I feel horrible; I forgot to write Don’s birthday blog post! If there is one birthday you shouldn’t forget to blog about, it’s your boss’!

For those of you who know Don, you probably already know how great of a guy he is.  I’m truly blessed to have him as a boss.  If you know Paul and Don, you also know they balance each other out perfectly just as any partnership should.  Don’s been an excellent mentor to me over the last five years for which I’m extremely grateful.  He is always willing to take the time to teach us something new or hear us out if we have questions.  Don is very patient, kind, and passionate about what he does (and is so without being a complete geek… just kidding).  One of the best complements we get as CPAs is that we don’t come across as CPAs… at least the stereotype CPA.  This is a complement Don receives frequently and we all strive to achieve as a firm.

Happy belated birthday, Don.  I hope you had an amazing birthday weekend.

The older I get, the more I turn into my mother.  It’s not a bad thing, it’s just interesting that it happens.  When I was younger, one of my punishments was to pull weeds.  What a horrible job as a kid.  Twenty years later, I don’t mind it.  In fact, I enjoy weeding; well maybe not so much the weeding as it is the gardening.  I love to garden and that is something my mom and her entire family are known for.  The older I’ve gotten, the more I enjoy this beautiful world God has created. 

San Diego Botanic Garden (former Quail Botanical Gardents) is an amazing oasis of beautiful gardens of all types, tucked away right here in our back yard (Encinitas to be exact).  There is nothing comparable in San Diego County.  I can’t wait until my son is a little older so he can enjoy the magical children’s gardens they’ve created.

You can explore four miles of garden trails, enjoy restful vistas, flowering trees, majestic palms, and the nation’s largest bamboo collection. Thanks to San Diego’s mild climate, plants from all over the world thrive here. The diverse topography provides a variety of microclimates giving you a sensation of going from a desert environment to a tropical rainforest, all within 35 acres.

If you’ve never been, it’s a must see for any San Diego resident or tourist.  I love being a tourist in San Diego and this is one of the spots I love.

Visit their website at www.SDBGarden.org for more information.

In Part I of the Schedule C “Hot Buttons” we touched on Gross Receipts and Cost of Goods Sold (COGS), as well as an explanation of why the IRS salivates over Schedule C audit opportunities.  Remember, once the IRS begins an examination of your tax return, expect them to dig deep.  All those personal expenses you’ve been running through as a Schedule C deduction will likely be found and subsequently removed, causing a chain reaction of increasing taxes and penalties you owe.

Part II of the “Hot Buttons” has 2 points of emphasis:  Automobile Expenses and Contract Labor.

1)      Automobile Expenses – You can deduct the actual expenses of running your automobile or take the standard deduction rate for business miles driven (whichever is higher).  Most important is to keep a log of the business miles driven, as well as an odometer reading on January 1^st and December 31^st of each year.  This will help determine the business use of the vehicle.  (WARNING to California Residents:  the Franchise Tax Board typically finds a noncompliance rate of 80% each year, so they scrutinize automobile expenses extensively).  Keep good records or risk losing the deduction all together.  No proof, no deduction.

a)      Actual expenses can include depreciation, registration fees, gas, insurance, repairs/maintenance, lease payments, personal property taxes, and parking fees.  If business use of the vehicle is less than 100 percent, expenses must be allocated between business and personal use.

b)      The standard mileage for 2010 is 50 cents per mile.  This can only be applied to business miles.

2)      Contract Labor – This area can cause headaches for those attempting to avoid payroll taxes, worker’s compensation insurance, etc.  If it is determined by an IRS auditor that the hired help is actually considered an employee, be expected to pay unpaid payroll taxes and penalties.

a)      If you are unclear on whether the worker(s) you hire are considered employees or non-employees, fill out Form SS-8 and send in for a final determination.  When in doubt, consider the worker as an employee until it is determined otherwise.  Contact your accountant if you have any questions about filing payroll taxes and any other employee or payroll related forms.  Also take a look at our previous blog on making the determination.

Most of you will not read this on December 31st and say ,”I better get a log book placed in the glove compartment of my business vehicle in the morning!”  But what about for 2010?  The answer is that it’s best to start now and estimate what the first part of the year was like, and do it sooner rather than later so that the likelihood to reasonably estimate what occurred will be as accurate as possible (especially for those of you who like to extend to October 15^th to file your personal tax return).

Up next for the Schedule C “Hot Buttons”, Part III – Depreciation, Other Expenses and the Home Office Deduction.

For many years the penalty for failure to file a federal partnership return was $50 per partner per month for a maximum of 5 months. Over the last couple of years, similar penalties have been extended to S Corporations, and the penalty rates have been creeping up.

The current federal penalty rate is $89 per partner or shareholder per month for a maximum of 12 months. The Worker, Homeownership, and Business Assistance Act of 2009 includes a provision to increase the penalty again. The new penalty rate will be $195 per partner or shareholder per month for a maximum of 12 months for a tax year beginning after December 31, 2009. The maximum penalty now will work out to $2,240 per partner or shareholder. This provision is projected to raise over $1.2 billion over the next 10 years.

Recently signed California legislation, SB 401, also increases the partnership late filing penalty and adds a new late filing penalty for S corporation returns. The FTB assesses the late filing penalty if a partnership or LLC, treated as a partnership, files a late or incomplete return. The current late filing penalty is $10 per partner, for each month or fraction of the month the return is late or incomplete, to a maximum of five months. Beginning with returns required to be filed after January 1, 2011, the penalty will increase to $18 per partner or shareholder for a maximum of 12 months.

Up to now, I’ve covered sole proprietorships, general partnerships, limited liability companies (LLC), and S-Corporations.  The last major entity option is a C-Corporation. 

As I mentioned in the piece on S-Corporations, in general, S-Corporations and C-Corporations have many of the same advantages and disadvantages. There are some very distinct differences you’ll need to consider.  Here are some advantages and disadvantages of a C-Corporation (yes, there is some duplication with the S-Corporation).

ADVANTAGES:

• Continuity of life – by operation of law the entity has an infinite life.  It is not dependent on its shareholders.
• Transferability – generally shareholders are free to sell or transfer their ownership interests at their own will.
• No liability – generally, shareholders do not have personal liability for the business’s obligations. Owners are only at risk for their investment.
• Bankruptcy – entity can file for bankruptcy.
• Publicly traded – most publicly traded companies are C-Corporations
• Ownership – There are no ownership restrictions like those of the S-Corporation
• Capital gain exclusion – original stockholders may be eligible for a capital gain exclusion on the sale of their stock up to $10 million if the stock is qualified small business stock and the stockholder holds the stock for five years.
• Tax rates – due to increasing personal tax rates, C corporation earnings may be taxed at a lower effective tax rate than individuals.
• Separation – complete separation from owners, tax-wise

DISADVANTAGES:

• Complexity – forming a corporation is nearly as complex and expensive as an LLC or LLP.
• Double taxation – The Corporation pays tax at the entity level.  Then distributions to its owners, aka dividends – are taxed again at the shareholder level.
• Formalities – once formed, there are certain formalities that should be followed
• Shareholders have no management rights – Shareholders elect the Board of Directors who elect the officers.  The officers manage the corporation.
• Dissolution – Unwinding generally involves a taxable transaction

See a professional when making these decisions. Every situation is unique and must be considered separately.

Part 1:  Gross Receipts and Cost of Goods Sold

Ever wonder what makes the “tax man” tick?  Unfortunately for you sole proprietors out there, you’re a high profile target for an IRS inquiry or examination.  The IRS has concluded that the most frequent contributors to noncompliance and false reporting are the small business taxpayers.  Based on what IRS examiners have found, roughly 60% of sole proprietors underreport their net business income.

So how is it possible to avoid getting a lovely examination letter in the mail from the IRS?  In short, you can’t.  However, you can limit your exposure by accurately and consistently reporting your business activities.  The main purpose for accuracy is not only honesty, but in the event of an IRS examination you will have nothing to be concerned about.

The first 2 points of emphasis are Gross Receipts and Cost of Goods Sold.

1)      Gross Receipts – What are considered gross receipts?  If there is any connection between any income received and a business, it’s considered business income and must be reported.  A Form 1099-Misc will usually be sent to the sole proprietor if amounts received were for $600 or more for services performed.  A copy is also sent to the IRS, so if your gross receipts on the Schedule C are less than the total from reported 1099’s…you may have just red flagged yourself.

a)      A good rule of thumb for those who don’t keep accurate records would be to go through the business’ bank statements for the year and add up all deposits.  Those deposits should be close to what is reported as gross receipts on the schedule C.  (WARNING:  separate your personal and business bank accounts.  You don’t want deposits to your personal account to be considered business income.)

2)      Cost of Goods Sold (COGS) – The simple formula for COGS is (beginning inventory + purchases + related labor costs + related materials and supplies – ending inventory).  Unless the sole proprietor is a manufacturer or involved in mining operations, the only parts of this calculation that will be used are inventory and purchases.

a)      Are you a sole proprietor with average annual gross receipts of $1 million dollars or more?  You may need to report on the accrual basis of accounting.  Contact your tax preparer for more information regarding proper accounting methods.

At the end of it all, your Gross Receipts minus your COGS will give you Gross Profit.  If everything is being reported accurately and consistently, the percentage of Gross Profit over Gross Receipts (gross profit percentage) should be relatively consistent from year to year.

Up next for the Schedule C “Hot Buttons”, Part II – Automobile Expenses and Contract Labor.

Up to now, I’ve covered sole proprietorships, general partnerships and limited liability companies (LLC).  Now let’s talk about S-Corporations.  The majority of our clients are S-Corporations.  I’d imagine that CPAs favor S-Corporations like lawyers favor LLCs.  It’s not the perfect entity, but we see advantages over the other entities for most privately held businesses.

In general, S-Corporations and C-Corporations have many of the same advantages and disadvantages. There are some very distinct differences you’ll need to consider.  We’ll focus on S-Corporations for today’s post and C-Corporations in part 5.

ADVANTAGES:

• Continuity of life – by operation of law the entity has an infinite life.  It is not dependent on its shareholders.
• Transferability – generally shareholders are free to sell or transfer their ownership interests at will as long as there is a willing buyer or transferee.
• No double taxation – an important difference from the C-Corporation; profits and losses flow through to the shareholders – and NO self employment tax! (Reader beware – Congress is trying to change the self employment tax part…)
• No liability – generally, shareholders do not have personal liability for the business’s obligations. Owners are only at risk for their investment.
• Bankruptcy – entity can file for bankruptcy.
• Distributions – shareholders can take distributions tax free, though they pay tax on their proportionate share of profits.

DISADVANTAGES:

• Complexity – forming a corporation is nearly as complex and expensive as an LLC or LLP.
• S-Corporation limitations –
  • No more than 100 shareholders allowed
  • Shareholders must be individuals, estates or certain trusts
  • Must be a domestic corporation
  • Generally only one class of stock allowed
  • All shareholders must be US residents or citizens
  • Formalities – once formed, there are certain formalities that should be followed.
  • Asset distributions – assets taken by shareholders must be removed at fair market value which can create a taxable transaction.
  • Shareholders have no management rights – Shareholders elect the Board of Directors who elect the officers.  The officers manage the corporation.
  • Dissolution – unwinding generally involves a taxable transaction

See a professional when making these decisions. Every situation is unique and must be considered separately.

You filed for an extension of your individual tax return in the spring but now it is time to face the task that you have been avoiding.  I am talking about getting those taxes done!  I know it is only July and the return is extended until October but the longer you wait the harder it will be to get started.

Here are some pointers to get you motivated whether you are preparing the return yourself or you are hiring a professional tax preparer.

1)      Start with your prior year tax return as a reference point.  Pull that 2008 tax return out of the filing cabinet and all the supporting documents.  Then pull out of the cabinet the file labeled “2009 taxes” and compare the 2009 to the 2008 documentation to compose an open item/missing list. 

2)       Don’t panic if you are missing several items!  It is easy to get a lot of the information on line.  Let’s say you are missing Form 1098 Home Mortgage Interest.  Most mortgage companies have that information available on line.

3)      Set a deadline to acquire all the missing information no later than August 15^th.

4)      Now think about any changes that took place in your life during 2009.  Do you have a new dependent in your family?  Did you start a new job?  Did you acquire a new rental property? Did you move?  These new situations may have tax implications so you should gather all the pertinent information and do some research or bring this new information to your tax appointment.

No more excuses…You have gathered all the information so it is time to tackle the tax return yourself or visit your tax preparer.  Do not wait until October 12^th to get started!!!  You will not be able to file a complete and accurate tax return at that point.  Also you will probably miss deductions and tax credits.  And last but not least, if you are hiring a professional tax preparer, remember that he can only do a good job if you give him all the information and enough time to evaluate your situation and process your tax return.

I previously wrote blogs on sole proprietorships and general partnerships.  I know this can be a little boring but hopefully it’s useful.  It’s important to know and understand all options.  Assuming capitalism doesn’t go by the wayside, one day you might start a company.  Heck, if high unemployment persists, you may have to start a company!

Before I go into the advantages and disadvantages of a limited liability company (LLC), I want to give you a question to ponder.  If you do decide to form a business, and you were a good boy or girl and sought the advice of a professional, one very important question should be, “What is your exit strategy?” The answer to this question could outweigh your opinions on other factors, even those on taxation.  This most important question is critical when considering choice of entity!

On to LLCs!  A Limited liability company provides the asset protection of a corporation and some of the tax liability of a partnership or (in case of a single owner) a sole proprietorship.  Lawyers love them and frequently suggest converting a sole proprietor to an LLC.  You still need to weigh the pros and cons.

Here are some (NOT ALL) advantages and disadvantages of a Limited Liability Company.

ADVANTAGES:

• Limited personal liability to members – members (owners) enjoy the limited liability that shareholders of corporations enjoy, meaning, members are NOT personally liable for the entity’s obligations beyond their investment in the entity.
• Flexible tax options – LLCs can elect to be taxed as a partnership, corporation or S-corporation.
• Bankruptcy – the entity is eligible to file for bankruptcy protection under Bankruptcy Statutes.
• Lower audit profile – the IRS does not audit LLCs as frequently as sole proprietorships.
• You can form a single member LLC which is taxed like a sole proprietor.
• Dissolution – when the LLC elects to be taxed as a partnership, it is possible to “unwind” an LLC without tax consequences to the entity or the owners; same as partnerships.

DISADVANTAGES:

• Expensive – forming an LLC is one of the most expensive and complex entities to form
• Self-employment tax – usually income is subject to self employment tax
• LLC fees – in the state of California, there is an LLC fee assessed on gross revenues, not profits.  This means your company could be bleeding from every corner, struggling to make money and still have the pay the fee. 
• Transferability is limited – in most states, there must be consent from all members to sell or transfer ownership interest.
• Limitations on types of businesses – many licensed businesses cannot use this form due to the limited liability such as contractors and accountants.
• Single member LLC – the IRS does not recognize a single member LLC and requires it to be taxed as a sole proprietor, therefore subject to self employment tax (yet still subject to the LLC fee in California).

A few additional facts about LLCs you might want to know:

• LLCs are formed by filing certain documents with the state.
• Unless the operating agreement states otherwise, all members have the right to participate in management of the LLC.
• Voting strength is not equal between members, voting strength is determined by each members’ proportionate ownership interest in the entity or by the operating agreement.
• Unless stated otherwise in the operating agreement, profits and losses are allocated on the basis of the members’ contributions.
• There are no rights to distributions.
• Unlike a corporation, entity life is limited.

See a professional when making these decisions. Every situation is unique and must be considered separately.

In my 6-3-10 blog post I identified potential problems with some estate plans if a spouse should pass away in 2010.  The crux of the problem lies in trust language that is designed to transfer the maximum exempt amount to an irrevocable Decedent’s Trust upon the death of the first spouse.  While this strategy worked well in 2009, it could be disastrous in 2010.  This article illustrates two examples of these which are too voluminous for a blog post. 

Click here for the full article.