Nicholas P. DiNatale, CPA -
Certified Public Accounting & Business Advisory

Business Resources - FAQ's

I am thinking of starting a new business, what do I need before I can start?

For the purposes of this discussion, we will assume you have arranged the cornerstones of your budding business: a great product or saleable idea, a catchy name, secured cash for a few months expenses, and the support of your family. You will face many challenges as your business develops, and the security provided by cash in the bank, and the knowledge that your family believes in you can make the difference between your success, or search for other employment.

The next step is to choose a CPA. Although it sounds like I am blowing my own horn, you will find that an experienced CPA will be your best source of information and guidance on the variety of issues that will face your business. Will you be subject to sales taxes? Do you plan to hire employees? Which type of entity should your business become? These are important questions, and your CPA will help you with the answers, as well as assisting with filing for the necessary licenses, identification numbers, etc. A CPA will also be able to point you towards an attorney who can further address any federal or state laws governing your operation, as well as drafting any legal documents or articles of organization.

Once you select the city where your business will be located, you will most likely need to register for a business certificate with your city hall and the state tax department. Generally, you will be required to show proof of occupancy; a copy of the rent agreement for your office should suffice here. Entrepreneurs who are starting in their apartments may have to get the blessing of their landlords, while homeowners can provide proof of ownership. State licensing requirements will also vary. A call to your state tax authority will provide you with the information regarding licensing in your particular state. You can now bring your business certificate to the bank of your choice and open a checking account. Again, your CPA should be able to point you in the direction of a business-friendly bank. All banks are not created equal, and a business friendly bank will provide you not only with an economical checking account, but small business lines of credit, e-banking, lock box and credit card support, and experience with your type of operation.

Armed with your check, you should go to your local office superstore and purchase one of the better accounting software packages. We recommend the latest version of QuickBooks as being not only inexpensive, but very easy to learn, flexible and powerful. You should also learn the basics of cash flow management, and other basic business ownership issues. Believe it or not, the IRS offers excellent courses to train the new business owner in these and other topics. Although it feels like inviting a vampire into your home, you can safely visit any IRS office for a brochure or visit the IRS website. With these tools, you are now ready to join the world of the self-employed. You will have to jump through hoops at times, but the result, success, is worth the effort.

We can assist you in addressing these challenges, as well as setting up your accounting software. We are familiar with the issues and obstacles facing you as you begin your new career, and can help you plan ahead and avoid some common pitfalls. If you would like us to assist you in setting up your systems and procedures, send us a request.

Who can I consider an "independent contractor"?

This question has been on the minds of both IRS agents and employers for years, and after so much wrangling there are still no hard and fast rules in either direction. Finding an answer to this question will take some analysis, and may further depend on industry practices in your area. The answer will depend mostly on control: you have the right to direct what is worked on, the manner in which that work is performed, and the end result of that work. If you manage these attributes, or simply have the right to do so, your hire is most likely an employee. If your person in question funds their own operations, does not work exclusively for you and otherwise operates independently of your direction, this person is likely an independent contractor. The idea of control is key here, but often the line between the two is blurry. You should consult your tax advisor before making a choice in this area. The cost of an error is high as is evidenced by the recent actions against Microsoft, Inc.

Once a person is identified as an independent contractor, that person should fill out a form W-9 for your files, which will accumulate all of the information to prepare the necessary 1099-MISC form at the end of the year. Generally, any person or business entity who is not incorporated, and is paid in excess of $600 in a calendar year for services must be sent a 1099-MISC form by January 31 of the following year. There are penalties for not filing these forms on a timely basis. The forms can be purchased from your local office supply store.

Limited Liability Company "LLC" (and "LLP") basics…

The LLC and LLP (limited liability partnership) are relatively new organizations that blend some of the flexibility and tax advantages of a partnership, while providing the liability protection of a corporation. Although the rules governing LLCs vary by state, the LLC is afforded some general attributes in all states.

Generally, corporate-type liability protection is provided to each member, limiting their personal exposure to the entity’s debts and liabilities. This is in contrast to the joint and several liability of general and limited partnership entities. This liability protection differs from that offered to limited partnerships in that LLC members can actively participate in the management of the organization, while limited partners may not. LLCs and LLPs differ here, insofar as the protection afforded to LLP members only protects against debts and obligations arising from the malpractice of other members, and generally does not protect against LLP debts and obligations arising during the ordinary course of business.

LLCs are pass-through entities, as such there is no tax at the entity level, much like partnerships and S corporations. It is the members who pay the tax on the results of operations, and not the organization itself. Ordinary income and losses, and certain tax preference items pass-through to the individual income tax returns of LLC members where the amounts are included as part of adjusted gross income. LLC ordinary income is generally subject to self-employment tax as well as income tax.

Since LLC members are not employees of the entity they are not paid as part of the regular "payroll." Compensation paid to members amount to "draws" or "guaranteed payments" which are subject to self- employment and income taxes. The LLC has the ability to allocate these distributions on a basis specific to each member in accordance with the operating agreement, (an opportunity not afforded to S-corporation shareholders). Since income and social security taxes are generally not withheld from these payments an effective tax plan is key for LLC members, as they will have to make estimated tax payments to cover any anticipated tax balances due.

Other benefits over the traditional S-corporation include no limits on type or number of members, or capital structure. Additionally, the LLC can distribute property to members without gain, and members can contribute appreciated property for membership interest, also without recognizing gain. These attributes enable the LLC to prove its value by serving in a variety of roles and uses where a corporation or partnership may provide significant deficiencies.

The LLC seems like the ideal choice of entity, but there are some significant disadvantages. Because a LLC is basically a partnership, most states require the organization to be comprised of 2 members. While local regulations may allow single member LLCs, federal regulations require single members to file their federal tax returns as sole-proprietorships. Also, to be considered is the effect of the varying state laws on the LLC when interstate commerce is an issue. Because each state views the LLC entity differently, entities doing business in multiple states should be aware of whether their LLC qualifies in the other jurisdictions, and how their income will be taxed by each authority.

Today’s most attractive employee benefit for emerging businesses is stock options. Because the LLC is not a corporation, it cannot issue stock options, or take advantage of other stock-based preferences. Since many companies, especially techs with an IPO in their future will be better served as a C-corporation, long-term goals should be considered when making the choice of entity.

Is an LLC right for your business? Your choice of entity is should be dictated by the type of business you are running, long-term strategy, and capitalization. The LLC/LLP is one of a number of entity types which should be considered. Consult your tax advisor for additional information.

Cash Basis or Accrual Basis?

Generally, there are two main bases on which to report income: cash and accrual. To provide a quick brush up for everyone who’s Accounting 101 book is a little dusty: in a nutshell, the cash basis reports income and expenses as cash is received and paid, while the accrual basis reports income and expenses as the right to receive the income or obligation to pay the expense first arises, and involves accounts such as accounts receivable and payable. It is popular for service companies to use the accrual basis for financial statement purposes and the cash basis for tax purposes for the ability to take advantage of profit planning and the marketability of a higher accrual basis net income, while the cash basis generally will enable the entity to pay taxes only on money it has received and utilize more aggressive tax strategies. A service business paying taxes on the accrual basis may risk being burdened with reporting income where cash has not yet been received if the accounts receivable balance is large.

The decision of which basis you should report your taxes may not be a decision at all. In many situations, the IRS mandates the use of the accrual basis. To simplify matters, in June the IRS New England district office released a Practitioner NewsFlash highlighting the circumstances when the accrual method was required.

Generally, the following entities must use the accrual method of accounting as their overall method for tax purposes: a) C corporations; b) partnerships that have a C corporation as a partner; c) trusts that are subject to the tax on unrelated trade or business income (but only for such income); and d) tax shelters (Code § 448 (a) and 448(d)(6)).

An entity is specifically allowed to use the cash method if: a) the entity is not a tax shelter; and b) is engaged in a farming or tree-raising business, c) is a qualified personal service corporation, or d) is an entity that has met the $5 million or less gross receipts test for all prior tax years beginning after 1995 (average annual gross receipts for the previous three tax years do not exceed $5 million).

Also, if the "production, purchase, or sale of merchandise is an income producing factor," you must report your taxes on the accrual basis. The determining factor is the income producing process, and not the existence of an inventory balance. In fact, "If [an organization] takes title to goods, even though the merchandise is shipped directly from the manufacturer to the customer" that organization must use the accrual basis for tax reporting. Merchandise is an "income-producing factor if the merchandise cost as a percentage of gross receipts is 15% or more." These statements open many companies who may take temporary title to a product or asset item to the harmful effects of a potential audit change for their reporting technique.

There is some relief for companies finding themselves in this predicament. Form 3115, Application for Change in Accounting Method allows taxpayers to spread the effect of a change in their accounting method over a 4 - year period. Consult your tax advisor if you find your organization in this situation.

How long do I keep my business records?

Most businesses will want to maintain business and tax records in the event of a tax audit. Of course there are other reasons, such as when dealing with the bank, or for other long-term research. Also visit our individual taxpayer page for answers on how long to retain your personal tax information. Before making a final decision to retain or dispose of any specific records, be sure to consult your tax advisor. The following is a brief guide to assist in making decisions on how long to store your business records:

Keep Three Years:

• Applications for employment
• Insurance policies (period beginning after expiration date)
• Reports of internal auditors
• Monthly (or quarterly) internal reports such as trial balances, accounts receivable reports, etc.
• Petty cash account expense invoices and other transaction support
  

Keep Seven Years:

• Accident reports and claims
• Accounts receivable and accounts payable ledgers and schedules
• Expired contracts and leases
• Expense analysis and expense distribution schedules
• Physical inventory sheets and analysis
• Customer invoices and sales records
• Notes receivable ledgers and amortization schedules
• Expired stock option ledgers
• Expense invoices and purchase orders
• Canceled stock and bond certificates
• Time sheets and/or time cards
• Payment vouchers, registers and schedules
  

Keep Indefinitely:

• Independent accountants’ (auditors’) reports and associated financial statements
• Check books, bank statements, canceled checks and bank statement reconciliations
• Renewed or renewable contracts and leases
• Correspondence with attorneys and CPAs regarding legal issues, tax positions, and other issues
• Deeds and titles to property, plant and equipment
• Mortgage agreements and closing statements
• Fixed asset listings and depreciation schedules
• Quarterly trial balances, adjusting entries and year end detailed general ledgers
• Insurance records, accident reports and claim details
• Minute books from Board of Director meetings and Shareholder meetings
• Independent appraiser’s property assessments
• Personnel files and inclusions such as signed I-9, W-4, W-9 forms, employee agreements, 401(k) withholding agreements, termination details, etc.
• Tax returns and supporting schedules, tax preparation worksheets and calculations
• Correspondence with tax authorities, tax audit reports and determination sheets
• Trademark, patent and copyright registrations
• Articles of incorporation, or organizational documentation for unincorporated entities
• Bankruptcy filings and related correspondences
  

Should I lease or buy the company car?

This question usually tailgates the decision to acquire a company vehicle. While there is no single right answer for all situations, knowing the tax attributes of each option will assist you with making an informed decision. The IRS has specific rules to govern the deductibility of corporate "luxury vehicles." Per the IRS, a luxury vehicle is any with an adjusted basis (generally the cost) greater than $15,800. This puts a Jeep Wrangler in the same class as a Jaguar XK8! The issue here is not the definition of a luxury vehicle, but the tax treatment. If your corporation purchased a luxury vehicle, your annual deduction is comprised of the interest on the loan payments, plus depreciation, which is limited to $3,060 for year 1 ($5,000 year 2; $2,950 year 3; and $1,775 thereafter). It will take over 16 years to fully depreciate a $35,000 vehicle with this method. These deductions are further limited by the percentage of personal use.

The opposing argument is simple: compare the limitations related to ownership to a current deduction for the entire amount of the lease payments. The IRS has noticed the benefit of leasing and has made a provision to even the playing field. This amounts to a "lease inclusion," an amount to be included as income meant to quantify the tax depreciation limitations. Even with this amount, which is only a fraction of the annual lease requirement, there is no contest. For most businesses, leasing is the practical decision.

There is an exclusion available which gives small businesses the opportunity to avoid the luxury vehicle burdens. The exclusion applies to vehicles weighing in excess of 6,000 pounds, and allows these automobiles to avoid the luxury car tax depreciation limitations. Here’s a shopping tip: while many standard sport utilities will not qualify, many will pass the 6,000 pound limit if equipped with the heavy towing package. Weight class information can be found on the sticker on the driver’s side doorsill. Although the heavy vehicle will not be subject to the luxury auto limits, the lease inclusion amount will still apply.

In all cases, the driver of a corporate vehicle will have to include in income an amount which represents the value of the personal use of the vehicle. Personal use includes commuting between an employee’s home and principal place of business and other non-business mileage. All drivers must keep a mileage log! I cannot stress enough how important this is as the IRS will DISALLOW vehicle deductions not supported with a contemporaneous mileage log. Such personal use inclusions are based on annual valuation tables published by the IRS and are subject to social security and income taxes.

Expenses related to corporate vehicles such as gasoline, insurance, maintenance, tires, car washes, etc. are current expenses of the organization.

How is basis computed for an individual who owns the stock of an S-corporation? Is this the calculation that's performed in the "accumulated adjustments account" (M-2) on the corporate tax return? Is this the same amount of money that is "at risk"?

To simplify the answer, lets assume the S-corporation has been an S-corporation since inception. If it hasn't, items such as accumulated earnings and profits (AE&P) and previously taxed income (PTI) will affect the basis calculation. If the company has always been an S-corporation, AE&P and PTI will not exist.

Calculating basis is a rather complicated matter. It sounds easy from the outside, but many factors come into play. There are also two types of basis: stock and debt. Lets begin with stock basis.

Depending on the way stock was acquired, the basis amount could be one of a number of amounts. Most stockholders acquire their S-corp stock by capitalizing the company with cash and/or equipment contributed to the company upon inception. If this is the case, the stock starts off with a basis equal to the cash paid in and/or the contributor's basis in the property or equipment given to the corporation in exchange for the stock. If equipment transferred to the company had leins against it, this will reduce basis as will the fair market value of assets taken back by the stockholder. Also, any gain realized on the transfer will increase basis. Some of the other ways stock could be acquired are:

1. Acquired by gift - basis in these shares is generally the carryforward basis of the giftor.
2. Acquired by inheritance - basis is generally the fair market value on the date of death or 6 months later if the alternate valuation date if elected. See the copy of the decedants form 706 for the reported fair market value.
3. In exchange for services - basis in this case is valued at the fair market value of the shares and not the value of the services performed in exchange for the stock.
4. C-corp converts to S-corp status - the basis of the C-corp shares carry forward to the new S-corp shares.

Once initial stock basis is established, the shareholder then adjusts this basis annually based on items reported on schedule K and passing through on form K-1. Initial stock basis is increased or decreased by tax basis passthrough income, distributions, and various loss and deduction items. These are the same items that are recorded on schedule M-2 as changes to AAA. Multiple shareholders will use their allocation of these items as reported on form K-1. Preparing schedule M-2 is a tax lesson in itself and is covered in sufficient detail in the form 1120S S-corporation tax return instructions and can be downloaded from the IRS website (www.irs.ustreas.gov).

Debt basis is the stockholder's basis in loan advances made to the corporation. Once accumulated losses have reduced stock basis to zero, the basis in the debt to the stockholder can then be used to further deduct losses. The purpose of this is to provide a tax incentive encouraging cash advances of operating capital to the company during difficult times.

Once stock and debt basis have been reduced to zero the stockholder has hit her "at risk" limit. Shareholders cannot deduct S-corp losses in excess of overall basis. Such losses will tracked by the stockholder and reported on their personal tax return on form 6198 and carried forward to future years when a net income is allocated to the shareholder on form K-1.

Once the corporation starts to become profitable, basis is restored in reverse order: debt first, stock second. Debt which has a zero basis due to deducted losses cannot be repaid to the stockholder. If so, a tax will result.

Do not confuse the stockholder's basis calculation with the accumulated adjustments account (AAA) on schedule M-2. AAA is a corporate level account and basis is calculated at the shareholder level. Generally, stock basis and AAA are the same, but due to various issues that may occur (debt basis, suspended losses, basis of contributed property, etc) AAA and overall stockholder basis will differ. AAA is basically tax basis retained earnings and will often differ from balance sheet retained earnings since the latter is calculated on book basis transactions.

Remember, this advice is general as I do not know the nature, history or other details occurring with your particular situation. If you need more personalized advice, let me suggest a meeting at your convenience where we could discuss your company in more detail.

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