Category: Accounting & Taxes

Is there an IRS audit in your future? Don’t simply hope the answer is no. How you handle your small business’ finances – in the way you spend money and how you document those transactions – can increase or minimize whether you’ll face IRS scrutiny. Focusing on red flags that’ll trigger an audit will help protect you and your business more efficiently. What the IRS says about the “examination process” includes a hopeful prospect: “Some examinations result in a refund to the taxpayer or acceptance of the return without change.”

Don’t count on it. And, remember: An IRS audit can inflict pain even if you come out smelling like a rose. The process of pulling together every financial record you need could put a strain on you and your bookkeeping department.

IRS Audit Triggers

So, what triggers an audit? General factors, according to the IRS, include the following:

• “Related examination.”

This means: If the IRS audits one of your customers or suppliers, and asks questions about your tax returns, you might be next in line for scrutiny.

• Information matching.

If there’s a discrepancy between your bank reports for the IRS (and you) and the interest it paid you over the course of the tax year, and what you report in interest income, a bright red flag goes up. Keep in mind that credit card transaction processors are required to file a 1099-K form to the IRS summarizing total payments you received that way.

• Local initiatives.

Sometimes, regional IRS offices decide to focus on particular business sectors because it has found a lot of abuse there. There’s not much you can do to reduce your changes of an audit in this scenario.

Also, all things being equal, the type of business that you are – whether you’re a C Corp, or a Sub S or sole proprietorship – can affect your odds of being audited. That’s because it’s easier to blur personal and business finances when your personal and business finances are combined in a single tax return.

Another factor is the size of your business. The larger the company, the more money there is to be reclaimed by the IRS in a typical audit scenario if there’s any abuse. So, you’re more likely to stay below the IRS’s radar if your revenue is $1 million than if your revenue is $10 million. Even so, that doesn’t mean that you shouldn’t grow your business merely to lower your chances of an IRS audit.

Automated Audit Trigger System

The heart of the IRS audit process is called the “discriminant function system,” or DIF. The IRS assigns varying DIF scores to taxpayers–individuals and businesses–based on numbers and ratios they report. Like Google, the IRS doesn’t reveal anything about the DIF. Still, there’s plenty of evidence of where it focuses.

A basic example is the ratio of your total claimed business expense deductions to your overall business income. Of course, you can operate at a loss from time to time. But if that happens often, the IRS will probably take a closer look. Still, you’ll be vindicated if all of your expenses are legitimate.

The DIF focuses on areas typically prone to abuse, such as business meal charges and travel. If you frequently expense for these reasons, keep detailed records and receipts. This goes for expenses of at least $75.

Since 2018, you’re required to separate your food and drink expenses from the entertainment portion. The cost of the entertainment portion (e.g. theater and sporting event tickets) isn’t deductible. As always, keep notes on the purpose of business meals, who attended, and your relationship to those individuals.

Here are some additional areas of IRS scrutiny for statistical anomalies when looking for audit candidates:

• Independent contractor overload.

If you use a lot of support from freelancers to whom you issue a 1099 instead of a W-2, this might trigger the IRS. Be sure you classify freelancers appropriately.

• Home office deductions.

Remember: You can’t deduct the cost of an entire room if you’re only using the corner. The time you spend working in that room compared to everything else you use it for, matters.

• Business use of a personal automobile.

This is an abuse-prone area, too, like food, drink, and entertainment expenses.

• Sloppy math.

You might think an error involving an inconsequential amount of money isn’t a big deal. To the IRS (and probably the DIF system), small errors can be an indication of larger errors also present and worthy of discovery.

• Large cash transactions.

In the unlikely event you are paid $10,000 or more in cash in a single transaction–and fail to report it on IRS form 8300–you could be audited.

There’s no set way of escaping the possibility of an IRS audit. But, by paying attention to red flags and preparing to answer possible questions about your expenses, you’ll save yourself a lot of grief in the long run.

Walk around any neighborhood and on just about every front step you’ll see boxes containing merchandise that was purchased online. What you see has everything to do with sales tax laws.

Consumers consistently turn to online shopping.  It’s convenient and is often less costly than buying from a brick-and-mortar store. For years, sales tax laws didn’t cover online orders. Forty-five states collect sales taxes on in-person purchases but couldn’t apply them to online ones – until now. A 2018 U.S. Supreme Court ruling now gives states collection rights for online sales tax. This was the result after South Dakota sued the online retailer, Wayfair.

The court decision almost immediately filled states’ coffers. Twenty-three states saw a five percent increase in year-over-year sales tax during the third quarter of 2019, according to a study by the nonprofit Urban Institute. The study attributed most of that growth to the new online sales tax laws.

While a boon for state budgets, online sales taxes have stressed small business owners. The internet opens the door to customers beyond a business’ geographic reach. The varying rates and rules for each state’s online tax is, understandably so, a source of confusion and frustration.

Getting Caught in a Nexus

Before the Wayfair ruling, a state could only tax companies that had a physical presence within its borders. But now, economic activity in a state – the “economic nexus” – can trigger an online sales tax. This can happen even if the business has no physical presence there.

Many small business owners feel as if they’ve been sucked into a complicated nexus of varying rules and expectations. That’s because what is subject to the online tax and what is owed differs from state to state. Some states have uniform standards for companies to follow, but other states, usually the big ones, have their own rules to sort through. Further complicating things, Alabama and Louisiana are two of five states that let their municipalities administer their own taxes.

Many small businesses typically lack the staffing and insight to grasp it all. As The Wall Street Journal recently reported, while larger businesses have the people and technology to keep track of online sales in each state and what that means for taxes, small businesses don’t have the means to keep up.

“Small businesses are definitely the ones that are really adversely affected,” Clark Calhoun, a state and local tax attorney in Atlanta, told the Journal. “A bigger business is typically going to have more robust sales-tax software,” he said, and “a better sense of where their products are going and will be well over the sales thresholds every single year.”

You Need a Scorecard to Keep Up

About those online sales thresholds. Some states exempt out-of-state sellers from paying online taxes if they had $100,000 or less in sales or fewer than 200 transactions in the state per year. A few other states don’t have a transaction threshold but have one for total sales. Some states set a $200,000 minimum, while California, New York, Tennessee and Texas set a $500,000 minimum. Kansas doesn’t have one.

The Federation of Tax Administrators, a group that represents state taxing authorities, created a handy chart that outlines the expectations for remote sellers. FTA, however, urges business owners to always double-check with a state in case of any changes.

Small businesses could turn to a marketplace facilitator to handle the sale and the burden of collecting tax. As The Wall Street Journal noted, 38 states and the District of Columbia now have laws requiring marketplaces such as Amazon, Etsy and eBay to collect and remit sales tax on behalf of third-party sellers.

Indeed, those marketplaces could relieve a burden for small businesses, especially with these big online sellers benefitting from a grace period that gives them time to align their procedures with the many state laws. Forbes notes that all but one state with marketplace facilitator laws allows up to three years to be fully compliant with online tax laws.

Do Your Online Tax Homework

Still, not every business wants to put the fate of its goods in the hands of Amazon or eBay. If you’re one of those businesses, having a deeper understanding of the vast online tax landscape should be a priority.

That won’t be easy, though. In the Journal of Accountancy, a publication for CPAs, attorney David Brennan points to how the U.S. has more than 10,000 tax jurisdictions. “While it is possible in some states to register at the state level for counties and municipalities, in other cases the law requires a separate registration in each state, county, and municipality” he wrote. On top of ensuring that they are registered with every possible government entity, businesses also have worry about the many different exemptions to goods. For instance, using Brennan’s example, many states tax the sales of clothing but a few exempt them, while some apply a cost threshold.

Two pieces of advice that Brennan offers to CPAs who represent businesses can also apply to small businesses themselves. First, know your company’s sales and number of transactions for each state and determine potential economic nexus exposure. This requires knowing which products and services are taxable in which states. Also, know the sales tax collection requirement in those states and whether there are any exemptions.

Don’t Go it Alone; Find Expert Help

Even though it’s best to know your businesses’ internet sales inside and out, trying to figure it all out against the backdrop of every state’s expectation might be too much when you already have a long list of financial obligations. You can seek the counsel of an accountant or go a step further and outsource all tax and accounting work to an outside service. Financial services provide not only expert advice but also, more often than not, the latest accounting software. They’ll bring a fresh perspective to your online sales and will already work closely with federal, state and municipal tax and revenue departments.

The expectations and chance of risk are far too enormous to try to handle this alone. Online sales introduce small businesses to a whole new world of customers, but also a whole new world of complexity. As daunting as the vast online sales tax landscape might be, with the right help and proper approach, your business won’t have to sweat the many small details and instead focus on serving your many virtual customers.

Hearing the word “budget” often conjures the image of belt-tightening. But small business budgeting is the down-to-earth process of planning for the growth and profitability of your business. It’s about translating ideas and predictions into numbers. The ROI of thoughtful budgeting includes being able to secure financing to help accelerate your growth.

So how do you go about the process of small business budgeting?

There are different approaches, but here’s one. First ask yourself: Am I where I want to be next year? If yes, that’s great, but you can’t just create your next year’s budget from the last year’s profit and loss statement (P&L). You need to think about the reasons for the results you had. Next, you need to make your best guess as to whether they’ll hold up going forward. For example, you might ask yourself questions like:

• Is it safe to assume that the competitive landscape will remain the same? Or do I need to prepare for the possibility that competition will heat up?
• Will I need to make any enhancements to my products or services to keep up with market conditions and technology?
• What changes might occur in my staffing needs? If I have to replace any key workers due to resignation or retirement, how will that impact my payroll?
• Can I count on no big changes in the cost and prices of the goods and services I consume to keep my business moving forward?
• Is any of my equipment wearing out or becoming obsolete?
• Should I plan for any changes in the economy, for better or worse?

Chances are, your answers to some of those questions will point to the need to roll up your sleeves, sharpen your pencil and get to work on a new budget.

Budget for Revenue, Profit Growth

Start with revenue, using the revenue categories on your P&L, assuming it’s reasonably detailed. Revenue is the hard part, but it’s also what largely determines the expense side of the budget. Before you start plugging numbers into a spreadsheet, think about and determine which of your products or services…

• Are the most profitable?
• Are the ones that you’re best at making or performing, and give you the greatest competitive advantage?
• Have the greatest potential for market growth?
• Are most likely to be in demand for a long time?
• Can expand your capacity to produce or perform?

Then think about new products or services that you might want to introduce.  What would it take to do so? And how quickly you can generate revenue from them?

Turn a Business Plan into a Budget

These questions are the foundation of a business plan that can be translated into a budget. It might be a multi-year budget, but the process forces you to become a strategic thinker.  Or, at the very least, it will allow you to translate your existing strategic plan into something concrete.

Next on the revenue side of budgeting comes this question: How conservatively or aggressively do you want to predict your revenue for the coming year? It’s a balancing act, and depends partly on your personality. It’s OK to be somewhat “aspirational” but without living in a dream world.

If you’re planning to borrow money or seeking to draw in some equity capital from outside investors, you might choose to be somewhat conservative. It’s usually better to under-promise and over-deliver, than the other way around. Besides, it can be very disruptive to business operations when you overestimate revenue, then have to retrench on spending midstream to protect your bottom line.

Also, you can give your sales team revenue goals that exceed your budget.  This lets you aim high without going out on a limb.

In picking revenue numbers, take your recent actual numbers within each product or service category, check to see how good you were in the past at predicting future sales, and learn what you can from the forecasting process you have used so far.

Forecasting Budgeted Revenue

If this is the first time you’re making a detailed budget, take your current revenue pattern and do your best to predict the impact that all the variables that go into sales results will have in the next year. Naturally, it’s easier to do if you’re not planning to make any big changes in strategy, such as raising prices, adding new products and services, increasing your sales and marketing efforts, opening new offices, and so on.

The small business budgeting process for expenses generally follows the revenue part. An exception would occur if you were forced into budgeting higher revenue (and figure out how to generate it) by an expected big jump on the expense side, such as a major increase in the cost of an important input. For example, higher import tariffs on goods from China are having this effect for some businesses. Others may be facing higher local minimum wage standards, or steep increases in health benefit costs.

As on the revenue side, you can use your P&L as the foundation for your expense budget. If you’re not planning any big changes in your business for next year, expense budgeting can be fairly straightforward. Certain changes in expense categories can be predicted, such as wage raises you plan to give, or additional staff you plan to hire. Other categories like rent and utilities generally aren’t hard to predict.

If you’re trying to improve your bottom line and aren’t expecting a surge in revenue, you’ll need to find savings on the expense side. If instead you’re expecting a significant increase in revenue based on a new business plan, you’ll need to incorporate the new expenses associated with the plan to build that revenue. It might be something as basic as higher sales commission and bonus expenses, or that plus many other expenses.

Don’t Neglect a Cash Flow Forecast

Small business budgeting also includes a critical component sometimes overlooked: cash flow forecasting. You might come up with a realistic budget that shows a healthy profit at the end of the year. But without a cash flow budget, you could find yourself with a depleted bank account and suppliers hounding you. That’s because your expenses and revenues rarely come in at the same rate every month.

You might accurately budget a big jump in sales in June, and some correspondingly higher vendor bills and payroll obligations that must be dealt with promptly, but the actual cash generated by those increased sales doesn’t come in before late August. A cash flow forecast will alert you to whether, without drawing on other resources, you’ll have enough money on hand to pay those bills.

And if your cash flow forecast points to a need for extra funds to tide you over a dry spell, it’s time to begin a conversation with a small business lender who can help you address that need. The better your budget and cash flow forecast, the better your prospects for a productive relationship with such a lender to help you achieve your business objectives.

Staying on top of your financial record keeping can be a challenge, especially when you already have a full plate running your business. However, the benefits of having a strong financial records system is critical. Whether you’re filing taxes or trying to understand your performance, accurate financial statements are key — and those are built on strong record keeping. Score reports that 82% of businesses that fail don’t understand their cash flow. Here’s how to avoid that trap and streamline your process in five quick steps.

Use Software or an Accountant

If you’re going it alone in developing a system for financial record keeping, it’s natural that you’d struggle. There are three easy options that can streamline your process:

• Work with an accountant: Hire an accountant who specializes in small business accounting. They can develop a system that works for you and help you track, record and consolidate your records each month.
• Hire a service: Increasingly, there are combo service-and-platform solutions that offer small business accounting as a recurring service. Bench.co and Xendoo are two popular options.
• Use software: If you prefer to manage your accounting internally, consider leveraging a solution like QuickBooks or Freshbooks. Manage billing, expenses and compiling your full profit-and-loss statements in one platform.

Implement a Month-end Close Process

Falling behind is the death knell for reliable financial record keeping. Implement a month-end close process where you submit all expenses, pay your bills, capture receipts, and reconcile accounts.

Doing this every month gives you real-time visibility into your financial situation and highlights issues to address before they become urgent problems. One strategy that can speed up the process is using an expense management app, such as Expensify or Wave.

Expense Management: The Key to Profit and Taxes

As a small business owner, deducting the business expenses that keep your organization running is crucial. It helps you really understand your profits and only pay the taxes you owe. However, every expense must be fully documented during that process.

The IRS has strict record keeping standards about substantiating any expenses. Record each expense, and retain two documents: a receipt showing what the purchase was for and confirmation that you paid it. For example, if you pay a vendor for a specific service, retain the receipt that outlines the provider, service and totals. Make sure you also keep proof of payment like a canceled check or credit card statement.

Tracking

Using your car for business can be a significant expense. However, tracking those expenses and capturing them on your financial statements and tax returns gets complex. Every trip must be logged, and then substantiated with other documents that show mileage throughout the year to separate business mileage from personal mileage. Consider automating the process with an app such as Mileage IQ. With these tools, simply download the app to your smartphone, and it will track the miles you drive. You add trip details directly into the app, and then have all the data on hand to the strictest reporting standards in case of an audit or future questions.

Use a Business Expense Template

When you work for a corporation, you submit expense reports to get reimbursed. These expense reports show the receipt, business justification and payment information for each purchase. Once they’re approved by management and accounting, you’re reimbursed.

Using a business expense report approach for your business can streamline financial record keeping in your own business. Create a template that fits your needs and records the essential details for each expense: the date, vendor, expense description, amount, payment type and business purpose. Jot down a few details about how you used the expense or how it relates to your business for later reference.

It’s important to have a plan for your financial records management. Not only does it give you deeper visibility into how your business performs, but it makes the financial management of your enterprise fast and easy. Whether a question arises regarding a business expense or you need to quickly apply for a small business loan, having your records in order allows you to quickly complete everything, and then get back to what matters most: running your business.