A Very Short Course in Depreciation

This is for basic information. Depreciation is a complex subject and it could fill a book. I want to make business owners aware of the theory so that they can plan. Please talk to your tax profession about specifics for your business.

On a trip to the local office supply store, you buy a new color laser printer and a set of replacement cartridges for your business. Since you keep your books up as you go, you add the purchase to your bookkeeping system and plan to use to whole purchase against this years income. The problem is that you really can’t do that. The ink cartridges are current expenses and fully deductible but the printer that has to be depreciated.

Depreciation is required for any asset used in a business (it could be equipment, capital improvements, or software, for example) that has a useful life of over one year and is not inventory. Simply, depreciation does two things. First it allocates the cost of purchase over the life of the asset. The IRS says that the laser printer has a life of 5 years. Divide the cost of the printer by five and that gives you’re the amount that you can depreciate for each year. The second use of depreciation is that it represents the effect of usage on the values of the asset. Say, you buy the new laser printer for $500. That’s the value that time. However, a year later, you could not sell that printer for $500 because of the wear and tear on the asset.

There are also two kinds of depreciation: “Book” and “tax.” “Book” depreciation is used for bookkeeping records and evenly spreads the reduction in value over the life of the asset. Our 5year printer would lose $100 in value each year for 5 years. It could continue to be used but it would not have any impact on the profit and loss of the business. “Tax” depreciation is a creation of the tax code and, for the most part, is considered accelerated deprecation. That is more depreciation is taken in the first years than in the final years. For simplicity, the IRS published the allowed depreciation in charts based on the life of the asset. As if depreciation wasn’t confusing enough, there are several charts of percentages. Your choice will depend many factors such as, when in the year the asset is put into service, if the asset is being used on a farm, are you calculating Alternative Minimum Tax or electing to spread out the depreciation out evenly instead of taking more at the start. To further confuse matters, there are special forms of depreciation that allow even more of the cost to be taken in the first year. Please see your tax profession about what options are available to you.

Are you confused yet?

What do you really need to know? You need to know that some of the things you buy for your business need special treatment. You need to keep track of them separately. But, use some common sense. Yes, the stapler will last more than one year and should be depreciated but that doesn’t mean that it can’t be lumped with other small equipment and depreciated that way. I do that with the off the shelf software and little things like calculators and staplers. The big thing you need to understand that you’re required to depreciate assets on your tax return. But that means that when you sell that asset the gain/loss must reflect the amount of depreciation taken. Let’s say you decide to sell that printer for $250 after you’ve had it for three years. You have taken $300 in depreciation off its value. The math looks like this: $500 original cost minus $300 in depreciation leaves a $200 basis. That is subtracted from the $250 you sell the printer for and you have a $50 gain on the sale. And that is taxable.

Keep track of long term purchases so that they can be treated correctly on your books and tax returns. And ask for help until you get the hang of depreciation.

IRS Videos

Information resources are vital to small business owners who have to wear so many hats. To help all taxpayers, especially small businesses, the IRS has created a website, the IRS Video Portal, to house all the non-written info they have created. The website has audio and video programs on a wide variety of topics. The programs can last a few minutes to hours and cover not just business topics but info for individuals too. There are some videos in Spanish too.

Topics range from starting or closing a business to contractors to audits. Of special interest to someone just starting a business,  is the Virtual Small Business Tax Workshop. This is a program the IRS has long shared with the public on CDs and is an excellent overview of the tax issues a business can face. (Note-The CD is in several languages but only in English on the video)

All the info on the Video Portal can be found in written form on the IRS's website but let's face it, sometimes hearing or seeing the info can help us understand what we're read better. So bookmark the page and check it out when you have a tax related question.

 

Income and Expenses

In this series, I’m focusing on providing an overview to give a new business owner something to think about and to show them where they need to get more info. This is especially true in the areas of income and expenses accounting. I can’t count the number of times that I have had a client tell me they’ve started a new business and they lost money. As the interview continues, it becomes clear that they can’t tell me how much they lost because they can’t tell me how much income or expenses they had. It sound very basic but that’s what really happens sometimes.

If you’ve set up your business books, you’re well on the way to being able to track your income and expenses. There are a few accounting terms that might good to discuss. Actual accounting procedures will depend on reporting year (calendar vs. fiscal) or if the business is a cash business or accrual business. Most individuals and small business are calendar based cash businesses. We report the income and expense in the year it is paid. Our year starts in January and ends in December. If a client pays me in January for a return I prepared in December, the income is reported in January because I am a cash business. An accrual business reports income in the year it is earned and expenses in the year they are incurred. In the example, that income would be reported as December income (even though I didn’t get it until January) if I was set up as accrual. (The only exception is that inventory is always treated as accrual. So I could be cash for everything else and accrual when it comes to my inventory. The IRS calls this a hybrid accounting method.) A fiscal year is any year that is not January through December.

Business income is the income that the business takes in during the course of doing business. This does not include any personal income; wages, interest, rentals, capital gain, etc.  A business can have more than one type of income. A repair shop would have  income from the sale of the parts used in the repairs, the income from the service labor, travel income and the cost of disposal that is passed on to the consumer. As you set up your business books, you need to decide if you’re going to lump income types together or have separate categories. My suggestion is to keep them separate. It gives you a better idea where your income is coming from and lets you check your markup on the parts vs. their cost. And if you have more than one business, these need to be kept separate.

The IRS says that legitimate tax deducible expenses meet the ordinary and necessary tests. And those are good rules for general business expenses too. Ordinary expenses are costs that are common in that type of business. If you are selling handmade jewelry, then the cost of making the products will be a key cost. Also the costs to sell the jewelry, like advertising, are ordinary costs. Necessary costs are helpful and appropriate to running the business. I could see our jewelry maker taking a trip to the plant which makes her supplies to learn about the products and how they are made. This would be an expense necessary to build a relationship with the firm and learn more about her materials for marketing and manufacturing. It is very good practice to keep expenses separated by type; travel, advertising, cost of goods, office supplies, to name a few. Most importantly you want to keep major purchases separate because they are handled differently. (You got it, another post.)

Let’s talk taxes for a second. I don’t want to scare anyone away from starting a business with a threat of an audit. In fact, good procedures will go a long way to keeping an audit away and letting you sail though one if you get hit. Besides keeping good records you need to keep the source documents. That’s a fancy way of saying you need to keep your receipts. Sorry, you can’t throw those away once you enter them into the computer or on your books. You need to create a system to keep those receipts should there ever be a question about an entry in your books. Let’s say our jewelry maker writes a check at Hobby Lobby for $150 for beads and she enters it into her checkbook and bookkeeping program as bead inventory. She’s done all she needs to operate the business efficiently. But if the IRS questions it, they’ll want proof that it was for beads and not Christmas decorations for her home. That’s where the receipt comes into play. This is especially true for any cash purchases and if a credit card is used. A credit card statement might not list the business name but the clearing house that actually processed the transaction. It’s easier to keep all your receipts safe and sound just in case there is a question later.

Shall we review? After careful research, you start your business and get separate bank accounts (and credit cards) for them. You create a bookkeeping system that you will use and will provide you with the info that you will need to operate the business and prepare your taxes. Does that mean success?  That depends on you and the business. But you now have the tools you need to analyze, adapt and grow your business. I only have a few more business issues to talk about and they all deal with taxes. The purpose of this series has always been to put on paper what I do face to face with clients who want to set up a business or need help with business tax issues. There is more to running a business but there are all kinds or resources available to help you with those issues.

More Dangerous Money

I just talked about payroll "trust fund" taxes and the need to make sure they are paid and reported on time. I forgot, however, to mention that the same applies to sales tax.

Sales tax isn't your money. You collect it from your customers and send it in for them. If you are required to charge sales tax, you need to create procedure to track this money and not spend it. Missing reports are caught quickly (at least in Kansas) and if you don't sent the report as requested the state may "estimate" your sales for you. If you don't make payments on time, you risk an audit of not only your sales tax liabilities but your compensating use tax liabilities. (Comp use is the sales tax on your internet and phone purchases where no sales tax is collected because the company doesn't have a presence in that state. In this case, the seller doesn't collect it from you so you are expected to pay it yourself. There has been a lot of talk, lawsuits, and legislation on this issue but you still pay it.)

So, you need to work out some procedure for saving sales tax you collect back and not spending it. And get the reports and payments in on time.

Dangerous Money

In a previous post, I talked about the reporting forms that are required for business payroll. In this post, I want to focus on the business killer - trust fund mis-management. As you pay employees, you withhold money from their paycheck and then submit it to the IRS and states for them. The deposits should be made electronically and you will need to set up the accounts before you need them. And you have to understand that the deposits may be made on a different schedule than filing the 941 and state payroll reports.

For Example: You agree to pay Sue $500 a week salary. That $500 will be reduced by her Social Security and Medicare contributions of $28.25 (current reduced rate) and her Federal and state withholding. That means you are writing her a check for say $378.97. That $121.03 that you withheld from her check is the most dangerous money, Trust Fund. It's called Trust Fund money since you are only holding it for Sue in trust until you are required to deposit it (based on the schedules the IRS and State gave you.) Of that $121.03, $28.25 is her SS and Medicare and $60.77 for Federal withholding and $32.01 for the state. You will also be expected to match the $38.25 (full rate) for your part of SS and Medicare. And you will be kicking in for Federal and state unemployment; say another $10. So: $378.97 paycheck + $121.03 trust fund money + $38.25 matching SS/Med + $10 for unemployment=$548.25 is what Sue's week really cost you. You write her a check for $378.97 and then what do you do with the remaining $169.28? That is where too many employers get into trouble. That money is allotted to be paid in a few days to months but it's still sitting in the checkbook where it can be spent on other things. Since Sue is your only employee, I would guess you'll be set up for quarterly deposit. At the end of the quarter, you fill out the Federal 941 and your state's forms for withholding and unemployment. Then you discover the IRS wants a check/deposit of say $1527.24 to cover this quarter payroll liabilities. And the state and state unemployment will want their shares too. Which by this time, you don't have.

If you are going to hire employees, you have to find a way to not be in this predicament. Some employers use a separate checking account for payroll and move into it the salary plus employer's obligations before they write the paychecks ($548.25 for this example). Other employers subtract the whole about out of the checkbook at the time. No matter what system you come up with, you have to do it religiously. If you don't, the letters will start.

The IRS catches shorts in payroll deposits and filings a lot quicker than short in income taxes. They have to because these problems can grow huge quickly. Penalties on Trust Fund money (what came out of employee's paychecks) can be up to 100%. Even a few days late will see a penalty. Remember this is the employee's money. You promised Sue $500 a week not $378.97. Withholding, Social Security and Medicare are credited to her accounts whether you pay them or not. The IRS needs to deter/scare employers into keeping payroll obligations current. That is the reason for the high penalties and tough enforcement.

If you find yourself in this situation, don't panic but don't ignore it. Put into place procedures so this won't happen again. File your reports and send in what you can. Call the IRS or your state department of revenue and work with them. Don't make promises you can't keep but get caught up and stay that way.

Payroll Reports

It’s time to take on the employee issue, at least the tax part of having employees. There are a lot of rules and things you should know when you add an employee. Most I’m not qualified to discuss such as labor laws. You’ll have to do your research to make sure that you are following the laws in your state. But I can outline the tax issues. I’m going to keep it simple and focus on payroll withholding and reporting. Issues such as setting up retirement and health insurance plans I leave to the experts.

Back when you applied for your EIN and state business numbers, you were asked to estimate your annual payroll. If you said you were not hiring at that time, you need to get a hold of the IRS and your state (and in a few cases local) tax people to tell them this has changed. They will set you up for a payment (actually a submission) schedule for your deposits and payroll reports. As an employer, you will have payroll reports for the Federal and state, payroll deposits for Federal and state, unemployment reports and payments for your state and an annual unemployment report for the IRS. This is on top of W-2 and W-3s for the year. Now you understand why employers could be tempted to treat employees as contract labor, less paperwork.

Let me skirt around the 800lb gorilla, money, until the next post and concentrate on reporting. Please understand that this is general info, so follow the requirements the IRS and your state has set up for you.

On the Federal level, you will need to file a form 941 on a quarterly basis. This reports (among a few other things) how much you paid in wages for the quarter, how much money should be credited to Social Security, Medicare and for Federal Withholding. It also tracks deposits of that money. You may also have a state report. The actual report and its frequency will depend on the state. In Kansas, there isn’t a report separate from the money until you send them the W-2s at the end of the year. Then once a year, the IRS wants a form 940 which reports and pays the Federal unemployment due. This form also gives you credit for the unemployment you have been paying your state Unemployment organization. Again, each state has their own rules and forms and you will need to do some research. In Kansas, it’s filed and paid on a quarterly basis.

This is where a good payroll bookkeeping system can come in very handy. If you want to run afoul of the IRS and States quickly, don’t follow these schedules. They will let you know within a few months about missing forms. Then the penalties begin. But more about those in the next post.

Business Financial Mistakes

Simple, but very good, article on INC online about the biggest financial mistakes a business can make. I'm very glad to see payroll taxes make the list.

Employee Or Not?

The worse problem with being a tax preparer is that I don’t hear about an issue until the client comes in to get their taxes done. That’s when they tell me about the 401K distribution, starting social security, a new business or hiring an employee. Too often, I’m told that the business paid $XXX in labor costs. No 1099MISC was issued and serious questions if those paid are really employees not contract labor. Then I have to clean up the mess.

A major issue with the IRS is the classification of an employee as an independent contractor. For the business owner, an independent contractor is easier. There is no withholding, only one form to file at the end of the year and the costs are lower. For the employee, being an independent contractor is great on payday but a killer at the end of the year when you have to pay self employment taxes and have no withholding. Big tax bills with no way to pay it off. No wonder the IRS is concerned.

When it comes to the employee vs. independent contractor issue, the IRS looks at the control the employer has over the worker. Someone hires me to do their bookkeeping as an independent contractor. We have an agreement about what work will be done but I do it at my office on my timetable. They have no control over my work procedures as long as I get the work done when they need it. At the other end of the scale, is the receptionist I hire during tax season. She has very little control over the job. I set the times she works and provide her with all the equipment and materials. I specify how I want the work done and supervise her. She is an employee. It can get gray in between the two end points. And let’s not forget the business owner trying to save money and work by treating employees as if they had their own businesses.

Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can be completed by the worker or business owner to clear up the gray areas. The completed form can be used by the business to document their classification decision. Or it can be submitted to the IRS and based on that information  they will determine if the worker is an independent contractor or employee. The forms covers issues like who decides what work is done, when it’s done and how it’s done. Who provided the tools and materials? How is payment made, expenses reimbursed, what benefits are provided? Who is in control basically? Whoever makes the determination, the proper procedures for that classification (employee or contract labor) will need to be followed.

If the IRS is involved because the SS-8 was submitted to them or they initiated the investigation, there is a possibility that the business will have to go back pay the back taxes for the now employee. That’s why it’s better to get this right from the start.

Keeping Books

Every business needs to set up a bookkeeping system. The actual system is not as important as being contemporary with your records. I use a bunch of programs and systems to track client’s income and expenses. It depends on the client and what shape their records are in when I get them. Some bring me computer files or reports, others use spreadsheets (paper or electronic) and too many bring me a bag of receipts and bank statements for their taxes. I wouldn’t recommend the last options.

To me there are two reasons to keep contemporary records. The first is taxes, of course. This is the info your preparer will need to prepare your business tax return. The best time to make notes and secure receipts is at they time you get the income or spend the money. But more importantly, don’t overlook that you need to know how your business is doing in order to make decisions to stay in business. That’s why you need to keep your financial books up to date. You or I can re-create your books from receipts and bank statements for taxes. But that doesn’t help you in June to know how much income you took in from a special promotion in May. A good set of books should do that.

Besides keeping your financial records up to date, I have a few other suggestions.

• First, it has to be a system that you will do. Bookkeeping doesn’t have to be complex. You don’t need the fanciest, most expensive accounting program on the market. Most small businesses don’t need thousands of report options or any other bells and whistles. But they do need a system they will use.
• Don’t be afraid of breaking down income and expenses into sub-categories. Otherwise, how do you know how much you have spent on radio vs. TV advertising?
• Keep larger purchases separate and well documented. It’s easy to lump a printer or office chair in with the pens and paper under office supplies, but don’t. Create categories for big equipment, small equipment, software, anything else that you expect to last for a while. These need to be depreciated or may qualify for special treatment.
• Keep your receipts even after they are in your system. And don’t rely on credit card statements as a proof of an expense. All you are getting is a vendor or cleaning house. The documentation is the actual receipt.
• This is not a place to skimp on professional help. Even if you are going to keep the books yourself, pay for an hour of a professional’s time. Make sure you understand what you will need to track and how business finance works.
• Keep your personal and business finances separate. I’ve talked about having a separate check book for the business. But what about credit cards and savings accounts. There may be a rare occasion that you have pay for a business expense out of a personal account or personal from a business so learn how to handle them properly.

 A key to keeping your business going is to track its financial health. It actually doesn’t take much time or money if you do it as it happens. And if you get behind, don’t panic; just take the time the catch up.

Business or Hobby

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.

First, what is profit? To start, I’ll define “profit” as the money remaining after the entity’s income is offset by the expenses. You open your business with $500 in the checking. As the year goes by, you deposit the business income and write checks for the business expenses. If you have more than $500 on December 31^st, you have a profit. The idea is to increase that profit as the business grows. So, what is a hobby? For the IRS, it comes down to the profit motive. A business is to make money and if it’s not making money, the owner changes the business or closes. If not, it’s a hobby. IRS’s “hobby” is not about the actual business but how the business is being run. Is the owner really trying to make money?

The IRS uses a concept of “presumption of profit.” to evaluate a business. Section 183(d) says that if a business makes a profit in 3 of the last 5 years (2 of 7 if horses are involved) it is presumed the business is being carried on for profit and it is not a hobby. But if a business doesn’t met those guidelines it can still be considered for profit? Yes, but it needs to be objectively evaluated. Some factors to consider:

• Does management keeps good books and tracks the results of the business’s activities? Do they try new methods and ideas to bring in more income or reduce expenses?
• How knowable is management about the field and business in general. How are they keeping up with the latest developments?
• How much time and effort is the owner putting into the business? It can be a part time activity but the owner need to regularly working it.
• Has the owner had other businesses before and how successful were they?
• Is this a dry spell for a previously successful business? What is the ratio of profits to losses?
• Does the owner depend on this business for their livelihood?
• Is the recreation/fun element of the business greater for the owner than profit element?
• I also look at what the expenses are. Would there be a profit if there was no depreciation or mileage or Office in Home?

 

Why the distinction? I can think of 2 reasons. The first is taxes. Income and losses from a hobby are handled differently than the income and losses from a business. Let’s look at 2 sole proprietors- very simplified of course. But remember this could be 2 partnerships, LLCs or S- Corps.

Business “P” will report its activities on a Schedule C or F on its owner’s Form 1040. All income, expenses and depreciation of the business will be reported and a profit or loss will result. The profit or loss will then carry to the front page of the 1040 and add to or decrease the owner’s other income. If there is a profit, it is also carried to Schedule SE and the self-employment tax is calculated and added to the owner’s other taxes. An adjustment for half of the self-employment tax is also carried to the first page of the 1040 and lessens the total income.

Business “H” doesn’t use a Schedule C or F. The income is reported on the “other income” line of the owner’s 1040. The only expense that can be taken off here is the cost of goods to manufacture the items being sold. (On the Sch. C, this would be the gross profit.) All the rest of Business “H’s” expenses have to be reported on the Schedule A and are limited to the remaining income. Business “H” can’t use a loss to offset other income. The expenses also have to be divided into 3 classes. The first class, are expenses which anyone can deduct on the Sch. A; mortgage interest and real estate taxes are the most common. The second class of expenses includes anything that doesn’t change the basis of the business assets. The final class is depreciation. The big catch is that both of these classes are reported a Misc. Deductions and are reduced by 2% of the income from the 1040 return. Then, the total of all the itemized deductions from the Sch. A has to be higher than the standard deduction to actually do any good. So it is possible for Business “H’s” expenses to be un-usable in reducing the tax on the income. Now the good news; Business “H” does not have to pay self-employment on any profits from their activities.

Now I’m sure someone has decided to make the decision between a hobby or for profit based on how their year went.  You’re a hobby in a year where you make money and avoid the SE tax and for profit when you have a loss to reduce your other income. Not a good idea. Can you say audit?

The other reason to think about the distinction between for profit and hobby has to do with how you approach your business and what that shows to others. There is nothing wrong with a business being considered a hobby for tax purposes, if that is what the owner wants. But if the IRS is treating you like a hobby, you can’t expect a bank, vendor or investor to treat you like a business. They don’t have to see your tax return to know if you are running the business for profit. They will look the same types of information as the IRS and come up with the same conclusion. Your decision not to be for profit will be transmitted to customers and employees by the way you approach the business hobby. The business may not work or you may have bad years. Businesses close all the time. Failure is okay. But don’t create the failure because you don’t want to work the business.