To circumvent stress for tax professionals and clients alike, preparation is key. Small businesses will benefit from consistent interaction with their tax professional throughout the year, as it not only allows for greater planning opportunities, but also for the design and implementation of strategies that ensure the upcoming filing season will be less…well, “taxing.”
Organize and Track Documents
Small businesses should maintain intact financial records on an ongoing basis. This is crucial for substantiating any deductions and credits claimed on a tax return, and also relevant to a potential IRS audit.
Generally, the statute of limitations for audits is three years. However, if the IRS suspects and can substantiate fraud, there is no limitation to how many tax years can be audited. Keeping a record retention system will not only support previously filed tax returns but also the preparation of future ones.
Report All Income
Many taxpayers are aware they must include income reported on 1099s on their tax return. However, they often forget to include income not reported on 1099s. This includes both cash receipts and in-kind receipts.
Taxpayers are usually most surprised that their bartering transactions (i.e., goods/services exchanged with another party for goods/services) are subject to income taxation.
Adequately Track Expenses
Are benefits of the refundable Employee Retention Credit being appropriately tracked? Are fixed assets being tracked? Were the business meals provided by a restaurant? Are business and personal expenses being comingled?
Small business owners frequently underestimate what is expected of their recordkeeping endeavors, so to always keep track of every financial detail. For 2021 tax returns, small business employers need to be aware that benefits derived from the Employee Retention Credit will reduce the related payroll deductions on the income tax return.
When it comes to fixed assets, it is easy to fixate on available §179 and bonus depreciation deductions and think very little about the appropriateness of a small business’s fixed asset records. Approximately 38 states have these business personal property taxes, subjecting property to annual state taxation regardless of the immediate deductions received on the federal income tax return. Thus, it is important for small businesses to have a fixed asset ledger to support any filed business personal property tax returns.
Additionally for 2021, businesses should be advised to track meal expenses according to whether the expenditures were made at a restaurant, as business meal expenses provided by a restaurant are temporarily 100 percent deductible on the 2021 income tax return as a COVID-19 relief measure. See IRS Notice 2021-25 for further details and what qualifies as a restaurant.
Small businesses also have a propensity to comingle business and personal expenditures. This often results from lacking separate bank accounts for business use and personal use, failing to use the correct account/card when making purchases, or even “accidentally” using the company account to deduct a personal expense as a business expense.
Small business owners who show a disregard for sufficiently tracking business and personal expenses may face greater scrutiny when audited and could even run the risk of their part-time gig being deemed a hobby rather than a business. Tax professionals know that the “hobby” classification can have extremely unfavorable consequences for a taxpayer.
Understand Multi-State Tax Issues
With the growth in digital marketing and increased ease in online retailing, it is becoming much easier for small businesses to interact with and provide goods and services to customers outside their domicile state. When it comes to small businesses with retailing activities, it is important to understand what the income tax, franchise tax, and sales tax implications are.
For income tax purposes, Public Law 86-272 (PL 86-272) provides many taxpayers with relief. Essentially, PL 86-272 limits a state’s ability to impose income-based taxes on the sale of tangible personal property. Thus, income tax can be avoided. This law, however, does not extend to franchise tax or sales tax. Though franchise tax may only result in a small amount of money, there are still returns to be filed, and taxpayers must be made aware of such filing requirements.
When it comes to sales tax requirements and online retailing activities, many states have imposed economic nexus standards in the wake of the Supreme Court’s Wayfair decision. This decision allows states to generally require an out-of-state seller to collect and remit sales tax on sales to in-state customers when the out-of-state seller has no physical presence in the consumer’s state.
Because of this, tax professionals and small business retailers need to work together to determine which states the business is interacting with and what the sales tax obligations are in each. Action can then be taken to file the appropriate registrations and returns with those states.
The process can be tedious, but it is an important step to ensure retailers are remaining compliant. Sales tax issues can spiral out of control quickly and become catastrophic to a small business.
PL 86-272 provides no protection to multi-state service activities, and the tax filing obligations depend entirely on whether the state the small business is in utilizes a cost-of-performance or a market-based sourcing approach. States utilizing a cost-of-performance approach source sales of services to the state where the service is performed, while states utilizing a market-based approach to source sales of services to the state where the customer receives the benefit.