Taking Care of Your Taxes


Note: For purposes of this article, it is assumed that the practitioner is a Sole Proprietor or Single Member LLC filing on IRS Form 1040, Schedule C. In most cases, unless otherwise noted, the information provided would also apply to other entities (e.g., S Corporations) but the form to file and the line numbers would be different.

The image of IRS agents sifting through returns and making taxpayers sweat through questions about each deduction has endured for years. So, if abject fear and extreme dislike are two feelings you have when you think of taxes, you aren't alone. Doing taxes is a necessary part of being in business, however, and whether you're newly licensed or have had a practice of your own for many years, keeping complete and timely financial records is a must. Being meticulous about your record keeping makes filing an accurate tax return less difficult - and gives you a good indication of how your business is doing and where you might need to make some adjustments.

Avoiding an Audit

Getting a letter in the mail saying you've been selected for an audit may be everybody's nightmare. There are ways you can decrease the risk of being audited, though, starting with how you keep your books.

When developing a bookkeeping system to record your business income and expenses, a little extra effort can help simplify tax return preparation. For example, you can tailor your system to reflect what the IRS is going to want to see on the return, saving you the time you might spend re-categorizing expenses at year's end.

The IRS doesn't require any specific type of record, with a few exceptions, such as auto, entertainment, per diem and gift expenses. What they are going to want to see in your books is your gross income, as well as details for your business deductions and credits. How you accomplish this task doesn't concern the IRS, but you need to have more than guesstimates and a shoebox full of receipts.

When the IRS receives your return, the data is statistically compared to all other returns of your type and business code. All likekind returns are combined, and deductions and income are averaged. With income used as the divisor and representing 100 percent, the lineby- line deductions on the return are calculated as a percent of income.

If your returns have deductions above the norm, you get discriminate index function (DIF) points depending on the variance between your return and the average. The IRS doesn’t give the exact method of computing these points, but the more you score, the more likely you’ll be audited.

Let’s have a look at how you can reduce your audit risk by adding subaccounts to your advertising expense category, for example. Assume your income on line 7 of your Schedule C is $20,000, and your expense for advertising, entered on line 8, is $2,000. You could use categories like the following:

Yellow pages $300
Classified ads $100
Website $800
Brochures $400
Coupons $400
Total: $2,000

If all of your advertising were included in line 8, these costs would account for 10 percent of your income. Per the latest IRS data, advertising averages approximately 3.8 percent of total income, meaning the 10 percent listed in the above example would be high enough to have DIF points affixed to the return.

To avoid the DIF points, you can use only the Yellow pages and classified ads in line 8, totaling $400. This amount equals 2 percent of income, well below the average, and you can claim the remaining three items on line 27 under other expenses. By doing this, you lower your audit risk and show the IRS that you are using several different methods to generate income.

Taking a Closer Look

Jim Taxpayer: Schedule C Analysis // Business Code 621399

  Sch C
Line #
   
Income:      
Gross Receipts 1 48,700 100.00%
Other Income 6 200 0.41%
Total income 7 48,900 100.41%
Expenses:      
Advertising 8 1,836 3.77%
Car Truck expenses 9 2,625 5.39%
Commissions 10 321 0.66%
Contract Labor 11 463 0.95%
Depreciation 13 1,539 3.16%
Employee Benefits 14 93 0.19%
Insurance 15 1,023 2.10%
Interest 16 409 0.84%
Legal and professional 17 726 1.49%
Office Expense 18 1,378 2.83%
Pension/Profit Sharing 19 73 0.15%
Rent of Equipment 20a 594 1.22%
Rent on other business property 20b 3,852 7.91%
Repairs and Maintenance 21 419 0.86%
Supplies 22 2,079 4.27%
Taxes and Licenses 23 604 1.24%
Travel 24a 1,164 2.39%
Meals and Entertainment 24b 356 0.73%
Utilities 25 1,412 2.90%
Wages 26 2,698 5.54%
Other Expenses 27 5,338 10.96%
Expenses for Business Use of Home 30 487 1.00%
       
Total expenses   29,489 60.55%
       
NET PROFIT 31 19,411 39.86%

Fair Trade

Here's a question: Are services and products you trade for a massage therapy session taxable? The answer is yes — but some of these trades will be deductible while others will simply be taxable income.

For example, if you trade massage therapy sessions with the person who cleans your office, you would include the cost of the massage as income and take the janitorial expense as a deduction.

If the trade was with your hairstylist, however, you would still have $50 of taxable income, but no deductions. Hair services are a personal expense and so can't be used as business deductions.

Bookkeeping 101

When recording your company's financial transactions, two of the major sources for information will be your business checkbook and credit card statements. Every transaction from both your checkbook and credit card statements should be entered in your accounting books, along with noncash income expenses, including trades, mileage, converted property and per diem allowances. Here are a few key items you are going to want to be aware of when doing your own bookkeeping.

Accounting journals: Records that keep transactions in chronological order by type. Cash receipts and your check register are two examples of accounting journals.

General ledger: A record that lists transactions by account type. Cash, massage income and office supply expenses are three examples of items that would appear on a general ledger.

Balance sheet: A balance sheet is a financial picture of a business on a specific date and includes assets, liabilities and equity. Assets include what you own and liabilities reflect what you owe. Your equity is essentially the balance difference when your total liabilities are subtracted from your assets.

Statement of income & expense: You may have also heard this referred to as a profit and loss statement. This statement summarizes income and expenses for a specific period of time. Most cash-basis taxpayers keep books and file income taxes on a calendar year. The profit or loss is determined by subtracting deductible expenses from taxable income. The income you report and pay taxes on in your Schedule C return is not the case you take out of your business, but rather the net profit or loss income from line 31.

Draws: Money you take out of your business for personal use.

To easily summarize many of these transactions, you might want to take a look at getting some accounting software. Regularly and habitually entering business information has a variety of advantages, including making calculating your quarterly estimated taxes less difficult; easing the burden of having to remember—and find—all the necessary paperwork, such as receipts and per diem mileage; and keeping you on track throughout the year instead of having to hurry to gather and calculate all transactions right before tax time.

Many of these programs also allow you to create subcategories for income and expenses, a feature that may prove useful when you are looking for additional detail at the end of the year. For example, you can set up subcategories for supply purchases, including linens, massage oils, aromatherapy, disposable face covers and cleaning products, giving you a few different options when you file your tax return. You may decide to include all these costs on a single line, or you might want to report these expenditures as two different deductions—supplies and other.

Income

Most massage therapists will be cashbasis taxpayers, meaning they pay tax on the income at the time they receive it and deduct expenses when they write their check or from the date on their credit card statements.

Life would be easy if all of your clients paid at the time of service and you could simply deposit the money in your business checking account. But life is rarely that simple. You might have clients that need you to bill insurance, for example, and payment from an insurance company can take weeks, sometimes even arriving in a different taxable year. Remember, income isn't taxed according to the date the service was provided but the year in which payment was received.

You might also give your clients a variety of discounts for particular events or milestones, such as their birthday, senior citizen status or first-timers. These scenarios can present a dilemma for massage therapy professionals who want to record these transactions accurately.

As an example, let's assume the following: You charge $50 per hour and give seniors a $10 discount. A 75-year-old client comes in for her monthly massage and pays you $40 for the massage and gives you a $5 tip. There are three different ways you might record this transaction.

Option 1    
  Debit Credit
Cash in bank $45  
Income   &$45

This income would be recorded on line 1 of your Schedule C tax return, and though correct as far as reporting the net profit, this option would not reflect exactly what happened.

Option 2    
  Debit Credit
Cash in bank $45  
Massage income
line 1 of Schedule C
  $40
Tip income
line 6 of Schedule C
  $5

This option separates the tip income, which can be recorded on line 6 of the Schedule C tax return. For the massage therapy profession, the IRS will be looking for tips, so I generally report this income separately to show I have accounted for them. This option is a better choice, but still doesn't reflect the entire transaction.

Option 3    
  Debit Credit
Cash in bank $45  
Discount
line 27 of Schedule C
$10  
Massage income
line 1 of Schedule C
$40  
Tip
line 6 of Schedule C
$5  

This option is the most thorough and accurate, accounting for every aspect of the transaction. When reporting income, remember to be as detailed as possible.

You need to reflect all income as income. Most sales are based on what your practice grossed, so these numbers will be particularly important if or when you sell your practice. If you consistently netted items against the income, the net profit on your tax return would be correct but the sales reported to the IRS would be lower than the service you actually provided.

By entering the full price of the massage, as seen in option 3, the income stays at full value and the discount is recorded as an expense. By reporting the discount as an expense, your income will be higher, in turn lowering your expense percentages when compared to the averages calculated by the IRS. If you have relatively few discounts for a year, you can put the total in line 27. Or, should you find you have a rather large number, you can create subaccounts for each type of discount and list them separately.

Reading List

Being able to quickly locate resources that can help you answer questions you might have during tax season will save you both time and frustration. Here is a list of a few items published by the Internal Revenue Service that can get you ready for April 15.

Publication Publication No.
Income tax information 17
Tax Guide for Small Business 334
Travel, entertainment, gift; business use of car 463
Tax withholding and estimated taxes 505
Depreciation 534
Business expense 535
Starting a business, keeping records 583
Business use of home 587
Tax calendar for small business, self-employed 1518
Small business resource guide 3207
Resource guide for small business owners 4395

Expenses

Operating expenses are the costs you incur in your day-to-day business, like rent, utilities, telephone and printing. When determining if these costs are deductible, two criteria must be considered—intent and documentation.

The first, intent, covers how the purchase is intended to be used. If you go to a department store and buy a telephone to use in your office, for example, the cost of the phone can be deducted. If, however, you use this phone in your home, the purchase is considered personal and cannot be deducted. If the telephone was originally purchased for your home but you later take it to your office, it’s considered converted property and is deductible at fair market value instead of original cost.

The second piece of the puzzle is documentation. A cancelled check or credit card statement will suffice. Other forms of documentation that meet the burden of proof required by the IRS are receipts for the vendor, written log and written evidence. Logs and evidence must be written at approximately the time of the transaction and contain all pertinent information, including who, what, where, when and why. Even just a few words jotted down in an appointment book or on the back of a business card would suffice.

The IRS requires additional information for deductions pertaining to travel, entertainment, gifts and auto expenses. Travel costs, for instance, are a necessary expense when you are driving to clients’ homes, but your residential home is not the same as your tax home. According to the IRS, your tax home is defined as your primary place of business, regardless of where you live.

The IRS allows you to deduct travel costs, even if you’re not gone overnight, if the following requirements are met: Your duties require you to be away from the general area of your tax home substantially longer than an ordinary day’s work, and you need to sleep or rest to meet the demands of your work while away from home.

Meals are deductible if they are business-related and are not deemed lavish or extravagant by the IRS. The definition of lavish is based on reasonable facts and circumstances, and documentation will be vital. A dinner in New York City could very well be $100, whereas in a smaller, less cosmopolitan area, $100 for dinner may seem excessive—geographic location will have a lot to do with determining what is reasonable.

You can deduct meals in one of two ways: by using the actual cost of the meal, using your receipt as documentation, or using the IRS per diem rate for the city and time of year. If you were in Miami, Florida in February 2008, for example, the IRS per diem rate for meals and incidentals was $58 per day.

When the actual cost is higher than the per diem rate, using the actual cost method would provide more of a deduction. You can switch between per diem and actual cost on a trip-by-trip basis, but can choose only one method per trip, even when multiple cities are involved. Ultimately, only 50 percent of the meal expense will be deductible, though some food items are 100 percent deductible, including food you buy for an open house at your practice, and snacks, water and tea you make available to your clients.

The deductions you can take for any gifts you give are limited. You can deduct no more than $25 per person, per calendar year. Any cost above $25 is nondeductible, unless considered incidental. Packaging, gift wrapping and mailing would fall into this category and not count toward the $25 limit.

In My Estimation

Financial records that are up to date can help you estimate your quarterly taxes, and you’ll be able to more accurately predict what you owe. Estimated taxes are based on one of two things: the prior year total tax liability or 90 percent of the taxes for the current year calculated with actual financial data compiled through the end of the month preceding the due date.

Estimated taxes are due according to the following schedule:
January 1–March 31 are due on April 15
January 1–May 31 are due June 15
January 1–August 31 are due September 15
January 1–December 31 are due January 15 of the following year

Working from Home

If you use any part of your home for business, you may be eligible for some home office deductions. The IRS has very speciic requirements, however, when determining if you qualify for these deductions. Two top considerations are the importance of the activities you perform in your home and the amount of time you spend doing the work.

According to the IRS, a home office must meet two requirements to qualify as your principal place of business. You must use the space exclusively and regularly for administrative or management activities for your business, and you must not have another fixed location where you conduct substantial administrative or management activities.

Exclusively means you use a definable, specific area of your home only for business. The dining room table where you pay the bills but also enjoy family dinners would not meet the requirements for a home office deduction. That being said, the area does not have to be a completely separate room within your home. If you use a 6-foot by 8-foot portion of your 12-foot by 12-foot family room for your desk, computer, file cabinet and bookshelf, you could use the 48 square feet you use for business purposes as a deduction.

There are exceptions to the exclusivity policy. If part of your garage is used to store inventory or product samples, for instance, you may be able to claim a business deduction. There are five different criteria that must be met:

  1. You sell products at wholesale or retail in your trade or business.
  2. You keep the inventory or product samples in your home for use in your trade or business.
  3. Your home is the only fixed location of your trade or business.
  4. You use the storage space on a regular basis.
  5. The space is separately identifiable and suitable for storage.

A photograph of the space you plan to claim is a good way to document the deduction. An audit may arise several years after you have filed the return, and you may have moved from the home by the time you get notice. Using pictures for documentation when you can is a good way of meeting IRS requirements, and ensures you’ll be able to do so if or when an audit arises.

Regular use does not mean you sit at your desk for eight hours a day, 40 hours per week. The IRS uses what is called a “facts and circumstances” test to determine if the deduction is allowable in the taxpayer’s specific situation. The amount of hours Mary spends utilizing the space may be different than John, who does all of his accounting and bill paying himself. Again, documentation is key, and can be as simple as logging the time you reserve for necessary paperwork tasks in your appointment book.

Administrative and management activities can include any time you spend on essential components of your practice, other than time spent doing massages. Paying bills, updating bookkeeping records, confirming appointments, reading technical and educational journals, developing your marketing plan or opening mail are just a few examples.

Once you’ve determined your space qualifies for the home office deduction, you need to gather the information to complete the necessary form. The calculation of the business percent will apply whether you rent or own, but will not apply in cases where you do neither, including living with your parents or a partner where you pay no rent.

The home office deduction is calculated on form 8829, and the allowable expense is entered on line 30 on your Schedule C return. This deduction will decrease your profit, effectively lowering both the income tax and the self-employment tax.

At Your Fingertips

You are bound to have some questions while figuring your taxes, and the Internal Revenue Service's website, www.irs.gov, has some great information. But how do you easily find it? Knowing which key words will get you to the information you need saves you time. The following list comprises topics you may find useful, as well as the key words you need to enter in the search function located in the upper righthand corner of the website.

Topic // KEYWORD

  • Small business, self-employed // SMALLBIZ
  • Starting, operating, closing a business // STARTING, OPERATING OR CLOSING
  • Common Errors // TAX GAP
  • State resources for small businesses // STATE LINKS
  • Small-business tax workshops // WORKSHOPS
  • Online small-business tax workshop // ONLINE CLASSROOM
  • Tax forms, publications // FORMS
  • Local IRS office locations // LOCAL OFFICE
  • IRS hotlines, free numbers // HOTLINES

Measure Up

To start figuring your home office deduction, calculate the square footage of the areas you use for business. If you have more than one place in your home you use for business purposes, a spare bedroom and the garage, for example, measure both areas and add them together to give you the total square footage.

Then, determine the total livable space of the entire home. You can look for records at your county assessor’s office, or ask your landlord if you rent. In cases where both of these options aren’t possible, then using a measuring tape and getting as accurate a measurement as possible should suffice. Be sure to take photos of the entire space, as well as the speciic areas you are claiming.

Next, divide the square footage used for business purposes by the square footage of your entire living space. For example, if your office is 10 feet by 10 feet, you’d have 100 square feet of office space. Assuming your entire living space is 1,000 square feet, you’d have a 10 percent business use that would apply to all of your home costs.

Once you’ve calculated the business percentage, gather information on your home’s expenses. If you own, mortgage interest and property taxes would be a factor. If you lease, include the amount you pay in monthly rent. Other costs that can be included in either scenario are utilities, insurance, repairs and association fees, to name a few.

Travel Expenses Made Easy

If you have to travel, there are certain expenses that can be deducted. Be sure you check with a tax professional, however, before claiming these items.

Transportation. You can deduct the cost of airline travel, bus and train fare, as well as mileage you put on your car between your home and business.
Taxi/Bus. The cost of transportation between the airport and your hotel, as well as transportation between your hotel and where you will be conducting business, is deductible.
Shipping. If you send baggage, samples or display material to your temporary work location, you can deduct these costs.
Car. You can deduct the cost of operating and maintaining your car when traveling on business, including actual expenses or standard mileage rate, tolls and parking. If you rent a car while away from home on business, only the business-use portion of the expenses can be deducted.
Lodging and meals. If you need to stay overnight or stop for sleep or rest, you can deduct the cost of lodging. Meals include what you spend on food, beverages, taxes and tips.
Communication. Any business-related calls you make are deductible, as are communication by fax machine or other devices.
Other. This category is used to deduct ordinary, necessary expenses related to business travel. These expenses might include public stenographer's fees, computer rental, and operating and maintaining a trailer.

Keep in Mind

You should spend some time researching how your business stacks up against similar practices, as the IRS is going to compare your income and expenses with all other returns filed with the same business code.

To get an idea of the numbers for past years, you can visit www.irs. gov. When you search statistics on income for non-farm proprietorships, you’ll be able to see nationwide data for businesses who filed the Schedule C return. You can get information for your specific zip code, but may have to pay a fee for more recent years.

Lastly, don’t be afraid to get help from professionals. Look for someone who has expertise in small businesses, as you may need to file additional returns, such as personal property, business license, and city and county taxes. Obviously, hiring someone to help you will cost you some money, but may end up saving you in the long run. The tax laws continually change, and keeping up with new regulations may take more time than you want, or care, to spend.

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