By Marti Myers-Garver
In his first State of the Union address, President Obama stated: "Jobs must be our number one focus in 2010." He called for a host of tax breaks and incentives to stimulate jobs growth, especially for small businesses. He said: "We should start where most new jobs do - in small businesses, companies that begin when an entrepreneur takes a chance on a dream, or a worker decides it's time she became her own boss."
Small business owners are the backbone of our economy; they have always faced unique challenges. The small business tax environment is further exacerbated by our declining economy, high unemployment levels, and new health care regulations.
Hiring Incentive to Restore Employment Act (HIRE)
Under the Hiring Incentives to Restore Employment (HIRE) Act, enacted March 18, 2010, two new tax benefits are available to employers who hire workers who were previously unemployed or only working part time.
Employers who hire unemployed workers this year (after February 3, 2010 and before January 1, 2011) may qualify for a 6.2-percent payroll tax incentive, in effect exempting them from their share of Social Security taxes on wages paid to these workers after March 18, 2010. This reduced tax withholding will have no effect on the employee's future Social Security benefits, and employers would still need to withhold the employee's 6.2-percent share of Social Security taxes, as well as income taxes. The employer and employee's shares of Medicare taxes would also still apply to these wages.
In addition, for each worker retained for at least one year, businesses may claim an additional general business tax credit, up to $1,000 per worker, when they file their 2011 income tax returns.
The two tax benefits are especially helpful to employers who are adding positions to their payrolls. New hires filling existing positions also qualify but only if the workers they are replacing left voluntarily or for cause. Family members and other relatives do not qualify.
In addition, the new law requires that the employer get a statement from each eligible new hire certifying that he or she was unemployed during the sixty days before beginning work or, alternatively, worked less than a total of forty hours for someone else during the 60-day period.
The IRS has released forms and instructions for the employer tax breaks in the Hiring Incentives to Restore Employment (HIRE) Act. The IRS unveiled new Form W-11 (Employee Affidavit) which covered employees can use to certify that they meet the criteria of the HIRE Act. It also revised Form 941 (Employer's Quarterly Federal Tax Return), and Forms W-2 (Wage and Tax Statement) and W-3 (Transmittal of Wage and Tax Statements) to reflect the HIRE Act.
Health care tax credit
Included in the Patient Protection and Affordable Care Act is one of the first health care reform provisions. The credit, which takes effect this year, is designed to encourage small employers to offer health insurance coverage for the first time or maintain coverage they already have.
In general, the credit is available to small employers who pay at least half the cost of single coverage for their employees in 2010. The credit is specifically targeted to help small businesses that primarily employ low- and moderate-income workers.
For tax years 2010 to 2013, the maximum credit is thirty-five percent of premiums paid by eligible small business employers. The maximum credit goes to smaller employers--those with ten or fewer full-time equivalent (FTE) employees--paying annual average wages of $25,000 or less. Because the eligibility rules are based in part on the number of FTEs, not the number of employees, businesses that use part-time help may qualify even if they employ more than twenty-five individuals. The credit is completely phased out for employers that have twenty-five FTEs or more or that pay average wages of $50,000 per year or more.
Eligible small businesses can claim the credit as part of the general business credit starting with the 2010 income tax return they file in 2011.
Employment Tax National Research Project
The IRS has begun its first Employment Tax National Research Project in twenty-five years. Business practices regarding employment tax issues have changed significantly since the last IRS employment tax study in the 1980s, necessitating the need for this study. Examinations comprising the study will be conducted to collect data that will allow the IRS to understand the compliance characteristics of employment tax filers. The results will allow the IRS to gauge more accurately the extent to which businesses properly comply with employment tax law and related reporting requirements.
The IRS will focus on historic areas of non-compliance including (a) the misclassification of employees as independent contractors, (b) executive compensation, including stock options, (c) fringe benefits (and whether taxable fringe benefits have been properly reported in employees' income), and (d) return filing compliance, including the filing of W-2s, 1099s, 940s, and 941s.
Misclassification of employees as independent contractors deprives employees of critical workplace protections and employment benefits to which they are legally entitled.
Facts that provide evidence of the degree of control and independence fall into three categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker's job controlled by the payer? (These include things such as how a worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no "magic" or set number of factors that "makes" the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
IRS reclassification as an employee occurs when persons claimed as independent contractors are re-categorized by the IRS, or by state tax authorities, as W-2 employees. The reclassification can result in the imposition of fines, penalties, and back taxes for which the employer is generally liable. The U.S. Government Accountability Office (GAO) reports that the IRS claims to lose millions of dollars in uncollected taxes because of the misclassification of independent contractors by taxpayers.
Limited Liability Company
When we ask, many of our clients proudly proclaim their business is an LLC. The tendency is to state LLC as a limited liability corporation rather than a limited liability company. Therefore, they are unable to distinguish what type of entity their business is for income tax purposes. LLCs are created and regulated under state law. For income tax purposes, LLCs are treated by default as a pass-through entity. If there is only one member, it is treated as a "disregarded entity" for tax purposes, and the owner reports the LLC's income on his or her own tax return on Schedule C (Profit or Loss from Business). For LLCs with multiple members, the LLC is treated as a partnership and must file Form 1065 (U.S. Return of Partnership Income). As an option, LLCs may also elect to be taxed like a corporation by filing IRS Form 8832 (Entity Classification Election). They can be treated as a regular C corporation (taxation of the entity's income prior to any dividends or distributions to the members and then taxation of the dividends or distributions once received as income by the members), or an LLC can elect to be treated as an S corporation.
Tax practitioners are constantly aware of recordkeeping issues with small businesses. Small businesses generally rely upon the taxpayer's efforts being the main work force and source of income. When faced with the option of working for income versus recordkeeping, which does not result in any perceptible income, the choice is usually to generate the income. Often, explaining to taxpayers that the time spent on recordkeeping could possibly reduce their tax liability falls on deaf ears.
Recordkeeping methods do not have to be as cumbersome as Charles Dickens' Bob Cratchit bending over huge journals, painstakingly entering number after number. QuickBooks or other software may seem more daunting than using a spreadsheet. Explaining that complex programs are not necessary may encourage the owner to reconsider a previous decision of using a "shoe box" method of recordkeeping.
Generally, the law does not require any specific kind of records. Small business owners can choose any recordkeeping system suited to their business that clearly shows income and expenses. For many small businesses, the business checkbook, and debit and credit card transactions are the main source for entries in the business books. While the tax law does not say how to keep business records, a business could be required to have them and produce them at IRS' request.
Other common issues with the small business owner and his recordkeeping include commingling of funds and misclassification of expenses. Even though there may be a separate bank account for the business, it is not uncommon for taxpayers to use the business credit/debit card for a personal expense. (Juicy Couture and Babies R Us clearly would not be business expenses for a male salesman). Cash withdrawals for personal use from a business deposit are another method for commingling. Business owners often believe that specific expenses that are personal should be considered as business expenses. Most common are the use of mobile phones, vehicles, and computers.
The Tax Reform Act of 1984, decided to restrict the depreciation deduction for the business use of items "lending themselves easily to personal use", which were labeled "listed property." Included as listed property were passenger automobiles, property of a type generally used for entertainment, recreation, or amusement, computers, and related peripheral equipment.
In 1989, cell phones and "similar telecommunication equipment" were added to this "list" under Internal Revenue Code Sec. 280F (d)(4)(A)(v). *Taxpayer Assistance Act of 2010 (HR 4994) which the house passed April 14, calls for removal of cell phones from listed property. [email protected]'s prognosis for this bill is that the Senate will either take it up right away and pass it by unanimous consent or, more likely, refer it to the Senate Finance Committee where some or all of the provisions may emerge in a stand-alone bill or as part of a more expansive tax bill. Knowing Congress, however, there is also the distinct possibility that the bill goes nowhere.
Small business owners seem oblivious to the "listed property" rules. Purchases of computers, cameras, and cell phones are most often considered by the taxpayer to be 100% business use.
Internal Revenue Code Sec. 274(d) (4) requires that the small business owner keep detailed records to document the business use of "listed property."
For automobiles a mileage log should be kept, clearly identifying the miles used for business and those used for personal.
For computers, cameras, and audio/video equipment, the log should note the date, length of time, and purpose for each use of the item. Business use should show enough detail to enable proof of the relationship to the small business. With a cell phone the log would indicate the date, number called, person called, business purpose, and length of call. If the bill listed each call separately, the cost for each call would be indicated on the log. If a flat fee is paid for unlimited minutes, a calculation for each monthly bill would be required.
De minimis expensing
Sec. 167 of the IRC states:
"General rule: There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) - (1) of property used in the trade or business, or (2) of property held for the production of income."
To be depreciable, property must have a determinable useful life. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes. Additionally, to be depreciable, property must have a useful life that extends substantially beyond the year you place it in service.
Historically, many taxpayers have expensed the cost of tangible property that they acquired, if the property's cost was less than a certain dollar threshold (the de minimis rule). These taxpayers generally determined their threshold amount by conforming to their financial accounting policy for expensing assets. (Tax practitioners have been known to use a varying amount from $100 to $1,000). However, because of a desire for increased certainty and uniformity among taxpayers, taxpayers requested that the government provide guidance that specifically included a de minimis rule for federal income tax purposes. As a result, the IRS began considering whether a de minimis rule was appropriate. Proposed regulation 168745-03 provided a $100 de minimis rule within the definition of materials and supplies. Materials and supplies include a unit of property that has a production or acquisition cost of $100 or less, without regard to the treatment of the item in the taxpayer's financial statements. Allowing small items to be treated as materials and supplies resolves uncertainty with respect to whether those items represent a depreciable asset or a material and supply, and $100 is a low enough threshold to alleviate concerns about the potential distortion of income.
The IRS allows businesses to deduct up to $25 for business gifts they give to any one person per year. There is no limit on how many people can be given business gifts during the year, nor on how much is spent for those gifts, although the business gift deduction is limited to $25 per recipient. The $25 limit does not include incidental costs, such as packaging, gift-wrapping, engraving, or mailing. Costs are considered incidental if they do not add substantial value to a gift.
The $25 limit for business gifts includes both direct and indirect gifts. Figuring out if you gave a direct gift is a pretty straightforward determination. If fruitcakes were given to each of ABC Corporation's ten employees, then a direct gift was given to each one of them. Determining whether you made an indirect gift is trickier because in an audit situation, the IRS will want to know who received the gift, and also who was actually intended to benefit from the gift. However, if the gift is not intended for the eventual personal use or benefit of a particular individual or a limited class of individuals, and it is not practical to determine who actually used the gift, the gift will not be considered to be made to an individual and the $25 limit will not apply.
Office in home
More than half of all small businesses operate from home. Just because you work from home does not automatically mean you are entitled to claim a home office deduction. The small business owner can claim this deduction only if the home is used as:
- Exclusively and regularly used as the business' "principal place of business" or
- A place to meet or deal with customers, clients, or patients in the normal course of business.
To qualify under the exclusive use test, the business owner must use a specific area of his or her home only for the trade or business. The area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition.
To qualify under the regular use test, the specific area of the home for business must be used on a regular basis. Incidental or occasional business use is not regular use. All facts and circumstances must be considered in determining whether the space is used on a regular basis.
The "principal place of business" usually is the location where most of the owner's time is spent and where the money is earned. For instance, a plumber or interior designer's principal place of business would typically be customer locations. However, the law allows the owner to treat the home office as a principal place of business if it is used it to do substantial administrative chores, such as keeping your books, ordering supplies, and scheduling appointments, and if there is no other fixed location for the business, such as a storefront or office somewhere else.
**Special note: Recently this author was made aware of an interesting conundrum. When a Schedule C taxpayer attempts to qualify for a mortgage loan, the office in home deduction can be a distinct disadvantage. While underwriters for mortgages will commonly "add back" to income the depreciation expense, the office in home deduction is not. This can artificially reduce the income for purposes of loan qualification.
Marti Myers-Garver, EA, passed the SEE in 1986, became an NTPI Fellow in 1989 and an American Academy of Tax Practice member in 2002. She has spoken before numerous EA groups. She began teaching IRS VITA volunteers worldwide in 1987. For the last three years, she has trained VITA military volunteers at an "undisclosed location in Southeast Asia." Marti's tax preparation/representation firm, Armed Forces Tax Assistance Center, specializes in assisting military around the world while geographically located in Las Vegas.