Employee or Independent Contractor?

In my upcoming e-course “Starting Your New Business”, I have a bonus discussion on the difference between employees and independent contractors.  I discuss what makes a person an employee as opposed to an independent contractor.  The items that the IRS takes into consideration when deciding are also discussed.

To make a point of the difference in the responsibilities, I made two lists.  Wow!  Put it in black and white, and it’s obvious why everyone wants independent contractors instead of employees.  Take a look:

Responsibilities when your business has employees

  • Withhold federal and maybe state and local income taxes
  • Withhold social security tax and medicare tax
  • Pay the employer’s share of social security tax and medicare tax
  • Make federal tax deposits
  • File Employer’s quarterly 941 tax return
  • File state and local tax returns
  • File annual federal unemployment tax return
  • Pay federal unemployment tax
  • File annually W2’s and W3
  • File state unemployment reports
  • Pay state unemployment tax
  • Comply with New Hire Reporting requirements

Responsibilities for Independent Contractors

  • File 1099 if you paid a contractor $600 or more during the year

Big difference in those two lists!

Start Up Expenses — Don’t Lose Them!

The expenses of starting a business can really add up, but new owners sometimes think that because they aren’t in business yet — the expenses don’t count.  You can’t deduct them on your taxes until you are actually in business (not necessarily making a money!), but keep up with them.  The first $5,000 of start up expenses can usually be deducted the first year and the rest are amortized (spread out) over fifteen years.  So, what are start up expenses?

Start up expenses are all of those expenses that you incur to get your business started.  Consulting with CPAs and attorneys.  Learning about running your business and how to set it up, marketing exploration,  website and design services, the legal costs to become an “entity.”  Learn about the different entities here.  Setting up a new business takes a lot of running around and with today’s gasoline prices — keep a log of miles traveled.  TIP – Keep up with everything, and let your tax professional sort through it.

Also, keep up with all equipment purchases, supplies, things that you will use in your business.  These aren’t “start up” expenses, but can be deductible once you are actually in business regardless of when you paid for the items.  TIP – Keep receipts.

Inventory – Counting Beans

Inventory — do we need to count those beans?  Yes, I know, these are peas but you get the picture.  First decision is whether or not inventory is important — to you, to the IRS or to your state.  State?  Yes, numerous states have a tax on inventory, so keep that in mind.

Some common examples of inventory include: Merchandise for sale, raw materials, work in process, finished products and supplies that become part of an item for sale.  If you’re a retail store or a manufacturer then inventory is important.  Keeping up with inventory and “valuing” inventory (if it’s determined to be important) are topics for another day.

Let’s take for example an artist, a jewelry maker.  They have all sorts of materials that go into making a piece of jewelry.  And at any given time they have materials on hand, jewelry they are working on and finished pieces of jewelry.  Do they need to worry about inventory?

When they sell a piece of jewelry, they will want to know what it cost them to make.  Yes, to price the item, they do need to know the cost of the materials and their time — does it need to be exact?  If it’s exact they aren’t going to have time for making jewelry!  But I’ll bet they all have a pretty good idea, and this is good enough.  Don’t make it more difficult than it needs to be.

Now, when it comes to tax reporting, time isn’t important, only materials.  The formula is:

Beginning inventory + purchases – ending inventory = cost of goods sold.

Chances are that inventory (and this is going to depend of $$$) isn’t going to be very important on the tax return, but here’s a sequence that shows why you need at least a general idea of your inventory and report it.   You’ve purchased a lot of materials and made a lot of jewelry, but at the end of the year you still have it.  Not reporting it as inventory would make it look like have a bigger loss than you exactly do.  So, this stuff should be reported as inventory instead of cost of goods sold.  Next year, you have all this stuff so you don’t buy any more, but hey, you sell a ton of it and hardly have anything left at the end of the year.  If you reported inventory in the first year, then it would be become your cost of goods sold and you taxable income is less.  But say you didn’t classify it as inventory the previous year and took a loss — now you have a big profit to report.  Inventory is a way of matching income and expense — it evens out the ups and downs.

Do I need to count those beans?  No, but I need to know that the bag costs around a dollar, and at year end I have half a bag left for inventory.

Chart of Accounts – The Backbone – Part I

Ha!  Chart of accounts is just an accountant’s thing — not important to me as a business owner.  Think again.  The “Chart of Accounts” or some simply call it categories, is the structure for your bookkeeping.  Think of it as the framing of a house — you wouldn’t try laying bricks, placing windows, etc. without a house being framed.  Sloppy chart of accounts equals sloppy financial records.

Here are some tips for a workable chart of accounts.

1.  Look at the IRS forms that you will be reporting, i.e. a schedule C for sole proprietors and single member LLCs.  This will give you an idea of the categories that are necessary.  The difference between the entities is all in the “equity.”  Income and expenses are the same, so a schedule C is a good place for everyone to look.

2.  Think of what categories YOU want for keeping up with certain aspects of your business.

3.  Use a numbering system for your chart of accounts.  This is good habit building if you’re doing it by hand, but best practice if you are using a computer program.  With a numbering system you’ll be able to print your financial statements with income and expenses in alphabetical order, and in general, things will be easier to find.  And you’ll be consistent with the rest of the accounting world.  Leave space when numbering so that you’ll be able to add if needed.

4.  Most important — KEEP IT SIMPLE.  You need a nice balance.  If you make the chart of accounts too detailed, you will lose interest in categorizing items.  A too detailed chart can also become confusing.  There are other ways to keep up with details rather than making a new category in your chart of accounts.

5.  Don’t over-think it.  Nothing is set in stone.  You should have two goals in sight with your bookkeeping system: Know how your business is doing and be able to accurately report to the IRS.

6.  Always have a category called “Ask my accountant.”

Accounting 101

When I went from Philosophy to Accounting, I thought I would find certainty and truth.  Alas, in accounting I found one absolute TRUTH (now keep in mind, my research isn’t exhaustive).  Luca Pacioli, an Italian mathematician, first published this equation in 1494, and it’s been THE method of accountants and bookkeepers ever since.

Another way of saying this is:  everything you own less everything you owe is what you’re worth.  When you list your assets, liabilities and equity together on paper, it’s usually called a “balance sheet”.  It’s a snapshot of your business just as if you had snapped a picture.  It tells nothing of the past, nothing of the activities, and nothing of the future.  A snapshot.  Obviously, if you want to know how your business is doing (and the IRS has a big interest in this little tidbit), you’re going to need something else.

The second part of Luca’s clever little idea:  Income and Expenses.  These aren’t like snapshots — they’re more like a video.  They record a period of time — a day, a month, a year.  Income less expenses equals your profit or loss, and this is called an Income Statement.  Profit or loss then fits into equity on the balance sheet.  And in a good and perfect world, Debits = Credits.

Other than a brief accounting lesson, the point of this is that when people set up their accounting on a computer (and ALL computer accounting programs are based on this method whether they let you know or not) without an understanding of this, strange and scary things happen.  I have clients bring in an income statement to me off of their Quickbooks program.  I say, “where’s the balance sheet?”  They say, “Oh, it’s so messed up that I can’t make heads or tails of it.”  What they don’t understand is that is all fits together.  You can’t trust the income statement if the balance sheet is screwed up.

Now this isn’t to say that you can’t by “hand” keep up with your income and expenses, and have a quite good summary of your business.  It can easily be done.   And I suggest that business owners begin that way.  It never hurts to understand your business.