Preparing Your Business for Tax Season

As business owners clean up the end-of-year financials, it's good to keep in mind that the next need for these numbers will be for the tax filings. While this is not an exhaustive guide to filing taxes, here are a few things to keep in mind. They are points to consider, not tax advice!

The Entity Type Drives Your Filings

Federal (and likely state) tax filings depend on how the business is classified. A common tax problem is misalignment between the state law status and the IRS tax classification.

A sole proprietorship is filed using Schedule C with the owner's Form 1040 and is subject to income tax and self-employment tax.

A partnership or multi-member LLC files a Form 1065 and issues K-1s to its partners. The partners pay taxes individually.

An S Corporation (which may also be an LLC) files a Form 1120-S and issues K-1s to the shareholders. There is a reasonable salary requirement for owner-employees.

A C Corporation files a Form 1120, and the corporation pays its own tax. This means that dividends may be taxed again at the shareholder level.

For any entity, doing business internationally may add many complications to tax filings.

Depending on the complexity of owner and investor issues, the business filings may need to include or take into account basis tracking, distribution versus salary, loans to or from owners, equity grants or options, and related-party transactions.

Recognizing Income Appropriately

A business must be sure that its gross receipts are tracked and reported. The accounting method should be consistent, either cash basis or accrual. Some things to watch for are deferred revenue (retainers could be categorized as a liability until they are fully earned), advance payments, and refunds. These should be entered in a way that accurately reflects income but does not make it appear that income exists where it has not been earned yet or has been refunded.

Keeping Business Expenses Legitimate

Legitimate business expenses are ordinary, necessary, and well-documented. Some key categories to review (perhaps with your CPA) are payroll and contractor payments, rent and utilities, professional services, business expenses like meals (which are usually 50% deductible), travel, and depreciation versus expensing.

Areas of risk can be created in several ways. One is by running personal expenses through the business. If the person or the business accidentally or for practical reasons pays something that the other should have, it can be reimbursed back to the proper entity. Poor documentation can create risk even when there is no fraudulent activity. Lastly, aggressive deductions without adequate support can create risk. For example, the owner's eight-year-old should probably not be on the payroll.

Taxes for the Employees and Contractors

If the business has employees (which may or may not include the owner/s), there are federal payroll tax filings, W-2s and W-3s, state payroll filings and workers' compensation and unemployment tax compliance. Proper worker classification is very important, because it can create all kinds of fines and penalties to get it wrong, besides being unfair to the workers.

Businesses that have employees in more than one state must pay careful attention to tax issues in all of the relevant states.

As mentioned before, in an S Corporation, an owner who is an employee must be fairly compensated before taking dividends. If the business isn't making much money yet, your CPA or tax attorney may be able to suggest a fair division. Paying too little in salary and too much in distribution may trigger an audit.

At the end of the year, it's important to be current with W-2s and W-3s for employees and 1099s for contractors. These must be sent both to the IRS and recipients. An electronic format (such as Quickbooks) is highly recommended for convenience and repeatability from year to year.

State and Local Taxes

Businesses may overlook some types of taxes. There can be state income or franchise taxes. Some states have gross receipts taxes. There may be sales and use tax filings. And there could be local business or occupational taxes.

Online sales create their own tax issues, as do multi-state operations.

Estimated Tax Payments

Most businesses must pay taxes throughout the year, including quarterly estimated payments. Depending on the profitability of the business, there could be underpayment penalties if these are missed or underpaid.

Even throughout each quarter, it makes sense to set aside the money that will need to be paid at the end of the quarter. This helps to avoid cash-flow shocks and scrambling.

Strategic Approaches

The IRS looks for consistent reporting year over year. If the business has up and down swings, which could also trigger an audit, clear and consistent business records are doubly important. Swings in payroll can also be a red flag. The tax filings should align with payroll records, bank statements, and financial statements. It's wisest to keep all financial and tax records for seven years.

While tax season is a nuisance, it's a good time to: review financials; review growth and plan for the future; consider any problems with the entity structure; and update legal, accounting, and payroll support. Good financials are also important if the business is looking for an investor, or if there may be a change in ownership.