Here are our learning objectives for lesson one.
By the end of this lesson you will be able to: explain the purpose of an employer identification number, describe basic recordkeeping requirements for tax purposes, define basic bookkeeping and accounting methods and terms, list the forms of business organizations, select a paid tax preparer.
As a business owner you may be required to get a Federal Employer Identification Number or EIN.
The EIN identifies tax returns filed with the IRS.
If you don't have an EIN you need to get one if you: pay wages to employees, have a self-employed retirement plan, operate your business as a corporation or partnership, or are required to file any of these tax returns, employment, excise, fiduciary, or alcohol, tobacco, and firearms.
If you're a sole proprietor with no employees and don't meet any of these requirements you don't need an EIN for dealing with the IRS.
But you may need one for dealing with other businesses including banks that require an EIN to set up business accounts.
The IRS will give you an EIN even if you don't need it for IRS purposes.
Let's look at the application process.
The easiest and fastest way to get an EIN is online.
Just go to irs.gov, keyword EIN and complete the form, you'll get your EIN within minutes.
While the IRS calls this a provisional EIN, the IEIN is actually the permanent federal employer identification number for your business.
This IEIN may be cancelled if, the name and social security number of the principle officer do not match the social security administration records or your business already has an EIN.
The next topic we need to discuss is recordkeeping.
You must keep receipts, sales slips, invoices, bank deposit slips, cancelled checks, and other documents to substantiate items of income, deductions, and credits.
Recording these items will help you pay only the tax you owe.
Good records can help you identify sources of receipt, you may receive cash or property from many sources.
Unless you have records showing the sources of your receipts you may not be able to prove that some are non-business or non-taxable.
Prevent omission of deductible expenses.
You may forget expenses when you prepare your tax return unless you record them when you pay them.
Establish earnings for self-employment tax purposes.
Your records should show the amount of earnings reportable for self-employment tax purposes.
Self-employment tax is explained later when we talk about business tax returns, and explain items on your income tax return.
If IRS examines your income tax return you may be asked to support the entries on your return with sales slips, invoices, receipts, bank deposit slips, cancelled checks and other documents.
These items of support are necessary for you to have adequate and complete records.
Recordkeeping rules require that you keep adequate documentary records or sufficient evidence to support your own statements.
Make sure you keep receipts and a log or diary for: deductions you take for travel, transportation, entertainment and business gift expenses, and any deduction you take for certain business property.
Your records must support the claimed amount, the time and place, the business purpose, and your business relationship to any other persons involved.
If your records are incomplete they may not support your deductions.
If you lose your records due to circumstances beyond your control such as by flood or earthquake, you may substantiate a deduction by reasonable reconstruction.
May I get a receipt please?
Let's see, amount $24, time 4:30 p.m., location, International Airport.
Business purpose, new product meeting.
Business relationship, client.
For more information about recordkeeping see Publication 583, Starting a Business and Keeping Records.
Always keep your business records available for examination by the IRS.
How long do I have to keep all this stuff?
You must keep your records as long as their contents may be material in the administration of any Internal Revenue Service law.
Usually the statute of limitations for an income tax return expires three years after the return is due or filed or two years from the date the tax is paid, whichever is later.
To support items of income or deduction on your tax return, you must keep records until the statute of limitations for that return expires.
But in many cases you must keep records indefinitely.
For example, if you change your method of accounting, records supporting the necessary adjustments may be material for an indefinite time.
Another example, you must keep records relating to the basis of property for as long as they are material in determining the basis of the original or replacement property.
That's a lot to remember.
Is it written down anyplace?
You can find records retention timeframes in Publication 583, table 3.
As with most IRS publications you can access Publication 583 at irs.gov.
And if you have employees, then you have to keep employment tax records too.
You must keep all employment tax records for at least four years after the date on which the tax return becomes due or the tax is paid, whichever is later.
Need more information?
Publication 15, Employer's Tax Guide has answers to most employer tax questions.
A copy of your most recent return helps you compute and prepare future tax returns.
If you need to correct what is on file the copies help you prepare an amended return and for the benefit of your heirs, previously filed tax forms may be helpful to the executor or administrator of your estate.
Now onto our next topic.
Bookkeeping systems.
Many people who operate their own one person business never bother to set up a business bookkeeping system.
Their personal checking account serves as both a personal and a business account.
The IRS recommends that you open a separate business bank account.
There are two types of bookkeeping systems, single entry, and double entry.
The single entry system is the simplest to keep.
With the single entry system you record a daily and a monthly summary of business income and a monthly summary of business expenses.
Single entry is not a complete accounting system but it shows income and expenses in sufficient detail for tax purposes.
The system focuses on the businesses profit and loss statement and not on its balance sheet.
The more complicated double entry system has built in checks and balances and is more accurate than the single entry system.
The double entry system is also self balancing.
Since all business transactions consist of an exchange of one thing for another, double entry bookkeeping is used to show this two fold effect.
If you want to learn more check with your local library.
Once you select a bookkeeping system you'll also need to select an accounting method.
Your accounting method is a set of rules that you use to decide when and how you report your income and expenses.
The two most commonly used accounting methods are the cash method and the accrual method.
On your tax return you must use the same accounting method you used to keep your records.
Under the cash method you report all income in the year you receive it.
You usually deduct expenses only in the tax year in which you pay them.
Under the accrual method you report income in the year you earn it regardless of when you receive the payment.
You deduct expenses in the tax year you incur them, regardless of when you pay them.
Businesses that have inventory for sale to customers must generally use an accrual method for sales and purchases.
My business takes me to rural America.
I find and purchase American quilts and sell them to big city art galleries.
Some of the quilts are contemporary and some of them are over 100 years old.
In this business you make sales on account.
Customers pay 45 days after delivery.
I use an accrual method of accounting.
I record the sale in the month when I ship the quilt even though I don't receive payment until after the following month.
Robert knows how to apply the accrual method of accounting.
He records revenue when he earns it, that is when he ships the quilts.
On the other hand if Robert recorded the revenue when he received it, he would be on the cash method.
For more information check out Publication 538, Accounting Periods and Methods.
Now, for some good news, there are bookkeeping and accounting computer software packages.
These packages are very useful, relatively easy to use and require very little knowledge of bookkeeping and accounting.
But be careful, if you use software you must be able to produce records from the system to support what is on your tax return.
Always keep a backup copy in a safe place.
Now let's learn some useful business terms that help you describe what's going on in your business.
The first one is income statement.
An income statement gives an overview of your company's revenues, costs, and profitability.
The next term is cash flow analysis.
A cash flow analysis is a detailed monthly account of how money flows into your business as income and flows out of your business as expenses.
Subtracting expenses from receipts gives you a monthly result of how well your business is doing.
Now let's review what you've learned.
It's the end of August, I spent all month pulling together my records and updating the books.
Then I prepared my financial statement just in time.
The bank asked to see the income statement and balance sheet.
They wanted to make sure that I could pay back my loan.
Imagine that, I've had a loan with the same bank for two years and I never missed a payment.
I think it's strange that they insist on reviewing my financial statements.
Don't you think they could just trust me?
Maria isn't considering the bank's point of view.
The bank manager wants to make sure Maria can continue to make her payments in the future.
The manager will review the income statement to see if the business made a profit.
Then the manager will analyze the assets and liabilities on the balance sheet.
Early in the life of your small business you decide on the structure of ownership.
There are five types of business organizations, sole proprietorship, partnership, limited liability company or limited liability partnership, S corporation, and corporation.
Let's look at the advantages and disadvantages of each.
A sole proprietorship is an unincorporated business that one person owns.
It is the simplest type of business organization, the business does not exist apart from the owner.
The owner assumes the risks of the business to the extent of all their assets, even if they don't use their personal assets in the business.
Usually the ability to finance the business, known as capital, is limited to whatever the owner can come up with.
This may limit the expansion of a business when new capital is required.
A common cause of failure for sole proprietors is lack of capital.
Limited capital makes it harder to operate a start up when profits are usually low.
During an economic rough spot it's harder to stay in business when your capital is limited.
A sole proprietor files their taxes using either Schedule C or Schedule C EZ, Net Profit From Business.
They include schedule C with their form 1040 to report their profit or loss from operating their business.
The sole proprietor also files Schedule SE Self-Employment Tax to report the social security and Medicare taxes on net profits of the current year's threshold.
We'll talk about self-employment tax later.
The second type of business organization is a partnership.
A partnership is a relationship between two or more persons who join together to carry on a trade or business.
Each person contributes money, property, labor or skills.
Each expects to share in the profits and loss of the business.
Any number of persons may join in a partnership.
The advantages to a partnership are: it is easy to organize, it may have greater financial strength than a sole proprietorship, it combines managerial skills and judgements of the partners, it has a definite legal status, and each partner has a personal interest in the business.
The disadvantages to a partnership are: the liability of the partners is usually unlimited, each partner may be held liable for all the debts of the business, therefore if one partner does not exercise good judgement, that partner could cause not only the loss of the partnership's assets, but also the loss of the other partner's personal assets.
And decision authority is divided.
Partnerships report profits or losses from operations on Form 1065 US Partnership Return of Income.
Form 1065 summarizes the business activity of the partnership.
A partnership does not pay tax on income from daily operations.
All income, losses, deductions, and credits generated by a partnership pass through to the partners.
The partners report the items on their personal income tax returns.
Each partner gets a schedule K1, income expenses and credits flow from schedule K1 to form 1040.
If you need more information about partnerships check out Publication 541, Partnerships and the instructions to forms 1065 and 1040.
The third type of business entity is a limited liability company, LLC.
This is a relatively new business structure allowed by state statute.
LLCs are popular because similar to a corporation owners have limited personal liability for the debts and actions of the LLC.
Other features of LLCs are more like a partnership, providing management flexibility and the benefit of flow through taxation.
For federal income tax purposes, an LLC may be treated as a sole proprietorship, a partnership or a corporation.
If you want to tell the IRS how you want your business to be treated for federal income tax purposes, file a form 8832, entity classification election.
If you don't file form 8832, IRS will treat your business as a partnership if it has two or more members, and as a sole proprietorship if it has a single owner.
And that means what?
In other words if you have a business of two or more people you're automatically classified as a partnership for federal tax purposes.
If you are a one person business you're automatically classified as a sole proprietor for federal tax purposes.
So if I don't do anything my business will be classified anyway?
Of course there are instructions with the form that explain the classifications and exactly how to fill it out and if you disagree with the default classification you can file a form 8832 to request a change.
Okay, let's move on.
The fourth business entity is the S corporation.
An S corporation is a small business corporation whose shareholders elect to have corporate income taxed like a partnership.
Partnerships are taxed once, corporations are taxed at the corporate level.
Then when the income is distributed as dividends it is taxed again at the shareholder level.
Organizing shareholders of a corporation who wish to avoid double taxation can file form 2553, election by a small business corporation to be recognized as an S corporation.
This election must be submitted by the 15th day of the 3rd month of the 1st S corporation year.
For example if your 1st S corporation tax year begins on January 1st, you must submit form 2553 by March 15th otherwise the election is effective for the next tax year.
IRS sends you a CP261 notice, notice of acceptance as an S corporation to let you know we have received and approved your election.
You should receive your approval within 60 days.
If you do not, contact the IRS campus where you filed your 2553.
The instructions for form 2553 have more information.
An S corporation does not pay tax on income from daily operations.
All income, losses, deductions and credits generated by an S corporation pass through to the corporate shareholders.
The shareholders report the items on their personal income tax returns.
However, there are situations where an S corporation is subject to an entity level tax.
S corporation officer shareholders who provided services to their corporation are employees.
Their compensation is subject to employment taxes.
By law officers of corporations are employees for employment tax purposes and their compensation is wages.
An S corporation must pay reasonable compensation to a shareholder employee in return for the services the employee provides the corporation before a non-wage distribution may be made to that shareholder employee.
In other words they have to be compensated or paid first.
Then they get the distribution.
An S corporation has the combined advantages and disadvantages of the partnership and regular corporations.
S corporations file form 1120S, return for an S corporation.
The S corporation provides each shareholder a K1, Form 1120S, Shareholders Share of Income, Credits, Deductions, etc.
The shareholder uses the schedule K1 to complete part II of schedule E, form 1040 and any other forms and schedules the shareholder must file with their individual return.
Okay, now for the last type of business organization, the corporation.
The law treats a corporation as a legal entity.
It has a life separate from its owners and has rights and duties of its own.
The owners of a corporation are the stockholders.
In case you're wondering, one person can be a corporation.
The managers of a corporation may or may not be stockholders.
Forming a corporation involves the transfer of money or property or both by the perspective shareholders in exchange for capital stock in the corporation.
For the purpose of federal income tax, corporations include associations, joint stock companies, and trusts, and partnerships that actually operate as associations or corporations.
The advantages of a corporation are: the life of the business is perpetual, the stockholders have limited liability, transfer of ownership is easy, sale of stock, it is easier for corporations to raise capital and to expand than it is for other forms of business.
Management may be more efficient and it is adaptable to both small and large businesses.
The disadvantages are: it is subject to tax on its income at the corporate level and when the income is distributed as dividends it is taxed again at the shareholder level.
It may be more difficult and expensive to organize.
It is wise to consult an accountant and attorney specializing in corporate law.
The corporate charter filed with the secretary of your state restricts the types of business activities and it is subject to many state and federal controls.
In forming a corporation a business must organize by applying for a charter through the state government in the state where the principle business activity will occur.
To increase its financial ability the charter permits corporations to sell stock to numerous shareholders' owners.
The corporation is empowered to create debts separate from the shareholders.
A corporation takes the same deductions for expenses as the sole proprietor.
Special deductions are also available to corporations.
Profits of the corporation are taxed to the corporation on either Form 1120A U.S. Corporation Short Form Income Tax Return, or Form 1120, U.S. Corporation Income Tax Return, as well as to the shareholders if the profits are distributed.
However, shareholders can not take a loss if the corporation does not operate at a profit.
Let's review.
There are five types of business entities.
One, sole proprietorship, two, partnership, three, limited liability company or limited liability partnership, four, S corporation, and five, corporation.
My friend Tasha and I are going to start a business.
We're graphic artists, our business will develop logos, letterhead, and business cards for other companies.
We're discussing the form of business organization that we should establish.
Tasha said that because there are two of us we are required to form a partnership.
On this point you better not listen to Tasha.
Two or more individuals that go into business together do not have to form a partnership.
They can form a partnership or a corporation.
As a small business owner you have many factors to consider when you choose the form of business organization.
For example, depending on the situation, the owners of some daycare centers will choose the sole proprietorship form of business.
Others will decide on the partnership form of business and others will select the corporate form of business.
Carpenters and computer programmers may also choose to form sole proprietorships, partnerships or corporations.
It's your decision based on your individual circumstances.
Okay, we're down to the last topic of lesson one, choosing a paid preparer.
You may decide to prepare your own taxes, some business owners prefer to do their own.
Others are more comfortable with a paid preparer.
If you decide you need a paid preparer, the IRS has some information for you to consider.
Most return preparers are professional and honest and provide excellent service to their clients, but choose carefully when hiring an individual or firm to prepare your return.
You are legally responsible for what's on your own tax returns.
Let's review some points you need to be aware of when selecting a tax preparer.
First, avoid preparers who claim they can obtain larger refunds than other preparers.
Avoid preparers who base their fee on the amount of your refund.
Look for a reputable tax professional who signs the tax return and gives you a copy for your records.
What can you do?
Ask questions and get references.
Find out the person's credentials.
Find out if the preparer is affiliated with a professional organization.
Never sign a blank tax return.
Never sign a completed form without reviewing it and making sure you understand the entries.
Finally, consider whether the preparer will be around to answer questions about the return months, even years after the return is filed.
Tax evasion is both risky and a felony crime punishable by up to five years imprisonment and a $250,000 fine.
Remember no matter who prepares the tax return the taxpayer is legally responsible for all the information on that return, so when in doubt, check it out.
If you hear unusual claims from return preparers check it out with a trusted tax professional or the IRS before getting involved.
And that wraps it up for lesson one.
Let's review the objectives and concepts for this lesson.
We explained the purpose of an employer identification number.
We described basic recordkeeping requirements for tax purposes.
We defined basic bookkeeping and accounting methods and terms.
We reviewed the forms of business organization, sole proprietorship, partnership, limited liability company, LLC, S Corporation and corporation.
And finally we looked at selecting a paid tax preparer.
There's a lot to learn when you start your own business and you're off to a good start.
Lesson one gave you an overview of what it takes to start your business off right.
Lesson two will help you with the tax aspects of owning a small business.
It covers things like keeping track of your income and taking advantage of the tax deductions and credits that apply to your business.
Good luck in your new business and thanks for joining me.
For resources discussed in each lesson, please visit the Lesson 10 Supplement.
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