The IRS uses a computer program called the Discriminant Function System (DIF) to analyze tax returns and red flag them if they deviate from statistical averages. When a return draws a high DIF score, an agent evaluates it and decides if an audit is necessary. Your business should always be prepared for an audit, and that includes avoid these audit triggers when filing your small business taxes.
Higher Than Average Income
If you report a high amount of income, this may draw red flags for the IRS. Approximately 50% of the returns audited belong to taxpayers earning more than one million dollars per year. For taxpayers who earn more than $5 million, their odds of being audited more than doubles those of taxpayers who earn less.
Underreporting Cash Transactions
Don’t make the mistake of thinking that the IRS has no way to trace cash transactions. Credit card processors submit 1099-K forms to the IRS, which include a report of the total credit card transactions your business processed for the year. The IRS then applies these figures to an undisclosed formula in order to calculate the amount a business should have generated in cash sales. Therefore, if your reported cash sales reflect a lower figure than their formula detects, your business could be at risk for an audit. It’s a smart idea to keep detailed records of both cash and credit card transactions so you can support your claims should your business be audited.
Taking Too Many Deductions
Deductions are important to a small business owner, but claiming too many can raise red flags. Higher than average meal expenses and claiming your car as 100% business can set off alarm bells for the IRS and trigger and audit.
The IRS states that a legitimate business expense must be both ordinary and necessary to qualify as a deduction.
- Ordinary expenses = common and accepted in your trade or business
- Necessary expenses = helpful and appropriate for your trade or business. Note that an expense does not need to be indispensable to qualify as necessary.
Claiming Consistent Business Losses
Given the primary purpose of a business is to generate money, reporting losses year after year can lead the IRS to question the legitimacy of your business. If your business gets audited and you claimed losses, be prepared with documentation to demonstrate your business’ earnings and expenses throughout the year.
Be Prepared for an Audit
Your business may never need to go through an audit process, but you should manage your business always knowing that it’s possible. Keep precise records, make sure the numbers on your tax return are accurate and honest, report all income, and take suitable deductions. Lastly, consult with an accountant to be sure the totality of your revenue, expenses, and documents are free of missteps or miscalculations.
Congress passed the Paycheck Protection Program Flexibility Act (PPPFA) on June 5, 2020, amending several provisions in the original PPP loan program. Along with granting business owners more flexibility and time to spend the PPP loan proceeds, the Act permits funds to be used on a wider-ranging variety of expenses while still allowing for loan forgiveness. Here is how this will affect businesses moving forward with a PPP loan.
Extended Covered Period
Originally, borrowers had 8 weeks from the receipt of loan proceeds to spend funds on forgivable expenditures. Now the covered period specifies 24 weeks after the origination of the loan, or December 31, 2020, whichever is sooner. To qualify for forgiveness, however, borrowers must maintain payroll levels for the full 24-week period. Borrowers do have the option to stick with the 8-week deadline, and they must likewise maintain payroll levels through the full 8 weeks to qualify for the full loan forgiveness amount.
Additional extensions include the timeline for eliminating reductions in workforce and wages, as well as restoring workforce levels and wages to pre-pandemic levels required for loan forgiveness (both extended to December 31, 2020).
Changes to Percentage of Payroll Costs
The PPPFA reduced the payroll expense requirement from 75% to 60%, which means that 40% of the PPP loan funds may now be put towards forgivable non-payroll expenses such as mortgage interest, rent, and utilities. Note that the expenses originally designated as forgivable have not changed.
Changes to Repayment Period
For borrowers whose loans are not forgiven, the PPPFA increases the repayment timeline from two years to five years. The 1% interest rate remains the same.
Changes to Rehiring Requirements
The PPPFA also extends the rehire date to December 31, 2020 and allows for a reduced headcount. Rather than basing loan forgiveness on a borrower’s ability to rehire the same number of employees on payroll as was used to calculate the loan, the PPPFA allows for loan forgiveness amount to be determined by documentation showing that the borrower was (1) not able to rehire former employees and unable to hire similarly qualified employees, or (2) not able to return to pre-pandemic levels of business activity in response to federal guidelines related to COVID-19.
Changes to Payroll Tax Deferment
The CARES Act originally prevented borrowers who received PPP loan funding from deferring additional payroll tax once the lender decided to forgive the loan, but the PPPFA eliminates this restriction, and borrowers can now defer the payroll tax for the period from March 27 to December 31, 2020.
Overall, the PPPFA will ease the burdens of businesses that received PPP loans, but it doesn’t fix everything or answer all the questions, so expect more regulations and changes to the PPP program in the near future.
With the learning curve of the first tax filing season in the TCJA era behind us, year-end tax planning is a perfect time to incorporate those lessons learned. Here is a general overview of some steps business owners can take in their year-end tax planning.
If your business has acquired a fixed asset or property (one that you don’t intend to sell for at least one year and will be used to earn long-term income), and it’s placed in service before the end of the year, you can typically write off the cost in 2019. Thanks to changes made by the TCJA, this now applies to both new and used assets. The TCJA boosted the deduction limit to $1.02 million with a phase-out threshold of $2.55 million for 2019. It also increased bonus depreciation to 100% for property placed in service after September 27, 2017 and before January 1, 2023.
The IRS recently clarified that food and beverage costs are deductible by 50% in certain circumstances and when those costs are stated separately from entertainment on invoices or receipts.
One of the most significant changes made by the TCJA affects owners of pass-through entities (partnerships, S corporations, and LLCs) as it authorized a deduction of up to 20% of the owner’s qualified business income (QBI) for the tax years 2018 through 2025. The QBI deduction is reduced for some taxpayers based on the amount of their income, so some individuals may need to consider reducing their taxable income so it falls under the $157,500 threshold ($315,000 for married filing jointly), whether by making contributions to retirement plans or health savings accounts, or even through charitable contributions. Something to keep in mind is that specified service business owners, which includes most personal-service providers, are not eligible for the deduction if their taxable income is above a certain threshold.
It isn’t a bad idea to complete minor repairs by the end of the year because the deductions can offset taxable business income. However, costs of improvements to business property must be written off over time. If you’re unsure whether a specific renovation or upgrade falls under a repair or an improvement, the IRS recently issued regulations that clarify the distinctions.
Estimated Tax Payments
If your corporation is anticipating a small net operating loss for 2019 but a substantial net income in 2020, you might think about accelerating just enough of the corporation’s 2020 income to create a small amount of net income for 2019. You could also choose to defer some 2019 deductions. This way, rather than having to pay estimated taxes based on 100% of your 2020 taxable income, you will be able to base your estimated tax installments on the comparatively small amount of income shown on your 2019 return.
With additional guidance and regulations released consistently since President Trump signed the Tax Cuts and Jobs Act of 2017 into law, one thing remains clear: strategic tax planning is key to lowering a business’s total tax liability. Read on for some moves on lowering your 2019 business tax bill.
Establish Tax-Favored Retirement Plan
Current tax rules allow for significant deductible contributions, so if your business doesn’t already have a retirement plan in place, it’s worth considering. Small business retirement plan options include 401(k), SEP-IRA, SIMPLE-IRA, and the defined benefit pension plan. Some of these plans can be established up until December 31 and allow for a deductible contribution for the 2019 tax year, except for the SEP-IRA and SIMPLE-IRA, which mandate a set-up deadline of October in order to make a contribution for the same year.
Review Your Reports
The end of the year is typically a time for businesses to begin goal setting for the next year, so it’s crucial to have a firm grasp on how your business performed financially this year. Make sure your books are up to date and accurate so you have a clear picture before diving into next year’s plan.
Defer Income If It Makes Sense
Depending on where your income level is, you can potentially cut your tax bill by postponing any end-of-the-year income until January 1 or later. Ask your accountant if shifting receivable income to the new year makes sense for your business.
Purchase Business Essentials to Take Advantage of Deductions
Upgrade equipment and furniture, stock up on office supplies, take care of repairs, and make vendor payments in advance in order to maximize deductions. And thanks to the TCJA, you can claim 100% bonus depreciation for qualified asset additions that were acquired and put in place in 2019.
Make Charitable Contributions
Tis the season for giving…and claiming a deduction for the fair market value of your donations. In addition to money, think outside the box and contact a program that sponsors families for the holidays. They often need food, bedding, toys, cookware, and clothing. It’s a great way for employees to feel like they’re making a difference too. Just don’t forget to get the necessary documentation and receipts to keep with your records.
Start Preparing for Next Year
If you put these tips into action, you’ll be better prepared at this time next year. For instance, you’ll already have a retirement plan in place. By going through the process of tax preparation this year, you have the opportunity to create systems for organization that will expedite the process next year.
When doing your taxes, the goal is to maximize the tax credits and deductions for which you’re eligible. But tax credits are worth more than deductions with the same value, so knowing the differences between the two will help you save money on taxes.
Both credits and deductions lower your tax bill but in different ways and with different outcomes. Tax credits lower your tax liability while tax deductions reduce your taxable income. For instance, someone who’s in the 25% tax bracket with a $100 tax credit will save $100 dollars in taxes, but if that same person has a $100 deduction, they will only save $25 in taxes (25% of $100).
Tax credits are a dollar-for-dollar reduction on your tax bill, regardless of tax rate, which explains the $100 savings with a $100 tax credit in the previous example. Taking advantage of eligible tax credits after applying all deductions will help to slash your taxes due. Some of the more popular tax credits include:
- Earned Income Tax Credit (EIC or EITC)
- Child Tax Credit
- Child and Dependent Care Credit
- American Opportunity Tax Credit
- Lifetime Learning Credit
- Adoption Credit
- Saver’s Credit
- Residential Energy Tax Credit
Refundable Tax Credits vs. Non-Refundable Tax Credits
Some tax credits are refundable while others are not. When you claim a refundable tax credit that exceeds your total tax liability, the IRS will send you the difference. For example, if your tax liability is $1,000 and then you apply your EITC, which is $2,500, you would use that $2,500 to pay your liability and the remaining $1,500 would be refunded to you. By contrast, a non-refundable tax credit can reduce your federal income tax liability to zero, but any leftover balance from the credit will not be refunded.
There are two types of tax income deductions, which reduce the amount of income you’re taxed on: itemized deductions and above-the-line deductions.
Itemized deductions are certain tax-deductible expenses that you incur throughout the year. For some taxpayers, those expenses add up to be greater than the standard deduction amount, in which case, they should itemize their tax returns rather than take the flat-dollar standard deduction. Keep in mind that if you plan to itemize, you should accurately track your spending throughout the year, and keep supporting documentation (receipts, bank statements, check stubs, insurance bills, etc.) in the instance that IRS would ask for proof.
Common itemized deductions include:
- Medical expenses
- State and local income taxes
- Property taxes
- Mortgage interest
- Charitable contributions
The standard deduction is a fixed amount that varies in consistency to your filing status. For 2019 returns, the standard deduction is:
- $12,200 for single filers and married filers filing separately
- $24,400 for married filers filing jointly
- $18,350 for heads of household
If you claim the standard deduction, you can use “above-the-line” deductions, which reduce your adjusted gross income (AGI), to lower your tax bill. Some of these deductions are:
- Health savings account (HSA) contributions
- Deductible contributions to IRAs
- The deductible portion of self-employment taxes
- Contributions to self-employed SEP-IRA, SIMPLE IRA, and other qualified plans
- Self-employment health insurance premiums
- Penalties on early savings withdrawals
Above-the-line deductions typically aren’t as valuable as tax credits, but they help to lower your AGI, which can slash your tax liability and qualify you for other tax breaks based on income limits.
As a small business owner, the more you can stay organized, improve daily operations, control business expenses, and generally make life as an entrepreneur run a little more smoothly, the more proficient and prolific your business will become. Below are some top-rated apps and programs available to help you manage your business’s financial situation.
Though it’s intended mainly for individual users, this financial tracking app is effective for businesses too. Aside from tracking bills and cash flow, Mint also has Quicken MyBusiness, a tool for small businesses that helps categorize expenses, and gives you up-front information for tax filing.
With the ability to connect to your bank account, PayPal, Square, credit cards, and more, you can use QuickBooks to track sales and expenses, view financial statements, pay employees and vendors, track unpaid invoices, maximize tax deductions, and more. With QuickBooks Online, you can access QuickBooks on both iOS and Android phones and tablets.
For businesses and freelancers alike, cloud-based FreshBooks helps you create personalized invoices, with an option to automatically bill clients for recurring invoices, and generate customizable business reports, such as profit and loss statements. You can also automate tasks like organizing expenses and receipts, tracking your time, and following up with clients.
Created for businesses with nine or fewer employees, Wave is an accounting software platform that has the ability to track sales and expenses; manage invoices, customer payments, and payroll; scan receipts; and generate accounting reports. With Wave’s free apps for iOS and Android, you can send invoices on the go, and get notified when an invoice is viewed, becomes due, or gets paid. Also available through the platform is a free personal finance software to help small-business owners manage their finances in one place.
Once you connect your accounts to the Truebill app, it will generate a report of where your money is going, categorizing and charting subscriptions and expenses. An added bonus with Truebill is a feature that compares your bills and subscriptions to average service levels, and with your initiation, will call providers and negotiate on your behalf.
Intended for small and mid-sized businesses, this accounting app (accessible by both desktop and mobile platforms) can handle payments and expenses, asset management, bank account reconciliation, invoicing and purchase orders, sales tax calculations, and multi-currency accounting.
If you’re looking for a forecasting program to help with strategic planning and analysis, PlanGuru might be a good fit. It’s pricey, with business plans starting at $99 per month, but with an analytics dashboard, Excel add-on, a budget and forecasting platform, and training, it might be worth the cost to keep business spending in check.
This simple expense tracker uses multiple platforms to keep tabs on expenses and mileage by reading and importing expenses from linked bank accounts and credit cards. And with the ability to scan and upload receipts, expenses can easily be submitted to employers.
This bookkeeping service halts the need to invest in big bookkeepers and implements tax services for small businesses. It also helps with forecasting by syncing with bank accounts and credit cards to predict future cash flow determined by current trends and previous expenses.