Tax Tips Blog

NOTE: I have received several requests as to why I have not been posting.  There are many reasons, but mostly because most of the questions I am receiving I have previously answered.  If you search my site you may be able to find an answer to your question.  Having said that I will try to post some of the past questions I have received and perhaps some reminders of what to watch for this tax season.

Without further ado…

Joyce Asks: I am wondering if it is not possible to treat the children as independant contractors  which would mean that you do not have to contend with unemployment compensation (are you really going to fire your own child?).  You could then set up a very simple contract for services between you (the sole proprietor) and your independant contractors.  The bookeeping would be very simple.  You could do a payment per task completed type of contract.

Also, I am wondering if the children can open a Roth IRA which could give them quite a jumpstart towards a wealthy retirement? They most likely wouldn’t need the tax deduction if they made less than the threshold traxable amount.

My reply: I have discussed much of this before in these three articles:  Benefits of hiring your children and parents, Hiring Children, and Employee or Independent Contractor.

First, I would think it would be very hard to hire most children (depends on their age, maturity level and other source of income) as an independent contractor and be able to support that decision.  As I stated in my previous article, you don’t get to just choose if your workers are employees or independent contractors it is a matter of law.  The first thing that the IRS looks at is are you providing them a place to work?  If your child has their own place to work that surely is impressive.  Second the IRS wants to know if you are providing them the tools to do their job.  If your children have their own money from a source other than you and they used that money to purchase whatever tools they will need to do their job (dust rags, window cleaner, whatever), then I guess that works.  The third thing the IRS wants to know is if you need to tell them how to do their job and/or provide them any training?  If you need to do this, then they’re your employee.  There are many other questions as well, including, do you want to retain the ability to fire this person?  If so, they’re an employee.  So, as you can see it’s hard for a child, especially a young child, to be properly classified as an independent contractor.

Second, and again, as I have explained in one of those prior articles, if you are self-employed (sole proprietor or LLC taxed as a sole proprietor) you will not have to withhold Social Security or Medicare taxes nor will you have to pay unemployment taxes as long as your child is working for you and they are under the age of 18 and you will not have to withhold Federal or State taxes if they earn less than the minimum required to do so.

Third, and again, as I stated in one of those prior articles, yes you are allowed to open IRAs for your children, which can further reduce taxes and help save for their college education and/or retirement.

Melissa writes:
Hope you can help me with a couple of questions:
I am starting a small dog walking business and I am going to pay my children that are ages between 11-14 yrs to make flyers and put them out ,do some light office work and perhaps help with the walking.Since I am just starting out do I need to show a profit to do this?
Chances are I might be able to make what I have already put into my business by the end of the year but its’s questionable.
I am a soleproprietor and do not yet have a EIN # I am assuming I probably need one if I am going to pay my children,right?
How do I figure how much I am suppose to take out for my taxes?
State
FICA
Fed
Is there a certain percentage?
Do I pay that at the end of the year when I file my earnings with my husbands earnings and they just take it out or do I pay quarterly?
Thanks I have gone on the IRS site numerous times I just get more confused.
Melissa

My reply:
Congratulations on starting your business!

While reading my reply, please remember that you didn’t say what state you’re in and you’ll probably be subject to state taxes so please visit your state’s department of revenue to find out more about that.

It is very common that when businesses first start out they do not make a profit. The IRS doesn’t expect to see a profit in the first year of business; however they do expect you to run your business in such a way that it is reasonable to believe that you will make a profit. If you do not run your business professionally or you do not generate a profit after a certain number of years, the IRS will assume that this venture is a hobby and not a business.

Yes, if you hire your children (or anyone for that matter) you will need to obtain an Employer Identification Number (EIN), which you can get online at the IRS website. Again, you may also need a state ID number, please check with your state department of revenue.

As for how much to withhold and when to deposit the withholdings, your state department of revenue will help you with determining the amount of state tax to withhold, if any. Your state department of labor will help you determine the amount of unemployment compensation to withhold, if any. IRS Publication 15, Circular E is the most helpful for determining your basic withholding and depositing responsibilities. The IRS also publishes two supplemental guides, Publication 15-A and Publication 15-B (all publications can be found at the IRS website, they won’t let me link directly to the publications sorry), which explains other payroll items and withholding that you may run into at some point in your business. You may want help with your payroll. If so, many have found my fees very reasonable and I do help employers in various states.

Since you stated you are a sole proprietorship and your children are under age 18, you will not have to pay Social Security or Medicare tax on their wages and, usually, no state unemployment or disability taxes, but you should confirm that with your state. And assuming this is your children’s only source of income, the wages you are paying them are considered “earned income,” which means that the first $5,450 received by each child in 2008 is not subject to Federal taxes. Because of all of this, payroll is usually pretty easy for sole proprietors with young children, but you still must be professional and treat them as employees with a full job description, time card, etc.

Best wishes,
Gina

Rick writes: Hello Gina,

Found your website doing a google search. I’m looking for a good list of deductible items for an independent contractor. I am a pharmacist with a regular job, but also do some relief work.
I only do extra work about 8 times per year, but I don’t have a good handle on what I can deduct. Would your book, WORTH MORE THAN RUBIES be of any help with that?

Thanks for any help,
Rick

My reply:

Rick,

Thanks so much for visiting my website and writing me.

First, I did not write the book, “Worth More Than Rubies”. Second, I don’t think that is the book you are looking for in this situation. That book is more for “stay-at-home” parents who are afraid to work from home. It gives them encouragement to go ahead and try.

As for what you can deduct - there is no real list anywhere because what is deductible depends on your specific business needs. What I usually tell my clients is when they incur an expense they need to ask themselves these two questions:

• What was the business purpose of this expense?
• Would someone else who is in the same line of business also incur this expense?

If there is a valid business purposes and someone else in your line of business would also incur the expense then it’s deductible.

Having said that there are exclusions (these are not exceptions, but certain items or part of the items expense is “excluded” or not deductible no matter what your business). The exclusions relate to meals & entertainment, travel and what I like to call “walk away” devices (cell phones, PDAs, laptops, etc.).

Please let me know if you need help with something more specific.

Best wishes,
Gina

Bryan from VA writes:

Hello Gina,

I have been reading your blogs, and I thank you for some very informative reading.

Lately I have become increasingly interested in starting my own small business. I am looking for advice as to how I should go about doing this. Before taking this risk, it would help me to have you provide me with some steps or processes I need to look into before taking this risk. I am currently in the military, and I am trying to arrange a means of additional income to offset the military - civilian pay gap. For myself as a network engineer I earn less than half of the average civilian of like experience, and qualifications.that could help me in this area?

This may be a premature question, however any advice would be appreciated.

- Bryan

My reply:

Hello Bryan! Thank you for writing. I’m glad you enjoy my blog. I tried to email you this reply, but your email doesn’t seem to be working, so I’m hoping you’re reading this as well.

I’m excited to hear that you’re thinking about starting your own business. It’s not an easy thing to do nor decision to make, but obviously you’ve already made some tough decisions in your life, since you choose to enter the military.

When considering starting a business the first question that I believe you need to answer is whether or not your business idea will work. Contact companies and start your research. Ask them how they are currently handling their network, what’s working and what isn’t. Have they ever considered hiring a consultant to help them? Why or why not? Basically, you’re trying to find out if you will be able to sell your service and sell it for a profit.

Once you have figured out that there’s a need for your service, then it’s time to for you to write your business plan. There are many websites, books, and consulting firms who can help you write your business plan. The main aspects of your business plan include description of what your company is going to do, the research you obtained about the market (pretty much what I described above that I believe you should do before you start writing your plan), how you plan on organizing and managing your company, how you plan on marketing your company, how you plan on selling your services (or products), what you expect your start up cash, equipments, furniture, etc. will be, what you expect your total start up costs will be, your anticipated budget and your financial forecast.

Perhaps it’s because I’m a CPA or perhaps it’s because I’ve seen too many businesses with great ideas fail, but I cannot stress enough the importance of your financial budget and forecast. Most of the start ups that I see fail, have failed due to insufficient funds. Make sure you have a very good idea of how much it will cost to start your business and then add a cushion of error, because no matter how carefully you plan, there always seems to be some expense that you didn’t anticipate. Make sure you know what your break-even point is, what do your sales have to be to cover your expenses? How much money do you have? How long will your savings keep your business going while you’re ramping up your sales? Is this long enough to establish your business? If not, then you need to look into obtaining financing. This will not be easy, but it can be done, either through a bank or the Small Business Association.

The next step is to plan the opening of your business. You need to decide on a business name, entity structure, obtain any licenses or permits that your business may require, gather your list of advisors (CPA, lawyer, insurance agent, mentor, banker, etc.), start purchasing any furniture, equipment, tools, etc. that you may need, advertise and open your doors (I may have left out a thing or two here, but I think you get the idea).

I hope what I’ve written has been helpful.

Best wishes,

Gina

Now that you’ve organized your business records you need to develop a bookkeeping system.

A bookkeeper’s job is to record your books of original entry. This means they write checks, create invoices, make out deposit slips, try to collect on old accounts and deal with creditors. For most start-ups and small businesses this “bookkeeper” is also the owner. Most owners want and need to spend time managing their business and not doing their books. For this reason, you need to create a bookkeeping system that is efficient, accurate and cost effective. Your bookkeeping system will either be a manual system or a computerized system.

Manual System

Many small businesses do not need a computer for their business operations. In these situations, it is rarely cost effective to purchase a computer to perform your bookkeeping tasks. When you purchase a computer to do your bookkeeping your business you will be incurring not only the cost of the computer, but also the cost of virus protection software, the cost of firewall software, the cost of your backup method, the cost of your bookkeeping software, and ongoing upgrades and maintenance costs.

For those businesses who decide to forgo the computer I like to recommend that they use a “one-write” also called a “pegboard” system for their bookkeeping. A pegboard is used to align one-write forms (like checks, deposit slips, invoices, etc.), such that as you write on the form the information is automatically entered into the appropriate bookkeeping journal. Checks are automatically recorded in your disbursement journal. Deposits are automatically recorded in your receipts journal. This system allows you a means to keep a running checkbook balance and a place to put your general ledge code.

I have found that clients like a one-write system because it is easy and always available. They do not have to go to the computer to write a check and they don’t have to figure out what computer report to view to find a previous check that they wrote. They have the option of coding the checks at the end of the month or the end of the year, instead of being put on hold until the right general ledger account is determined. In addition, it is difficult to mess up your books with this method, you’d pretty much have to lose the journals.

Computerized System

If you need a computer for your other business operations, then it may be cost effective to have a computerized bookkeeping system. This is usually true because you already had to pay for the computer, anti-virus software and firewall. The only other major expense will the cost of the bookkeeping software that you choose. For new small businesses who are unsure of their income potential, I like to recommend any of the following free software packages:

• Choice Accounting,
  
• QuickBooks Simple Start,
• Microsoft Office Accounting Express
  

but any system that you understand and will use regularly and correctly will do just fine. The key is that you need to remember to enter everything into the computer accurately.

Conclusion

Whether you determine that a manual or computerized system is right for your business (or which accounting software is best for your company), the important thing to remember is that the bookkeeping functions are extremely important to the success of a business and should not be taken lightly. The books of original entry are summarized and used to prepare financial statements and tax returns.

A good accountant gives you advice based on reading your financial statements and tax return. If your books of original entry are not accurate then your financial statements, tax returns and the advice your accountant is giving you based on them will not be accurate either.

Seth writes: I work several times a year as an independent contractor for a company. I travel to various cities and deliver lectures. I receive a set fee for each lecture. In the past, I always submitted my receipts for my travel expenses and was reimbursed by the company. At year end, the only income ever reported to me on my 1099-Misc from this company was from the lecture fees. The money received for my reimbursement expenses was not reported. I was just been notified that this year the income I receive from reimbursed expenses will be reported on my 1099-Misc. Does this change in reporting mean that I will have to pay income taxes on this company’s reimbursement of meals since 50% of meals is not deductible? Thanks in advance for any help. Seth

My reply:Hello Seth and thanks for visiting.

Since you are an independent contractor being reimbursed by your client (the company), and if you adequately document those expenses to your client (the company), then you are not subject to the 50% limitation.

In this situation the 50% limit applies to your client (the company). You can read more about this in IRS Pub. 463, Travel, Entertainment, Gift and Car Expenses, www.irs.gov/pub/irs-pdf/p463.pdf.

Best wishes, Gina

Ryan asks: I’m retired with a federal pension and social security. Financially I do not need to work, but I miss it. I really enjoyed working, but I don’t want the pressure of a full time job anymore. I’ve been told that if I set up a foundation, I can freelance, doing the same work I use to do, only instead of having people pay me, ask them to donate the money to my own foundation. I’ll get to continue to do the work that I enjoy. Technically I will not have any earnings, so I won’t have to pay any taxes on the money I earn. I will get to direct 100% of my earnings to charities of my choosing. And everyone who hires me will get a tax write-off, so it will work great for everyone. My question is, how do I go about setting up this foundation?

My response:Hello Ryan!  By any chance does your idea sound a little bit too good to be true? Well it is.

In the situation you described, you would be providing your services as an independent contractor (note how many times you referred to the income as “earnings” - that should have been a hint that it was taxable).

As far as tax law is concerned, you are not allowed to “assign income”; thus anything you earn are your earnings to report. In the case you described above you would be reporting your earnings as a sole proprietor and you will owe federal taxes and self-employment taxes on any net income from your activity. If you are younger than full retirement age as far as social security is concerned it may affect your social security benefits.

The fact that you wish to donate your earnings to charity, whether that be your own foundation or another charity, is irrelevant; thus, under the circumstances that you described I don’t think you would like to set up a foundation. If one were to want to set up a foundation, a qualified attorney can help you do so.

Best wishes,

Gina

All small business owners must deal with the massive amounts of paperwork. How you organize that paperwork is totally up to you; however most small business owners would like more guidance.  The following is generally how I advise my new business clients to set up their records:

Purchase three plastic manila folder boxes. Label them as follows:

• Enter into Computer
• To Be Paid
• To Be Filed

Every receipt that your business obtains should first go into the box labeled “Enter into Computer”. After you have entered the item into your computer, then it either needs “To be Paid” or it needs “To be Filed”.

When an item needs “To be Paid”, it is placed in that box, filed by the date it is to be paid. After the item is paid, you should mark on the item the date it was paid and how (what check number or if by credit card, which card). If you have check stubs, staple the stub to the receipt indicating it was paid. Then the item is moved to the “To Be Filed” box.

Items in the “To Be Filed” box should be filed at least weekly, if not daily. These items will be filed, either in the filing cabinet or in a binder.

Purchase a filing cabinet. Filing cabinets can be expensive so if money is tight, look for used ones at Goodwill, yard sales, etc.

Purchase manila folders, to be placed in the filing cabinet, to hold all your business expense receipts.  The following are examples of how your files may be labeled. Your business may not have all these expenses – if you don’t, then you don’t need a folder for it. If your business has an expense category that isn’t listed, just label the folder accordingly. File the folders alphabetically in your filing cabinet. Inside each folder group your receipts according to vendor (for example, in “Car and Truck Expenses” you may have receipts from Jiffy Lube, Shell and Tire Max), preferably alphabetically.

• Advertising

• Car and Truck Expenses

• Charitable Contributions

• Commissions & Fees

• Contract Labor

• Employee Benefits

• Insurance

• Legal

• Meals & Entertainment

• Other Professional Services

• Office Expense

• Payroll

• Pension & Profit Sharing Plans

• Rent or Lease

• Repairs or Maintenance

• Start-up Costs

• Supplies

• Taxes & License

• Travel

• Utilities

• Wages

• Business Use of Your Home

Purchase large binders and label them as follows:

• Bank Statements – After you have reconciled your bank statement each month, staple the reconciliation to the bank statement and file it by month in this binder.

• Fixed Assets – Every time you purchase something for your business that you expect to last longer than one year, file it in this binder. Divide your purchases into groups such as Furniture & Fixtures, Computers & Equipment, Vehicles, Leasehold Improvements, etc.

• Accounts Receivable – After a sale is generated, if it was not paid for immediately, file it alphabetically by customer last name in this binder. Once a customer has paid their bill, remove it from this binder, mark how and when it was paid and put the invoice in the box labeled, “Enter Into Computer”.

• Sales Collected – After you have received payment for a sale and it was entered into the computer the sales invoice should be filed in this binder by month received.

• Long-Term Debts – Any time you enter into a long-term financing arrangement (bank loan, line of credit, shareholder loan), file that paperwork in this binder, divided by loan.

• General Ledger – Every month, after all transactions for the month have been entered, print a detailed general ledger for the month and file it, by month, in this binder

• Financial Statements – Every month, after the detailed general ledger is printed, print your financial statements (Balance Sheet and Income Statement) and file them by month in this binder

• Minutes – Even if you are not required to keep company minutes it is a good idea to get into the habit of recording important business decision throughout the year. I often will tell clients to make notes of things in their records, like why they decided to increase their sales prices or why they decided to discontinue a product line or why they had an unusual business expense, etc. This is where all those notes should be kept. Then if you do decide to incorporate you would have already developed the habit of keeping business minutes.

All folders in your filing cabinet, items in your Bank Statements binder, Sales Collected Binder and Financial Statements binder can be boxed up every year. Label the boxes and store the boxes for at least 4 years, but there’s no need to keep them longer than 10 years. The items in the Fixed Asset binder and Long-Term Debts binder should be kept in the binder until the item is no longer of use to the company (the asset was sold or removed from service, the debt was paid in full or refinanced, etc.). At that time it can be boxed up and stored for at least 4 years or the remainder of what it’s useful life was plus 4 years, whichever is greater.

You do not have to set up your filing system this way. You do not have to use a computerized bookkeeping system. But you do have to have some sort of system which will enable to find information when you need it. For additional information visit the IRS website and view the following articles:

• Why should I keep records?
• What kind of recrods should I keep?
• How long should I keep records?

Rusty asks: I inherited some land back in the 80’s. A logger would like to harvest the trees. He is going to pay me 8,000 for the trees. How would I treat this? Capital Gain? Is it all taxable? Part of it? Thanks, Rusty

My reply:Timber sales are complex; thus it’s best to have a qualified tax professional help you with this.

In order to report your gain or loss you must first determine the type of gain or loss you have.

Standing timber is treated for income tax purposes as either a capital asset or a non-capital (ordinary) asset.

Proceeds from the sale of forest products other than standing timber are treated as ordinary income. This includes logs, lumber, pulpwood, poles, mine timbers, maple syrup, nuts, bark, Christmas greens and nursery stock.

In addition, income from the sale of firewood or pulpwood produced from the limbs and tops of trees is ordinary income.

If you are in the business of selling timber then you would report your income/loss as either one or a combination of the following:

• Ordinary Income-Form 1040 as Other Income
• Capital Gains-Schedule D, Form 1040
• Timber income incidental to Farming-use Schedule F, Form 1040 for ordinary income and Schedule D, Form 1040 for capital gains

If you are in the business of selling timber (or timber related products), then you would report your income/loss on either or both of the following:

• Ordinary Income-Schedule C, Form 1040 if sole proprietorship
• Capital Gain-Form 4797 and Schedule D, Form 1040

You should probably take a look at Form T, from the IRS website. As a matter of good business practice and record keeping, the appropriate sections of Form T such as purchases, sales, planting should be completed each year.

If you claim a deduction for depletion of timber or for depreciation related to a timber account, you must complete and attach Form T to your tax return. Form T should be filed when a taxpayer sells or cuts standing timber or has a casualty claim.

The amount of your gain or loss is determined by taking your proceeds and reducing that amount by your basis in the trees and any other related expenses. Related expenses would including marking the timber for sale (which I’m guessing you didn’t have to do), costs of inspecting the timber to determine the amount of lumber yield and paying for professional services directly related to the sale.

You stated that you inherited the land - I will assume that land included timber when inherited. If so your basis is the fair market value or special use value that was reported on the federal estate tax return. If the land was not separately stated from the timber for this valuation you may have to go back to the appraiser in order to properly divide your basis.

Your gain is determined by subtracting your basis of the timber sold and any other expenses directly related to making the sale from the proceeds you receive. If only part of your timber is sold, your cost basis must be allocated or spread against the total timber potentially for sale.

The allocation of basis is called depletion. The depletion unit is the basis amount per unit (tree, cord of wood, board feet, etc.) in your timber. Depletion is determined by dividing the adjusted basis by the available quantity of timber.

For example, if it cost you $2,500 to plant 4000 trees then the depletion unit per tree is $.625/tree; 2500 / 400 = $.625. If instead of planting you inherited the trees and the fair market value of the timber as of the date you inherited it was $10,000 and it was determined that there were 100,000 board feet of marketable timber at time of inheritance, then the depletion unit of the marketable timber at time of inheritance would be $.10 per board foot; $10,000 / 100,000 = $.10.

Three side notes:

1. You should review how your land was zoned and taxed for property taxes. If you’ve received a reduced property tax rate for forest land, you might owe yield taxes on what you harvest.

2. You should also consider protecting yourself to ensure that the logger cleans up the property to meet state forestry standards and your own desires. This may include replanting, stream restoration and slash removal. You should request that he provide a bond large enough to cover the work pending your and state forestry sign-off. If you don’t, then the state will require that you do the work.

3. Are you sure the $8,000 a fair price?

Best wishes, Gina

Question from Ted:Sweet site! I’m doing my own taxes with Tax Cut and I have a question. I have a regular job, but I worked part-time, as a fitness instructor for a local gym. They sent me a 1099 with the amount they paid me reported as “non-employee compensation”. I’m not self-employed, do I just put this amount on Line 21, Other Income? Thanks, Ted

My response: Hello Ted. I’m glad you found my site too.

Although you might not think of yourself as self-employed, it sure sounds like it to me. You may want to read my article, “Employee or Independent Contractor” and the IRS’s frequently asked questions regarding non-employee compensation.

But don’t let being self-employed get you down, having your own business has benefits. If you have the time and are willing to do this work on a more regular basis, make some business cards and drop them off at other fitness centers. Hire a qualified tax professional, who works with small businesses and is available to help you year round.

These tax professionals can help you make sure you are appropriately documenting and maintaining your records in order to take advantage of all available deductions. He/she will help you determine when it’s time to incorporate, start retirement plans, hiring employees, etc.

Until then, you should report this income on Schedule C (or Schedule C-EZ) as well as any expenses you may have incurred and can substantiate. The most common expense I see for fitness instructors is the cost of their certification.

Best wishes, Gina