Do I Need an Accountant?

Maybe TurboTax isn’t as easy as it looked.  Maybe you’re seduced by H&R Block’s claims that they save the average tax payer $1800.  Maybe you just don’t know how categorize that shoebox of receipts you keep under your desk, but chances are, you’ve wondered whether you should hire professional help.

This tax season I bit the bullet and hired an accountant.  I hired a guy who is both an accountant and a lawyer, and I figured that he would know enough loopholes and secret deductions to more than make up for his $375 price tag (for comparison purposes, H&R Block charges about $300 in San Francisco).  That did not turn out to be the case, but I’m still glad I hired him.

It turns out, partially due to the research I’ve done for this blog, that I would have paid the right amount of taxes had I filed them myself.  This meant, however, that I did not have a lot to explain to my accountant during our one-hour session and got to spend most of my time asking questions and receiving advice.  Here are some of the things I learned:

  • Unless you run a business that is really open to litigation, you may want to think twice before changing your sole proprietorship to an LLC.  LLCs require a lot of paperwork and things like officers and meetings.  Also, in California, the annual filing fee is $800, which is a lot more than your typical liability insurance premiums, so you’re better off just getting insured.
  • Watch your inventory.  You can only deduct the cost of inventory you sold last year, not all the inventory you bought.
  • Always look out for standard deductions (like 48.5 cents/mile for car costs) and compare them to your itemized deductions.  Very often one will be much higher than the other.
  • If you use bookkeeping software like QuickBooks (which works great with TurboTax), file your taxes according to cash accounting reports, not accrual accounting reports.
  • Gifts under $12,000 are always tax free for the recipient, so that birthday check from Grandma is not taxable income.
  • You can’t deduct your home office if your self-employment income does not exceed your expenses, but the deductions keep carrying over from year to year until you post a profit, so keep track of them as they pile up.

In the end, the knowledge I gained from my meeting was well worth the expense.  I am new to self-employment, and I liked having the peace of mind that I had prepared things correctly. Since next year will be my first year of inventory, I will probably hire my accountant one more time.  In my third year of business, however, I am aiming to strike out on my own and file my taxes by myself.

Dear Diary, Today I Went to Starbucks

If you are self-employed and either eat out or drive on the job, chances are you’ll want to deduct what you spend on those things. But meals and car expenses are two of the most likely things on your tax return to get scrutinized by the IRS, and who wants to organize hundreds of receipts for small dollar amounts? An easy alternative is to keep a spending diary — or two or three. A spending diary eliminates the need for you to keep tons of receipts for tiny amounts and is also one of the only spending records the IRS will accept as legitimate.

I have two spending diaries: a small notebook that I keep in my purse for meals/entertainment/public transportation, etc., and a pad taped to the dashboard of my car for mileage and car expenses. I recommend a separate diary for your car because it will be organized slightly differently than a regular diary. Some people like to use a digital or cassette recorder in lieu of paper (Blackberry/iPhone users, I’m looking at you) but either method is fine as long as it contains the proper information.

Like all documentation prepared for the IRS, a spending diary must follow a series of somewhat complicated rules in order to be admissible. Here’s how to set up an iron-clad meals and entertainment diary, for example:

  • Include only entertainment and meals you ate out (not groceries!) that totaled $75 or less. You will need to keep a receipt for any meal or entertainment expense over $75 (no matter how many people you paid for).
  • Create the following set of columns for your diary:
    • The date
    • The amount you spent
    • Where you spent it (establishment and city)
    • The names and business relationships of anyone you entertained
    • The business you were doing or discussing
  • Fill out the information the day you spend the money

For your car diary, just follow the format from this IRS example:

mileage log

Source: http://www.irs.gov/publications/p463/11081l08.html

Tip: record the entries from your diaries into a spreadsheet every week when you do the rest of your bookkeeping. This will help you to budget future spending and will save you time when you need to prepare your taxes.

Steady at the Wheel: Car Deductions

One of the areas of your tax return at which the IRS looks most closely is the section covering car deductions. There’s a reason for this: it’s a difficult set of tax laws to navigate and many people over-deduct or use sloppy estimates, resulting in more money for the government when they catch you. You don’t need receipts for everything, since it’s difficult to get receipts for things like mileage, but you do need detailed records of everything.

Car deductions are easy if you have a company car. In this case, you can just deduct the whole shebang. What’s more complicated is if you use your personal vehicle for business purposes. If you fall into this latter category and need to itemize your deductions, here are the basic steps:

  1. Keep a mileage diary in your car at all times. Write down the date, the starting and ending mileage, tolls, and one of the following purposes for any business-related trip you make:
    • Overnight travel away from home
    • Shopping for your business (not shopping for yourself, even if you use the purchase at your business, like a suit)
    • Travel to a professional development event such as a seminar or conference
    • Sales calls
    • Deliveries
    • Travel for marketing or promotional purposes
    • Travel to a job site or meeting as an independent contractor — NOTE** if the job site you are traveling to has you on the books as an employee rather than as an independent contractor, you are now technically commuting, which is not deductible.
    • Travel between job sites
    • Any other qualifying travel during your business day.
  2. Keep all receipts and statements for tolls, maintenance and repairs, gas, auto registration, inspections, etc.
  3. At the end of the year, total up your business mileage and divide it by your total mileage for the year. This will give you the percentage of your car that was used for business. Also, look up the amount by which the value of your car has depreciated (must be $2,660 or less if your car was bought new that year or was worth more than $12,800 at the beginning of the year).
  4. Total up your car-related receipts and depreciation for the year and multiply the total by the percentage you just came up with.
  5. Multiply just your business mileage by $0.31. This is the standard automobile deduction, calculated by mile.
  6. Compare the results of steps four and five. You will use the higher of these two numbers to get your deduction.
  7. If you are 100% self-employed, stop here. Your costs are fully deductible.
  8. If you are on the books at anyone else’s business as even a temporary and/or part-time employee, your car costs are subject to the “2% floor.” In this case, total up your Adjusted Income for the year (income minus expenses) and multiply it by .02. Subtract that amount from the business-related car expenses you came up with in step 6. This is the total amount you may deduct. If you come up with a negative number, you may not claim a deduction.

See? It’s complicated. I didn’t even mention things like specific deductions for hybrid vehicles or certain trucks, driving for charitable purposes and deductions for interest on leased vehicles. For all the nitty gritty stuff, start with this page directly from the IRS.

A+BxC=Audit

Most everyone knows that there are certain common parameters that make you more likely to get audited by the IRS, such as:

  • making more than $100,000
  • having low income and high expenses
  • carrying inventory
  • claiming high deductions for meals and entertainment, travel, and car expenses
  • being self-employed and/or claiming a home office
  • holding a mostly cash-income job, such as waiting tables or bartending

But did you know that the IRS actually uses a very strict formula to determine most of the tax returns that get scrutinized? It’s called the “DIF Score,” (Discriminate Income Function) and while the actual formula is very closely guarded secret, it generally works by comparing your income and deductions to other people in your tax bracket. If you donate an unusual amount to charity, or claim an unusual amount of driving mileage compared to others who make about the same as you, your DIF score goes up. The highest scoring returns then get scrutinized by an IRS agent, who determines whether your return warrants an audit. There are other factors that go into your DIF score as well, such as your age and where you live. If you’re 45, live in Beverly Hills, and claim a $25,000 income, for example, your score goes up simply for having unrealistic numbers.

So how can you stay under the radar? There are several strategies, but here are some of the most common:

  • File a neat, professional-looking return. Messy, handwritten returns require closer scrutiny to begin with, and are more likely to include things like mathematical errors.
  • File at the last possible minute. Prepare your return early and have it checked, but don’t turn it in until as close to April 15th as possible. You may even be able to file as late as the October 15th extension date (though you will still need to pay by April 15th). The later you file, the more likely it is that the IRS will have already reached their audit quota.
  • Check and re-check your return. Mathematical errors, wrong social security numbers, lack of signatures, disagreements between your state and federal returns, and numbers that don’t match your W-2 or 1099 forms (of which the IRS gets their own copies) will all red-flag you.
  • Preempt unusual deductions (e.g. your car got totaled or your office burned down) by including a note and receipt about the incident with your return.
  • Watch your medical expenses. You can only claim non-reimbursable expenses (whether you were actually reimbursed for them or not) in excess of 7.5% of your adjusted gross income. This is a complicated deduction, and one that people very often claim incorrectly, so the IRS really likes to pounce on this one.
  • Don’t round numbers up or down.
  • Avoid the use of “miscellaneous” or “other” categories as much as possible.

In the end, even if you manage to blend in with the masses, your return may still be flagged for a random audit. It is therefore best to keep neat receipts and records for everything you claim (see future posts for how to keep proper expense diaries). The more organized you are, the quicker and less painful an audit will be.

Sources: http://money.cnn.com/2004/02/27/pf/taxes/avoidanaudit/index.htm
 http://www.totaltaxsolutions.com/avoid-audit.htm
http://www.askmen.com/money/investing/40_investing.html
http://articles.moneycentral.msn.com/Taxes/AvoidAnAudit/5waysToAvoidAnAudit.aspx

Tax Tip #2: Home is Where the Profit is

If you’re like me and you have the smallest of small businesses (i.e. the home office), you’re probably hoping to take a nice, juicy deduction for the portion of your rent and utilities that goes towards supporting your home office. Do you want the good news or the bad news first?

Alright, first the bad news: if the income you made working for yourself is less than your total expenses for the year, including the home office portion of your rent and utilities, you cannot take this deduction. In other words, the IRS will not let you deduct the office portion of your home if it operates at a loss. In my case, because I was teaching for most of 2007, I was an employee during those months and not working for myself. Nevertheless, I was also starting a business, so my expenses for the year were about $2,000 more than the income I made working for myself rather than for the school.

Okay, now the good news: the home office deduction rolls over from year to year until your self-employment income exceeds your expenses. That means that in 2008, assuming my business makes a tidy profit, I can deduct the rent and utilities for my home office from 2008 and 2007!

In short, if you have a home office that eventually makes some money you will get your deduction, just maybe not right away. Be careful about the size of the refund you are expecting this year, especially if you started your business in 2007 or finally took it full-time.

My, That's a Lovely Deduction. What, This Old Thing?

It’s that time of year again. Time to sort through your shoe box of receipts in preparation for the tax man. As I hack my own path through the jungle of deductions, I’ll be sharing the little truffles of information I dig up along the way. (Oh c’mon, that metaphor was awesome).

Here’s the first: did you know that you can deduct things you use for your business that you bought long before you even had a business? It’s true. If you bought a bookcase for your living room three years ago and this year it migrated to your office, your business “bought” it from you. You can’t deduct the price you originally paid for it, but you can deduct what it’s currently worth on craigslist.

Tip courtesy of accountant Bob Silver, at http://robert-silver.com/info.php?a=selfemploy