Lesson 1 - What you need to know about federal taxes and your new business
Hi I'm Ned and I'm a social media consultant.
I started my company this year and I'm having a little difficulty keeping up with all this business recordkeeping.
What is this EIN? What does EIN stand for, anyway?
Entrepreneur Something Number?
That doesn't sound right. Receipts, receipts, receipts! I don't know what to keep and what I can get rid of. This is just a taxi receipt, I couldn't need that. Maybe I should have kept that. I'm not even sure I have all the information I need. I'm definitely a sole proprietor, but maybe a Limited Liability Company. Maybe I should just incorporate.
Maybe I should just get through this mess first.
And I still need to make sure I'm using the right accounting method.
Cash, I guess... or maybe accrual is better. I don't know. How long do I have to keep all of this stuff? Maybe I should just pay someone to do it for me. But who?
Let's see if we can help bring some order to the chaos that Ned is experiencing. Welcome to What You Need to Know about Federal Taxes and Your New Business.
In this lesson, we'll provide a basic overview of what you need to know about successfully operating your business as well as provide you with some resources for additional information.
In this lesson, we'll explain the purpose of the employer identification number, describe basic recordkeeping requirements for tax purposes, define basic bookkeeping and accounting methods, explain the forms of business organizations, and finally, suggest how to select a paid tax preparer.
Before we begin, however, we want to remind you that you need to understand federal, state, and local tax reporting requirements. As you begin your business, review your state and local tax reporting requirements in accordance with the state requirements.
Throughout this lesson we'll also be hearing from Ned, a small business owner, as he learns how to organize his business to meet his federal tax obligations.
Employer Identification Number, or EIN
Let's start first with the federal Employer Identification Number, or EIN.
An EIN identifies tax returns filed with the IRS, and, as a business owner, you may be required to get an EIN.
Okay...Why or when would a business owner need an EIN?
Ned, you will need an EIN if you pay wages, have a self-employed retirement plan, operate your business as a partnership or corporation, or if you are required to file any of these tax returns: employment; excise; fiduciary; or alcohol, tobacco, and firearms.
So .. if you are a sole proprietor with no employees and don't meet any of these requirements, you don't need an EIN? Well....You may need an EIN for dealing with other businesses, including banks, that require an EIN to set up business accounts. The IRS will give you an EIN even if you don't need it for IRS purposes.
Okay...What is the application process to obtain an EIN? Ned, the fastest- and easiest-way to get an EIN is online. Just go to www.irs.gov and type in the keyword EIN. From there, you'll find more information, including the application. Although the IRS calls this a provisional EIN, the EIN is actually the permanent federal employer identification number for your business. This EIN may be canceled if the name and social security number of the principal officer do not match the social security administration records or if your business already has an EIN.
Now, let's discuss recordkeeping for your business.
What records does a business owner need to keep?
Ned, you must keep receipts, sales slips, invoices, bank deposit slips, canceled checks, and other documents to substantiate items of income, deductions, and credits. Although it may sound like a lot of work, unless you have records showing the sources of your receipts, you may not be able to prove that some are non-business or non-taxable. Remember, recording these items will help you pay only the tax you owe.
How in-depth and how long to keep records
How in-depth do records need to be? And how long do business owners need to keep them?
Records must support the claimed amount, the time and the place, the business purpose, and your business relationship to any other person involved. If your records are incomplete, they may not support your deductions. You must keep your records as long as their contents may be material in the administration of any Internal Revenue Service law. Usually, the statute of limitations for an income tax return expires three years after the return is due or filed or two years from the date the tax is paid, whichever is later. To support items of income or deduction on your tax return, you must keep records until the statute of limitations for that return expires.
What records do I need to keep if I have employees?
If you have employees, then you have to keep employment tax records, too. You must keep all employment tax records for at least four years after the date on which the tax return becomes due or the tax is paid, whichever is later.
Are there any records that I need to keep longer?
Are there other circumstances in which records may have to be kept longer? And what if an owner loses them?
If you change your method of accounting, records supporting the necessary adjustments may be material for an indefinite time. Additionally, you must keep records relating to the basis of property for as long as they are material in determining the basis of the original or replacement property. For example, you must keep these records to figure any depreciation, amortization or depletion deduction, and to figure your basis for computing gain or loss when you sell or otherwise dispose of the property.
What if I lose my records?
If you lost your records due to circumstances beyond your control, such as a flood or an earthquake, you may substantiate a deduction by reasonable reconstruction.
Wow...This is a lot for new business owners to remember. Where can I find more information?
For more information about recordkeeping, see Publication 583, Starting a Business and Keeping Records. For information about employment tax records, see IRS Publication 15, Employer's Tax Guide. You can find these at www.irs.gov.
Now...onto our third topic: bookkeeping systems.
Many people who operate their own one-person business never bother to set up a business bookkeeping system. Their personal checking account serves as both a personal and a business account. The IRS, however, recommends that you open a separate business bank account.
What are the types of bookkeeping systems?
Well Ned, there are two types of bookkeeping systems: single entry and double entry.
Single entry system
The single entry system is the simplest to keep: with the single entry system, you record a daily and a monthly summary of business income and a monthly summary of business expenses. This system focuses on the business's profit and loss statement and not on its balance sheet. While single entry is not a complete accounting system, it shows income and expenses in sufficient detail for tax purposes.
Double entry system
The double entry system is more complex: it has built-in checks and balances, is self-balancing, and is more accurate than the single entry system. Because all businesses consist of an exchange of one thing for another, double entry bookkeeping is used to show this two-fold effect.
Once you've selected a bookkeeping system, you'll also need to select an accounting method. Your accounting method is a set of rules that you use to decide when and how you report your income and expenses.
Common accounting methods
What are the common accounting methods?
The two most commonly used accounting methods are the cash method and the accrual method. On your tax return, you must use the same accounting method you used to keep your records.
Under the cash method, you report all income in the year you receive it. You usually deduct expenses only in the tax year in which you pay them.
Under the accrual method, you report income in the year you earn it, regardless of when you receive payment. You deduct expenses in the tax year you incur them, whether or not you pay them that year. Businesses that have inventory for sale to customers must generally use an accrual method for sales and purchases. However, many small businesses with gross receipts averaging less than 10 million dollars a year may use a cash method for sales and purchases.
Test your knowledge
Now, up to this point we have covered quite a lot, and it's time for you, the viewer, to test your knowledge. Let's hear from Sandy about her business and then you decide whether she is using the correct accounting method.
Hi, I'm Sandy. I have a Website where I sell custom-ordered and handmade knitted goods- hats, scarves, and socks. Customers order online, but because it could take a few weeks or even a few months to get the supplies and finish the order, I don't charge them until the product actually ships. I use the accrual method of accounting. I record the sale in the month when I ship the product, not in the month that the person orders it.
Is Sandy correct in using the accrual method?
Is Sandy correct in using the accrual method?
You're correct: Sandy can use the accrual method of accounting. She records revenue when she earns it; that is, when she ships the product.
Actually, Sandy can use the accrual method of accounting. Because there can be some length of time between when a customer places an order and when it ships, Sandy records revenue when the customer is charged; that is, when she ships the order.
For more information on accounting . . . .
For more information on the differences between the cash and the accrual methods of accounting, see IRS Publication 538, Accounting Periods and Methods.
Do business owners have to do all of this bookkeeping and accounting by hand?
Not at all, Ned. There are computer software packages that are very useful, relatively easy to use, and require very little knowledge of bookkeeping and accounting.
If you use software . . . .
But be careful, if you use software you must be able to produce records from the system to support what is on your tax return. And, always keep a backup copy in a safe place.
Now, let's turn our attention to business structures.
Early in the life of your small business, you'll need to decide on the structure of ownership. There are five common types of business organizations: sole proprietorship, partnership, limited liability company or limited liability partnership, S corporation, and corporation. Let's look at the advantages and disadvantages of each.
A sole proprietorship is the simplest type of business organization. It is an unincorporated business that one person owns. The business does not exist apart from its owner, and it is the owner who assumes the risks of the business to the extent of all his or her assets, even if the owner does not use his or her personal assets in the business. Additionally, the ability to finance the business, known as capital, is limited to whatever the owner can come up with.
What kind of forms does a sole proprietor need to file?
A sole proprietor files his or her taxes using either a Schedule C or a Schedule C EZ, Net Profit from Business. The Schedule C is included with the Form 1040 to report the profit or loss from operating the business. The sole proprietor also files Schedule SE, Self-Employment Tax, to report the Social Security and Medicare taxes on net profits of the current year's threshold. If you or your spouse jointly own and operate an unincorporated business in a non-community property state and share in the profits and losses, you are partners in a partnership and not a sole proprietorship; so, you should not use a Schedule C or a Schedule C EZ. But, there are exceptions to this. For example, if you and your spouse wholly own and operate an unincorporated business as community property under the community property laws of a state, you can treat the business either as a sole proprietorship or a partnership.
Qualified joint venture
There's another exception for Qualified Joint Ventures for spouses. If you and your spouse each materially participate as the only members of a jointly owned and operated business and you file a joint return for the tax year, you can make a joint election to be treated as a "Qualified Joint Venture" instead of a partnership. This allows you to avoid the complexity of partnership Form 1065, US Return of Partnership Income, but still gives each spouse credit for social security earnings on which retirement benefits are based.
The second type of business organization is a partnership. A partnership is a relationship between two or more persons who join together to carry on a trade or business. Each person contributes money, property, labor, or skills, and each expects to share both in the profits or the losses of the business. Any number of persons may join in a partnership. The advantages of a partnership are that it is easy to organize, it has a definite legal status, and it may have a greater financial strength than a sole proprietorship.
What are the disadvantages?
The first disadvantage is that decision authority is divided. The other disadvantage to a partnership is that the liability of the partners is usually unlimited; that is, each partner may be held liable for all the debts of the business. For example, if one partner does not exercise good judgment, that partner could cause not only the loss of the partnership's assets, but also the loss of the other partner's personal assets.
How are partnership profits and losses reported?
Partnerships report profits or losses on Form 1065, US Return of Partnership Income. Form 1065 summarizes the business activity of the partnership. A partnership does not pay tax on income from daily operations, and all income, losses, deductions, and credits generated by a partnership pass through to the partners. Each partner gets a Form 1065 Schedule K1, Partner's Share of Income, Deductions, Credit, etc., and the partners report these items on their personal income tax returns. If you would like more information about partnerships, see IRS Publication 541, Partnerships, as well as the instructions to Forms 1065 and 1040.
Limited liability company (LLC)
The third type of business entity is a limited liability company, also known as an LLC. LLCs are popular because owners have limited personal liability for the debts and actions of the LLC, without many of the formalities of a corporation. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of flow-through taxation. How are LLCs treated for tax purposes? For federal incomes tax purposes, an LLC may be treated as a sole proprietorship, a partnership, or a corporation, which we'll discuss soon.
If you want to tell the IRS how to treat your business for federal income tax purposes, you need to file Form 8832, Entity Classification Election. If you do not file Form 8832, for tax purposes the IRS will treat your business as a sole proprietorship if it has a single owner or as a partnership if it has two or more members. Note that even though the LLC is treated as a sole proprietorship for tax purposes by the IRS, the single member owner of the LLC generally maintains limited personal liability protection from the debts and actions of the LLC, unlike an actual sole proprietorship, where the owner would be equally liable for the debts and actions of the sole proprietorship. There are instructions with the form that explain the classifications. If you disagree with the default classification, you can file Form 8832 to request a change.
The fourth business entity is the S corporation.
An S corporation is a small business corporation whose shareholders elect to have corporate income taxed like a partnership. Partnerships are taxed once. Corporations are taxed at the corporate level; then, when the income is distributed as dividends, it is taxed again at the shareholder level. Organizing shareholders of a corporation who wish to avoid double taxation can file Form 2553, Election by a Small Business Corporation. This election must be submitted by the 15th day of the 3rd month of the 1st S corporation year.
Can you give an example to help clarify the process?
Sure. If your 1st S corporation tax year begins on January 1st, you must submit Form 2553 by March 15th; otherwise, the election is effective for the next tax year. The IRS will send you a CP261 notice, Notice of Acceptance as an S Corporation, to let you know it received and approved your election. You should receive your approval in 60 days. If you do not, contact the IRS campus where you filed your Form 2553. For more information, see the instructions on Form 2553.
How does an S corporation pay taxes?
An S corporation does not pay tax on income from daily operations. All income, losses, deductions, and credits generated by an S corporation pass through to the corporate shareholders. The shareholders, then, report the items on their personal income tax returns. However, there are situations where an S corporation is subject to an entity, or corporate, level tax. For example, S corporation officer shareholders who provided services to their corporation are employees, and their compensation is subject to employment taxes. By law, officers of corporations are employees for employment tax purposes and their compensation is wages.
An S corporation must pay reasonable compensation, or wages, to a shareholder employee in return for the services the employee provides the corporation before a non-wage distribution may be made to that shareholder employee. In other words, they have to be compensated first; then, they get the distribution. An S corporation has the combined advantages and disadvantages of partnerships and regular corporations.
And what forms do S corporations need to file?
S corporations file Form 1120S, U.S. Income Tax Return for an S Corporation. The S corporation provides each shareholder a Form 1120S Schedule K1, Shareholder's Share of Income, Deductions, Credits, etc. The shareholder uses the Schedule K1 to complete Part Two on Form 1040 Schedule E, Supplemental Income and Loss, as well as any other forms and schedules the shareholder must file with the individual return.
Now, for the last type of business organization, the corporation. Corporations are treated by the law as legal entities; that is, the corporation has a life separate from its owners and has rights and duties of its own. The owners of a corporation are known as stockholders or shareholders, and, it may be worth noting, one person can be the sole shareholder of a corporation. Managers of a corporation may or may not be shareholders. Forming a corporation involves the transfer of money or property or both by the prospective shareholders in exchange for capital stock in the corporation. For the purpose of federal income tax, corporations include associations, joint stock companies, and trusts as well as partnerships that actually operate as associations or corporations.
What are some of the advantages and disadvantages of structuring a business as a corporation?
The advantages of a corporation are that the stockholders have limited liability for corporate debts or actions, transfer of ownership is easy, stock can be sold, and raising capital and expanding the business may be easier. The disadvantages are that the corporation is subject to tax on its income at the corporate level and, when the income is distributed as dividends, that income is taxed again at the shareholder level. It is wise to consult an accountant and an attorney specializing in corporate law as corporations may be more difficult and expensive to organize than other business structures. Additionally, the corporate charter filed with the secretary of your state restricts the types of business activities and is subject to many state and federal controls.
How is a corporation formed?
In forming a corporation, a business must organize by applying for a charter through the state government, usually in the state where the principal business activity will occur. To increase its financial ability, the charter permits corporations to sell stock to numerous shareholders. Furthermore, the corporation is empowered to create debts separate from the shareholders. A corporation takes the same deductions for expenses as the sole proprietor, and special deductions are also available to corporations. Profits of the corporation are taxed to the corporation on Form 1120, US Corporation Income Tax Return, as well as to the shareholders if the profits are distributed. However, shareholders cannot take a loss if the corporation does not operate at a profit. We've just covered the five common types of ownership structures: sole proprietorships, partnerships, limited liability companies or LLCs, S corporations, and corporations. As a small business owner, you have many factors to consider when you choose the structure of your business, and your decision will be based on your individual circumstances.
Choosing a paid preparer
Now, for the last topic for this lesson: choosing a paid preparer.
Do you have any advice? There seem to be so many options.
If you do decide to use a paid preparer, the IRS has some information for you to consider. And remember, even if you decide to use a paid preparer, you are still legally responsible for the information on your own tax returns. Let's review some points you need to be aware of when selecting a tax preparer. First, avoid preparers who claim they can obtain larger refunds than others. Second, avoid preparers who base their fees on the amount of your refund. Third, look for a preparer who signs the tax return and gives you a copy for your records. Fourth, never sign a blank tax return and never sign a completed form without reviewing it and making sure you understand the return. And finally, consider whether the preparer will still be available to answer questions about the return for months or even years after the return is filed.
The IRS now has a registration and certification process for preparers. To ensure that you are working with an honest and reputable preparer, make sure that the preparer has a valid Preparer Tax Identification Number, also known as a PTIN. All preparers, whatever their professional designation, must have a valid PTIN. There are variations, however, in the type of return preparer, the testing they must undergo, their continuing education requirements, and their practice rights before the IRS. For the purpose of this lesson, we'll be focusing on three types of preparers: enrolled agents, CPAs, and attorneys.
An enrolled agent is a person who has earned the privilege of representing taxpayers before the IRS. Most enrolled agents have passed a three-part comprehensive IRS test covering individual and business tax returns and client representation rules. They must adhere to ethical standards and complete 72 hours of continuing education courses every three years. Enrolled agents have unlimited practice rights, which means they are unrestricted as to which taxpayers they can represent, what types of tax matters they can handle, and which IRS offices they can represent clients before. To learn more about enrolled agents, see Treasury Department Circular 230 or visit www.irs.gov/agents. Some individuals become enrolled agents through experience as a former IRS employee instead of passing the three-part test. These individuals may be limited in their practice rights to only the matters they have expertise in as a former employee. Both Certified Public Accountants, also known as CPAs, and attorneys have their own professional requirements for continuing education and both groups have unlimited practice rights before the IRS.
That's the end of this lesson, but before we close, let's see how Ned is doing now.
I think I have a better understanding of what I need to do. Can I have a review, though?
Here's a review for everyone. In this lesson, we explained the purpose of the employer identification number and how to obtain one, defined basic bookkeeping and accounting methods and terms, reviewed the different forms of business organizations, and suggested criteria for selecting a paid preparer. There's a lot to learn when you start your own business, and we hope this lesson has provided you with an overview of what it takes to start your business off right. I want to thank Ned for helping us out through this lesson, and I want to thank you for joining us. Best wishes on your new business.