Small Business Tip Audit Proofing Your Business Financials Part 2

Today I’m talking about…

During the course of your business, you often buy things. You might go to Office Depot, Staples, Walmart, wherever you buy your office supplies from. Some items you buy are really inexpensive. For example, a pen, pencils, they cost $5, $10, $15, $20. And sometimes you buy more expensive items like computers, equipment’s you need for your business, and things of that nature. So, when you buy more expensive items, do you treat it in the same way like you do an expense? Which means you just put it in your income statement and take the expense right away and decrease your net income. Well, that’s what we’ll be talking about in this lesson.

According to the tax code, you’re allowed to deduct all ordinary and necessary expenses in carrying out your trade or business. However, the cost of purchasing and improving assets, this means purchases where the purchase will last more than a year. So, for instance, you buy a computer, you’re not going to use it up in a year unless you buy a computer every year. You’ll probably use it over multiple years, three years, four years, five years. So, the IRS wants you to take your expense over the number of years you’re going to use that asset. So, this is a requirement of the tax law. However, taxpayers are allowed to make an election to expense in one tax year, expenses under $2,500 per invoice, and that just means per purchase.

Now, this is different from the Section 179 where you capitalize an asset and then make an election to expense in one year. This right here, bypasses the balance sheet altogether. And that means, you don’t have to claim it as an asset, you just expense it right away. It’s called the de minimis safe harbor election. Now, this election gets rid of the burden of having to determine when an asset purchase should be expensed in one year or over multiple years. The election must be made with each year and attached to your tax return. Also, you must document your policy and keep it with your tax records.

So now, let us take a look at an example. Here is an example with the election and without the election. So, we make a purchase of $2,500 for equipment. It can be anything. Let’s say it’s a computer. So, with the election, we see we can take that computer expense all in one year. And now, net income becomes $49,500. So, without the election, let’s say we depreciate over five years. Just for ease, I’m just going to make it straight five years, which is $2500 over 5, which is $500 per year. Our net income becomes $51,500. With the election, our tax is $12,375. Without the election, our tax is $12,875. With the election, we have a $500 tax savings.

So, we can see why this is important. Well, you can say like, “I don’t need to make the election. I can just use the Section 179 and deduct all my expenses in one year.” Which is, Section 179 is a special provision in the tax bill that allows you to deduct all the cost of a capitalized asset in one year. Well, yeah, you can do that, but here’s the thing. With the Section 179, you still have to capitalize the asset, which means it’s much more paperwork on your end, it’s more documentation, additional forms and schedules that need to be filed, which if you’re paying somebody, guess what? They do charge you more for that. And also, with the Section 179, you have limitations. A lot of small businesses normally are okay and don’t hit the limitations, but there are limitations. And especially, if you’re approaching those limitations of Section 179, making this election is a great way to go.

Now, let us move our attention to independent contractor versus employee. As we all know, as small business owners, it is less expensive to classify a worker as an independent contractor rather than an employee. Moreover, small business owners find it very difficult to deal with the administrative requirement of hiring employees. So, there’s always that temptation to classify employees as independent contractors because of the ease of dealing with a contractor status. However, the problem with simplicity is not the deciding factor of how a worker should be classified. There are consequences if the IRS decides to reclassify a worker; we’re talking about back payroll taxes, penalties, interest. You’re talking about state agencies getting involved, we’re talking about Department of Labor getting involved. There are big consequences both on classifications, so you better really think twice about this.

The business relationship you have with the worker determines how they should be classified. There are three main factors used to determine business relationships, namely, behavior factors, financial factors, and permanency of the relationships. First, let’s talk about behavior factors. Behavior factors measure the extent to which a business owner can control the worker’s behavior. Example of controlled factors are, you can control the time the worker comes in or out, the extent to which an individual is required to use the employee’s method versus their own method. So in other words, if you say, “You got to do ABC exactly this way.” Well, they’re more likely your employee than they are your independent contractor.

Next, we’ll move to financial factors. Financial factors focus around how much the hired person can control their own earnings. Do you tell them, “Hey, you’re making $10 an hour for 20 hours a week?” Or do they provide you with an invoice to say, “Here’s what I did and here’s what you pay me.” And also, do they provide similar services to other members of the public or do they work just for you? All of these things really play into effect as far as the extent of the relationship. ‘Cause the more control you have, the more likely that they are really employed rather than an independent contractor. And then, the permanency of the relationship. Is this a one-off relationship or is this a long-term relationship? There are some relationships that are going to be long-term that are more independent contractors because they provide this service to members of the public.

So, if you have a worker who is working with you, there’s no ending period in which they’re working for you, but they always work, and they work for only you over a long period of time, then probability is, they are more your employee than they are your independent contractor. Obviously, this is a fact and circumstance situation, so you have to take each situation and look at it, the facts and circumstances, and make an educated decision based on this. Like I said, there are big consequences for choosing wrongly. So, don’t say, “Oh, I’m trying to save money, so I’m going to classify them as independent contractor.” You want to do what is right.

So that wraps it up for today. Today, we talked about expenses or assets, and then we talked about independent contractors and employees. If you need to review any of this material, just go back to the video. Next time, we’ll be talking about policies you should have to protect you. And then after that, we’ll talk about how to conduct an annual meeting. All these are things you can do in your business to protect you in the case of an audit. See you next video.

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