Taxation

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Taxation
Every year, the tax code is updated to reflect changes made during the previous year. Knowing
these changes enables business owners to plan and make decisions that optimize tax savings.
Judge Learned Hand once said, “In America, there are two tax systems; one for the informed
and one for the uninformed. Both systems are legal.” The best way to stay informed is to view
taxes as a year-round activity and plan for it accordingly. Planning involves organized record
keeping, accurate financial reports and good tax advice.
This month’s topic will focus on the fundamentals of taxation that enable better decision-making.
Our experience in working with small businesses reveal that many do not take full advantage of
tax benefits, while others over-emphasize tax planning. Here we will cover the following tax
planning topics: business expense deductions, asset purchase write-offs, and compensation.
There are five sets of taxes that affect business owners: income taxes, self-employment/payroll
taxes, sales taxes, excise taxes and property taxes. The largest tax burden is on profits,
therefore most planning focuses on keeping taxable profits as low as possible. Why should you
pay more than is necessary? Judge Learned Hand puts it this way:“ There is nothing sinister
about arranging one’s affairs as to keep taxes as low as possible…for nobody owes any public
duty to pay more than the law demands.”
The new federal administration and many states will be putting forth opportunities to reduce
taxes by hiring new people, purchasing new equipment and similar kinds of activities designed
to stimulate the economy. Unfortunately, for many companies the cost of the activity and
complying with the tax filings may outweigh the benefits, and others are simply not be aware of
these benefits.
I. Deductible Business Expenses:
The government knows that businesses have to spend money in order to make money.
Therefore, there are deductible expenses that reduce taxable income. For an expense to be
deductible, it must be ordinary and necessary for the business, not extravagant, and
primarily for the business (not personal). Examples of deductible expenses include:
1. Direct product and service costs – For retail, manufacturing and service companies
the expenses directly related to the production, acquisition and delivery of products and
services are accepted as deductible. Where inventory is involved, proper inventory
methods need to be used to reflect goods actually sold during the year. The various
accounting methods for recording these costs and expenses offer good tax planning
opportunities. Given the changing economic environment, past practices may not be a
favorable in the future, therefore a fresh look may be warranted.
2. Supplies – Supplies like paper clips and copy paper are deductible.
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3. Entertainment and Meals – This includes food, drinks, recreation or amusement for
customers, clients or employees, and business meetings during which there must be a
substantial discussion of business. Generally, 50% of meals and entertainment
expenses are deductible. The following are exceptions to the 50% limit rule:
• Transportation with a client or customer, employee parties, public entertainment
and events for charitable organizations.
• Reimbursed expenses and accountable plans
4. Gifts – Client and customer gifts are 100% deductible up to $25 per client, per year. If
the gift cost less than $4 and your business name is imprinted in it, it does not count
against the $25 limit.1
5. Travel – Travel expenses are deductible so long as they are business related. Types of
deductible travel expenses include: transportation (taxis, limos, buses, trains and cash
tips), lodging, laundry, and miscellaneous (telephone, internet access) are 100%
deductible. Meals and tips to servers of meals during travel are 50% deductible.2 IRS
classifies costs other than transportation which is deducted separately as “lodging,
meals and incidentals.” The per diem (per day) or actual expense method can be used
to deduct travel cost. To use the actual expense method, detail records and receipts
must be kept whereas the per diem method requires just a specific IRS approved
deduction amount per day.3
6. Health Insurance – Premiums you pay for employees’ health insurance are 100%
deductible as ordinary business expense. Sole proprietors, partners, limited liability
members and S Corporation shareholders active in a business can deduct 100% of their
health insurance premiums for themselves and their families.4 However, owners’
premium deductions cannot exceed net profit. Owners who are eligible for coverage by a
spouse’s plan cannot claim this deduction whether or not they are covered by spouse’s
plan. Medical expenses not covered by insurance can be claimed as personal itemized
deductions on Form 1040 to the extent they exceed 7.5% of adjusted gross income.
7. Education Expenses – Tuition, fees, and supplies are business deductions if they are
related to business, trade or occupation.5 The education must be either to maintain or
improve skills or required by law or the employer. Note that education that qualifies an
employee for a new job or a different business is not deductible. For example, education
expenses incurred while improving a skill set to change jobs or start a new business is
not deductible.
8. Business Insurance – Business insurance such as the following are deductible: vehicle
insurance, liability insurance, fire, theft, and flood insurance, malpractice or errors and
omissions insurance, worker’s compensation insurance, and business interruption
insurance. Only C Corporations are allowed to deduct life insurance.
9. Domestic Manufacturing – This is a tax break for manufacturers including software,
film production, clothing production, agriculture and mining. Any business with more than
1
http://www.irs.gov/publications/p463/ch03.html
http://www.irs.gov/publications/p463/ch01.html#d0e1112
3
See IRS Publication 1542, per diem rates
4
IRC Section 162 (l)
5
IRC section 162
2
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one employee that acquires tangible personal property can get a bonus deduction of up
to 9% in 2009 of new purchases.6 Check with your tax advisor to see if you qualify.
10. Vehicle Expenses – Use a mileage log to keep records so that business-related
mileage can be deducted. Use the standard mileage or actual expense method to
calculate your deductible mileage. Commuting from home to work is not deductible
mileage. Home-based office owners can deduct trips from home to business related
activities.
If a corporation owns the vehicle, all personal use of the vehicle is taxable to the driver.7
If you use your car for both personal and business use, you must divide your expenses
between business and personal use. A common method figuring expenses is using
miles driven. Business related usage is 100% deductible.8
11. Advertising and Promotion – Marketing costs that have a clear connection to the
business such as website developments, marketing consultant fees, public relations,
business cards and yellow page listings are deductible. Depreciation of business assets
used for entertainment can be deducted though special rules apply.
12. Accounting, legal and professional fees – Fees paid to consultants, lawyers and tax
professionals are always deductible. However, in certain cases the deduction must be
spread over future years.
13. Taxes – Employment taxes (Social Security and Medicare) 50% paid by the company
are deductible. The other 50% withheld from employees’ wages is not deductible. Selfemployment taxes (Social Security and Medicare) are 50% deductible on the individual’s
Form 1040, but not as a business expense. Sales taxes are generally collected from the
customer and therefore are not income or expense. Excise taxes are generally a
business expense, but note they may relate to purchases that are not expensed, such as
inventory. Property taxes can include both real estate and personal property taxes.
These taxes are generally deductible for property owned or rented by the business.
Because of the level of taxation represented by these different tax groups, there are
planning opportunities for each.
The above deductible expenses are not an exhaustive list. Other deductible expenses to
consider include: bad debts, cost of going into business, interest, moving expenses, charitable
contributions (business owners or C Corporations), software, credit bureau fees, commissions,
bank service charges, etc. Your tax planner should help take advantage of all applicable
deductions.
II. Section 179: Expensing Business Assets
This is where tax planning plays an important role. Section 179 allows annual limits to write-off
purchases on certain assets. In 2008, the limit was $250,000.9 For 2009, the limit is $125,000.
Contacting your tax advisor is recommended because of the specific rules for this deduction.
6
IRC 199
See IRS Publication 917, “Business use of a car”
8
Business and personal use : http://www.irs.gov/publications/p463/ch04.html
9
http://www.irs.gov/formspubs/article/0,,id=177054,00.html
7
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Tax planning presents important opportunities to maximize the value of the business. However,
we have seen a number of clients focus too much on tax planning such that they have lost the
perspectives needed to manage their business. For example, tax deductions were utilized to the
extent that the business lost money. As a result the owner felt that the business was
underperforming. When we pulled out the tax planning components, leaving only the essential
costs for operating the business, the business was actually operating about right from an
expense perspective. We recommend thinking of expenses as a) essential to the business,
showing the operating results after these, and b) expenses related to the business with
appropriate elements of tax planning falling into this category.
III. Employees vs. Independent Contractors:
Properly identifying your staff as employees or independent contractors is fundamental to
proper tax treatment. According to the IRS, “in general, someone who performs services for you
is your employee if you can control what will be done and how it will be done.”10 The IRS
reviews behavioral control, financial control, and the type of relationship when determining
whether the company should be treating the staff member as an employee or an independent
contractor. An additional factor is whether the individual holds himself out as engaged in a
separate business. Having other clients is an example of such business activity for employees.
A company is responsible to withhold payroll taxes, to pay social security and Medicare taxes,
to pay Federal unemployment tax, to issue W-2’s annually, and to report wages to the IRS.
Independent contractor compensation is reported through Form 1099-Misc.
Penalties for misclassification of workers can include all back payments of employment taxes
plus 12% to 35% of the tax bill. If you already are in this kind of trouble, contact a tax expert for
the possibility of using an IRS classification settlement program.
V. Articles for Further Reading:
1. Small Business & Self-Employed Tax Center:
http://www.irs.gov/businesses/small/index.html
2. Top 10 Small Business Tax Deductions:
http://sbinformation.about.com/od/taxes/a/Topdeduction_ga.htm
3. Be familiar with contents of Publication 15 (Circular E), Employer’s Tax Guide:
http://www.irs.gov/pub/irs-pdf/p15.pdf
Phil Clements is CEO of Cathedral Consulting Group, LLC and a Managing Director in the
New York Office. Benson Agbortogo is a former Senior Associate located in the Wisconsin
Office.
For more information, please visit Cathedral Consulting Group LLC online at
www.cathedralconsulting.com or contact us at [email protected]
10
“Employee or Independent Contractor?” http://www.irs.gov/govt/fslg/article/0,,id=110344,00.html
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