CHAPTER 2
Getting Set Up for Tax Reporting and Business Operations

  1. Preliminaries
  2. Keeping Books and Records for Tax Reporting
  3. Business Reasons for Recordkeeping
  4. Tax ID Number
  5. Tax Year
  6. Accounting Method
  7. Decide Your Business Name
  8. What's Your IP?
  9. Obtain Licenses, Permits, and Permission
  10. What's Ahead

While you may conduct your personal financial life in a shoebox, sticking receipts and notes there for later reference by your tax preparer or you at tax time, you can't do the same for your business. The tax law requires businesses to keep books and records and to make them available to the IRS upon request.

Of course, good records aren't just for tax purposes. You can't run your business properly unless you can refer to records to know whether you're profitable, how your cash flow stands, and what you expect your upcoming expenses to be.

Once you set up a recordkeeping system that works for you, there are more steps to take to get started. To formalize your tax reporting, you need to make two decisions when you start your business activities: a tax year and an accounting method. For most self-employed individuals, the decisions are simple, but you still need to understand what these decisions mean to you.

Beyond your tax concerns, make sure you have the right licenses and permits to operate your business. Maintaining these licenses and permits is part of your ability to legally conduct business.

Preliminaries

In order to keep good records of your business activities, it's vital to separate your business life from your personal life. Be sure to set up a business bank account and obtain a business credit card; use both only for your business transactions.

Don't use your personal account or credit card for business activities. While you may think you'll remember which transaction is for business and which is for personal purposes, the reality is that you won't be able to do so when tax time rolls around. By then you'll likely have forgotten the reason for a particular expenditure at a restaurant—was it to host a prospective customer or wine and dine a friend?

There's another good reason to separate your business finances from your personal finances. If you have a loss for the year, the IRS may claim that your activities are merely a hobby and not a business, which can mean the loss becomes nondeductible (the hobby loss limitation is discussed in Chapter 4). One of the ways the IRS uses to determine whether you have a hobby is to check if you're running things in a businesslike fashion. This includes keeping a separate bank account as well as having a business plan to make a profit. If you've been using a single bank account for business and personal purposes, now is a good time to make a change and keep things separate.

Some self-employed people try to duck having separate accounts because of cost. Some banks charge more for business bank accounts than personal ones, with a slew of fees and charges for making deposits, writing checks, receiving paper statements, and using ATMs. Similarly, there may be added costs for business credit cards. Today, however, it's easy to find low- or no-cost business checking accounts and credit cards, if you shop around. Check sites such as Creditcard.com, LowCard.com, and NerdWallet.com to compare business credit card options. Linking a business account to a personal one in order to avoid monthly fees related to minimum balances is a good strategy for cost savings and won't adversely impact tax reporting.

Keeping Books and Records for Tax Reporting

There's good news and bad news. The good news: You don't have to be a numbers person or good at math to keep the types of books and records you need for your business activities. Today, there are numerous software and cloud accounting solutions. The bad news: You still have to do your books by inputting your numbers (or have someone do it for you, which may cost you money).

Software versus Cloud Solutions

The days of Bob Cratchit (from Dickens’ A Christmas Carol), where clerks made entries in paper ledgers, are long gone. While nothing says you can't use a paper ledger to record your income and expenses, today virtually everyone uses technology for bookkeeping purposes. It's easy to do, with little or no learning curve, and it's inexpensive. Many owners do their own books, but you can use someone to help you with this chore, such as a bookkeeping service or an accountant.

Which technology solution—software or cloud—is better for you? There's no single answer. You can make an informed decision as long as you know the facts:

  • Cost. Software is a onetime cost (which may be fully deductible, as explained in Chapter 6). Cloud solutions require a fixed monthly payment (which is also deductible). But the cost is modest (e.g., $5 per month for QuickBooks Online for Self-Employed). So do you want to buy or rent?
  • Updating. Software needs to be updated from time to time (usually done via downloads), and probably requires new purchases after a period of time. For example, at the end of May 2019, QuickBooks stopped providing support (including updates) for its 2016 version, effectively forcing users to buy the 2019 edition. Cloud solutions are automatically updated, with no effort or added cost on your part.
  • Backup. Software requires you to back up your data or risk losing it. Cloud solutions do not entail backup; this is done automatically because your data resides in the cloud.
  • Security. The jury is out when it comes to whether your data is more secure if you maintain it on your computer with backup or if the company you use for a cloud solution does. Either option can be secure as long as you take the right precautions.

In deciding which type of accounting solution to select, be sure to factor in your business needs. For example, if you want invoice tracking and certain other features, you may need to choose one product over another. Bottom line: Shop around.

Retaining Receipts

It's not enough to record an expense in your accounting system. For tax purposes, you also need a paper trail. This means keeping paper receipts for your business expenses. You can opt to eliminate some of the paper by scanning receipts into your computer for safekeeping or using a scanning service, such as Shoeboxed.com. Scanning may also help you organize your business receipts more effectively than a simple expandable file or shoebox. There are numerous apps you can use for this purpose, such as Expensify, Neat, Receipts by Wave, and Scan Genius.

Other Recordkeeping

For certain types of deductible business expenses, you must keep a diary or other record of certain information. This additional recordkeeping is required for travel, meals, gifts, and vehicle expenses (see Chapter 5). If you don't follow the recordkeeping rules and the IRS questions your return, you may lose out on otherwise legitimate business expenses. You can use a log based on an IRS sample, which has been adapted in Worksheet 2.1.

Fortunately, today there are many apps for mobile devices that you can use to meet this additional recordkeeping requirement. There are apps that effectively create electronic expense accounts where you can add the required tax information. There are apps for tracking the mileage of personal cars, trucks, and vans used for business. Many apps are free; the cost of any paid apps used for business is tax deductible.

Business Reasons for Recordkeeping

Tax reporting isn't the only reason why you must keep good books and records.

  • Tracking your profitability. Are you making or losing money? You may not be able to know for sure without good records. Money may be flowing in, but if you don't have a handle on expenses, you may be losing money on every job you do!
  • Generating financial statements. You may need to produce financial statements for third parties from time to time. If you apply for a personal mortgage on a residence, as a self-employed person you'll likely be asked for a profit and loss (P&L) statement and other business-related financial information. Similarly, if you apply for a business loan, you'll surely have to present financial statements as a condition of obtaining the loan. And if you seek outside investors, they will want to see financial statements to know what they're getting into.

When you use software or cloud-based accounting, these financial statements are a click away. You don't have to create the statements manually; the program does it for you based on the income and expenses you've entered.

Tax ID Number

On your personal tax return, you use your Social Security number (SSN) as your tax identification number (TIN). As a self-employed person, you may be able to use your SSN as your TIN as well. However, you may not be able to or want to in some situations.

Instead of using your Social Security number, you can obtain (at no cost and in just a few minutes) a federal employer identification number (EIN). An EIN is a nine-digit number assigned by the IRS; usually the number can also be used for state tax purposes. You can use an employer identification number even though you aren't an employer and don't have any employees.

Worksheet 2.1 Additional Records Needed

THEN you must keep records that show details of the following elements …
IF you have expenses for … Amount Time Place or Description Business PurposeBusiness Relationship
Travel Cost of each separate expense for travel, lodging, and meals. Incidental expenses may be totaled in reasonable categories such as taxis, fees and tips, etc. Dates you left and returned for each trip and number of days spent on business. Destination or area of your travel (name of city, town, or other designation).

Purpose: Business purpose for the expense or the business benefit gained or expected to be gained.

Relationship: N/A
Gifts Cost of the gift. Date of the gift. Description of the gift.
Transportation Cost of each separate expense. For car expenses, the cost of the car and any improvements, the date you started using it for business, the mileage for each business use, and the total miles for the year. Date of the expense. For car expenses, the date of the use of the car. Your business destination.

Purpose: Business purpose for the expense.

Relationship: N/A

Source: IRS Publication 463.

  • You must use an EIN (and can't use your SSN) if you:
    • Maintain a staff. You need the EIN for employment tax purposes.
    • Have a qualified retirement plan. If you set up a profit-sharing or other retirement plan to shelter your profits and save for retirement (see Chapter 8), you must obtain an EIN for this purpose.
    • Open a bank account. When you set up your business bank account, you may be required by the bank to have an EIN. Of course, some banks permit the use of your SSN for business accounts.
  • You may prefer to use an EIN:
    • To further separate your business life from your personal life.
    • For identity theft protection. As a self-employed person, you will be asked to provide a TIN for any business for which you perform services. This enables your customer to issue you Form 1099-MISC (after 2019, Form 1099-NEC) to report to you and to the IRS what you've been paid. Technically, these 1099s are required only if you receive $600 or more from a single customer or client in the year but you'll be asked for your TIN because the business may not know up front what you'll be paid in total for the year. Using an EIN protects your SSN and your personal identity.

Obtaining an EIN

You can do this yourself (you don't need an accountant or lawyer for this purpose) by going to the IRS website, IRS.gov, and searching “Employer ID number.” Select “apply online” to access an interview-style application. This online option gives you an EIN immediately and is available weekdays 7 A.M. to 10 P.M. ET.

Alternatively, you can fill in Form SS-4, Application for Employer Identification Number, and mail it to the IRS service center listed in the instructions to the form. Using mail can take several weeks.

Did you know …

Another business number you may want to get once you have your EIN is a DUNS number. This is a free nine-digit number assigned to you by Dun & Bradstreet at https://www.dnb.com/duns-number.html. Having a DUNS number is important for various purposes. It enables companies to check you out to see if they want to do business with you. It also expedites getting an SBA disaster loan should you ever need one (see Chapter 7).

Tax Year

The vast majority of self-employed people report their income and expenses on a calendar-year basis. This means their tax year runs from January 1 through December 31 each year. It's the same time period you use for your personal income taxes, so there's nothing new here.

In the first year of business you will have a short tax year unless you open your doors on January 1. Say you start your business on May 15 and report on a calendar-year basis. Your first tax year will run from May 15 to December 31. The same is true for your final year of business; it, too, will be a short year unless you wind up things on December 31. If you close your doors on August 8, your tax year runs from January 1 to August 8.

Even though the calendar year is the most popular accounting period and is the default tax year if no special action is taken, there are some self-employed individuals who do not use it for their tax reporting. Instead, they use a fiscal year, which is a tax year ending on the last day of any month other than December (e.g., March 31; June 30). Why do this? It may make business sense if there is a natural ending to your business cycle other than December 31.

Example

You're a wedding planner whose sales peak in June each year. You can adopt a fiscal year ending June 30 so that you can close your books at the end of June and go on vacation. Your fiscal year in this case starts July 1 and ends June 30.

If you want to learn more about a fiscal year, see IRS Publication 538, Accounting Periods and Methods.

Throughout this book it is assumed that you are reporting on a calendar year and all examples and strategies will be based on this assumption.

Accounting Method

An accounting method is a set of rules that you use to determine when and how much to record of your income and expenses on your books and for tax-reporting purposes. There are two main accounting methods: cash method and accrual method. Most self-employed individuals who are service providers use the cash method.

Cash Method

This method of accounting is the simpler of the two main accounting methods and is rather intuitive. Under the cash method, you report income when it is actually or constructively received. Actual receipt is the time when you have the income in your hands; constructive receipt is when it's under your control so that you can reduce it to actual receipt.

Example

You are a freelancer who sends a bill on June 20 for $1,000 for services performed on June 17. You receive a check in the mail on July 15. You deposit it into your bank account on July 16. You record the check as income on July 15. This is the date you constructively received payment because you have control over the funds. The fact that you didn't make the deposit or cash the check until a later date is irrelevant.

If a check you receive as payment for services you performed bounces, you don't have to report it as income at that time. It only becomes income when the check is later honored.

You may face a problem at year-end. Say you do work in December 2019 and send an invoice late in the year. You receive payment in January 2020. Under the cash method of accounting, you are required to report the income in 2020, the year of actual receipt. However, the customer or client may have sent the payment in December so that the 1099 reflecting the payment is issued for 2019. What do you do?

While the income is not taxable to you until 2020, you must report it on your 2019 return because IRS computers that match information from 1099s to 1040s will be watching. However, you can make a subtraction on your 2019 return to eliminate this income. Be sure to pick it up on your 2020 return, even though you won't receive another 1099 for this amount.

Like income, on the cash method of accounting you book your expenses when and to the extent they are paid. However, for tax purposes, even though you've made the outlay, you won't necessarily be able to claim a deduction because of tax law limitations.

Prepayment Rule

Advance payments, or prepayments, may be subject to restrictions that prevent you, as a cash method taxpayer, from making a big payment up front in order to generate a big write-off. Generally, prepayments that do not extend beyond 12 months are currently deductible. However, prepayments for items that extend beyond this period are deductible only over the period to which they relate.

Example

You have a subscription to a trade magazine. In November 2019, you renew for one year. You can deduct the full cost of the subscription in 2019. However, if in November you renew for three years, you'll have to spread the deduction for the subscription over this period; only one-third will be deductible in 2019.

Interest that is prepaid, such as points to obtain a mortgage on business property, is not deductible in full in the year of payment even if you're on the cash method. Instead, the points are deducted evenly over the term of the mortgage. Divide the points by the number of months that the mortgage runs and then deduct the portion for the year in which the mortgage was obtained.

Example

In January you pay points of $2,400 for a commercial mortgage you obtain when you buy a small office building. In the first year of a 20-year mortgage, you can deduct $120 ($2,400 ÷ 240 months × 12 months).

Each year thereafter, you can deduct 12 months of the portion of the points, which in this example is $120 each year. If you pay off the mortgage before the end of its term, you deduct the balance of the points in that year.

If you make a deposit or advance payment, it may not be currently deductible. For example, if you give a security deposit to the landlord for your office space and the deposit is refundable, you cannot take a deduction when you give the landlord the check. On the other hand, if the deposit is nonrefundable, it is a payment (even though called a deposit) and you can deduct it when you make it.

Other Accounting Methods

While most self-employed service providers use the cash method, it's helpful to understand that there are other accounting methods used by different types of businesses. These include:

  • Accrual method. Under this method, which is typically used by large businesses, you report income when it is earned, rather than when it is received. Similarly, you deduct expenses when they are incurred rather than when they are paid. Two tests are used to determine whether there is a fixed right to receive income so you can accrue it and whether an expense is treated as having been incurred for tax purposes so you can accrue it: all-events test (all events have transpired to fix the income and set the liability) and economic-performance test (you have provided the services giving rise to the payment).
  • Percentage-of-completion method. This accounting method is used by builders and contractors where the work cannot be completed within one year. Under this method income and expenses are estimated while the work is in progress and a percentage of these items is reported until the contract is completed.
  • Installment method. Regardless of which accounting method you use for your regular business activities, you may also use the installment method to report gain on the sale of business property. The method applies to an installment sale unless you elect not to have it apply. Under the installment method, you spread the reporting of gain over the period in which sales proceeds are received. However, any gain related to depreciation recapture (based on prior depreciation deductions) is taxable up front.

Decide Your Business Name

Shakespeare, in Romeo and Juliet, asked, “What's in a name?” The answer for business purposes is a lot. Your name is a key marketing tool to help create a brand in the mind of the public. Your name becomes your brand.

Many self-employed individuals simply use their own name and do not create any fictitious name for their business. This is fine and works well for consultants, freelancers, Uber drivers and other platform workers, and certain other self-employed individuals whose business is indelibly connected with them, their skills, and personality.

Other self-employed individuals may prefer to use a fictitious name. Before you select a name, which will appear on your business card, promotional materials, website, Facebook page, and every other business communication, think long and hard about your choice. In making your selection, decide:

  • Whether the name is available for use. If the name is already being used by a competitor, don't use it, even if you're legally able to. If the name is being used by a business that's in a different industry than yours, you may be able to use it, but it's not a good idea because web searches may turn up the other business, not yours. If you plan to incorporate in the future, you are barred from using any name that's already been taken by a business in your state, regardless of industry. As a local business, check on Yelp and other local search sites, or check your state filing office, to learn if the name has already been claimed by another business. As a national business, search through Bing or Google and see what comes up under your proposed name.
  • What the name says about you. Think about the name and its meaning, and whether it will serve your marketing goals. You can make up a name (such as Google or Yahoo), use a descriptive name (such as American Telephone and Telegraph, which is AT&T), or use your own name with some additional description (such as Amy Johnson Business Consultants). If you use a word, learn how it translates in other languages so you won't offend or confuse anyone. Best strategy: Keep it short, strong, and easy to spell.
  • Whether the name can become your domain name. If you plan to have a website for your business, check whether the name you're considering is already in use. Use name search tools at Register.com or GoDaddy.com to see if the name is in use (or available for purchase if you want to go this route).
  • Whether the name can be trademarked. See ahead.

You can get creative yourself or use online name generators, such as NameFind.com or Oberlo.com, to help. When you've selected a tentative name, ask friends and family what they think before you move forward and invest money under a name.

Legally, a fictitious name is called a DBA, which means “doing business as.” This requires you as a self-employed person to register your name with your city or county. The process is easy and inexpensive. You can do it yourself and don't need a lawyer for this action. Contact your county for details on the DBA registration process.

Did you know …

You can't put the term Inc., Corp., Ltd., or LLC after your name unless you have legally formed the relevant entity—a corporation or limited liability company—in your state. These designations are intended to inform the public that they're doing business with an entity in which the owners have no personal liability. Other businesses, such as a sole proprietorship, have no special designation after their name because the owner is personally liable for the debts of the business.

What's Your IP?

IP is shorthand for intellectual property. While you can't see or touch intellectual property, it is a valuable asset for your business. It is estimated that in 2019 Google's portfolio of trademarks (a type of IP discussed below) has a worldwide value of $44.3 billion. Even though your IP isn't worth that much, you need to identify what it is and how to protect it. The four types of IP are:

  1. Patents. A patent is an exclusive right to market an invention, formula, or new process for a set number of years. This right is obtained through the U.S. Patent and Trademark Office at uspto.gov. Obtaining protection is pricey, costing upwards of $25,000, and it can take years to secure. Depending on the item involved, keeping it as a trade secret as explained below (like Coca Cola's soda formula and the Listerine formula) can be a good alternative. Even if you do some preliminary legwork, like a patent search through the U.S. Patent and Trademark Office, you should use an experienced patent attorney to help you through the registration process.
  2. Trademarks. A trademark is a protection for a logo, slogan, or even a business name that is also obtained through the U.S. Patent and Trademark Office. (Big Ideas for Small Business® for a monthly e-newsletter and Idea of the Day® for a daily tip delivered by email are registered trademarks of Big Ideas for Small Business, Inc.) This protection, which lasts as long as you protect it and don't let it fall into generic use, can cost a few hundred to a few thousand dollars. You may be able to do it yourself inexpensively through sites such as LegalZoom.com (or at least do some initial searches through sites such as USPTO.gov), but it's safer to use an attorney for this important asset.
  3. Copyrights. A copyright is protection for original works of authorship, including literary, dramatic, musical, and artistic works, computer software, and architecture, for the life of the creator plus 70 years. Protection is obtained through the U.S. Copyright Office at copyright.gov. The cost of this protection is minimal and you can probably do it yourself.
  4. Trade secrets, customer lists, processes, and so on. This is confidential information, such as the KFC formula, that you treat as such. You don't obtain protection from the government; you have protection because you keep the information confidential.

Strategies for Protecting IP

Initial steps to secure protection are not sufficient to maintain protection. For example, if you've registered your trademark, you must patrol the Internet regularly to make sure it isn't being used without your authorization. Send a cease-and-desist letter to violators. If you fail to do this, the trademark can fall into generic use (as happened to the Allen wrench, bubble wrap, linoleum, pilates, yo-yo, and zipper), and you'll lose protection.

Obtain protection abroad if your business warrants it. Recognize that a U.S. patent or trademark does not automatically establish rights abroad; you may need to obtain protection in other countries and this can be very costly. There are numerous resources to help you understand global patent protection, which you can find at USPTO.gov.

To protect your trade secrets, treat this confidential information as confidential. Restrict access to this information by anyone using your computer, files, and other storage locations. Use lock-and-key where appropriate. When you eventually hire an employee, have him or her sign a nondisclosure agreement. Continually monitor secrecy of your valuable trade secrets.

Obtain Licenses, Permits, and Permission

You can't operate legally unless you obtain the licenses and permits required for your particular operation. You may not even be aware of the need for certain permission, but if you fail to get it you can expose yourself to penalties and lawsuits. Here are some licenses, permits, and permission you may need to legally run your business. Make sure you have your ducks in a row before opening your doors for business.

Government Licenses and Permits

Depending on what you do, you may have to obtain licenses or permits from your state or local government to operate your business. Some licenses are issued by the federal government (e.g., U.S. Department of Agriculture license for transporting animals or plants across state lines). Most licenses and permits are on the state or local level. For a professional, such as an accountant or attorney, you need to meet testing and continuing education standards to maintain a professional license issued on the state level. Other occupations, such as bill collectors and private investigators, also require licenses. New York, for example, has hundreds of services and occupations that require licensing. A landscape contractor in a New York City suburb may have to obtain up to 14 different licenses to operate. Licensing is a way not only to help regulate business practices to protect the public, but also to raise revenue for the government.

Check your state to determine your licensing requirement. Find a link to your state through the Small Business Administration (SBA.gov; search “state licenses and permits”).

Software Licenses

When you buy software, you have the right to use it on a set number of computers. If you use it for more than the permissible number, this is software piracy. Software piracy also results when software is copied and used by someone who has not directly purchased the software. Besides the fact that it's illegal (with severe civil and criminal penalties) and unethical to do this, pirated software doesn't have tech support and is vulnerable to malware attacks. Read your licensing agreement (that little “agree” box that many people check automatically).

IP Permission

If you want to use certain protected intellectual property, you may need permission from the property owner. If, for example, you want to use someone's copyrighted work in your sales materials (e.g., a photo from Shutterbox), determine whether you need permission to use it; if so, get that permission. If you want to use a company's design for your product, again permission may be necessary.

What happens to an infringer? Any or all of the following can result:

  • A temporary restraining order or injunction (preliminary or permanent) to prevent or stop infringement can be issued.
  • Actual damages plus additional profits of the infringer or statutory damages can be required.
  • Liability can be imposed for injury to business reputation or the dilution in the value of the copyright, patent, or trademark, plus costs and attorneys’ fees in some cases.

When in doubt, consult an attorney specializing in intellectual property.

What's Ahead

Now you know how to get started so you can properly report your income and expenses to the government and have the financial information at your fingertips if you need it to check on profitability, apply for loans, seek investors, or for other purposes. You also know that licenses, permits, and IP protection should be attended to. Next, you'll get an overview of your business return, called Schedule C.

Chapter Takeaways

  • You must keep good books and records.
  • You need more than accounting programs, such as receipts and certain written records, for tax purposes.
  • You'll probably use a calendar year and the cash method of accounting to report your income and expenses.
  • You may need a separate EIN for tax reporting, instead of using your Social Security number.
  • Protect IP with government registration and/or your own vigilance.
  • Obtain licenses and permits to operate within the law.
..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset