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Small Business Tax

Business Start-Up Costs — What’s Deductible?

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Launching a new business takes hard work — and money. Costs for market surveys, travel to line up potential distributors and suppliers, advertising, hiring employees, training, and other expenses incurred before a business is officially launched can add up to a substantial amount.

The tax law places certain limitations on tax deductions for start-up expenses.

  • No deduction is available until the business becomes active.
  • Up to $5,000 of accumulated start-up expenses may be deducted in the tax year in which the active business begins. This $5,000 limit is reduced (but not below zero) by the excess of total start-up costs over $50,000.
  • Any remaining start-up expenses may be deducted ratably over the 180-month period beginning with the month in which the active business begins.

Example: Gina spent $20,000 on start-up costs before her new business began on July 1, 2020. In the 2020 tax year, she may deduct $5,000 and the portion of the remaining $15,000 allocable to July through December of 2020 ($15,000/180 × 6 = $500), a total of $5,500. The remaining $14,500 may be deducted ratably over the remaining 174 months.

Instead of deducting start-up costs, a business may elect to capitalize them (treat them as an asset on the balance sheet). Deductions for “organization expenses” — such as legal and accounting fees for services related to forming a corporation or partnership — are subject to similar rules.

Home Office Tax Tips

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Working from home can potentially deliver some attractive tax advantages. If you qualify for the home office deduction, you can deduct all direct expenses and part of your indirect expenses involved in working from home. Note, however, that qualifying for such deductions became harder under the Tax Cuts and Jobs Act of 2017 (TCJA). If you previously claimed a home office as a miscellaneous deduction on your individual income tax return, the TCJA eliminated that deduction for tax years 2018-2025. You must now file a Schedule C on Form 1040 to be eligible for the home office deduction.

What Space Can Qualify?

Direct expenses are costs that apply only to your home office. The cost of painting your home office is an example of a direct expense. Indirect expenses are costs that benefit your entire home, such as rent, deductible mortgage interest, real estate taxes, and homeowner’s insurance. You can deduct only the business portion of your indirect expenses.

Your home office could be a room in your home, a portion of a room in your home, or a separate building next to your home that you use to conduct business activities. To qualify for the deduction, that part of your home must be one of the following:

Your principal place of business. This requires you to show that you use part of your home exclusively and regularly as the principal place of business for your trade or business.

A place where you meet clients, customers, or patients. Your home office may qualify if you use it exclusively and regularly to meet with clients, customers, or patients in the normal course of your trade or business.

A separate, unattached structure used in connection with your trade or business. A shed or unattached garage might qualify for the home office deduction if it is a place that you use regularly and exclusively in connection with your trade or business.

A place where you store inventory or product samples. You must use the space on a regular basis (but not necessarily exclusively) for the storage of inventory or product samples used in your trade or business of selling products at retail or wholesale.

Note: If you set aside a room in your home as your home office and you also use the room as a guest bedroom or den, then you won’t meet the “exclusive use” test.

Simplified Option

If you prefer not to keep track of your expenses, there’s a simplified method that allows qualifying taxpayers to deduct $5 for each square foot of office space, up to a maximum of 300 square feet.

Contact us today to discover how we can help you keep your business on the right track. Don’t wait, give us a call today.

Defer Tax with a Like-Kind Exchange (aka 1031 Exchange)

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1031People who sell real estate at a gain often want to use the proceeds to purchase additional real estate.  However, people have to pay tax on the gain before they can use the proceeds to buy more real estate.  Often, they are surprised that they have to pay tax on the gain when they’re rolling the proceeds into more real estate.

Taxpayers in this situation can avoid paying tax immediately on the sale by entering into a like-kind exchange.  In a like-kind exchange, taxpayers exchange their property with another taxpayer’s property without cash exchanging hands.  If taxpayers can’t find another party to exchange properties with, multi-party exchanges (described in my next blog) can be structured.

Like-kind exchanges can include business for business, business for investment, investment for business, or investment for investment property.  Inventory, partnership interests, and stocks and bonds do not qualify for like-kind exchange treatment.  The term like-kind refers to the nature and character of the property and not to its grade or quality.  Real estate can be exchanged only for other real estate, and personal property can only be exchanged for other personal property.

A major benefit of like-kind exchanges is that the taxpayer can acquire new property on a pre-tax basis.

Example:  Suzy has property with a $100,000 cost and a $250,000 market value.  If she sells the property she will pay tax of 15% on her $150,000 gain, which amounts to $22,500.  After paying tax, Suzy only has $227,500 of the proceeds left to purchase new property.  If Suzy can enter into a like-kind exchange, she can defer paying tax and will be able to acquire new property worth the $250,000 value of her old property.

With a like-kind exchange, tax is deferred rather than avoided.  When a taxpayer exchanges a property, the original cost of the old property is applied to the new property.

Example:  Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000..  Andy owns Parcel 2, which he bought for $120,000 but is now worth $250,000.  They exchange properties.  Barney now owns Parcel 2, with a cost of $100,000 and a market value of $250,000.  Andy now owns Parcel 1 with a cost of $120,000 and a market value of $250,000.  Neither pays tax at the time of the exchange.  However, tax is not permanently avoided because Barney will have a taxable gain of $150,000 when he later sells Parcel 2 and Andy will have a taxable gain of $130,000 when he later sells Parcel 1.

To fully defer tax, no cash or assets other than the exchanged properties can change hands.  If cash (including relief from debt) changes hands, taxable gain may be recognized to the extent of cash and other assets received.  Cash and other assets received in a like-kind exchange are referred to as “boot”.

Example:   Barney owns Parcel 1 which he bought for $100,000 but is now worth $250,000.  Andy owns Parcel 2, which he bought for $120,000 but is now worth $230,000.  They exchange properties and Andy pays Barney $20,000 because his property is worthless than Barney’s.  Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 cash he received.  Andy’s exchange is still completely tax deferred because he received no boot.

Example 2:  Barney owns Parcel 1 which he bought for $100,000 but is worth $250,000. Assume Barney has a $20,000 mortgage on Parcel 1.  Andy owns Parcel 2, which he bought for $120,000 but is worth $230,000.  They exchange properties and Andy assumes Barney’s $20,000 mortgage.  Since Barney was relieved of the $20,000 mortgage, he has received boot.   Barney’s economic gain is $150,000, but his taxable gain is limited to the $20,000 mortgage relief he received.  Andy’s exchange is still completely tax deferred because he received no boot.

The basis of the new property is equal to the basis of the old property:

  • Plus boot paid
  • Less boot received
  • Plus gain recognized

For both of the above 2 examples, Barney’s basis in Parcel 2 is:

Basis of Parcel 1:              $100,000

Plus boot paid:                  $0

Less boot received:          ($20,000)

Plus gain recognized:          $20,000

Basis of Parcel 2:               $100,000

If Barney immediately sells Parcel 2 for $230,000, he will recognize a gain of $130,000 ($230,000 sales price less basis of $100,000).  When you add this $130,000 gain on sale to the $20,000 gain Barney recognized when he received the $20,000 boot, you have $150,000 which is the economic gain Barney had in Parcel 1.  Notice how the economic gain of $150,000 is taxed as Barney received cash of $20,000 during the like-kind exchange, and $130,000 when he sells Parcel 2 for cash.

For both of the above 2 examples, Andy’s basis in Parcel 1 is:

Basis of Parcel 2:               $120,000

Plus boot paid:                  $20,000

Less boot received:                   $0

Plus gain recognized:                 $0

Basis of Parcel 1:               $140,000

If Andy immediately sells Parcel 1 for $250,000, he will recognize a gain of $110,000 ($250,000 sales price less basis of $140,000).  This is the economic gain he had in Parcel 2.

 

The SEP-IRA: Just Right for Small Businesses

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Traditional pensions plans and 401(k)’s may not be appropriate for small businesses and the self-employed. However, that doesn’t mean there are no other options. Learn about the powerful and adaptable SEP-IRA.

An employer-sponsored retirement plan can be a great way for employers to show workers they care about employees’ long-term financial prospects while giving workers a way to save on their taxes.

A simplified employee pension (SEP) plan lets business owners and self-employed individuals use a simple way to make contributions for retirement savings. SEP-IRAs come with streamlined rules that make them less onerous to set up and administer than are 401(k) plans and more complex choices.

Let’s see how they work:

  • Employers are responsible for setting up SEP-IRAs for employees. Self-employed workers play the role of employer and employee.
  • SEP-IRAs resemble other types of traditional IRAs. Money put into a SEP-IRA isn’t included as income to the employer. (Employees themselves do not contribute unless, as noted, they are their own employers.)
  • Investments in a SEP-IRA are tax-deferred, meaning that you don’t have to pay taxes on any income or gains that those investments generate until you make withdrawals from the SEP-IRA.
  • Employers can contribute as much or as little as they want each year. There is a maximum, which usually changes each year. The current limit is 25 percent of an employee’s salary, up to $57,000. That’s much more than allowed for in alternatives like SIMPLE IRAs and ordinary individual retirement accounts. For high-income individuals, it’s hard to match what SEP-IRAs allow.
  • It’s easy to set up a SEP-IRA. Most financial institutions make the paperwork uncomplicated, and the IRS offers a standard form — Form 5305 — to establish a SEP-IRA.
  • But there’s one thing to keep in mind — if you’re a business owner, you generally can’t make huge contributions to your own SEP-IRA without making equal percentage contributions to employees’ SEP-IRA accounts as well.

In many ways, SEP-IRAs work just like a traditional IRA:

  • Withdrawal of funds prior to age 59½ may be subject to penalty and taxes, except in certain special circumstances.
  • You can’t borrow from a SEP-IRA as you can from many 401(k) plans.
  • You can roll your SEP-IRA assets into another IRA account.
  • You can roll assets from another retirement account into your SEP-IRA.
  • You must take required minimum distributions from a SEP-IRA beginning at age 72.

SEP-IRAs make it easier to help employees save for retirement. They have far fewer requirements than alternative pension arrangements. It could be a good move for your small business, even if you are the only employee.

However, the choice of a retirement plan at your business is an important one. The tax and financial implications can be substantial, and there may be other restrictions and provisions. Also, your decision can have a substantial effect on employee satisfaction. Consult with professionals to make sure you establish the right plan for your business.

Business Auto Deductions: Two Ways to Calculate

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Do you drive your car for business purposes? The costs of operating and maintaining your vehicle are potentially deductible.

Here are some guidelines.

Two Methods

The IRS provides two basic methods for computing deductions for the business use of an automobile.

Actual expense method. With the actual expense method, you deduct the actual costs of operation, including licenses, registration fees, garage rent, repairs, gas, oil, tolls, and insurance. Additionally, you may claim depreciation deductions (and/or elect expensing under Section 179). If the car is leased, you deduct your lease payments rather than depreciation. (Certain limits apply.)

Standard mileage rate. Alternatively, you may choose to use an IRS-provided standard mileage rate. With this method, you multiply the number of business miles you drive during the year by the applicable rate (58¢ per mile for 2019). When you use the standard mileage rate, you don’t separately deduct expenses such as gasoline, oil, insurance, repairs and maintenance, depreciation, or lease payments. However, business-related parking fees and tolls are separately deductible.

Which Should You Use?

Generally, you will want to use the method that produces the largest deduction. If your vehicle is costly to own and operate, th

e actual expense method may be more advantageous. Conversely, if your vehicle is fuel efficient and/or inexpensive, the simpler standard mileage rate method may be a better choice.

With either method, the IRS requires that you keep records that substantiate your business use of the car: the date, place, business purpose, and number of miles you travel. When you use the actual expense method, you’ll also need records substantiating the amount and date of car-related expenditures. You can avoid having to retain receipts by using the standard mileage rate.

If you decide to use the standard mileage rate for a car you own, you may switch to the actual expense method in a later year. However, you won’t be able to claim accelerated depreciation deductions for the car. With a leased car, you have less flexibility. If you choose the standard mileage rate the first year, you must use it for the entire lease period.

Personal and Business Use

If you use your car for both personal and business purposes, you must keep track of your mileage for each purpose.

To figure the percentage of qualified business use, you divide the business mileage by the total mileage driven. Then multiply that percentage by your total expenses.

Getting a Handle on Payment Issues

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Most small business owners love what they do. But that’s not to say things can’t get a little difficult, especially when customers don’t pay their bills on time. Even one or two slow-pay or no-pay customers can be enough to throw your company’s finances off.

Understanding what might be going on with your customers and being proactive can help you keep your accounts receivable on steady ground.

Purchase Order Predicaments

Not all customers use purchase orders, but those that do rely on them to coordinate ordering and accounts payable functions. If there’s a mix-up involving a purchase order and your invoice doesn’t match up with the customer’s purchase order, your invoice could end up on the “problem” pile instead of the “pay” pile. Be proactive by verifying that the purchase order numbers on your invoices are correct before they are sent.

Strapped for Cash

Lack of money is a common excuse for not paying. One reason your customer may not be able to pay you is because your customer’s customers haven’t paid their bills. Regardless of the reason, be the squeaky wheel and keep communicating with your past due customers.

You can help reduce your exposure to customer cash shortfalls by tightening your credit requirements.

Disputes, Dilemmas, and Other Disappointments

Misships, damaged goods, late deliveries. Plenty of things can go wrong during the fulfillment process. Rather than make a phone call, customers may just “file” your invoice at the bottom of the pile.

Follow-up e-mails or phone calls to find out if your customers are satisfied will help smooth any ruffled feathers and could improve how quickly you get paid.

Vanishing Invoices

“We never received your invoice” is a weak excuse, but you still have to find a way around it. Once again, early follow-up is key. Paperless billing and the potential to monitor whether e-mailed invoices have been opened can also help eradicate this excuse.

Don’t get left behind. Contact us today to discover how we can help you keep your business on the right track. Don’t wait, give us a call today.