Updated: Jan 6, 2020
During the holidays, I had the pleasure of interviewing a fellow West Coast accountant, Charles J. Kelly, also known as "CJ The Smart Guy."
CJ is not only smart, he's a hustler. Similar to his favorite icon Nipsey Hussle, he's been puttin' in Overtime his whole life. He has a B.B.A. in Finance and Accounting from Texas Southern University, has done financial and budget work for the transportation industry, and recently founded his own consulting company. Most notably, he has passed all four sections of the rigorous CPA exam and will soon feel Bigger Than Life with that fresh new license!
His education and experience have qualified him to provide helpful tax and accounting advice for small business owners. I asked him a few frequently asked questions for his insight. Check out our interview below!
Q: What tax and accounting factors should a small business owner consider when determining an entity type?
A: When deciding whether to form an LLC, S-Corporation, sole proprietorship, or other entity type, I normally ask what a business owner's current and future visions are for their business. While it is possible to change the business entity at a later date, the accounting changes, operational changes, and even tax changes can become expensive and time consuming. It is best to start with the long-term vision or business plan and act accordingly.
Some factors to consider in your decision include the projected size of the company, business model, self-employment taxes, tax preparation fees, ownership percentage, profit splits, investors, goals and exit strategy (just to name a few).
Another important item to consider is that, the IRS defines a small business taxpayer as a taxpayer that
(a) has average annual gross receipts of $25 million or less for the 3 prior tax years and
(b) is not a tax shelter.
So, if either of those items are not applicable, then the owner might want to consider forming a legal entity that will provide the most favorable tax and legal incentives for their large business.
Q: What business expenses are tax deductible?
A: According to the IRS, a deductible business expense must be ordinary and necessary. Generally, if the expense was used to generate business revenue, it can be written off.
Abuses to the "ordinary and necessary" rule can be detrimental to you and your business. For example, in 2015, the U.S. Tax Court did not allow a Chiropractor to deduct a Microsoft Xbox 360 or Nintendo Wii on his tax returns as they were not required for his trade or business (he really went for it y'all!) (David W. Laudon v. Commissioner, TC Summary Option 2015-54 (2015)) . Not only did he have to amend his return, he also had to pay a hefty tax penalty.
Please consult your accountant prior to purchasing any questionable business expenses.
Q: What is the home office deduction?
A: The home office deduction is for business owners who use a percentage of their home for business. To deduct this percentage, you must regularly use a part of your home exclusively for conducting business.
For instance, a retail business owner that uses his garage to store inventory can most likely deduct the property tax, utilities, rent, and other related expenses that are exclusively allocated to the garage.
Q: Who qualifies for the Qualified Business Income (QBI) Deduction?
A: The answer to this is "it's complicated." If we have to generalize, we can say that business owners who are not "professionals" (lawyers, CPAs, doctors, etc), make under a certain threshold, and who are not organized as a C-corporation typically qualify to deduct approximately 20% of their business income.
The QBI Deduction was implemented under the 2017 Tax Cuts and Jobs Act. Click here for an in-depth overview of the deduction.
Q: Do business owners have to file a tax return if they don't owe tax?
A: Whether a business or individual, I always recommend filing tax returns regardless of tax liabilities or refunds.
Filing a tax return is not just a government requirement. Tax returns are needed for certain financial moves including:
Qualifying for a business loan,
Purchasing real estate or other assets, and
As an individual, you are required to file a tax return if your income is higher than the standard deduction, you expect a tax liability for certain retirement accounts, you had self-employment earnings over $400, and other unique situations. The IRS has a helpful survey to help you determine whether or not you are required to file a tax return.
Q: What taxes do small business owners pay?
state taxes in the state they earned the income and their state of domicile,
self employment taxes,
payroll taxes, etc.
Most cities and states have different taxes and laws. Typically, I will recommend a small business owner consult with a business lawyer who specializes in state tax filing requirements.
Q: What income tax forms are required for a business owner?
A: Different income tax forms are required for different entities and income sizes. The possibilities are numerous. Here are a few:
Form 1040, Schedule C: Personal income tax return where I report business activity for sole proprietors and single-member LLCs.
Form 1120: Corporation tax form where I report business activity for C-Corporations. Dividends distributed to shareholders are reported on Form 1099-DIV.
Form 1065 or 1120-S: Flow-through entity tax forms where I report business activity for Partnerships and S-Corporations. The activity will flow through to individual Partners via Form K-1.
Form 1099: Independent Contractor tax forms where I report compensation paid to non-employees.
Form W2: Employee tax form where I report base compensation, Social Security compensation, Medicare compensation, and various other types of compensation provided to the employee during the year.
Applicable state returns: almost every state has their version of the Form 1040, Form 1120, Form 1065 and various other registration forms on which I report business activity applicable to the state.
Q: Should online sellers (eBay/Craigslist/Facebook Marketplace) set up a formal business entity?
A: Unless the online sales qualify as a "hobby," I suggest protecting any entrepreneurial income with a legal identity.
Whether it's through an LLC, business insurance, or a corporate structure, it is in the best financial, legal, and overall interest for any business owner to set up some type of business protection and/or entity.
Legally, you are required to report the income, so why not write off the expenses while protecting your personal assets?
Keep in mind that other legal requirements are required for business formation. Even sole proprietors will often need a seller's permit, a business license, and an EIN.
Q: When should a business owner contact a CPA?
A: A business owner should contact a CPA when they seriously are CONSIDERING becoming a business owner. Before you set up your entity, you will want a CPA to advise on accounting software, tax preparation, compensation analysis, and more. If you are already a business owner, you should have a CPA on retainer.
CPAs are licensed in tax law, financial accounting, economics, and other key business areas. Not only that, they are held accountable by their state and federal CPA societies. They have access to a network of business professionals to provide communal advice for your business.
CPAs, however, are NOT legal advisers. Always consult an attorney for legal business questions.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.