Over the next two years, the requirements for issuing Forms 1099 will be increasing significantly.  The 2,409-page health reform bill included a significant change in the filing requirements for a 1099-MISC.  This one change will likely require that hundreds of millions of additional 1099s will be issued each year.  This requirement does not, however, take effect until 2012.

The first expansion of 1099 reporting was enacted in 2008 and goes into effect in 2011.  This one even generated a new offspring of the 1099 series, the 1099-K.  This form requires reporting by financial firms that process credit or debit card payments.  Fortunately, the threshold for reporting is rather high, so it should not have a massive effect until the limits are lowered.  A 1099-K must be issued by the card processor to any merchant having at least 200 transactions totaling more than $20,000 in any given year.  To put this in simpler terms, Bank X processes credit cards for Joe’s Car Wash.  Over the course of the year, Joe has 10,000 credit card transactions totaling $60,000.  Bank X must issue Joe a 1099-K for the amount of these credit card payments.

But let’s bring this closer to home.  You sell merchandise on eBay and accept payment through PayPal.  If you have over 200 transactions in a year totaling $20,000 or more, PayPal will issue you a 1099-K.  IRS Commissioner Doug Shulman stated that this gives the IRS a tool to reduce the tax gap and provide better documentation for the business taxpayer to report their income and expenses.  In other words, the IRS is going to collect more tax.

The 1099 provisions included in the health reform act have a number of important, far-reaching consequences.  At present, a business must report certain payment to individuals for services rendered when those services equal or exceed $600 in a given year.  There are two important words in that previous sentence – “individual” and “services.”  Payments to corporations and payments for merchandise do not currently require 1099 reporting.  However, that is about to change.

Under the new rules, any business making any payment to a corporation or other business must issue a 1099 when the amount paid to the vendor is $600 or more in a given year. This includes not-for-profit organizations.  You have a small Schedule C business and you buy your office supplies from Staples.  Buy more than $600 per year, you must issue Staples a 1099.  Buy a computer from Dell, send them a 1099.

This means you must obtain the tax ID number for anyone you buy from and you must supply your TIN to your business customer.  You don’t have the TIN number?  That’s OK; you can overcome the problem by doing backup withholding.  This simply means you withhold 28% federal income tax on the payment.  So you buy $1,000 of merchandise from a vendor.  You don’t have their TIN.  Send them $720 and remit the balance to the IRS.  But what if you buy $500, then later in the year you buy another $100 from a company and don’t have their TIN?  Better get the TIN.  If anyone thinks that all businesses are going to file all of this properly and the IRS is going to process it correctly, I have a bridge I’d like to sell you.

A second problem I foresee with this is that the requirement is that gross proceeds be reported.  This is going to create a couple of issues.  I sell an item for $1,000 that cost me $600 for a $400 profit.  Only the $1,000 gets reported to the IRS.  They don’t see where I report it, so they send me a bill for tax on $1,000 – similar to the existing scenario with Form 1099-B.  A second issue is how is the IRS going to sort out my $100,000 in sales between what is reported on a 1099 and what is not reported.

A third problem is the undue burden this requirement places on businesses.  This is going to require small businesses to keep better records (not a bad idea, incidentally) and incur significant expense in tracking and reporting these payments.   Many small businesses are likely to turn to bookkeeping and tax preparation firms for the record-keeping and form preparation.

This is not something companies can ignore and hope it will go away.  The risk is too great, as the penalty for not filing a proper 1099 is $50 per form for an inadvertent failure and $100 per form for intentional failures. Those penalty dollars can mount up quickly.  A company that does not properly use backup withholding when required can be held liable for the amount required to be withheld.

If there is any good news in this, it is that these new requirements do not go into effect until 2012, so companies have over a year to get ready for them.

Your sole proprietorship business has done very well over the past few years.   What started as a small, part-time operation is now your full-time job and people are telling you that you should incorporate your business.  Maybe that is a good idea, but maybe not.  There are a number of factors to consider in choosing to incorporate, both tax and non-tax factors.  A corporation is a separate legal and accounting entity, so certain procedures must be in place to keep your personal finances separate from the corporate records.  One area this will impact is what to do about your home office deduction.

In order to take a deduction for a home office you must have an area in your home that is used regularly and exclusively for business.  This does not have to be an entire room, but it must be an area that is solely used for business purposes on a regular basis.  On your sole proprietorship Schedule C, this is deductible using Form 8829.  If you incorporate, you lose the advantage of deducting the home office on Schedule C.

This leaves you with three alternatives to handling the home office deduction.  First, the home office expenses may be deducted as employee business expenses on Schedule A under miscellaneous itemized deductions.  This can create a couple of problems.  First, the deduction is limited to any amounts that exceed 2% of your adjusted gross income.  This means that you will not get a full deduction for the home office expenses.  Second, if you do not itemize your deductions, you get no tax benefit from the home office.

Obviously, this is not a good solution in most cases.  The other two alternatives offer a better solution to deducting your home office expenses.  Your second choice is to have the corporation pay you rent for your home office.  This rent is deductible by the corporation, and you must report the rent on your 1040 via Schedule E.  However, you can set the amount of rent equal to the expenses associated with the home office and show no gain/no loss on the rental activity on your 1040.

Using this method you can create some personal cash flow as deducting depreciation on the office as an allowable expense.  You should be aware that, if you sell the home, any gain represented by depreciation taken on the office will be taxable.

The third alternative is to have to corporation pay you for any out-of-pocket costs of a home office under an accountable plan.  Reimbursed expenses must be actual job-related expenses that you must substantiate by providing the corporation with receipts or other documentation.  These expenses can include a portion of mortgage interest, property taxes, utilities, insurance, security service, and repairs.  They would be reimbursed based on the percentage of the home that is represented by the office area.  Any deductible personal expenses that are reimbursed, such as mortgage interest or property taxes, must be reduced on Schedule A by the amount of reimbursement.

The last two alternatives are clearly superior to deducting the expenses as a miscellaneous itemized deduction.  The choice between the two may depend on a number of personal factors.  However, make no mistake that both of these choices require rigorous record-keeping.  Failure to maintain a proper accountable plan or to have incomplete records can result in a denial of the entire deduction.  This will result in additional tax plus penalties and interest.  Additionally, the distinction between the corporation and the individual must be maintained to preserve the integrity of the corporate form of organization.

In my previous article, I discussed changes in the tax code for individuals as a result of the recently-enacted health reform acts.  While those may have seemed complex, they are nothing compared to the changes in the tax code for businesses.

Small businesses (25 or fewer employees and average annual wages of less than $50,000) and individuals are eligible for a tax credit designed to increase levels of health insurance coverage.  The credit is up to 50% of certain contributions the business makes on behalf of its employees for health insurance premiums.  Tax-exempt organizations would get a 35% credit against payroll taxes.  Get smaller, get more credit.  Employers with 10 or fewer employees and average wages of less than $25,000 would get a 100% credit.  To me this sounds like a disincentive for employers to hire more employees and an incentive to keep their wages low.  This is being phased in as of 2010.

Large employers get the other end of the stick.  They are hit with a penalty of $166.67 for each employee in excess of 30 for any month they are subject to the penalty.  They will be subject to the penalty if:

• The employer does not offer coverage for its full-time employees,
• The employer offers minimum essential coverage that is unaffordable, or
• The plan’s share of the total allowed cost of benefits is less than 60%.
• And any full-time employee is certified as having purchased health insurance through a state exchange.

This provision goes into effect January 1, 2013.

Beginning in 2011, employers who subsidize prescription drug coverage for employees eligible for Medicare Part D will not receive a deduction for those expenses.

The Patient Protection Act requires insurers to report health insurance coverage information to the covered individual and to the IRS.  The required information includes:

• Name, address, and taxpayer ID of the primary insured along with the name and taxpayer ID for any individual obtaining coverage under the policy.
• The dates during which the individual was covered
• Whether the coverage is a qualified health plan offered through an exchange.
• The amount of any premium tax credit or cost-sharing reduction received by the individual related to the coverage, and
• Such other information as the secretary of the Treasury may require.

This reporting requirement begins in 2014.  An additional reporting requirement is effective beginning in 2011 and requires that each employee’s W-2 reflect the value of the employee’s health insurance coverage provided by the employer.  Big brother is watching.

Beginning October 1, 2012, there is a fee of $1 times the number of lives covered under the policy.  The issuer of the policy is liable for the fee.  A similar fee is imposed on self-insured health plans.  A year later the fee doubles.

If you opt for a high-cost plan in your business, be prepared to pay an “excise tax.”  If the value of the plan exceeds a threshold of $10,200 for individual coverage or $27,500 for family coverage a tax will be assessed on the insurer.  This tax is 40% of the amount that the value of the plan exceeds the threshold amount.  This is effective beginning in 2018 and the threshold amounts are indexed for inflation.

A final provision levies a 2.3% tax on “any medical device intended for humans.”  Exempted are items such as eyeglasses, hearing aids, and medical devices generally sold at retail to the public for individual use.  This exception apparently applies to items that can normally be purchased by a consumer in a pharmacy.  It is not clear at this point exactly what is covered in this exception.  Not covered under the exception are Class II and Class III medical devices under the FDA classification system. These are typically implanted devices such as hip replacements, stents, pacemakers, and similar medical devices but also include some orthotics and prosthetics such as cranial helmets.  Medical technology is subject to the tax.  This is effective beginning in 2013 and is expected to generate $20 billion in tax revenues.  Obviously, much this tax will be passed on to the consumer, raising the costs of certain aspects of health care.

As certain provisions of these bills are further interpreted by the secretary of Treasury or other officials, it will become clearer how the provisions will be applied in practice.  Stay tuned.  It looks like an interesting few years for anyone involved in our nation’s tax system.

In today’s recessive economy, businesses are seeking to reduce costs.  Companies have cut back on services, reduced payroll, and approached the problem from many perspectives.  Unfortunately, some companies have sought illegal means to reduce their costs.  But this is not new, some have always attempted to cut corners to save a few dollars.

Specifically, I am referring to companies reducing their payroll tax costs by classifying W-2 employees as independent contractors, giving them a 1099-MISC at year’s end.  This move can save the employer 7.65% of payroll by not paying the employer’s portion of social security and Medicare.  In addition, the company avoids payment of state and local unemployment taxes.  This tactic can also result in savings from not providing benefits to the independent contractors.  Sounds good, but it is probably illegal and places a greater tax burden on the employees.

Misclassification of employees as independent contractors is an area of concern to the IRS and to state departments of labor.  As this behavior becomes more widespread, the IRS is increasing its efforts to detect these misclassified workers.  The first Employment Tax National Research Project in 25 years was recently announced by the IRS.  This project has two main goals:

• To secure statistically valid information for computing the Employment Tax Gap and
• To determine compliance characteristics so the IRS can focus on the most noncompliant employment tax areas.

In other words, they are attempting to find out the magnitude of the problem and find out the characteristics of those not complying with the law. This will allow the IRS to audit companies with the greatest perceived compliance risk.  The project will involve randomly selecting 2,000 taxpayers each year over the next three years, and doing a thorough employment tax audit of those taxpayers.

Presently, the IRS has a list of 32 points that it uses to help make a determination of the proper status of an employee.  Additional factors are included for service providers or sales persons.  These factors can be found on Form SS-8. This form can be completed and submitted to the IRS for a determination of the proper classification of an employee or group of employees.  Since business practices have changed significantly over the past 25 years since the IRS last visited this issue, there could be some changes in the relevant factors.

While it is not the purpose of this article to discuss these factors in detail, it can be said in summary that it boils down to control.  Form SS-8 distinguishes three categories – financial control, behavioral control, and the relationship between the worker and the firm.  Although no one factor is decisive, the IRS will look at all relevant factors to reach a decision.  It is a good exercise to review these factors and make an educated guess about how the IRS would classify your employees/independent contractors.

If an employee has been classified as such and receives a W-2, switching them to a 1099 contract employee is generally not a valid move.  If you misclassify employees as independent contractors, the savings may be short-lived as the IRS is likely to investigate and discover the misclassification.  That will result in payment of the tax in addition to penalties and interest.

Finally, employees who feel that they have been misclassified may file an SS-8 form.  If they receive a favorable determination, and the employer does not issue a W-2, they may file a Form 4852 as a substitute W-2.

Sounds like a good deal.  You paint my house, I prepare your tax return.  Or an employer gives an all-expense paid vacation to employees meeting certain performance goals. Everyone benefits and no one pays taxes on the transaction.  Not so fast.  These transactions are known as “barter” and are subject to income tax laws, the same as if you had received cash.    Bartering is the exchange of one product or service for another and the fair market value of the goods or services received is taxable income.

In a direct barter exchange you deal with the other party face to face.  Generally speaking, no tax-related paperwork is required but this needs to be recorded in your accounting records and reported on your tax return.  It’s just like a sale for cash.  Whether you are a cash-basis or an accrual-basis taxpayer, the IRS treats bartering as income received.

For example, suppose you are a plumber.  Your neighbor is an income tax preparer.  He prepares your income tax return and you fix his kitchen sink.  The value of the services rendered to your neighbor is $250.  You report $250 income from the barter transaction.  The cost to you for tax preparation  is $250.

It is not uncommon to participate in a barter exchange.  This simplifies bartering as you don’t have to find someone who has what you want and needs what you have.  With a barter exchange, you receive credits for goods or services you perform, which may be exchanged for goods or services you need.  Use of a barter exchange does not change the nature of the transaction.  It remains taxable income.  However, use of a barter exchange carries an additional twist to the process.  The barter exchange is required to issue you a Form 1099-B.

You may be saying, “Wait a minute.  Isn’t a 1099-B the form I get if I sell stocks or other securities.  Yes, that’s correct.  The actual name of that form is “Proceeds from Broker and Barter Exchange Transactions.”  The barter part is often overlooked.

Obviously, you should maintain records of any bartering transactions you enter into.  The IRS suggests that you label all barter income and expense documents as “bartering” and retain all original source documents such as invoices or Forms 1099-B.

Bartering as compensation is another issue in this regard.  A business may pay bartered goods as a bonus or part of the compensation package to employees.  Referring to the all-expense paid trip mentioned at the beginning of this article, if that trip was obtained by the employer in exchange for advertising (to use an example) the company should report that barter exchange in its records.  But it also must report the bartered items as compensation on the employee’s W-2.  It is also subject to employment taxes.  The same reporting holds true if the company “gives” the bartered item to an independent contractor.  It must be reported on a 1099-MISC issued to that contractor.

It has been said many times that “there is no such thing as a free lunch.”  Once again, that proves to be true as that bartered lunch could be taxable income.

In a prior article, we discussed an overview of issues relating to Schedule C.  In this article we will offer some guidelines for the proper preparation of a Schedule C along with some tips help avoid an audit.

First and foremost, submit a complete Schedule C.  This includes completing all sections of the form including your accounting method, your business code, whether you materially participated, and if you started or acquired the business in the current year.

Second, be sure to place expense items in their proper places on the Schedule C.  Place as few items on line 27 – other expenses – as possible.  If there is a specific line item for the expenditure, place that amount there, not in “other expenses.”  For example, line 23 if for taxes and licenses.  Property taxes, employment taxes, business licenses all should be included here.

The third step is to have accurate and complete records and documentation of your income and expenses.  To help you do this, you should have a separate checking account for your business and deposit all receipts in the account.  Keep receipts for all expenditures, along with a mileage log for business travel.    An excellent investment in this regard is a good software accounting program, such as QuickBooks.  This will show the auditor that you keep good records and are organized in how you approach your business.  Additionally, it helps insure that you keep up with your expenses and do not accidentally omit a legitimate expense.

Fourth, if it is a legitimate expense that you incurred in your business, deduct it.  Many people will fail to deduct an expense because they fear it might raise a red audit flag.  Instead of omitting it, document it.  Automobile expenses, meals and entertainment, and home office deductions are among the most common items that invite IRS scrutiny.  They don’t want to deny a legitimate deduction, but you must be able to prove that it was incurred in a business context.

Automobile expenses should be evidenced by a “contemporaneous log” that includes mileage and date driven, the purpose of the trip, and where you went.  You can deduct the IRS standard mileage rate or you may choose to deduct actual expenses.  Meals are deductible for out-of-town travel.  Entertainment expenses must be related to the business in order to take a deduction.  Business may be discussed before or after the entertainment event.  Meals and entertainment are limited to 50% of their cost.  For meals consumed during travel, you may choose to use the IRS per diem amounts.  It is a common misconception that the IRS has a per diem amount for lodging.  As proof, it is often cited that there is a federal per diem rate at www.gsa.gov/perdiem.  This lodging per diem rate is not an allowed amount for income tax purposes, it is the rate the federal government will reimburse its employees.

A home office deduction is allowed for a business owner if there is an area in the home that is used regularly and exclusively for business purposes.

Fifth, you should consider having your return prepared by an enrolled agent or CPA.  Self-prepared returns are more likely to be audited because the IRS believes that a nonprofessional is more likely to take a deduction that is not allowed.

Finally, you should be aware that if you show a profit in three out of five years there is a presumption that the activity is one that is carried on for profit.  Failure to earn a profit in three of five years does not automatically make your activity a hobby; it simply means that you have a greater burden of proof to convince the IRS that you have a legitimate business activity with a profit motive.

These steps will help you avoid an audit, but they are not foolproof.  Despite your best efforts, you may get a letter from the IRS one day, informing you of an impending examination.  If you have followed these six steps, it should minimize any trauma from the audit and help you successfully negotiate it.  As a final reminder, the IRS never contacts taxpayers by e-mail, you will learn of an examination by letter.  If you get an e-mail that is supposedly from the IRS, hit the delete button immediately.

Reporting Business Activity on Schedule C

Approximately 23,000,000 Schedule C forms are filed each year.  Most of these represent small, often home-based, businesses.  However a significant number represent large, on-going, or full-time business enterprises.   According to IRS statistics, the annual tax gap is approximately $345 billion.  This is the difference in the amount of tax that is collected and the amount that should be collected.  Of that amount, approximately one-third is underreported income or overstated deductions on Schedule C businesses.  It should come as no surprise, then, that Schedule C filers are frequent targets of IRS audits.

We will be looking at some Schedule C basics starting with who can and should file a Schedule C.   This schedule is required for any business that is a sole proprietorship – a one-owner business that is not incorporated.  In addition, a single-member LLC may elect to file a Schedule C.   As of January 1, 2007, members of a qualified joint venture may report its operations on two Schedule C’s.  A qualified joint venture is an unincorporated business owned by husband and wife.  Both spouses must materially participate in the business and elect to report the business results on a separate Schedule C for each spouse.  This is in lieu of filing a partnership return, Form 1065.  If you have multiple sole proprietorships, you are required to file a separate Schedule C for each business.  This prevents disguising losses of one activity against the gains of another activity.  An LLC owned and operated by a husband-wife team is not a qualified joint venture and may not file on two Schedule C’s.  They must file a partnership or corporate return at their election.

Having a sole proprietorship does not require any legal formalities, you just start the business.  Many people may do occasional “odd jobs” and receive compensation for that work, but not consider themselves as “having a business.”  You don’t need to have a name, or a formal business structure, but you are likely to be required to file a Schedule C if you sell goods or perform services.  Yard sales do not normally subject you to Schedule C filing, as it is not ongoing and you are not selling the items for more than they cost.

Another source of the tax gap that is related to sole proprietors is unpaid self-employment taxes.  If your Schedule C shows a profit of $400 or more, you are also required to file Schedule SE and pay self-employment tax.  The self-employment tax represents the employee and employer portion of social security and Medicare taxes.  The good news is that you may take a deduction on line 27 of the 1040 for one-half of these taxes.

Since the sole proprietorship has no formal legal structure, when the business is sold, it is treated as a sale of assets rather than a sale of the business.  Gain or loss is recognized on the sale of each individual asset that is transferred.  This includes tangible as well as intangible assets.  The sale of these assets is reported on Form 4797 and line 6 of the Schedule C.  If any of these assets are converted to personal use, a Form 4797 is required and there may be a taxable gain on the conversion.

An owner of a Schedule C business has a number of options available as far as pension plans are concerned.  An individual 401(k) plan as well as Keogh and Profit Sharing Plans are available.  In addition, a simplified employee pension (SEP) or SIMPLE plan may be established.  SEP and SIMPLE plans are not qualified retirement plans and do not require the filing of Form 5500.  Regarding health insurance, if the owner is not eligible to participate in a subsidized plan, up to 100% of the cost of a health insurance covering the owner, spouse, and dependents may be deducted on line 29 of the 1040.

Another advantage of a Schedule C business is that the owner can hire a spouse or children and reap some tax benefits.  These employees must be engaged in meaningful work for the business.  This compensation is deductible and the family members are eligible for benefits.  Tax savings can be realized as children under age 18 are not subjected to social security and Medicare taxes.  Of course, having employees mean that appropriate employment-related forms must be filed including a W-2.  The owner may establish a plan to reimburse employees for out-of-pocket medical expenses. This cost would be a business deduction, and the plan must be in writing, meeting IRS guidelines.

Finally, a word of caution.  The activity reported on Schedule C must be one that is engaged in for profit.  The IRS has a number of guidelines to assist in making this determination.  The bottom line is that you cannot have a hobby, treat it as a business, and deduct all your expenses.

In a future blog, we will deal with how to file a “safer” Schedule C and hopefully avoid an IRS audit as a result.