Owning your own business can be rewarding, but as most entrepreneurs know, it also means a lot of work, much more than a traditional salary-based job working for someone else. While many small business owners may consider it a labor of love, there’s definitely one aspect that very few appreciate: doing the business’ income taxes.
Whether a business is incorporated and files returns as an entity, or is an LLC and the owner files a Schedule C with their personal 1040 income tax return, there are many potential areas for errors, from misreporting income or expenses, to missing potential money-saving tax credits.
Here are some of the most common tax mistakes that small businesses make, according to Jason Hamilton, a certified public accountant (CPA) and senior tax manager with Decosimo CPAs, a tax and accounting consultancy serving thousands of businesses and individuals from offices across the country.
1. Mixing business and personal accounts and expenses.
One of the biggest errors that small businesses, especially Sch. C entities, make is what is called “comingling” of accounts. While having separate bank and credit accounts is not strictly required, it is advised by most tax professionals, because it not only makes tax time much easier, it also ensures much more accurate bookkeeping overall, as well as financial reporting.
At the very least, Hamilton says, business owners should maintain an accurate balance sheet, so that expenses can be more easily identified. Among the tax advantages of maintaining separate financial accounts for the entity is that all expenses and income are more easily identifiable, whereas in a mingled account, deductible business expenses can be missed, and income can often be missed and end up unreported.
2. Misclassifying employees and independent contractors.
The rules for determining whether a person should be considered an employee or a contractor are not as vague as many small business owners may think. The IRS has issued general tips for identifying which they are, but it boils down to a few key points:
- Does the business dictate how, when and where the person does the task they’ve been assigned, including working hours?
- Does the business reimburse for expenses, or provide tools and supplies at no additional cost to the person?
- Is there a contract or defined benefits, such as a pension, insurance, vacation time, etc., and is the work relationship considered an ongoing, key aspect of the overall business?
Misidentifying a person who should be considered an employee can lead to penalties and interest for non-payment of the employer share of employment taxes. Also, the business needs to make sure that every employee receives a W-2, and every contractor that was paid more than $600 receives a Form 1099-Misc.
For self-employed individuals, nonpayment of the employer share, aka “self-employment taxes,” can also get the person in trouble with the IRS. These should be included with quarterly estimated tax payments throughout the year, Hamilton noted.
3. Not paying S-Corp shareholders “reasonable” wages.
For the employee-shareholder in businesses organized as an S corporation, the IRS requires reasonable wages be paid to them as taxable income. This is before non-wage distributions can be made, because the non-wage distributions are taxed differently.
The official instructions for the 1120S income tax return state, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
In short, if the shareholder plays an active, day-to-day role in the operations and management of the business, they are an employee and should be paid a salary that is appropriate to that position.
4. Overstating business expenses or missing out on valid deductions.
A fast way to get the attention of the IRS is to have expenses that either exceed the business’ income over several years, or to have certain types of expenses that are outside of common percentage thresholds. Whether it’s for business travel, meals and entertainment, printing supplies, or other usually legitimate deductions, the IRS’ computers are good at looking at what similar small businesses in an industry type spend on similar expenses.
Hamilton noted that Schedule C small businesses often have the most challenge when it comes to business expenses, since many items may be partially used for business purposes and personal use (mixed-use assets). For home office use, however, the IRS has strict rules that the room is not supposed to be used for any other purposes than the business. And if an audit happens, the business owner had better be able to convince them of that. (No, the corner desk in a bedroom does not pass this test.)
On the other hand, there are many deductible expenses that, as the IRS defines them, are “ordinary and necessary” as a part of running a business- just make sure you keep the receipts. Unfortunately, many Sch. C filers can miss some legitimate expenses when they prepare their taxes and, therefore, miss the deductions. Hamilton says this is especially likely to happen to those who do not strictly manage their business and personal finances independently (see mistake No. 1).
For most small businesses, operating expenses are deductible in the year they are incurred. However, capital expenses, such as the cost of purchasing vehicles, buildings, long-life manufacturing equipment, etc., can be depreciated over several years. The IRS has an online resource center for determining how certain business expenses should be treated.
5. Not planning ahead.
Taxes are complex and not everything that a do-it-yourself tax program says you can do is necessarily the correct thing to do. The best advice is to be proactive! Seek the advice of a qualified tax professional such as a CPA or Enrolled Agent, to plan ahead before tax season. These professionals can help identify credits that you may not be aware of, and can often save the business much more than the cost of their professional services.
Additionally, they can help the business better manage their accounting and business processes overall, helping the entity and its shareholders to be more financially secure. And if the IRS initiates an audit or sends a scary letter, a CPA, EA or licensed tax attorney can represent the person or business on their behalf.
Isaac M. O’Bannon is the managing editor and digital content manager for CPA Practice Advisor (www.CPAPracticeAdvisor.com), drawing on nearly two decades of experience covering the areas of professional accounting, taxation, business productivity and consumer technologies. He is also a U.S. Navy veteran.