Starting a New Business? What to Deduct and When

Starting a brand new business usually requires the expenditure of money on things like:

  • legal and accounting fees
  • licenses, permit, and other fees
  • the cost of investigating what it would take to create a successful business, including research on potential markets or products
  • advertising costs, including advertising for your business opening and creating a business website
  • office rent and utilities paid before the business begins operating
  • rental of business equipment such as computers and office supplies
  • costs for employee training before the business opens, and
  • expenses related to obtaining financing, suppliers, customers, or distributors.

Once your business begins, the cost of all of such items are deductible as business expenses. However, they are not so easily deducted if they are incurred before your business starts. Such business start-up expenses are capital expenses—costs that you incur to acquire an asset (a business) that will benefit you for more than one year. Normally, you can’t deduct these types of expenses until you sell or otherwise dispose of the business. However, a special tax rule allows you to deduct up to $5,000 in start-up expenses the first year you are in business, and then deduct the remainder, if any, in equal amounts over the next 15 years. (I.R.C. § 195.)

Example: Diana Drudge is sick of her office job. She decides to start a fashion design business.
Before her business begins, she spends $20,000 of her life savings on advertising. Her business finally starts on July 1, 2014. Because such advertising is a start-up expense, she can’t deduct the full cost in her first year of business—instead, she can deduct $5,000 of the expenses the first year she’s in business and the remaining $15,000 in equal installments over 15 years (assuming she’s in business that long). This means she may deduct $1,000 of the remaining $15,000 for each full year she’s in business, starting with the first year. However, Diana’s business is open for only six months her first year, so she may deduct only $500 of the $15,000 that year, plus the initial $5,000 she’s entitled to. Her total first year total deduction is $5,500.

Obviously, you want to spend no more than the first-year ceiling
on start-up expenses so you don’t have to wait 15 years to get all your money back.

Special Rules for Some Expenses

There are some costs related to opening a business that are not considered start-up expenses. Many of these costs are still deductible, but different rules and restrictions apply to the way they are deducted.


The largest expense many home business people incur before they start their businesses is for inventory—that is, buying the goods (or the materials to make them) that they will sell to customers. For example, if you decide to start an eBay business selling items you buy at flea markets, you would treat the items you purchase for resale as inventory. You deduct the cost of inventory as it is sold or if it become unsalable.

Long-Term Assets

Long-term assets are things you purchase for your business that will last for more than one year, such as computers, office equipment, cars, and machinery. Long-term assets you buy before your business begins are not considered part of your start-up costs. Instead, you must treat these purchases like any other long-term asset you buy after your business begins: You must either depreciate the item over several years or deduct the cost in one year under Section 179. However, you can’t take depreciation or Section 179 deductions until after your business begins.

Research and Development Costs

The tax law includes a special category for research and development expenses. These are costs a business incurs to discover something new (in the laboratory or experimental sense), such as a new invention, formula, prototype, or process. They include laboratory and computer supplies, salaries, rent, utilities, other overhead expenses, and equipment rental, but not the cost of purchasing long-term assets. Research and development costs are currently deductible under Section 174 of the Internal Revenue Code, even if you incur them before the business begins operations.

Organizational Costs

Costs you incur to form a partnership, limited liability company, or corporation are technically not part of your start-up costs. However, the rule for deducting these costs is the same as for start-up expenses. (I.R.C. § 248.) But, if you form a one-member LLC, you get no deduction at all if your start-up expenses exceed $5,000

When Does a Business Begin?

Once your business begins, the same expenses that were start-up expenses before your business began become currently deductible business operating expenses. For example, supplies you purchase after your business starts are currently deductible operating expenses, but supplies you buy before your business begins are start-up expenses.

So, just when does a new business begin? The courts have held that a new business begins for tax purposes when it starts to function as a going concern and performs the activities for which it was organized. (Richmond Television Corp. v. U.S., 345 F.2d 901 (4th Cir. 1965).) The IRS says that a venture becomes a going concern when it acquires all of the assets necessary to perform its intended functions and puts those assets to work. In other words, your business begins when you start doing business, whether or not you are actually earning any money.

For example, if your business involves providing a service to customers or clients—
such as accounting, consulting, financial planning, or law—your business begins when you first offer your services to the public. No one has to hire you; you just have to be available for hire. For example, a consultant’s business begins when he or she is available for hire by clients.

If you’re a knowledge worker—for example, a writer, artist, photographers graphic designer, computer programmer, app developer—your business begins when you start using your business assets to make saleable products. The products don’t have to be completed, nor do sales have to be solicited or made. Thus, an inventor’s business begins when he or she starts working on an invention in earnest, not when the invention is completed, patented, or sold. Likewise, a writer’s business begins when he or she starts working on a writing project.



Plan to Sell Your Company Someday? Slash Your Taxes Now

Unfortunately, minimizing the tax burden of your sale isn’t as simple as hiring a top-notch tax professional a few weeks before your closing. Some of the tax moves discussed below take time. So get up to speed on these tax strategies now and talk to the experts–a business broker, your accountant, a tax expert–to get your tax minimization plans in place sooner rather than later.


Tips for Minimizing Postsale Tax Liability

Regardless of whether you’re selling a sole proprietorship or a corporation, it’s important to understand the tax implications of the sale long before you pull the trigger on your business exit. There are several tax strategies.

  • Conversion to an S corp

    To avoid double taxation, consider converting your C corp to an S corp prior to sale. Although restrictions may apply, by converting to an S corp, shareholders are taxed for the gain on the sale, but the corporation avoids paying corporate-level tax. This significantly reduces the total tax liability on sale proceeds. But it can’t be done overnight–this conversion needs to be made 10 years prior to the sale of your business.

  • An installment sale

    An installment sale is one of the most common tax-deferment strategies for sellers of small businesses. In an installment sale, the buyer purchases either stock or assets using an installment promissory note, committing to pay a portion of sale proceeds over time. Sellers do not permanently avoid tax on sale proceeds, but this strategy delays taxes until payments are received and helps spread out the tax burden.

  • An ESOP sale

    Employee stock ownership plan, or ESOP, sales enable sellers to defer payment of tax on the sale of stock. As long as the ESOP owns at least 30 percent of the company’s stock postsale and the seller invests proceeds in qualified securities, it’s possible to create a tax strategy that defers the payment of taxes through a managed account. This creates a permanent tax savings for your estate following your death.

  • Qualified small business stock exception

    There is a provision in tax law that allows for an exclusion of gain from the sale of qualified small business stock, or QSBS. As of January 1, 2014, the QSBS exclusion is set at 50 percent for the sale of C corp stock in a company with total gross assets of $50 million or less. Be aware that other restrictions may apply and an AMT tax preference can further limit your tax savings. Talk with a tax professional to see if this could be an option for you.

The only thing worse than paying tax on the sale of a business is paying too much tax. Given the amount of money that changes hands in a typical business transaction, even small actions can significantly increase the size of your bank account when you exit your company. By working closely with a tax professional in the months or years leading up to the sale, you can improve your tax position and lay the groundwork for more money in the long run.


10 Easy Tips to Avoid Getting Scammed

We are all targets and we are all vulnerable. Criminals across the country and around the globe – small-time thieves and devious computer hackers – are working around the clock to steal your money and your personal information. There’s nothing you can do to guarantee you won’t get taken, but there are many things – some of them very simple – that can reduce the risk. Raedle / Getty Images

Con artists and disreputable companies will do or say whatever it takes to get what they want. So you need to be vigilant. Because once you wire off your money or give a crook your Social Security number, the damage is done. Life in the digital age does not come with an “undo” button.

With most scams the warning signs are there, if you look for them – let’s review the rules:

Be skeptical

Question everything: phone calls, mail solicitations, email offers, links on social media. Don’t take things at face value. Con artists know how to make their scams look and sound legitimate. They can doctor pictures, copy logos, fake testimonials. It’s also easy to “spoof” caller ID and create fake websites.

Think it through and check it out before you respond in any way. A phone call or quick web search could keep you from losing thousands of dollars or giving out very personal information. You can check out companies and offers with the Better Business Bureau, Federal Trade Commission and National Fraud Information Center.

Guard your personal information

Fraudsters use a variety of tricks to get you to divulge account numbers and passwords. They send bogus emails designed to look like it’s from your bank and make calls pretending to be with your credit card company.

There’s always a reason why they need your personal information. A common ruse is for a phone bandit to ask for your account number and PIN to solve a computer problem or to stop fraudulent transactions spotted on your account.

It doesn’t matter what they say – hang up! Those who need your account numbers, PINs or passwords already have them. They’d never call you or send you an email asking for them. When in doubt, contact the company in question by phone – use a number you know to be legitimate, from your statement or the phone book – and ask what’s up.

Your Social Security number is the key to your life. A thief can use it to steal your money and your identity. Social Security numbers are also used to access many financial and medical records. So guard that number and only give it out when absolutely necessary to someone you know and trust.

Beware of counterfeit checks

When you sell something online, never accept a check that’s made out for more than the agreed-upon price. Fraudsters will do that and instruct you to wire back the extra amount. The check may look legit, but it’s counterfeit. The bank may tell you the check has “cleared” and the money is in your account, but once that check is found to be bogus – which could take weeks – the bank will withdraw those funds from your account. That means you’ll be left holding the bag for all the money you wired off.

Take your time

Don’t let anyone rush you into making a purchase. The buy-now-or-else approach is designed to keep you from comparison shopping. Don’t fall for it. If they’re really offering a bargain, they don’t have to high-pressure you into buying on the spot. If the sales person tells you the price won’t be good if you walk out the door – turn around and leave.

Get it in writing

Verbal promises don’t count. It doesn’t matter what the salesperson tells you, the only thing that matters is what’s written down. Most sales contracts specifically state that verbal promises are not binding. That’s why you need to read, understand, and agree to the terms before you sign any contract.

Be wary of all links and attachments

It’s so easy to click on a link in a text, email, or social media post. It’s so tempting to open an email attachment, especially when the message says it’s a shipping invoice or some other document you’d want to see.

Fraudsters count on curiosity and that instant response to load malicious software onto computers, smartphones and other mobile devices. And with shortened URLs, you really don’t know where that link will take you – maybe a malicious site run by the crooks.

Unless it’s something you’re expecting and know for sure who it came from, don’t open that attachment and resist the temptation to click any links.

If you’ve really won a prize – it’s free!

Never pay to play a contest or to claim a prize. If the contest is legitimate, you’re not required to buy anything or pay any money to get your prize – that’s the law. You don’t have to send in a processing fee, pay shipping or handling charges, or provide your credit card or bank account numbers for any reason. And if you owe taxes on your prize, you pay them to the government, not the contest promoter.

Remember: You can’t win a contest you didn’t enter. If someone says you did, they’re lying.

Don’t be fooled by free merchandise offers or money back guarantees

Free is good, but be skeptical of ads that offer to send you a free sample. The initial product may be free, but they’ll probably make you pay for shipping and handling. To cover that charge, you’ll need to provide your credit or debit card number. Some dishonest companies then sign you up for additional monthly purchases – whether you realize it or not – which can be hard to stop.

A money-back guarantee is designed to get you to make a purchase you might otherwise skip. That guarantee is only as good as the company that offers it. Sometimes the rules are so restrictive it’s impossible to get a refund. For example, simply opening the package might void the offer. If you are allowed to return the product, you can expect to pay to ship it back.

Use a credit card for online and mail order purchases

A credit card gives you better fraud protection than a debit card – credit cards are governed by different federal rules. With a credit card, you can dispute an unauthorized charge and the credit card company must take that charge off your bill while it investigates. That’s not always the case with a debit card. You can also dispute a credit card charge if the merchandise doesn’t arrive or if it’s defective and the company won’t help you.



Tips for Paying Estimated Taxes

The United States has a “pay as you go” tax system in which tax payments are made to the IRS throughout the year, not as one lump sum when the tax annual return is filed. Employees have their income and Social Security and Medicare taxes withheld by their employers and paid the IRS quarterly or monthly. This includes business owners who have formed corporations to own and operate their businesses. However, most small business owners are not incorporated. Instead, they are sole proprietors (one-person businesses) or partners in partnerships or members of limited liability companies. Such business owners are self-employed for tax purposes.

estimated-tax-payments-660x369When you’re a self-employed no taxes will be withheld from your compensation by your clients and customers, or by your business itself. It’s up to you to pay your income and Social Security and Medicare taxes yourself. Ordinarily, this is done by making four annual estimated tax payments to the IRS each year.

You must pay estimated taxes if you expect to owe at least $1,000 in federal tax for the year. However, if you paid no taxes last year—for example, because your business made no profit or you weren’t working—you don’t have to pay any estimated tax this year no matter what your tax tally for the year. But this is true only if you were a U.S. citizen or resident for the year and your tax return for the previous year covered the whole 12 months.

You also don’t have to pay estimated tax if, in addition to running a business, you have an employee job and the amount withheld from your pay by your employer will amount to at least 90% of the total tax you’ll have to pay for the year.

When to Pay Estimated Taxes

You must ordinarily pay your estimated taxes in four installments, with the first one due on April 15, as shown in this chart:

Screenshot 2015-05-14 08.51.51

Don’t get confused by the fact that the January 15 payment is the fourth estimated tax payment for the previous year, not the first payment for the current year. The April 15 payment is the first payment for the current year.

You don’t have to start making payments for any given year until you actually earn income. If you don’t receive any income by March 31, you can skip the April 15 payment. In this event, you’d ordinarily make three payments for the year, starting on June 15. If you don’t receive any income by May 31, you can skip the June 15 payment as well and so on.

You can also skip the January 15 payment if you file your tax return and pay all taxes due for the previous year by January 31 of the current year. This is a little reward the IRS gives you for filing your tax return early. However, it’s rarely advantageous to file early because you’ll have to pay any tax due on January 15 instead of waiting until April 15. In other words, you’ll lose three months of interest on your hard-earned money.

How Much do You Have to Pay?

Ideally, the four estimated tax payments you make each year will add up to your tax liability for the year. However, if your income varies substantially from year to year, it can be hard to estimate how much you must pay during the year. If you don’t pay enough estimated tax, the IRS will impose a penalty.

Fortunately, there is a way to avoid having to estimate how much you’ll make this year. No matter what your income for the current year turns out to be, you won’t have to pay any penalties if the estimated tax you pay is at least the smaller of: 90% of your total tax due for the current year, or 100% of the tax you paid the previous year or 110% if you’re a high-income taxpayer (those with adjusted gross incomes of more than $150,000 or $75,000 for married couples filing separate returns).

Note that, if you’re a partner in a partnership or LLC member, you must pay individual estimated tax on your share of the partnership or LLC income whether or not it is actually paid to you. The partnership or LLC itself pays no tax.

Many self-employed people establish separate bank accounts to save up for taxes into which they deposit a portion of each payment they receive from clients. This gives them some assurance that they’ll have enough money to pay their taxes. The amount you should deposit depends on your federal and state income tax brackets and the amount of your tax deductions. Depending on your income, you’ll probably need to deposit 15% to 50% of your pay in the highest tax brackets. If you deposit too much, of course, you can always spend the money later on other things.

How to Pay Estimated Tax

Paying estimated tax is easy: you can do it by check, electronic funds withdrawal, or even by credit card. You should use IRS Form 1040-ES, Estimated Tax for Individuals, to pay your estimated tax. The form includes detailed payment instructions.

What if You’ve Paid too Little?

The IRS imposes a money penalty if you underpay your estimated taxes. Fortunately, the penalty is not very onerous. You have to pay the taxes due plus a percentage penalty for each day your estimated tax payments were unpaid. The percentage is set by the IRS each year. Currently, it’s about 3%. This is the mildest of all IRS interest penalties. Many self-employed people decide to pay the penalty at the end of the tax year rather than take money out of their businesses during the year to pay estimated taxes. If you do this, though, make sure you pay all the taxes you owe for the year by April 15 of the following year. If you don’t, the IRS will tack on additional interest and penalties. The IRS usually adds a penalty of 1/2% to 1% per month to a tax bill that’s not paid when due.

For more details on estimated taxes, refer to IRS Publication 505, Tax Withholding and Estimated Tax.


Deducting Employee Benefits: An Overview

If you have employees, you are undoubtedly aware that you can claim a business expense deduction for the wages and salaries that you pay them. However, you may not be aware that other benefits that you provide can be deducted. For example, if you give your employees a discount on the cost of your goods or services, or if you provide paid holidays or vacations, then you have provided a deductible benefit.


Employee Benefits Can Be Taxable or Nontaxable

The deductibility of an expense by the employer is a different issue than the taxability of the benefit to the employees. (And in some cases, the cost to the employer and the value to the employee are not the same, at least in the eyes of the IRS.)

Some types of benefits are not taxable for payroll tax purposes. These benefits are not taxable to the employee for FICA or income tax withholding purposes, and they are not taxable to you for FICA or FUTA tax purposes.

Common examples of this type of benefit are health insurance, qualified retirement plan contributions, and group-term life insurance up to $50,000. Even if the benefit is not taxable to the employee, you can still deduct the cost of providing the benefits, provided that you meet all the requirements.

The value of fringe benefits that are not tax-free under the Internal Revenue Code must be included in the employee’s taxable income. This is also true when the benefits are of a type that would be excludable if they met all the federal requirements, but for some reason your plan does not meet the requirements.

For instance, some types of retirement plans are not permitted to discriminate in favor of highly compensated employees such as the business owners. If the plans do discriminate, the value of the benefits will generally be taxable compensation to the highly compensated employees who receive them. 

Again, the fact that the value of the benefit must be included in the employees income is a separate issue than whether you can deduct the cost of providing the benefit. The cost of the benefit is still deductible by you.

For example, if you let your sales representatives use a company car, the value of this noncash fringe benefit must be included in the sales representative’s wages as part of his or her compensation. You will not be able to deduct the value of this fringe benefit as a wage expense. However, you can deduct your costs of providing the cars, including the depreciation expense.

Retirement Contributions May Be Deductible

One of the best ways to reduce your tax bill, while increasing your net worth and future security, is to invest in a retirement plan. When you own the show, you’re in a position to tailor-make a plan that suits your needs precisely. If you set up a plan that meets the IRS requirements, you can make tax-deductible contributions to the plan, which will build up tax-free until you withdraw them.

As a self-employed business owner, your major retirement plan options are:

  • Keogh plans. Defined benefit, defined contribution, or hybrid retirement plans set up by a self-employed person or partnership. Common types of Keoghs include money-purchase plans and profit-sharing plans.
  • Simplified Employee Pensions (SEPs). A very flexible, easy plan to set up that involves making contributions to special Individual Retirement Accounts (IRAs) set up for the business owner and each eligible employee.
  • SIMPLE plans. The Savings Incentive Match Plan for Employees (SIMPLE plan), which allows employees to make elective contributions of up to $12,000 in 2013 and 2014), and requires employers to make matching contributions.
  • Individual Retirement Accounts (IRAs). The easiest solution to retirement savings, although your contributions are limited to $5,500 in 2013 and 2014) (Those who are age 50 and above can contribute an additional $1,000.)

Work Smart Small employers 100 or fewer employees can claim a tax credit of 50 percent of the start-up costs incurred to create or maintain a new employee retirement plan for the first three years of the plan. The amount claimed is limited to $500 in a tax year.

Reporting Plan Contributions Varies Based Upon the Plan

If you are a sole proprietor, contributions made for employees to a Keogh plan, an SEP, or a SIMPLE plan are reported on Line 19 of Schedule C, “Pension and profit-sharing plans.” Contributions made to the plan on your own behalf would be reported on Line 28 of your Form 1040.

There are also some special tax reporting requirements with regard to the Keogh or other retirement plan itself. Generally, an annual report on IRS Form 5500-C/R (for plans with fewer than 100 participants) must be filed with the IRS by the last day of the 7th month after the close of the plan year. Single-participant plans can use Form 5500-EZ. See the instructions for these forms (available from the IRS by calling 1-800-TAX-FORM, or at its website or see your professional tax advisor.

If your IRA contribution is deductible, you don’t need to file any special forms to claim it, nor do you need to itemize your deductions on Schedule A of Form 1040. Simply write the amount of your contribution (and your spouse’s contribution, if married filing jointly) on Line 32 of Form 1040, or Line 17 of Form 1040A. To report any nondeductible IRA contributions, you must file IRS Form 8606, Nondeductible IRAs, with your tax return. To claim a tax credit for your retirement contributions, if you are eligible, you must file IRS Form 8880, Credit for Qualified Retirement Savings Contributions,.

Accountable Plans Provide Significant Benefits When Reimbursing Employees

If your employees pay business expenses from their own funds, you will generally want to reimburse them for these expenses. It is important to be aware of, and follow the rules, when making the reimbursement or you could cost yourself a business expense deduction and trigger additional income for your employees.

You will want to make sure that the reimbursements, particularly for automobile, travel, meals and entertainment expenses, are made under an “accountable plan.” 

Expenses reimbursed under an accountable plan are deductible as business expenses and are also excluded from the employee’s gross income. If you are a sole proprietor filing Schedule C, you would deduct these reimbursed expenses in the Schedule C categories to which they pertain. So, reimbursed employee travel expenses would be added to your own travel expenses on Line 24a; reimbursed meals would be reported on Line 24b etc.

Reimbursements under nonaccountable plan. However, if the reimbursements are not made under an accountable plan, you must include the reimbursements in the employee’s wages on IRS Form W-2. In addition, you have to withhold income taxes and employment taxes on reimbursements made, or considered made, under a nonaccountable plan and you have to pay the employer’s portion of the payroll taxes

The employee will have to report the reimbursement as income and must must generally claim a miscellaneous itemized deduction for the allowable business expenses if he or she wants to get any tax benefits from them. This is a harsh result for the employee because it requires that the employee itemized deductions and the miscellaneous itemized deductions are subject to a two-percent income floor. If you are a sole proprietor, you’d include the reimbursements on Line 26 of Schedule C, “wages.”

What Is an Accountable Plan?

Clearly, reimbursing under an accountable plan is better for both you and your employees, from a tax perspective. So, what is an accountable plan? A reimbursement arrangement that meets the following three requirements is considered an accountable plan:

  1. The reimbursements must be for deductible business expenses that are paid or incurred by an employee in the course of performing services for you.
  2. The employee must be required to substantiate the amount, time, use, and business purpose of the reimbursed expenses to you. In order to do this, the employee should submit an account book, diary, log, statement of expense, trip sheet, or similar record, supporting each of these elements, that is recorded at or near the time of the expenditure. The records should include any supporting documentary evidence, such as receipts. An employee who receives a mileage allowance is considered to have substantiated the amount of the expenses if the employee substantiates the time, place (or use), and business purpose of the travel.
  3. The employee must be required to return to you any excess of reimbursements over substantiated expenses within a reasonable period of time.

How long is a “reasonable period?” The IRS will generally accept your plan if the employee is required to provide substantiation within 60 days or return unsubstantiated amounts within 120 days after an expense is paid or incurred. If you furnish your employees with periodic statements (not less frequently than quarterly) of unsubstantiated expenses, amounts substantiated or returned within 120 days of the statement will be considered returned or substantiated within a reasonable time.

You can use a mileage allowance – even one that exceeds the standard mileage rate – and if it is reasonably calculated not to exceed the employee’s actual or anticipated expenses, it will be treated as meeting this return requirement even if the employee does not have to return the excess of the allowance over the standard mileage rate.

Is all this recordkeeping worthwhile? The major financial advantage to having an accountable plan is that you are not required to pay the employer’s portion of FICA taxes on reimbursements. The plan also will increase your employees’ satisfaction with you because they will not have to pay taxes on the amounts, or deduct them on their own tax returns. 

In contrast, if you don’t meet the requirements for an accountable plan, you will have to withhold income taxes and employment taxes on any reimbursements you make. While an accountable plan is not required, it could be a real money saver in the long run depending on how many employees you have and the extent to which reimbursement plays a part in your business.

Special Rules Apply to Employer-Provided Meals, and Lodging

If you pay your employees in the form of food or housing, you can deduct your actual costs of providing these items. You would deduct them as direct costs of your business, not as employees’ wages.


If you are a sole proprietor and you rent a house for your temporary workers to live in, you can deduct the cost of the rental payments as “rental expenses” on Line 20b of your Schedule C, not as “wages” on Line 26.

Meals for employees. Special, more restrictive rules for meals state that only 50 percent of the costs of meals provided to employees are deductible, unless the value of the meals is included in the employees’ taxable wages.

However, certain free meals provided to employees for the convenience of the employer are 100 percent deductible by the employer and are not taxable to the employees. To be considered “for the convenience of the employer,” they must be taken on the business premises.

Work Smart – You can deduct the full cost, not just 50 percent, of providing an occasional social or recreational event for your employees, such as a company picnic or holiday party.

If an employer provides meals to its employees on the premises and more than one-half of the employees are receiving the meals “for the convenience of the employer,” the meals will not be taxable to any of the employees and the employer can deduct the entire cost of all the meals. The question of exactly what “convenience of the employer” means remains an unsettled question in the law. Generally, if your employees must remain on the premises in order to be available to work if needed, or if the lunch breaks are too short to allow employees to go out to eat, the meals would be considered to be for the employer’s convenience.



Protect Your Small Business

If you own a small business, it might seem like there are an infinite number of ways you can get in trouble with the government. This is not quite true—the number is not infinite. Here are the four most common ways small businesses get into truly serious legal trouble with the government.

1. Failing to Pay Payroll Taxes to the IRS

Whenever you hire an employee for your business, you become an unpaid tax collector for the IRS. You are required to withhold and pay to the IRS your employees’ income taxes. You are also required to withhold and pay their Social Security and Medicare taxes and make a matching contribution out of your own funds. You must pay these taxes to the IRS throughout the year—smaller employers usually pay them monthly.

As far as the IRS is concerned, an employer’s most important duty is to withhold and pay Social Security, Medicare and income taxes. These are also known as “trust fund taxes” because the employer is deemed to hold the withheld funds in trust for the U.S. government. If you fail to pay trust fund taxes, you can get into the worst tax trouble there is. The IRS can—and often does—seize a business’s assets and force it to close down if it owes back payroll taxes. Although rare, you can also get thrown in jail.

At the very least, you’ll have to pay all the taxes due plus interest. The IRS may also impose a penalty known as the trust fund recovery penalty if it determines that you willfully failed to pay the taxes. The agency can claim you willfully failed to pay taxes if you knew the taxes were due and didn’t pay them. If you paid such taxes in the past and then stopped paying them, that constitutes pretty good evidence that you knew the taxes were due.

The trust fund recovery penalty is also known as the 100% penalty because the amount of the penalty is equal to 100% of the total amount of taxes the employer failed to withhold and pay to the IRS. This can be a staggering sum.

If you’re a business owner, you’ll be personally liable for the 100% penalty—in other words, you will have to pay it out of your own pocket. Business owners include sole proprietors, general partners, and corporate officers such as the president, vice president, secretary, and treasurer, whether or not they own any stock.

Small businesses that are starved for cash sometimes “borrow” the taxes they are supposed to withhold and pay to the IRS. Obviously, this is insanely stupid. It is the absolutely last thing any business owner should ever do.

To make sure all your payroll taxes are filed properly and on time, it’s wise to use the services of a reputable payroll tax service. The cost will be quite small if you only have a few employees. You can find a list of payroll service providers on the IRS website at Your bank may also provide payroll tax services.

Be aware, however, that even if you use a payroll tax service, you remain personally liable if your taxes are not paid on time. The IRS recommends that an employer: (1) keep its company address on file with the IRS, rather than the address of the payroll service provider, so that the company will be contacted by the IRS if there are any problems; and (2) contact the IRS about any bills or notices you receive as soon as possible. This is especially important if it involves a payment you thought your payroll service already made.

2. Misclassifying Workers as Independent Contractors

You can avoid having to pay payroll taxes to the IRS by classifying a worker as an independent contractor, instead of an employee. Independent contractors are not entitled to any of the benefits that employers are usually required to provide employees, including workers’ compensation insurance coverage, unemployment insurance, or health insurance (required by Obamacare starting in 2015 for employers with over full-time 50 employees).

However, a worker is not an independent contractor simply because you say so or he or she signs a piece of paper saying so. The worker must actually be in business for himself or herself. A worker who is solely dependent on you for his or her livelihood and subject to your direction and control on the job, is your employee, no matter what label you use.

A common way small business owners get into trouble with the government is misclassifying workers as independent contractors to avoid their responsibilities as employers. Federal and state agencies are well aware of this problem, and worker misclassification is a hot button issue for them. These agencies include the IRS, state unemployment insurance agencies, and workers’ compensation agencies. Because these agencies share information with each other, misclassifying workers as independent contractors can lead to a cascade of government audits, resulting in costly assessments that can put you out of business. For this reason, you need to take great care when you determine whether to classify a worker as an employee or independent contractor, and properly document your actions. For details, see the article Hiring Employees and Independent Contractors.

State unemployment insurance agencies

The worker misclassification issue most frequently arises when a fired or laid off worker who has been classified as an independent contractor files a claim for unemployment compensation, claiming he or she should have been treated as an employee for unemployment insurance purposes. When this happens, state unemployment auditors will investigate the hiring firm. If the state auditors determine the worker should have been classified as an employee, they will require the company to pay all the unemployment taxes it should have paid for the worker going back several years—three years is common— plus interest. In addition, auditors usually impose penalties for the misclassification. To add insult to injury, if other workers do similar work for the same company, the employer will have to pay UI taxes for those employees
as well. The misclassified employees will also be eligible for workers’ compensation benefits and any fringe benefits the company provides its employees such as overtime, health insurance, and retirement plans.

State workers’ compensation agencies

Unemployment insurance audits can also lead to audits by your state workers’ compensation agency. They also frequently occur when a worker who is injured on the job files a workers’ comp claim. You will suffer harsh penalties if you misclassify an employee as an independent contractor for workers’ compensation purposes and have no workers’ compensation insurance.

Most state workers’ compensation agencies maintain a special fund to pay benefits to injured employees whose employers failed to insure them. You will be required to reimburse this fund or pay penalties to replenish it.
In addition, in most states, the injured worker can sue you in court for personal injuries. Most states try to make it as easy as possible for injured employees to win such lawsuits by not allowing you to raise legal defenses you might otherwise have, such as that the injury was caused by the employee’s own carelessness.
You will also have to pay fines imposed by your state workers’ compensation agency for your failure to insure. The workers’ compensation agency may also obtain an injunction—a legal order—preventing you from doing business in the state until you obtain workers’ compensation insurance.
Finally, in almost all states, failure to provide employees with workers’ compensation insurance is a crime—a misdemeanor or even a felony. An uninsured employer may face criminal prosecution, fines, and, in rare cases, prison.


Worker classification is also an issue frequently explored in audits of small businesses by the IRS. If the IRS conclude that you have misclassified employees and independent contractors, you’ll have to pay back taxes, interest, and penalties. The assessments the IRS can impose for worker misclassification vary, depending upon whether the IRS views your misclassification as intentional or unintentional. If the IRS determines you unintentionally misclassified a worker for whom you filed all required 1099 forms, you’ll have to pay about 20 cents for every dollar you paid the worker, and 25 cents for every dollar if you didn’t file 1099 forms. But if the IRS finds your misclassification intentional, you’ll have to pay about 50 cents for each dollar you paid the worker.

3. Violating Federal and State Labor Laws

Employees enjoy a wide array of rights under federal labor and antidiscrimination laws. Among other things, these laws:

  • impose minimum wage and overtime pay requirements on employers
  • make it illegal for employers to discriminate against employees on
    the basis of race, color, religion, gender, age, disability, or national
    origin, and
  • protect employees who wish to unionize.

Most states have similar laws protecting employees.

In recent years, a growing number of employees have brought lawsuits against employers alleging violations of these laws. Some employers
have had to pay hefty damages to their employees. In addition, various watchdog agencies, such as the U.S. Department of Labor and the U.S. Equal Employment Opportunity Commission, have authority to take administrative or court action against employers who violate these laws.

Most of these laws, other than some nondiscriminination laws, apply only to employees, not independent contractors. If you have employees, you need to understand and follow these rules. For more information, refer to the United States Department of Labor elaws web page (short for employment laws assistance for workers and small businesses).

4. Violating Federal Immigration Law

Many workers in the United States are immigrants. And some of these immigrants work illegally—that is, they are not U.S. citizens and don’t have a green card or other documentation of their legal status. All employers must verify that their employees are either U.S. citizens or nationals, or legal aliens authorized to work in the U.S. To do this, the employer and employee must complete USCIS Form I-9. The employee must provide identifying information and documents establishing the employee’s citizenship status, such as a driver’s license, Social Security Card, or U.S. passport. The form must be kept by the employer, but need not be filed by with the government.

You are not required to verify citizenship when you hire an independent contractor. However, although you are not required to verify the immigration status of ICs or others coming within these exceptions, it is still illegal for you to hire any worker whom you know to be an illegal alien. The federal government can impose a fine of up to $2,000 for the first offense.



Good News: IRS Audit Rate Drops

Your chances of facing an IRS audit rate dropped to the lowest level in at least a decade in 2014 and are expected to fall further this year, according to new data USA TODAY obtained from the nation’s tax agency.

The audit rate, the percentage of individuals’ tax returns IRS revenue agents examined either in person or via correspondence, fell to 0.86% last year, the data show. That represents the lowest rate since at least fiscal year 2005.

After rising steadily from 2005-10, the number of IRS audits for individual taxpayers fell 21.4% during the succeeding five years, the data show.

The IRS audited slightly more than 1.2 million individuals last year, down more than 162,000 from 2013, and a drop of nearly 339,000 from 2010.

Audits fell in virtually every individual category and across income levels, even as the number of individual tax returns filed rose in all but two of the past nine years, the data show.

The IRS audited slightly less than 1.1 million taxpayers with income of less than $200,000 in 2014, a drop from more than 1.4 million in 2010. While nearly 41,000 individuals with annual income of $1 million or more faced audits in 2012, the number of similar audits in that category dropped to just more than 34,000 last year, the data show.

The audit declines coincide with recent drops in IRS funding and a steady falloff in revenue agents. It also comes as the tax agency seeks congressional approval for a fiscal year 2016 budget hike after being buffeted over dwindling taxpayer services and allegations it targeted conservative tax-exempt groups for increased scrutiny.

IRS Commissioner John Koskinen conceded in a Monday phone interview that the tax agency is “not the world’s most beloved.” But he warned that the audit rate decline could eventually “corrode” Americans’ faith in the federal tax system and undermine voluntary payment compliance.

“At this point, we do have a tax compliance ethos and people pay their fair share,” said Koskinen, who’s expected to cite the audit trend during a Tuesday speech to New York State Bar Association’s tax section. But he added: “If you’re in Des Moines and you’re writing that check, and you feel that maybe your neighbor down the street isn’t, or is getting away with something, that’s a problem.”

Arguing for additional budget funding, Koskinen cites IRS data that show restoring the number of revenue agents would produce nearly $1.3 billion in new government enforcement revenue once new hires complete training and reach full working potential in fiscal year 2018.

Asked whether the IRS could shift workers from other jobs to revenue agent duties, he said audits require time-consuming training. Additionally, the tax agency’s overall personnel count is down 13,000, a total that will rise to an estimated 16,000 this year, he said.

“Anyplace in the IRS is short-staffed,” said Koskinen.

However, the agency’s operations and quest for increased funding face “especially tough scrutiny,” Sen. Orrin Hatch, R-Utah, who chairs the Senate Committee on Finance, told Koskinen during a Feb. 3 budget hearing.

“And unfortunately, the IRS’ operations do not appear to be able to withstand such scrutiny at this time,” added Hatch, who cited the agency’s treatment of tax-exempt groups and other issues.