Tax Challenges of Business Income

 

FS-2008-20, April 2008

WASHINGTON—Internal Revenue Service research indicates that understated business income contributes significantly to the tax gap, with the majority understated by small businesses.

To assist small business and self-employed taxpayers better understand their reporting obligations, this fact sheet addresses the issue of income and how to determine gross income.

Business Income, Gross Receipts or Sales

If there is a connection between any income received and a business, the income is business income. A connection exists if it is clear that the payment of income would not have been made if the business did not exist and operate.

Small business owners and self-employed taxpayers must report on their tax returns all income received from their businesses unless specifically excluded by law. In most cases, business income will be in the form of cash, checks and credit card charges.

But business income can be in other forms, such as property or services. There are many forms, including: bartering, real estate rents, personal property rents, interest and dividend income, canceled debt, promissory notes, lost income payments, damages, economic injury payments, as well as kickbacks.

All income earned is taxable. Directing payment of income to a third party does not remove the reporting and payment requirements for small businesses and self-employed taxpayers.

Cost of Goods Sold

Some businesses may make or buy goods to sell. If so, these businesses may deduct the cost of goods sold (COGS) from their gross receipts. To determine these costs, the value of inventory at the beginning and end of the year must be calculated.

There are several factors that go into determining COGS, including: inventory at the beginning of the year; purchases less cost of items withdrawn for personal use; labor costs (generally applies to manufacturing and mining operations); materials and supplies (generally a manufacturing cost); other costs (generally applies to manufacturing and mining operations); and inventory at the end of the year.

Inventory, net purchases, cost of labor, materials and supplies, and other costs are added together. Inventory at the end of the year is subtracted from this total to determine COGS.

Gross Income

To calculate gross income, first determine net receipts (gross receipts minus returns and allowances) and minus the cost of goods sold. Returns and allowances include cash or credit refunds made to customers, rebates and other allowances off the actual sales price. Then add any other income, including fuel tax credits. Gross income must be determined first before deducting business expenses.

Tools to Use

There are tools available to assist small business owners and the self-employed track and report income such as the use of: a formal set of books and records with strong; accounting/financial computer software; and separate bank accounts for business and personal income and expenses.

Small businesses and self-employed taxpayers greatly benefit by accurately recording and reporting all income. Insufficient recordkeeping could cause income to be over-reported and too much tax paid or too little income reported and too little tax paid.

The Small Business and Self-Employed One-Stop Resource is a Web based tool. It contains a wealth of information to educate business owners and the self-employed on their unique tax filing and reporting obligations.

Another Web based tool is the Online Learning and Educational Products section of IRS.gov which allows business owners to view a streaming video of an IRS Small Business Workshop, order the Small Business Workshop on DVD, take an IRS course, or complete an online, self-directed version of a workshop taught live around the country.

These tools can help to more accurately determine income and expenses as well. There are benefits beyond accurate income and expense reporting to be gained. Formalized financial records will help small businesses when it is time to apply for loans or efforts to obtain capital for expansion.

Links:
• Publication 334, Tax Guide for Small Business
• Publication 583, Starting a Business and Keeping Records

Tax Tips: Record Keeping

New Law Eases Cell Phone Reporting

In 1989, when the old cell phone rules were developed, cell phones were expensive and considered a luxury item used primarily by executives.  Congress decided to tax them the same way it taxes the personal uses of employer-provided automobiles.  Under this classification, called “listed property”, employers are denied a tax deduction unless they document the cell pho9ne business use and business purpose.  Employees were required to include the value of their personal use in their income.

Starting in 2010, cell phones and similar telecommunication devices used for business are no longer subject to the “listed property” reporting requirements.  This means employers may deduct the cost of providing cell phones to employees for business-related use without having to satisfy the strict substantiation requirements for listed property.

Four Tax Tips about Tip Income

If you work in an occupation where tips are part of your total compensation, you need to be aware of several facts relating to your federal income taxes. Here are four things the IRS wants you to know about tip income:

1. Tips are taxable. Tips are subject to federal income, Social Security and Medicare taxes. The value of non–cash tips, such as tickets, passes or other items of value, is also income and subject to tax.

2. Include tips on your tax return. You must include in gross income all cash tips you receive directly from customers, tips added to credit cards, and your share of any tips you receive under a tip–splitting arrangement with fellow employees.

3. Report tips to your employer. If you receive $20 or more in tips in any one month, you should report all of your tips to your employer. Your employer is required to withhold federal income, Social Security and Medicare taxes.

4. Keep a running daily log of your tip income. You can use IRS Publication 1244, Employee's Daily Record of Tips and Report to Employer, to record your tip income.

For more information see IRS Publication 531, Reporting Tip Income and Publication 1244 which are available at http://www.irs.gov or can be ordered by calling 800-TAX-FORM (800-829-3676)

Links:

• IRS Publication 1244
• IRS Publication 531

Eight Facts About Filing Status

The first step to filing your federal income tax return is to determine which filing status to use. Your filing status is used to determine your filing requirements, standard deduction, eligibility for certain credits and deductions, and your correct tax. There are five filing statuses: Single, Married Filing Jointly, Married Filing Separately, Head of Household and Qualifying Widow(er) with Dependent Child.

Here are eight facts about the five filing status options the IRS wants you to know so that you can choose the best option for your situation.

1. Your marital status on the last day of the year determines your marital status for the entire year.

2. If more than one filing status applies to you, choose the one that gives you the lowest tax obligation.

3. Single filing status generally applies to anyone who is unmarried, divorced or legally separated according to state law.

4. A married couple may file a joint return together. The couple’s filing status would be Married Filing Jointly.

5. If your spouse died during the year and you did not remarry during 2010, usually you may still file a joint return with that spouse for the year of death.

6. A married couple may elect to file their returns separately. Each person’s filing status would generally be Married Filing Separately.

7. Head of Household generally applies to taxpayers who are unmarried. You must also have paid more than half the cost of maintaining a home for you and a qualifying person to qualify for this filing status.

8. You may be able to choose Qualifying Widow(er) with Dependent Child as your filing status if your spouse died during 2008 or 2009, you have a dependent child and you meet certain other conditions.

There’s much more information about determining your filing status in IRS Publication 501, Exemptions, Standard Deduction, and Filing Information. Publication 501 is available at http://www.irs.gov or by calling 800-TAX-FORM (800-829-3676). You can also use the Interactive Tax Assistant on the IRS website to determine your filing status. The ITA tool is a tax law resource on the IRS website that takes you through a series of questions and provides you with responses to tax law questions.

Link:

Publication 501, Exemptions, Standard Deduction, and Filing Information (PDF 196K)

To slash taxes, buy assets and lease them back to your company

This strategy works especially well with real estate and other assets that are likely to appreciate in value.

It's bad enough when you have to pay tax once to the IRS. But C corporation owners are hit with a double tax whammy: first, when the corporation pays tax, and second, when Uncle Sam taxes them personally on dividends paid out by the company.

Strategy: Buy property and assets personally and lease them back to your company.

That way, the company pays you deductible lease payments instead of nondeductible dividends, and you can offset the income with depreciation or amortization deductions.

That technique works particularly well with real estate and other assets that are likely to appreciate in value.

In fact, if your company already owns a business building, you can buy it from your company now and then lease it right back.

Example: sale-leaseback deal. Suppose your company bought its building years ago and has since depreciated it down to zero. You estimate that the building and adjacent land are currently worth $1.5 million. Your company needs a quick cash infusion for proposed expansion, but money is tight.

Solution: Buy the building from your company for $1.5 million—using mostly cash you've borrowed—and lease it back. Then you begin depreciating the building all over again, using a 39-year write-off period. Your company pays the going rate for rentals in your area, but the rental income is offset by the depreciation and other related expenses.

Your, company now has the cash it needs for expansion and can deduct rental payments for a building that had previously been fully depreciated.
In comparison, your company receives no tax deduction for money paid to you as dividends. The downside is that the company must pay tax on the gain.

Fly under IRS radar. This technique can be perfectly legal, but the IRS often casts a skeptical eye on such deals. To make sure your deal is legit and satisfies IRS standards, meet these five requirements:

1.    The property's useful life must exceed the lease term.
2.    Any lease renewal is set at a market value.
3.    The buyer reasonably expects to profit from the deal.
4.    The property is sold at a fair price, and the buyer assumes the risk of losing money.
5.    A valid nontax business reason exists for the rental (e.g., leasing assets instead of owning them can release working capital).

Five Tax Tips for Recently Married Taxpayers

Are you getting married this summer?  If you recently got married or are planning a wedding, the last thing on your mind is taxes.  However, there are some important steps you need to take to avoid stress at tax time. Here are five tips from the IRS for newlyweds to keep in mind.

1. Notify the Social Security Administration Report any name change to the Social Security Administration, so your name and Social Security Number will match when you file your next tax return. Informing the SSA of a name change is quite simple. File a Form SS-5, Application for a Social Security Card, at your local SSA office. The form is available on SSA’s website at www.socialsecurity.gov, by calling 800-772-1213 or at local offices.
2. Notify the IRS If you have a new address you should notify the IRS by sending Form 8822, Change of Address. You may download Form 8822 from IRS.gov or order it by calling 800–TAX–FORM (800–829–3676).
3. Notify the U.S.Postal Service You should also notify the U.S. Postal Service when you move so it can forward any IRS correspondence.
4. Notify Your Employer Report any name and address changes to your employer(s) to make sure you receive your Form W-2, Wage and Tax Statement, after the end of the year.
5. Check Your Withholding If both you and your spouse work, your combined income may place you in a higher tax bracket. You can use the IRS Withholding Calculator available on IRS.gov to assist you in determining the correct amount of withholding needed for your new filing status. The IRS Withholding Calculator will even provide you with a new Form W-4, Employee's Withholding Allowance Certificate, you can print out and give to your employer so they can withhold the correct amount from your pay.

Nine Tips on the 10 Percent Tax on Tanning Services

Starting July 1, 2010, many businesses offering tanning services must collect a 10 percent excise tax on the tanning services they provide. This excise tax requirement is part of the Affordable Care Act that was enacted in March 2010.

Here are nine tips on the tanning excise tax that providers must collect.
Businesses providing ultraviolet tanning services must collect the 10 percent excise tax at the time the customer pays for the tanning services.
If the customer fails to pay the excise tax, the tanning service provider is liable for the tax.

The tax does not apply to phototherapy services performed by a licensed medical professional on his or her premises.

The tax does not apply to spray-on tanning services.

If a payment covers charges for tanning services along with other goods and services, the other goods and services may be excluded from the tax if they are separately stated and the charges do not exceed the fair market value for those other goods and services.

If the customer purchases bundled services and the charges are not separately stated, the tax applies to the portion of the payment that can be reasonably attributed to the indoor tanning services.

The tax does not have to be paid on membership fees for certain qualified physical fitness facilities that offer indoor tanning services as an incidental service to members without a separately identifiable fee.

Tanning service providers must report and pay the excise tax on a quarterly basis.

To pay the tax, businesses must file IRS Form 720, Quarterly Federal Excise Tax Return using an Employer Identification Number assigned by the IRS. Businesses that don’t already have one can apply for an EIN online at IRS.gov.

Find more information about the excise tax on tanning services, IRS Form 720 and other tax provisions of the Affordable Care Act at IRS.gov.
Links:
IR-2010-73, IRS Issues Regulations on 10-Percent Tax on Tanning Services Effective July 1
Excise Tax on Indoor Tanning Services Frequently Asked Questions
Affordable Care Act Tax Provisions

YouTube Video:

Tanning Services Excise Tax: English | ASL