It’s that time of year again. Tax season. This time, you’re sure you’ve got things under control. Yes, you’re stressed, you have eight different spreadsheets open on your screen, and you’re waiting for yet another government website to load, but you’re almost at the finish line. And after spending hours filling out multiple forms—triple-checking that you’ve made the right estimated payments, tracked the right expenses, and applied the right deductions—you finally file your taxes.
But as the weeks go by, a little feeling of doubt keeps nagging at you: Are you absolutely certain you provided the correct information? Could you have made a mistake without realizing it? You’re months into 2019, but you can’t stop thinking about your 2018 taxes. As if on cue, your mail person tosses a thick envelope on your desk. It’s a letter from the Internal Revenue Service.
Don’t let this nightmare become your reality this year. Before you file your return, be sure you’re not falling prey to one of these all-too-common mistakes business owners make during tax time.
Forgetting to Register in Every State in Which They Do Business
Incorporated in Delaware but sell to customers in California? Your business needs to file returns in both states. In fact, as the Supreme Court recently clarified in its major decision in South Dakota v. Wayfair, a company is legally obligated to pay taxes in every state in which it does business—even if the company has no property or employees located within the state. If you operate an e-commerce company, for instance, you may owe sales taxes to every state you’ve shipped an order to in the last 12 months. The same is true for many service providers.
Many startups and small businesses also don’t realize that they may need to file returns for states in which their employees are located. If your Delaware-incorporated, California-based business has a founder in Wisconsin and a programming team in Washington, you may be looking at four separate state forms (note that contractors don’t count).
While the rules frustratingly differ from state to state, here’s a quick, three-prong test you can use to determine if you may owe taxes in a given state:
- Do you have property in the state?
- Do you have payroll in the state?
- Do you have sales in the state?
If the answer to any of the above is “yes,” there’s a good chance you need to file a return for the state in question.
Neglecting to Amortize Their Pre-Revenue Expenses
Becoming profitable takes time—and more than a little upfront investment. Before launching a restaurant, for example, you might need to purchase equipment, recruit chefs, develop menus, obtain a liquor license, and so on. The pre-revenue process could last months and demand a considerable chunk of money.
A business doesn’t necessarily need to report those expenses on their tax return and take the expenses all at once. Instead, the company can choose to offset its costs through amortization. When you amortize an expense, you write off its initial tax burden and pay it back incrementally. You simply capitalize the expense, put it on your balance sheet, and then pay a percentage of taxes on it over the course of a set number of years in the future.
Companies in their pre-offering period frequently use this strategy to reduce their tax liabilities. Research and development, legal fees, loans—any expense can be amortized so long as it relates to an intangible asset with a definite lifespan. You can amortize the costs of creating a patent, for example, but you can’t amortize the costs of building a brand.
Filing as the Wrong Business Entity
As you probably know, most businesses in the U.S. fall into one of five categories: limited liability companies (LLCs), partnerships, S corporations, C corporations, and sole proprietorships. Although your business entity type may change over time, the form you file in your first tax year often has implications for your future filings.
When your business incorporates as a partnership or an LLC, how you file in your first year sets an important precedent. Here’s where countless business owners screw up—ready to get into the weeds?
An LLC is not a federally defined business entity, but a state designation. If your company does business as an LLC, the IRS will treat it as an S corp or partnership, or—for sole proprietors—a disregarded entity. (In IRS-speak, “disregarded” means the business is not separate from its owner.) Single-owner LLCs may be taxed as disregarded entities or S corps. Companies with more than one owner are taxed as partnerships.
Keep in mind these designations are only for tax purposes; they don’t change anything with your state, but they do affect which federal forms you’ll need to file this year and next.
Say you’re the only person working for your LLC. For tax year 2018, you would file as a disregarded entity. But if, over the course of 2019, you hire a few people and change your LLC’s status to an S corp, you’ll need to file a different form next year: Form 3115, Application for Change in Accounting Method.
It’s up to the IRS to not only approve changes to entity types (i.e. accounting methods), but to determine how businesses actually operate. If your business calls itself one thing but acts like another, the IRS will find out and send you a bill for any taxes you should have paid.
Failing to Pay Themselves Reasonably
Another tricky thing about business entities: depending on how your company is structured, you could owe yourself money. The IRS requires C corps and S corps to pay their owners “reasonable compensation.” Of course, this being the federal tax code we’re talking about, the meaning of “reasonable compensation” is exactly the opposite for one entity as it is for the other.
To understand why, it’s important to know the differences in how each entity is taxed. S corps, partnerships, and sole proprietorships function as so-called “pass-through” companies: income passes through the company to the owner, who then pays the income tax on their individual return. Owners of C corps, meanwhile, pay their individual income taxes on top of their business income taxes.
With that in mind, let’s dig into reasonable compensation. In an S corp, the owner is taxed on their entire income, minus whatever gets taken out of the owner’s 1040: i.e. payroll taxes and social security. This taxable income must be equivalent to at least 50% of the owner’s net taxable income what the business would pay a third party to do the same job. You can’t pay yourself less than you’re worth—hence the significance of “reasonable compensation.” If you don't hit that threshold, the IRS will treat you like a sole proprietor and charge you self employment tax on your income level.
For C corps, the goal is to provide owners with wages that eliminate double taxation. Remember that C corps, unlike S corps, are taxed on both the business level and on the individual owner level. When evaluating C corp owner compensation, the IRS is on the lookout for excessively high wages that cannot be justified as “reasonable.”
Attempting to Handle Their Taxes Alone
These are just a few of the potential mistakes business owners make when they attempt to manage their taxes without professional support. There are plenty of other common pitfalls (Did you know, for instance, that you need to pay $10,000 per foreign owner or subsidiary in your company?).
Don’t take on tax season alone. The tax and accounting professionals at inDinero can help you organize and prepare all the paperwork you need, save money on filing, reduce your tax liability, and minimize your chances of receiving that dreaded IRS letter. Learn more about what can do for your business.