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.

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

Thanks, Dubya!

Today when I opened my mailbox, I found a notice from the IRS about the “economic stimulus act of 2008.”  I wrote about this back in January, but Congress apparently made it happen in time for this tax season.

There’s plenty of confusing language in the one-page letter, and lots of provisions that don’t fit quite so neatly into their “How to Determine Your Stimulus Payment” chart, but basically it breaks down like this:

  • If you made less than $75,000 in 2007 and you owe income tax (i.e. you’re not expecting a refund), your “stimulus payment” is $600.
  • If you made between $3,000 and $74,999.99 and you are expecting a refund, your payment is $300.
  • If you made less than $3,000 and you are expecting a tax refund, you do not get a payment.

The one thing to watch out for when you do your taxes this year is a calculated refund of less than $300.  If that’s the case, remove enough deductions so that you end up owing the IRS a few dollars.  That way, you’ll get the $600 payment rather than the $300 payment and come out on top overall.

For more specific info like payments for children, reduced payments for higher income taxpayers and what counts as “qualifying income,” you can visit the IRS’s Economic Stimulus Payments Information Center.

Making Your Extra Income Work for Your Business

Unless you have truly hit upon “the next big thing” and your business takes off without any effort from you, you will likely need an extra source of income while you get started. Up until this fall I was a full-time teacher, so it would have been fairly easy to keep teaching part-time while starting my business. But teaching requires a lot of take-home work, and uses up a lot of mental energy even when you’re not on the job. It’s also not the kind of work that I could ultimately apply towards Sweet Meats. Mine is primarily a product design business, so I wanted to support myself financially in a way that would also open up new opportunities in my current field.

There are four valuable things I’ve learned in my search for relevant extra income:

  1. The key to moving into a new industry is to start with the areas that bridge your current field and your desired field.
  2. Sometimes you can create a job where one doesn’t already exist.
  3. The value of a job is often measured beyond how much it pays you. A job that pays very little, for example, but provides excellent networking opportunities, relevant lines on your resume, or exposure for your business can be much more valuable in the long-term than one that simply pays the rent.
  4. Be symbiotic with your friends.

stitch loungeTo elaborate: there is a sewing studio in my neighborhood called the Stitch Lounge, where you can take classes and rent time on their equipment. I originally looked at it as a place I might be able to consign some of my homemade creations, but then noticed that they didn’t have anyone teaching a plush or pillow class. So I approached one of the owners with a plush class proposal. It turns out that someone had recently asked her to add a plush offering and with my background as a teacher (including a semester of Home Ec.), I was hired right away.

As a source of income, Stitch is not particularly lucrative. I teach 2-3 classes a month, which only amounts to a couple hundred dollars. The opportunities for networking, however, are worth much more than that. Before I had even taught my first class, for example, the owner who hired me referred me to her friend at PSY/OPS, a local type foundry, to help them develop some of their letter forms into decorative plush objects. Not only does design consulting pay more than than teaching, PSY/OPS is a fantastic client to include in a product design portfolio.

the present groupProduction work for friends is also an excellent stepping stone to design jobs. My friends Oliver and Eleanor, of “The Present Group,” sometimes hire me to do production work with them on particularly complex pieces. Likewise, I have also hired them to help with photographs or production when I get swamped. Though we’re basically just doing each other mutual favors, working together like this allows us to confidently refer each other to other clients and provide examples of the work we’ve done.

One final note about extra income: it takes a while (usually at least a few months) for the networking mill to bring enough referrals your way to make ends meet. It is therefore much easier to quit your full-time gig if you have a bit of a savings cushion or a partner who can help support you for a while. That said, if you put yourself out there and you’re good at what you do, the work will find you, I promise.