Accounting and Finance for Your Small Business Second Edition_12 pot

For income taxes withheld and for Social Security FICA taxes,the employer files a quarterly report on federal Form 941.. This report, form W-2, includes all wages, tips, other com-pensat

What Wages Are Subject to Taxes? The Internal Revenue Service(IRS) makes available publications on what constitutes wages forthe purpose of tax liabilities Essentially, wages subject to taxesinclude all compensation given to an employee for services per-formed The pay may be in cash, vacation allowances, bonuses, andcommissions Other special considerations to be checked in currentIRS publications include:

• Partially exempt employment

Filing Returns and Reporting Taxes. FUTA taxes are reportedquarterly, using Form 940 The deposit is due by the last day of thefirst month after the quarter If the amount due for any quarter isless than $100, it may be carried over and paid in the next quarter’sreport

For income taxes withheld and for Social Security (FICA) taxes,the employer files a quarterly report on federal Form 941 Thereare some exceptions to this rule related to agricultural employers,household employers, state and local governments, and some others.Willful failure to file returns and pay taxes when due will result

in criminal and civil penalties The same is true for willful filing offalse or fraudulent returns In some cases in which income and SocialSecurity taxes are not withheld and not paid to the IRS, individuals

of the corporation or partnership may be held individually liable forthe payment of these taxes along with a penalty of up to 100 per-cent of the taxes wrongfully uncollected.

Wages and Tax Statement. By January 31 of each year, anemployer must provide each employee a statement of wages andtaxes This report, form W-2, includes all wages, tips, other com-pensations, and withheld income and Social Security taxes Otherpayments may be included when applicable: bonuses, vacationallowances, severance pay, moving expenses, taxable fringe bene-fits, some kinds of travel expenses, and others

Income Tax Return

Tax rules vary according to whether the operation of the business is

as a sole proprietorship, a partnership, a regular C corporation, or

an S corporation These tax rules may affect how the firm carriesout its business activities

Sole Proprietorships. In order to qualify as a sole proprietorship,you must be self-employed and the sole owner of an unincorpo-rated business Schedule C is filed with a federal Form 1040 (per-sonal tax return) by April 15 of the year following the fiscal yearreported

In a sole proprietorship, there is no tax effect for taking moneyout of the business for personal use or transferring personal money

to the business However, you should set up and keep separateaccounts to keep track of identifiable business expenses and per-sonal withdrawals Failure to keep adequate business records hasbeen the downfall of many sole proprietorships

Partnerships. A partnership is the relationship between two ormore persons for the purpose of carrying out a trade or business for

a profit Each person contributes money, property, labor, or skill,expecting to share in the profits or losses of the enterprise

If a husband and wife carry on a business together and expect toshare in the profits and losses, they may come under the definition

of a partnership for the purposes of taxes This may occur even by

operation of law, where the husband and wife have not executed aform of partnership agreement.

Income from a partnership is reported on Form 1065, U.S.Partnership Return of Income Also included will be a separateschedule SE, Computation of Social Security Self-Employment Tax.These are “information only” returns Taxes will be paid in quarterlyestimates as a part of the partners’ personal (1040) tax reporting.But for a few exceptions, a partnership determines its income

in much the same way that an individual determines his or herincome In determining their income tax liability for the year ontheir own income tax returns, partners must take into account,

separately, each partner’s distributive share This consideration must

be made whether these items are distributed or not:

• Gains or losses associated with the sale of capital assets

• Gains or losses from sale or exchange of certain property used

by the business

• Charitable contributions

• Dividends or interest for which there is an exclusion or deduction

• Other items of income, gains, or losses, as explained inSchedule K, Form 1065

Corporations. Many areas of corporate taxation are quite plex and cannot adequately be dealt with here For a more com-plete discussion of corporate tax consequences, the IRS publication

com-542, Tax Information on Corporations, may be helpful to you.Every corporation must file a tax return, even if it had no tax-able income for the year and regardless of the amount of its grossincome for the year The income tax return for the regular corpora-tion is Form 1120 As in the case of individual taxpayers, the fed-eral government has a short-form application for taxes of small U.S.corporations: Form 1120-A, U.S Short-Form Corporation IncomeTax Return In order to qualify to use the short form, the businessmust meet certain requirements, which have usually been:

• Gross receipts do not exceed $500,000

• Total income does not exceed $500,000

• Total assets do not exceed $500,000

• No foreign owners, direct or indirect, of 50 percent or more ofits stock.

• It is not a member of a controlled group or a personal holdingcompany

• It is not a consolidated corporation return filer

• It is not undergoing liquidation or dissolution

• It does not owe alternative minimum tax

• It is not an S corporation, life or mutual insurance company, orother company filing a specialized form For more information,use the instructions for Forms 1120 and 1120-A

If the corporation files a return on a calendar-year basis, thenthe return is to be filed by March 15 following the calendar year

If the corporation uses a fiscal year other than a calendar year,then the report must be filed by the fifteenth day of the thirdmonth after the fiscal year The return is filed with the InternalRevenue Office serving the area where the corporation maintainsits principal office—that is, where it maintains its principal booksand records

A corporation will receive an automatic six-month extensionfor filing a return by submitting an application for an extension onForm 7004 The IRS can terminate this extension at any time prior

to the expiration of the six-month period Interest is charged on thedifference between the tentative tax reported on Form 7004 andthe actual tax the corporation must pay when it files its Form 1120.Failure to file on the date required without good cause shownmay result in the imposition of a delinquency penalty of 5 percent

of the tax due This penalty will apply to the first month due andmay be increased by 5 percent per month for each subsequentmonth, up to a cap of 25 percent To avoid penalties, you will have

to give an explanation of good cause; that statement will be madeunder penalty of perjury

If after filing Form 1120 or 1120-A you wish to correct an error

on the return, you may do so by filing a Form 1120X, AmendedU.S Corporation Income Tax Return You can use this methodwhen you discover that you may have misstated income or failed toclaim a deduction or credit

Estimated Income Tax. Many, if not most, corporations arerequired to file and pay an estimated tax A corporation’s estimatedtax is the amount of its expected tax liability less its allowable taxcredits This estimated tax must be deposited with an authorizedfinancial institution or a federal reserve bank Each tax paymentmust be accompanied by a federal tax deposit coupon, according tothe instructions in the coupon book.

S Corporations. Some business owners prefer not to be subject tofederal corporate income tax liability If the corporation qualifies,its income will be taxed to the shareholders individually, like apartnership, rather than the corporation For a complete discussion

of the tax liabilities and calculations, the Internal Revenue Service

provides publication 589, Tax Information on S Corporations.

To qualify as an S corporation, these requirements normallyhave been applicable:

• All shareholders must elect to be an S corporation

• The corporation must have a permitted tax year

• The corporation must file Form 2553, Election by a Small Business

Corporation, indicating the choice to be treated as an S

corpo-ration

• It must be a domestic corporation

• It must have only one class of stock

• It must not have more than 35 stockholders

• It must have only individuals or their estates as stockholders

• It must not have a nonresident alien as a shareholder

• It must not be a member of an affiliated group of corporations

• It must not be:

• A domestic international sales corporation

• A company that serves as a financial institution, taking depositsand making loans

• An insurance company taxed under Subchapter L

The permitted tax year is generally a calendar year endingDecember 31 Other years may be requested but require approvalfrom the IRS

Other Specialized Reporting Areas

Specialized Business. Businesses such as those dealing in firearmssales and transportation, tobacco sales, liquors and spirits, ethanolproduction, travel agencies, and others have special reports Mosthave some relation to the health, safety, morals, and welfare of cit-izens These reporting requirements vary for different businesses.For example, dealers in firearms require federal licenses depending

on whether the dealer sells rifles and shotguns or handguns, ortransports weapons in interstate commerce In addition, sales have

to be reported on various forms prepared and submitted by thedealer

Special Agencies. Many federal agencies require periodic andregular reporting of various business functions Examples of agen-cies requiring reporting are the Environmental Protection Agency(EPA)—air and water quality; Occupational Safety and HealthAdministration (OSHA)—workplace safety and employee health;Federal Energy Regulatory Commission—utility fuel costs; InterstateCommerce Commission (ICC)—motor and rail carrier rates andcharges; Federal Communications Commission: depreciation rates,service charges, and terms and conditions of service

The discussion of federal reporting requirements has been, bynecessity, brief and general An accountant and/or attorney should

be consulted to assure compliance with all reporting requirements.Also, it is a good idea to make use of the publications provided bythe various agencies

State Government Requirements

Unemployment Insurance

Unemployment insurance provides a temporary source of income

to make up a part of the wages lost by workers who lose their jobsthrough no fault of their own and who are willing and able towork Although the programs may vary from state to state, thisdescription is representative

The employer generally pays for unemployment insurance as

one of its businesses expenses Typically, workers pay no part of thepremium The premiums go into a reserve fund to pay claims as theyarise Many states consider the stability of an employer’s employ-ment history when establishing a tax rate.

New employers are required to report initial employment in themonth following the calendar quarter in which employment begins.The regulating agency then determines whether the employer isliable for taxes Typical state eligibility requirements include:

• That in a calendar year a business has a $1,500 quarterly payroll

or one or more employees

• Liability for federal unemployment tax

• Purchase of a liable business

If the employer is liable for the payment of unemployment ance, it will be required to make periodic reports and payments oftaxes It may be required to report:

insur-• Total wages paid to covered workers, excess wages, taxablewages, and taxes due

• Individual wage listings with each employee’s Social Securitynumber, name, weeks worked, and total wages paid

This report usually is required to be filed along with the properamount of taxes one month after the quarter in which the qualify-ing employment occurred Timely filing is necessary in order to:

• Receive the maximum amount of credit against the federalunemployment tax for the state unemployment taxes paid

• Get proper credit for calculating the experience rating

• Avoid penalty and interest charges established by law for latepayment and late reports

Sales and Use Taxes

Sales and use taxes vary greatly from state to state Their ity, rates, and exemptions from taxation are dissimilar across stateboundaries In addition, many countries and cities have local option

applicabil-sales and special use taxes Information relative to the employer’sstate and local government should be obtained from the offices of

the state department of revenue or taxation and from the county or

city government This discussion will serve as an example but maynot be typical of your state

Registration. Every person, partnership, corporation, or S ration desiring to engage in business in the state generally will berequired to secure a certificate of registration for each place of busi-ness within the state A business may not have to comply with thisrequirement if it is engaging in an enterprise not subject to salesand use tax There is usually a nominal fee ($5–$25) associated withthe filing for a certificate Sales tax of about 4 to 8 percent is levied

corpo-on qualifying sales made within a state A use tax is generally thesame rate, but the tax is paid on qualifying items brought into thestate to be used, consumed, distributed, rented, or stored for use orconsumption

Exemptions in Some States Include:

• Groceries and produce, except those prepared within a premisefor consumption

• Medical—prescription and household medicines

• Telephone and utility service (other taxes, however, may apply

State Corporate Income Taxes

Many states have a form of corporate income taxes These taxes areimposed on all domestic and foreign corporations for the privilege

of doing business or earning or receiving income within the state.Generally, individuals, partnerships, and estates or trusts are notliable for this tax

Reporting. A return is generally required by a state if (1) a federalincome tax return is filed or (2) the taxpayer is liable for payment

of taxes The return is usually filed on the first day of the fourthmonth after the close of the taxable year or the fifteenth day afterthe due date for the filing of the related federal returns for the tax-able year Some states allow for automatic extensions However,they usually require payment of estimated taxes Any underpay-ment of estimated taxes usually will be assessed both penalty andinterest These can be as much as 12 to 15 percent on the amount

of underpayment Remittance of the tax is due at the same time thereturn is filed Some states have provisions related to the federalpenalty provisions for nonfiling without just cause Interest gener-ally is applicable at a fixed rate, and the state may even penalize acompany for fraudulent returns Some states assess a penalty forfailure to file a return even when no taxes are due

Tax Basis and Rates. The tax generally is applicable to all forms ofincome, including capital gains at (usually) a uniform rate Statestypically model their code provisions so as to be consistent withapplicable federal code provisions

Individual Income Tax

If the business operates as a sole proprietorship, a partnership, or an

S corporation, the profits may be subject to individual state incometaxes One of the initial considerations that should be made in setting

up the form of business is the tax considerations of the entity andthe individuals involved Therefore, the state’s individual personalincome tax (if it has one) may be a valid consideration in the opera-tion of the business and the policy for the distribution of profits

Other Possible Tax Returns

Intangible Tax. Intangible taxes are levied on the ownership,control, or custody of taxable intangibles, such as notes, bonds, andother obligations to pay money that are secured by a mortgage,deed of trust, or other lien on real property within the state In addi-tion, the state generally levies this tax on shares of stock in incor-porated businesses, bonds, notes, accounts receivable, and otherobligations for payment

Ad Valorem Tax. Ad valorem tax is a tax on the value of real estate

as assessed by a duly authorized appraiser appointed or elected toserve in that capacity The rate of taxation—the millage—usually isexpressed in one-thousandths of a dollar For example, 23 milsmeans $.0023 Various states and even counties within a stateapply various rates (and even various values) for tax purposes Thistax applies to land, buildings, fixtures, and all other improvements

to real estate physically located within a jurisdiction

Some states may have special taxing districts that assess an advalorem tax on the property for special services (water manage-ment, flood control, fire, school, and many others)

Documentary Stamp Taxes. Documentary stamp taxes are taxesassessed against the execution of certain documents Althoughvarying in rates across states, this tax generally is applicable onpromissory notes, mortgages, trust deeds, security agreements, andother written promises to pay money Typically not a significant tax(usually being about $.15–$.20 per $100 face value), it is an obli-gation that must be met in the consummation of certain financialtransactions

Tangible Personal Property Tax. Tangible personal property taxes,like ad valorem (real property) taxes, generally are assessed bycounties at a rate sometimes equal to the ad valorem tax This tax

is based on the assessed value or the value declared by the owner,for business supplies, fixtures, furnishings, and so on Some statesextend this tax to motor vehicles, rail cars, trucks, buses, aircraft,and even ships and boats Often states that exempt these items from

this tax collect a like amount through licenses Some states includeinventories and work-in-process in this class of taxable property.

Others. States may have enacted various other miscellaneoustaxes and fees that may impose both a reporting and filing require-ment For example:

• Charter tax: A fee or tax associated with the filing of articles of

incorporation, amendment to the articles, merger, tion, or dissolution

consolida-• Excise tax: Tax usually collected directly from the ultimate

con-sumer on the sale of utility services

Local Government Requirements

Local governments—cities and counties—have varying amounts oflicensing and taxing authority These powers arise as a result ofconstitutional provisions, state statutes, county ordinances, specialacts of state legislatures, and charters and municipal code provi-sions Some of these requirements may include:

• Occupational licenses Counties and incorporated municipalities

may be authorized to levy a tax for the privilege of engaging in

or managing a business, profession, or occupation within thejurisdiction The basis and rates for license payments vary con-siderably Inquiries concerning these restrictions usually can behandled by individual county or city clerks

• Zoning restrictions Land use restrictions and limitations may be

governed by a local zoning board This may be under the ity of city or county governments Zoning restrictions usuallyare established for an area or a parcel Variances to restrictionsmay be petitioned for on an exceptional basis Often the nature,character, and use of parcels will change over time, bringingabout updating and change to land use plans For example, withthe growth of suburbs, land previously zoned agricultural may

author-be changed to residential; some may change to commercial toaccommodate malls, shopping areas, and business activities

• Sales taxes Sometimes counties or cities impose local option

sales taxes These may be ongoing taxes or may have limiteddurations designed to meet specific needs (e.g., construction of

a jail or courthouse, road improvement, modernizing a hospital

or school) These taxes may be collected by the state and ted back to the city or county

remit-• Gasoline and special fuels taxes Generally all gasoline and diesel

fuel used for on-road vehicles is taxed by the state and federalgovernments However, counties may have an additional localoption tax Sometimes special fuels sold for residential, agricul-tural, or commercial marine purposes are exempt from this tax

• Local income taxes Some large cities (notably New York) have

local income taxes These are levied in addition to federal andstate income taxes There is often a credit or deduction applica-ble for state and local income taxes against federal income tax

Creditors

Companies that have advanced credit to a business or that haveinvested money in the enterprise want to know how their invest-ment is faring Generally they will insist on some form of statusreport on a timely basis—weekly, monthly, quarterly, or other reg-ular period The frequency of the necessary reporting will depend

on various factors: risk, volatility of the market, past performances,solvency, and others

Often several documents must be prepared (balance sheet,income statement, cash flow statement) to inform creditors of thebusiness status and financial conditions

Together these reports afford a comprehensive model of theoperations, liquidity, and the past and current operations of thebusiness Creditors may also request pro forma or forward-lookingfinancial statements to create an educated future forecast of thebusiness operations of the enterprise

When loaning money to a business, creditors may require notesand mortgages to carry conditions or covenants In Chapter 5, weexplained how the investors of debt capital probably will conditionthe loans on a showing of certain ratios We also discussed how you