Insurance for homeowners, auto, and even health under the new laws are items that individuals recognize as necessary for everyday life. Insurance for business owners should be no different to help mitigate losses due to accident and other events. As small business owners there are several types of tax deductible insurance that should consider be for their business:

·         General Liability Insurance: In the age of needing “Caution! Hot Coffee” on coffee cups even businesses that believe they have minimal liability exposure should consider this type of policy. This protects the business in the event that the business owner or employee causes property damage or injury to a third party.

·         Property Insurance:In addition to owning buildings there are companies with very expensive equipment that the loss of could be costly. This insurance protects from damage in the event of theft, fire, or vandalism to name a few.

·         Worker’s Compensation: This can vary state-to-state, but all states require business owners to have this if there are employees on payroll. Worker’s compensation protects business owners from being sued by injured employees and provides medical payments and compensation if injured.

·         Professional Liability Insurance: Also known as errors and omissions insurance, this provides protection from improperly performing professional services. Typically owners of these policies include consultants, real estate agents, salons, lawyers, etc. General liability insurance does not provide this type of protection and must be purchased separately.

·         Catastrophic Loss:Being near the coast here in Wilmington this is a policy that cannot be ignored. This insurance financially protects a business from closing due to loss from flood, hurricane, or other natural disaster.

·         Life Insurance:So far all the above insurances discussed are fully tax deductible. However, life insurance can be tricky if set up incorrectly. This insurance is only deductible if it is “life insurance covering your officers and employees if (the business or business owner) is not directly or indirectly a beneficiary under the contract”. Make sure these policies are set up correctly to be deductible.

There are many more types of insurance available to businesses, but these are the more common types we come across. The key to deciding what types of insurance you need is to be educated on what options are available to businesses. While we are not experts on insurance we are happy to help guide you to someone who can answer what we do not know!

As a business owner each year there will come a time when the bookkeeper or CPA will ask:

What is the value of your ending inventory?

This question can cause panic and stress for business owners when a good inventory management system is not in place. More importantly, most owners do not understand how inventory affects business and individual income taxes. First, let’s discuss the most common ways to value inventory:

·         Actual Cost – Each piece of inventory is tracked by its actual cost. When the item is sold the actual cost is expensed. This method is typically used by businesses that have larger ticket items or low volume of inventory. Variations of the actual cost method are below:

o   First-In, First-Out (FIFO) – The first items purchased are calculated as the first to be sold. This method will result in a lower cost of goods sold amount in a period of rising costs to purchase inventory (regular inflation). Lower costs of goods sold results in increased net income, which results in increased taxes.

o   Last-In, Last-Out (LIFO) – The last items purchased are calculated as the first to be sold. This would be for a business that consistently has older inventory left over after they year is closed. LIFO results in higher costs of goods sold and lower taxes in a period of rising costs.

·         Average Cost – The weighted average is calculated on all units available for sale during a specific period (week, month, year, etc). The amount on hand at the end of the year would represent the average cost of items purchased throughout the year. This method is typically used by businesses that sell a large amount of small tickets items.

Whatever method is chosen, it is important that it is consistently applied. Once the business decides the most reasonable way to value inventory, costs of goods sold are calculated for taxes according to the following formula:

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

Here are the facts for an example: beginning of the year inventory was $10,000, purchases for the year were $50,000, and end of the year inventory is $20,000. Current year cost of goods sold would not be the $50,000 spent, but the following:

$10,000 + $50,000 – $20,000 = $40,000 Cost of Goods Sold deduction

This $40,000 is the deduction taken on the tax return even though $50,000 was spent during the year. The IRS only allows businesses to deduct what they sell in the current year. This can be tough for start up businesses when a large cash outflow occurs to purchase inventory, but they are not allowed to see the tax benefit by expensing those items until they are sold. As time goes on cost of goods sold should increase or decrease relative to sales. Whether it is monthly, quarterly, or yearly inventory should be adjusted to what is actually on hand to produce accurate financial statements. For tax purposes if inventory is overstated this will result in decreased expenses for the year and more taxable income to you as the business owner. This is why we stress the important of keeping an accurate account of inventory that is on hand.

Keeping up with inventory throughout the year will greatly reduce stress at year end and will ensure income taxes are not being overpaid due to poor inventory management. Please contact us if you are interested in learning more about how inventory affects your tax situation.

Over 10 million Americans are self-employed. Our firm specializes in working with these individuals to grow their businesses and optimize their tax situation. Between running the business, getting financial records in order, and managing tax liability there is one important part of their plan for success that is often overlooked: retirement savings. Just like planning for taxes, planning for retirement is a key component in being able to walk away from business when you are ready. An alarming recent study by TD Ameritrade found the following:

  • 40% of self-employed individuals are not regularly saving for retirement.
  • 28% of self-employed individuals are not saving for retirement AT ALL.

The common reason cited for not saving for retirement was “irregular income”. All too often improper budgeting and savings can result in retirement planning being put on the back burner due to unexpected capital expenditures, tax bills, and other personal life events. We help our clients plan for tax bills and recommend retirement planning options, but most are aware they need to be saving for retirement but are not doing so.

If self-employed individuals are not saving for retirement will they ever be able to retire?

They may be able to retire, but not maintain the lifestyle that they have become accustomed to. Also with the underfunded status of the social security system retirement planning is more important than ever.  According to the TD Ameritrade study only 14% of business owners believe that they could sell their business in the future and live off the profits from the sale. If the business sells in the future for a profit, it should be a supplement to retirement savings, not the entire plan.

What are self-employed retirement plan options?

  • Traditional and Roth IRAs – Can contribute up to $5,500 per individual per year as long as both have earned income. If the business generates a loss then IRA contributions cannot be made since there is no taxable earned income. Contributions can be made up until the due date (including extensions) of the individual tax return.
  • SEP (Simplified Employee Pension) IRA  – Can contribute as much as 25% of net earnings from self-employment up to $52,000 for 2014. Taxpayers have until the due date (including extensions) of the individual income tax return for the year to set up this type of plan.
  • Individual/Solo 401(k) – Salary deferrals up to $17,500 with total contribution rates as much as 25% of net earnings from self-employment up to $52,000 for 2014. Solo 401(k) plans can have Roth options, but remember these plans provided no immediate tax benefit.
  • SIMPLE (Savings Incentive Match Plan for Employees) IRA – Can contribute all net earnings from self-employment in the plan up to $12,000 in salary deduction. There is typically either a 2% fixed contribution or a 3% matching contribution requirement for these plans. Note that this option requires salary deduction so would be tailored for business owners taxed as a S Corporation.

Regardless of the plan chosen, business owners need to make retirement planning a priority. Retirement contributions should be part of every self-employed business owner’s budget just like other costs to the business. Aside from the current tax benefits of retirement planning, enjoying a long retirement will only be possible if proper planning is done now.   As is usually the case, the devil is in the details so be sure to discuss any plans you consider with a professional to make sure it is best for your situation.

Summer is here and vacations are being planned. It is common in the Wilmington area for individuals and couples to own secondary rental homes for coastal vacationers.  At the end of the year rental income is reported on the individual tax return and taxed at ordinary income tax rates. Taxpayers can deduct mortgage interest, real estate taxes, maintenance, utilities, insurance, etc to help offset the amount of rental income that is taxed. In addition to those items the building portion of the rental property can be deducted through depreciation over 27.5 years.

                The act of owning and renting out is treated as a passive activity for tax purposes (unless you are a real estate professional). If the rental property is operating at a loss those passive losses are typically only deductible against other passive income. In practice, taxpayers can only deduct rental losses if they have other passive income to offset those losses (ex. limited interests in partnerships). Fortunately there is a special allowance to deduct rental losses up to $25,000 for each year on the individual tax return. This special allowance is allowed in full until adjusted gross income exceeds $100,000. The allowance is reduced until it is completely disallowed once income exceeds $150,000 and the losses are suspended. If income is above these marks all is not lost because when the property earns income or the property is sold these suspended losses can be used to help offset the taxable income.

                Other than higher income limiting losses, taxpayers need to be careful of personal use days. A rental property is considered a partial personal residence if the owner uses it for more than the greater of:

  1. 14 days
  2. 10% of the total days it is rented to others at a fair rental price

Personal use can include use by yourself, family members, or a friend if you rent to them below fair rental price. This can be a huge disadvantage for tax purposes so we recommend limiting the personal use to the above. If the property is used more than the above limits than any losses will be disallowed and expenses will have to be allocated between rental and personal use. However, the personal portion of mortgage interest and real estate taxes can be deducted as itemized deductions. Keep in mind that the reverse of this rule is true as well. If a taxpayer’s personal residence is rented for fewer than 15 days reporting rental and rental expenses is not required.

The rules on vacation rentals can be confusing, but consult a tax professional if you are planning on purchasing a rental property or converting your primary residence to a rental property.

 

Summer is here and vacations are being planned. It is common in the Wilmington area for individuals and couples to own secondary rental homes for coastal vacationers.  At the end of the year rental income is reported on the individual tax return and taxed at ordinary income tax rates. Taxpayers can deduct mortgage interest, real estate taxes, maintenance, utilities, insurance, etc to help offset the amount of rental income that is taxed. In addition to those items the building portion of the rental property can be deducted through depreciation over 27.5 years.

                The act of owning and renting out is treated as a passive activity for tax purposes (unless you are a real estate professional). If the rental property is operating at a loss those passive losses are typically only deductible against other passive income. In practice, taxpayers can only deduct rental losses if they have other passive income to offset those losses (ex. limited interests in partnerships). Fortunately there is a special allowance to deduct rental losses up to $25,000 for each year on the individual tax return. This special allowance is allowed in full until adjusted gross income exceeds $100,000. The allowance is reduced until it is completely disallowed once income exceeds $150,000 and the losses are suspended. If income is above these marks all is not lost because when the property earns income or the property is sold these suspended losses can be used to help offset the taxable income.

                Other than higher income limiting losses, taxpayers need to be careful of personal use days. A rental property is considered a partial personal residence if the owner uses it for more than the greater of:

  1. 14 days
  2. 10% of the total days it is rented to others at a fair rental price

Personal use can include use by yourself, family members, or a friend if you rent to them below fair rental price. This can be a huge disadvantage for tax purposes so we recommend limiting the personal use to the above. If the property is used more than the above limits than any losses will be disallowed and expenses will have to be allocated between rental and personal use. However, the personal portion of mortgage interest and real estate taxes can be deducted as itemized deductions. Keep in mind that the reverse of this rule is true as well. If a taxpayer’s personal residence is rented for fewer than 15 days reporting rental and rental expenses is not required.

The rules on vacation rentals can be confusing, but consult a tax professional if you are planning on purchasing a rental property or converting your primary residence to a rental property.

                There are plenty of benefits to being self-employed that can be found in business books and on the internet. The ability to work from home, to make your own schedule, and to be your own boss are at the top of those lists. We love working with self-employed entrepreneurs, but all too often decisions to make an employment change are made without considering the tax implications. It is prudent to know all the facts before making the career and lifestyle change of becoming self-employed. Beyond the loss of employer provided benefits like health insurance and a retirement plan, one of the major differences for tax purposes is self-employment tax.

What is self-employment tax?

As an employee, Social Security and Medicare taxes are being withheld from your pay (whether you are aware of it or not) in additional to Federal and state income taxes. The percentages withheld under the current law are 6.2% for Social Security and 1.45% for Medicare. What you also may not realize is that your employer is required to match or pay in the same amount on your behalf. This means that a total of 15.3% in Social Security and Medicare taxes are being remitted to the government by your employer. As a self-employed individual you are both the employer and the employee of your own business so you will be required to pay in the entire 15.3% as a separate tax.   The maximum amount of income subject to the Social Security tax in 2014 is $117,000.

How does self-employment tax work?

Self-employment tax is calculated on the individual income tax return at the end of the year and is an additional tax on top of Federal and state income taxes. Some clients come to us having heard to plan on giving 1/3 of their net earnings to taxes at the end of the year. Unfortunately this is not a bad estimate and depending on the household income mix can be an even higher percentage. Self-employment tax is assessed on 92.35% of net business income from your business. Net business income means gross income earned less all allowed expenses. This is the silver lining of being self-employed for tax purposes. Any and all out of pocket expenses incurred by being self-employed are deductible against income. This can include office supplies, equipment, home office expenses, mileage, etc.

Is there any good news?              

Of course! As mentioned above the perk of being self-employed (in addition to the lifestyle benefits) is that all expenses incurred are deductible against gross business income. Health insurance payments for self-employed individuals as well as pre-tax retirement contributions are deductible as well. Also, there are tax planning strategies to help minimize self-employment tax once the business makes enough net business income to do so. S Corporation elections are weekly conversations in our office and if you are planning on being self-employed full time that discussion should happen sooner rather than later. The best thing for self-employed individuals to do is to be proactive. Know the tax implications of being self-employed, be sure to plan for higher income goals to accommodate for these taxes, and make estimated tax payments throughout the year to help reduce tax surprises at the end of the year. Being self-employed is at the top of my list as reasons to consult a CPA, so feel free to do so and as always we are here to help!

In the final part of our Children and Taxes series we will discuss the tax implications of children transitioning into adulthood.

Personal Exemptions

For tax year 2014 the IRS allows a $3,950 personal exemption deduction for each person on the tax return. For a married filing jointly couple with a child they would be entitled to $11,850 for the three of them so you can see how this adds up in households with multiple children. Personal exemptions directly reduce taxable income. A personal exemption can be claimed for both a qualifying child and a qualifying relative. For the scope of this discussion we will cover the requirements for a qualifying child:

  • The child must be a son, daughter, stepchild, eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or adopted child. The child could also be a child of any of the before mentioned individuals like a grandchild or niece/nephew.
  • The child must be under the age of 19 or under the age of 24 and a full-time student. Keep in mind age is determined as of December 31st of the preceding tax year.
  • The child must live with the taxpayer the entire year except for short term absences in the case of a student living away at college.
  • The child must not provide more than half of their support. They are still allowed to have a job and may be required to file their own tax return depending on the situation.
  • Only one person can claim a child. In the event of divorced parents there are rules for determining who can claim the child.

Tuition and Fees

In addition to allowing the personal exemption benefit to continue through college there are tax benefits that parents can utilize for tuition and fees paid for education. Expenses covered are qualified tuition and related expenses including books and other required course materials. Parents have the option to claim the Tuition and Fees Deduction or the American Opportunity Tax Credit when filing a single, head of household or married filing jointly return. The Tuition and Fees Deduction is a reduction in adjusted gross income up to $4,000 of qualified expenses. The American Opportunity Tax Credit is up to $2,500 of qualified expenses. To claim the American Opportunity Tax Credit the expenses must be for the first four years of postsecondary education, the student must be pursuing a degree, must be enrolled at least as a half-time student, and must not have a felony drug conviction. The Tuition and Fees Deduction can be taken even if one or all of the credit requirements are not met. Like most deductions and credits, the IRS imposes income limitations to be able to take advantage of these credits that are adjusted for inflation each year. For our clients we calculate which will provide the most benefit if they qualify for both the deduction and credit.

Throughout the Children and Taxes series we have highlighted many of the tax benefits that children can bring. It is important to note that many of these benefits are phased out for high income earners and the rules for taking advantage of them can be complicated. Consult your tax professional to make sure all the benefits are captured.

Earned Income Tax Credit

The Earned Income Tax Credit was established to provide a benefit for working individuals and families that have low to moderate income. The tax credit reduces the amount of tax owed dollar for dollar and is also refundable. Like a lot of other credits, the taxpayer’s filing status cannot be married filing separately. To qualify the taxpayer cannot be a qualifying child of another person and must have earned income. Earned income is considered to be wages and salaries from an employer or income from running your own business.

To qualify for the earned income credit in 2014 adjusted gross income cannot exceed $46,997 for single and head of household filers and around $52,427 for married filing jointly filers. The maximum credit allowable, shown below, is increased significantly by having at least one qualifying child. For 2014 the maximum credits are:

  • $496 with no qualifying children
  • $3,305 with one qualifying child
  • $5,460 with two qualifying children
  • $6,143 with three of more qualifying children

Adoption Credit

At the beginning of 2013 the adoption credit was made permanent, but it was put into law as a nonrefundable credit. For tax years 2010 and 2011 the credit was refundable (which we hoped as tax professionals would continue). The tax credit for 2014 is up to $13,190 and any unused credit can be carried forward 5 years to offset future tax liability. The income limits are more generous than most IRS credits with $197,880 of income being the maximum allowed before being phased out and eliminated if income exceeds $237,880. The Adoption Credit is claimed on Form 8839, Qualified Adoption Expenses on the individual tax return.

Qualified adoption expenses are amounts reasonable and necessary to legally adopt a child. These can include:

  • Court costs
  • Attorney fees
  • Traveling expenses including meals and lodging

There are a couple of uncommon features of the credit that can provide benefit for special situations. Even if expenses are incurred and the adoption is not finalized the credit may still be claimed. The exception to this is that a foreign adoption can be claimed only if the adoption becomes final. For a special needs child the full credit may be claimed even if there were no qualified adoption expenses.

As represented above the rules and qualifications for the earned income tax credit and adoption credit can be confusing so we suggest consulting a tax professional if you believe you may qualify.

With the recent flood of college graduates into the workforce this spring we are reminded of an often omitted tax deduction, student loan interest. CNN late last year estimated that 59% of North Carolina graduates will graduate with student loan debt. The average for that 59% is around the $24,000 mark for student loan debt. The IRS allows a deduction for the lesser of $2,500 or amount of interest actually paid during the calendar tax year. To qualify to claim the deduction the loan must be a qualified student loan meaning that it:

(1)    Must have been taken out solely to pay qualified education expenses

(2)    Cannot be from a related person or made under a qualified employer plan

To claim the deduction on a tax return the student must be you, your spouse, or your dependent and have been enrolled at least half-time in a degree program. A dependent can be a qualifying child or relative. More information on dependents can be found here: Who can you claim as a dependent?

Keep in mind only the interest portion of the payments are deductible and not the entire payment much like mortgage interest. Student loan interest is typically reported on Form 1098-E and if not sent out by your loan provider can be obtained online or by phone. A Form 1098-E will only be issued if you paid $600 or more in student loan interest so taking further steps to get this information may be required for smaller loans.

Like a lot of tax deductions income can limit the student loan interest deduction. First, to take the deduction a married filing separately return cannot be filed. Qualifying filing statuses are single, head of household, qualifying widower, and married filing joint. For filers other than married filing joint the deduction is reduced when income is more than $65,000 and completely eliminated at $80,000. For married filing joint filers the deduction is reduce when income is more than $130,000 and completely eliminated at $160,000.

Due to the limited ability for high income earners to take this deduction there are an increasing number of supporters for repealing the student loan interest deduction. Some argue that the student loan interest deduction does not accomplish the goal of supporting higher education that the tax legislation intended. An alternative to this provision involves student loan debt forgiveness. Income-based repayment plans have provisions to provide forgiveness of outstanding loan balances after 20 or 25 years. Without a special provision the cancelled debt would be taxable to the loan holder in the year forgiven. An idea is to provide a provision that would eliminate this from income for taxpayers below a designated income threshold. This would provide relief for lower income households as well as promote timely loan repayment to avoid capturing the loan amounts into income for the average household.

As always we will stay tuned to see what happens. For now, the student loan interest deduction is here to stay so make sure it is not missed on 2013 and 2014 tax filings!

Child Tax Credit

When it comes to Federal taxes, having a child can provide several automatic tax benefits. The first is an additional personal exemption of $3,950 for 2014. A personal exemption is a deduction that reduces taxable income. The second is the child tax credit. Credits are better than deductions in that they directly offset tax liability, dollar for dollar. The child tax credit is $1,000 for every qualifying child under age 17. A qualifying child for the credit has to meet the following criteria:

  • Is a direct descendent (child, stepchild, niece, nephew or grandchild)
  • Has lived in the same residence with the taxpayer for more than half the year
  • Is claimed on the tax return as a dependent
  • Does not provide more than half their financial support

Generally most children qualify based on the above criteria and it is the next requirement that most individuals or couples fail to pass. Taxpayers start to lose the benefit of the credit at $75,000 of adjusted gross income for single taxpayers and $110,000 for married filers. With dual income households, this credit is quickly reduced or diminished for a lot of clients. However there is another child credit that is not phased out by income and only requires that both spouses work during part or all of the year.

Dependent Care Credit

In the next month or so schools will be letting out for summer! Depending on the home situation this can mean increased child care costs for parents. The dependent care credit can range from 20%-35% of qualifying expenses ($3,000 for one child and $6,000 for more than one child) depending on income levels. Here is how to qualify:

  • The dependent must be a child age 12 or younger when the care is provided or be physically or mentally incapable of caring for themselves.
  • Both spouses must be working and deductible expenses can be capped if either spouse’s income is below the expenses paid or threshold for deduction above.
  • To claim the credit a couple must file a joint return for the year if married. Other filing statuses that qualify are single and head of household.
  • Qualifying expenses are reduced by any dependent care benefits provide by an employer.
  • Care must be provided by someone other than your spouse or a dependent of you or your spouse. If the care is provided by an individual, taxpayers are required to file a Form 1099-MISC to report amounts paid that individual to qualify to take the credit. We can help with this! This is a simple form that requires the name, address and social security number of the person that amounts were paid to. This is why we recommend getting this information upfront before paying someone for childcare.

Although the above deduction and credit provides a small benefit compared to the total cost of caring for a child, it is important to us that our clients take advantage of every tax benefit the IRS allows!

It takes a village to run a successful small business. From a banker, financial planner, attorney, marketing consultant, business coach, and of course your CPA it can take some important resources to keep your business running. We are always looking for professional resources to help our clients succeed. Recently we have had an increasing number of clients needing advice on business start up and organization options. Below are just a few of the vast resources that Wilmington has to offer for small businesses that are in the startup stage and beyond:

Cape Fear Community College Small Business Center

Link to Seminars for 2014:

http://www2.cfcc.edu/sbc/

 

SCORE Counselors to America’s Small Business  

Counseling Office Hours:

http://wilmingtonscore.org/free_counseling.html

 

UNCW Center for Innovation and Entrepreneurship

Events and Resources:

http://www.uncw.edu/cie/index.html

 

UNCW Small Business Technology and Development Center

Business Basics Workshops and Webinars:

http://www.sbtdc.org/offices/uncw/events/

Business Counseling:

https://access.sbtdc.org/reg.aspx?mode=counsel&center=42011&subloc=0

 

Once the small business plan is established and the process to get started has begun it is important to start focusing on the following steps: setting up your organization, establishing funding, and developing an accounting system. Working with an attorney and developing a good banking relationship are essential to successfully completing the first two steps. The third, developing an accounting system, is usually the least favorite part of business for most of our business owners, but essential for running a successful business. While our firm does not focus on bookkeeping services we have a variety of resources for clients for bookkeeping services and training.

As a CPA firm we strive to be a year round advisor for our clients and not a once a year destination. Being tax efficient requires communicating and working with the resources in your village. Even with a properly organized business, sufficient funding, and pristine accounting records one of the major mistakes we see business owners make is that they only think about taxes after the year is over. There are tax planning strategies for all businesses to be as efficient as possible. It is hard to believe, but we are already almost a third of the way through 2014. If you have started a small business and have not thought about taxes yet, you are missing an important part of your village. Now is the time to plan for the rest of the year!