LEARNING HOW TO PREPARE A PROFIT & LOSS AND LOVING IT
By. Elizabeth Gonsalves, ESQ.
A profit and loss is simply a spreadsheet setting forth your gross receipts (gross income) against your categorical business expenses for purposes of arriving at your net income, or “taxable income.” “Profit” is the gross income or gross receipts, the total of all raw income you received, while “Losses” are the costs of doing business, the “operating expenses.” I have seen complicated Profit & Losses and simple Profit and Losses, neither is better than the other. What counts is 1) that the gross income claimed is accurate (matches reported income and/or deposits into bank accounts), and 2) that all business expenses claimed are legitimate business expenses that are permitted deductions or expenses that a business can claim to arrive at net business income.
NEW INCOME – COMMINGLED ACCOUNTS
Don’t bother beating yourself up if you have commingled accounts, take the time to avoid commingling going forward. Stated simply, commingling is the act of mixing personal income and/or personal expenses with business income and/or business expenses or any combination thereof. The strongly advised practice is to keep business income and business expenses completely separate from personal income and personal expenses. The primary reason to separate them is not only because the IRS or state will judge you poorly as a business person – the primary reason is simple, keep them separate so you can track them separately and know where you stand with each, respectively. It goes without saying, you can only analyze your business, its earnings, its operating expenses and its return on investments, if you know what your business makes and what its spends. Only then can you determine how to optimize profitability. Further, knowing your taxable business income is imperative to calculating estimated tax before taking income for personal expenses. Commingled accounts require far more work from a tax representative and make it more difficult for the revenue agencies to determine what business expenses are incurred, what personal income is received and how personal income is used to pay necessary personal expenses. It is the government’s job to find income and in doing so, tax owed. It is the taxpayer’s burden to prove their deductions (i.e., legitimated business expenses) against income. Keeping a clear record of your income and the expenses you incur to earn that income are your responsibility as the taxpayer and bring you the benefit of reducing your taxable income. Keep these records organized for yourself. Its empowering.
Personal Income Distinguished
Personal income can be wages (which do not belong in a Profit and Loss) or pension income, or some other source of income that should be included on your personal income tax return in the income section of the tax return (page 1). Distributions from a corporation of which you are a shareholder are not personal business income. They are personal income from a partnership, corporation or entity and are claimed on line 17 of a federal income tax return. Business income is income earned by a sole proprietorship (which is a non-entity) or income received by a disregarded entity such as a single member LLC, or income earned by you – just you by yourself in your name. Line 12 is for reporting income from a personal business such as a sole proprietorship or a single member LLC. Personal business income is income reported on Schedule C (or Profit & Loss which is a part of a personal income tax return) the net income of which flows over to Line 12 on a personal income tax return. If you operate as a DBA or a single member LLC or just as yourself, then the income received is “business income” and is reported on Schedule C. For purposes of reporting income on a personal income tax return and for simplicity’s sake, “business income” when defined in relationship to a personal income tax return does not include income received from an incorporated entity. Business income, for our purposes of speaking about self-employed individuals is the income received from clients, patrons, vendors, employers, etc. in exchange for your goods or services or both when your business is not incorporated. A “doing business as” or “DBA,” or “Fictitious Business” is an example of a business that is not incorporated. As previously stated, a single member LLC is also a disregarded entity for tax purposes. A single member LLC is also reported on a Schedule C in a personal income tax return. No corporate return is required to report “business income.” This type of income is subject to estimated tax requirements and maintenance of records to track both income “profits” and business expenses “losses” for purposes of determining taxable income, which is that income you net after reducing your profits by your losses. If the IRS or state only receives reports of your gross earnings as an independent contractor it assesses tax based on a figure that has not yet been reduced (via a Schedule C) by business expenses. The tax assessed on gross income is almost always more than it would be if assessed against net income (profits left over after paying all business expenses).
New Income v. Re-Deposits of Income Previously Received
If you withdraw income from your business, then put it in a personal account (or keep it in cash in a safe place) and later re-deposit it into your business’s accounts due to cash flow issues, the re-deposited funds are not new income and should not be included in your tally of gross receipts. Gross receipts are only the original income received in exchange for your goods and services.
All businesses are not made the same. All business do not pay for the same expenses. The expenses your business can claim relative to the next business are roughly the same but vary depending upon your industry. Generally speaking, what you must spend to earn business income is a business expense – with several exceptions.
Costs of Goods Sold
Some businesses sell goods in addition to services, such as a plumber or a mechanic. The patron hires you to fix a broken alternator. They need to purchase an alternator through you, but they also need you to install it. There are parts and labor charges to the patron and in most cases there are parts and labor costs to the business providing the service. Both the parts and the labor are deductible, meaning the money you receive from the patron to pay for the parts and the service you provide are first reduced by your costs to supply the part and the worker you pay to install it, the amount left over is your net income on that particular transaction – your net profit. Obviously, you need to charge such that there is a net profit, unless you are a charity or are otherwise working in a not-for-profit capacity. This means you need to know how much you can obtain the part for, how much you must pay your worker to install the part, all while remaining competitive relative to other mechanics. It is not enough to know you can reduce your taxable income by these expenses, the goal is to profit despite these expenses. If you fail to claim any expenses (i.e., fail to file a return), then the IRS or state assume you simply made $400, without knowing you obtained an alternator for the patron and spent $150 on the part and paid your employee $45 to install the part in order to earn that $400. In this example you were paid $400, but you spent $195 to earn that $400. This means your taxable income on the transaction is $205, not $400. “Cost of Goods Sold” refers to the costs for goods you must purchase to conduct the business that you do. The cost of goods sold is 100% deductible. As a side note, when selling goods in a wholesale capacity there is no sales tax; however when selling goods in a retail capacity, sales tax may also be implicated as an additional “expense” or obligation that you must collect from a patron and deliver to the state. Your costs and the tax on retail goods sold must be built in to every transaction to insure a net profit is realized. Costs of goods sold are a deductible expense and should be carefully analyzed and tracked by maintaining a year-to-date profit and loss.
Salaries and Wages
Salaries and wages paid to employees are 100% deductible. An issue which arises with salaries and wages occurs more recently in the case of corporate shareholders taking distributions of income from their business without first paying themselves a “reasonable salary.” There is a trend, particularly with the IRS, of assessing payroll tax against corporate shareholders who have paid themselves distributions (draws from the corporation) only. A corporate shareholder should register themselves as an employee of the business and pay themselves a wage. The reason for these payroll tax assessments against shareholders is to discourage shareholders from paying themselves distributions to bypass employer FICA and FUTA taxes against their income. A shareholder may pay themselves a distribution in addition, but the better practice is to pay a regular wage to a corporate shareholder and pay out any other net profits intended for the shareholder at the end of the year as a single wage or bonus pay check which deducts income tax as well as FICA and FUTA taxes. In the case of sole proprietors, DBA’s and single member LLC, an owner need not pay themselves in wages, they may simply take income from their business provided all income tax and self-employment taxes have been paid first. A sole proprietor may write off as business expenses the salaries and wages they report and pay to staff, but they need not pay themselves as a wage earner.
Business rent is straight forward unless you work from home. This expense is relevant to preparing a Profit and Loss and is tricky in a beneficial way if you work from home.
Business Use of Home
Whether you rent your home, your apartment, or own your own home or condo, the calculation is the same and is extremely important to the bottom line. Any part of your personal home (be it rented or owned) that is exclusively used for a business purpose is deductible as a business expense. It is recommended that you establish a distinct area of your personal home that is to be used for business and business only. Put your printer, your fax, your supplies, your storage for the business materials, etc. in this area. If you have a second bedroom in your apartment, or a garage or spare bedroom in your home, it is best to use such a space as your business space. Honor the boundaries, not just for you but for tax purposes. Calculate the total square footage of your home. Let’s imagine its 1000 square feet. Now, calculate the total square footage of your home that is now exclusively used for a business purpose – the “office.” In this scenario, let’s imagine the office is 400 square feet of your home. Divide 400 by 1000 to arrive at the percentage of square footage of your home that is used for an exclusive business use. We come to 40%. This means 40% of your rent/mortgage is now a business expense. Likewise, 40% of your home utilities such as gas or electricity is a business expense and may be claimed as such on your Schedule C Profit and Loss. If you have a fax line, or special internet service for your business operations you can probably claim 100% of it, as you probably would not pay for this service unless there was a business need to have and use such equipment. Business Use of Home is claimed on form 8829 of your personal income tax return and is a business expense deduction on your Schedule C. Now, don’t start abusing this by including Hulu, Netflix and cable as a business expense unless you are in the entertainment industry. Be reasonable, be smart, be ethical, be strategic and you will be okay in claiming these expenses.
Mileage is a red flag for most revenue officers, collections agents and examiners. The best advice is to carry and maintain a mileage log of travel for business. Track the date you traveled in your personal vehicle, the number of miles you traveled and the purpose of the travel. It is also worthwhile to note that you may not claim travel commuting from home to your office. Business travel is travel to a destination you must visit to conduct business beyond your normal commute from home to office and office back to home. Business travel does not include travel from home to your office to conduct business.
For example, if you have an office but must visit sites to earn new clients, the travel from your office to the prospective client are business miles which should be recorded in a business mileage log. If you have a prospective client that is closer to your home than your office, thus you opt to travel from home to the client then back to your office, the miles to the client from home are business miles. Arguably the miles from the client to your office are also business miles; however, the miles from your office back home are not business miles, nor are the miles from home to your office the following day.
PAYING CURRENT TAX AS A KEY TO MINIMIZING PAYMENTS FOR BACK TAX
Perhaps the most important aspect of being self-employed is calculating your estimated taxes and submitting them timely. A key strategy to negotiating an installment agreement or an offer in compromise with either the IRS or the state is making a case for the current tax that must be paid and prioritized before discussing a dollar amount you can afford to apply to your past due balances. If you’re preparing to provide financial disclosure to the IRS or the state, it is probably best to get a professional opinion and strategy for how to proceed, but as a general rule in going through the financial disclosure process to arrive at a monthly payment or offer amount, it’s a good idea to beef up and pay your current estimated taxes, then circle back to calculating how much is really owed for the year once the resolution has been established. This is important for a second reason, any balance owed after the 15th of April the following year will cause any agreement put in place to default. If you’re going to go through the trouble of dealing with the IRS or the state, do everything in your power to make sure you don’t have to do so on a regular basis. Dealing with the IRS and the state is uncomfortable, unpleasant and puts you at risk for enforced collections which everyone knows (or has heard) is no fun.
CALCULATING YOUR ESTIMATED TAXES
Federal & State Personal Income Tax
It is really very difficult to calculate current taxes without the assistance of tax software, for this reason the self-employed are required to submit estimated taxes on a regular basis. As a general rule, and specifically for tax year 2014 (tax rates may change annually), a self-employed individual must first calculate at the end of each quarter (March 31st, June 30th, September 30th, and December 31st) their net income, as discussed above. Once you have arrived at your net income on a year-to-date basis (all income over the year must be analyzed on a cumulative basis given tax brackets are derived from total annual income figures), check the income tax table for the current year for both the IRS and the state. Tracking your net income using these tables will give you a sense of the total federal and state income tax you owe against the net income you have earned. Make sure you submit at least this amount (keeping in mind you may have paid a portion of the balance due in a previous quarter earlier in the year when your net income was lower).
Federal & State Self-Employment Tax
Yep, you have more tax to pay beyond your income tax. You must also pay self-employment tax to the federal government when you earn 1099 income. Self-employment tax is essentially the employee side and employer side of social security and Medicare tax on the federal level. For self-employment income earned in 2013 and 2014, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
For both 2010 and 2011, the first $106,800 of your combined wages, tips, and net earnings are subject to any combination of the Social Security part of self-employment tax, Social Security tax, or railroad retirement tax. The amount increased to $110,100 for 2012, $113,700 for 2013, and $117,000 for 2014.
All your combined wages, tips, and net earnings in the current year are subject to any combination of the 2.9% Medicare part of Self-Employment tax, Social Security tax, or railroad retirement tax.
In 2013 an additional Medicare tax rate of 0.9 percent went into effect and applies to wages, compensation, and self-employment income above a threshold amount received in taxable years beginning after Dec. 31, 2012.
If you use a tax year other than the calendar year, you must use the tax rate and maximum earnings limit in effect at the beginning of your tax year. Even if the tax rate or maximum earnings limit changes during your tax year, continue to use the same rate and limit throughout your tax year.
COMMON MISUNDERSTANDINGS ABOUT FILING AN EXTENSION
An extension to file your tax return only extends the deadline for filing a return. An extension does not extend the deadline for paying the tax owed. When considering an extension in any given tax year, particularly if you are self-employed, it is important to first calculate the tax owed for the previous year so the tax owed can be paid to the IRS and state by April 15th of the following year to insure you are not subject to failure to pay penalties. If you file an extension, then file your return by the extension deadline of October 15th of the following year you can safely forego the assessment of failure to file penalties. The point here is that there are several types of costly penalties which accrue at an alarming rate if left unchecked. Tax is always due for a given tax year by mid-April of the year following the tax year in question. If the full amount of tax is not paid to the federal or state agencies by this date, penalties will be assessed and a default of any payment plan or other resolution put in place prior to that date will automatically default.
LIFE GOES ON EVEN WITH A TAX LIABILITY
Tax is not death or grave illness. Its stressful, its scary and it can put a really good sized wrench in your future financial plans but it is not the end of the world and its not permanent. There is a ten year statute of limitations for collecting a federal tax debt. There is a twenty year statute for collecting a California state tax debt. Balances due will expire, there are several ways to get your problem under control by preventing future assessments and, most importantly, by recognizing there is usually a lot that can be done to make the balances owed manageable for you. An important point to note here is that tax is owed to government agencies, not private lenders like banks, automobile financiers or credit card companies. Because the IRS and FTB collect funds owed to a secured creditor, they are powerful and they can mess with your life far more easily than a private creditor can and they can do so without having to jump through as many hoops as a private creditor must jump to reach your assets against your will. For this reason, its important to be responsive and cooperative with the agencies. Of course, you also want to be tactful and strategic in navigating their collections rules. There is a plus side to dealing with a government creditor. Because they are a government agency, cooperation, even cooperation without an ability to make meaningful payments, is acceptable to the agencies. The IRS and the state are very responsive to a taxpayer who is reasonable and cooperative. There is a lot more that can be done for a cooperative taxpayer who has insufficient funds to pay the balances owed than would be available to a borrower unable to pay their mortgage to a bank. Assets can be preserved, life can be lived with reasonable comfort in most circumstances as long as the taxpayer is being reasonable. The first step is taking the initiative to understand how the liability happened, how it can be avoided in the future, and how to deal with it in between the two.
Should you have additional questions or believe you may need the benefit of professional assistance, please do not hesitate to contact me for a consultation regarding representation before federal or state revenue agencies.
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