Tax Tips for Small Business Owners

Many small businesses, especially solo practitioners who may operate out of their home, often­times have sloppier accounting procedures than larger, more resource-rich firms.  However, it is important to note that in case of an IRS audit, the burden of defense rests on the taxpayer, who must show proof behind the expenses they have claimed as tax deduc­tions. The taxpayer is “guilty until proven innocent”, i.e. the auditor will disallow an expense if it cannot be shown to be true.

Here are 3 common traps to avoid:

MINGLING EXPENSES

Smaller practitioners can occasionally mingle personal and business credit card charges, auto­mobile use, cell phone and internet service, insurance payments, and other expenses. Once business expenses are put on personal credit cards, or personal bills are paid out of a business bank account, it becomes harder to defend legitimate expenses during an audit without strin­gent receipt backup, bookkeeping, and notes.

In addition, computers or waiting room TVs may be bought from retail electronic stores, and if the receipt is not kept, there is no way for the auditor to know what was purchased specifically. A line item for “Best Buy” for $1200 on a credit card does not show what was purchased, and could be construed by the auditor to be a personal item for the home. Small practices should make it a habit to:

• Issue business credit cards to those who may be charging in expenses
• Match the beginning and end balances of their credit cards and bank statements to their accounting records each month
• Keep receipts for all purchases
• Track any automobile mileage or maintain a separate business vehicle
• Fairly allocate shared expenses between personal and business, such as conference trips doubling as vacations

DEDUCTING LIFE OR DISBAILITY INSURANCE

There are two mistakes that are commonly made in the area of insurance:

1. Life Insurance deductions — if the company is directly or indirectly a beneficiary of a life insurance policy, the premiums are NOT supposed to be deducted. This applies to key man insurance or benefits that may be paid to the company (not family) in case a valuable employee passes away.
   
   
2. Disability Insurance deductions — in this case deductions are allowed because the proceeds benefit an individual and not a company, but are still not advisable. If an upfront deduction is taken on the premium cost, and if the policy pays out in case of a disability, the proceeds would then be taxable. I often advise clients not to deduct the premiums because there is not a huge tax benefit on the front end, and it will be costlier if they have to pay taxes on the proceeds, especially when they are disabled and need the funds most.

INCORPORATING IN ORDER TO DEDUCT EXPENSES

This is a classic mistake which many new, enthusiastic entrepreneurs tend to make. They believe they need to incorporate or form an LLC to deduct business expenses. Creating a for­mal entity involves additional paperwork and hassles that are not necessary to take legi­timate business expenses. A sole proprietorship can deduct expenses directly on their personal tax return using Schedule C. There is no difference in the type of expenses that can be deduc­ted in a sole proprietorship vs an LLC, S Corp, or other type of company. There are good reasons to form those legal entities such as liability protection or being able to bring in shareholders or investors.

But oftentimes it is best to wait a year or two and ensure a business is making some profit and will be continued before going through all the paperwork to formalize. If your business does not make a profit within a few years, it can be reclassified as a hobby by the IRS and no longer allowed to take business deductions, regardless of whether it’s a sole proprie­torship or corporation. So oftentimes my advice is to keep things simple, deduct expenses on a Schedule C as a sole proprietorship, and then incorporate in a few years.

While there are many other traps to avoid when accounting for your small business, in general the trick is to always keep supporting documentation, deduct only legitimate expenses, separate business from personal, and read the tax rules on any questionable deductions when in doubt. Follow these guidelines and you should be much better equipped to defend yourself in case of an audit.