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Whether your business is small or large, incorporating is a worthy consideration under Obama’s new administration. Many think of Obama’s administration as small business friendly, however, there is a new mandate to close the $400 billion tax gap and empower the IRS to get every penny it is entitled. Now, more than ever, small business owners need to consider the concept of adding, “Inc.” to their name.

I often advise clients to consider incorporating their business once profits reach a steady $100,000 plus per year. Beyond the tax consequences, the legal aspects of incorporating should be discussed with one’s attorney. The tax consequences, as well as the ability to function within a more restricted structure, should be discussed with one’s tax pro. Employee benefit packages and retirement plans should also be studied for comparison with existing strategies.

Income Splitting

When it comes to the income tax picture, income splitting is the primary reason to incorporate as a C Corporation. As a sole proprietor, you are the business. You declare your sales and subtract business expenses on Schedule C of your individual income tax return. Then you pay both income taxes and self-employment tax (15.3 percent) at the individual level.

By incorporating as a “Sub S Corporation,” no tax is paid at the corporate level and all income flows through to your personal income tax return. Since the self-employment tax does not apply to dividends, you will also enjoy some tax savings.

Incorporating gives birth to a legal entity which will exist at arm’s length from your personal finances. If structured as a C corporation, this entity files its own tax returns and pays its own taxes.

Americans enjoy–using the term loosely–a progressive tax system, in which the more you make, the higher your rate and the more you pay. So if your income is cut in half and allocated between your C Corporation and your individual income tax return, you are likely to save a lot of money. You pay taxes on this income at the individual level when you draw income from the corporation in the form of wages, dividends, rents, etc. There may be other non-taxable forms of income, such as employee benefits and expense account reimbursements.

For example, the net profit after paying yourself a reasonable wage, is $100,000. You take a qualified dividend of $50,000 which is subject to a tax rate of 15 percent through 2010. The C Corporation pays corporate tax on the remaining $50,000 at a rate of 15 percent and you have no self-employment tax to worry about. The overall tax rate is 15 percent.

Same scenario but the business is set up as a sole proprietorship: Your tax liability would be about 25 percent on a profit of $100,000 plus an additional 15.3 percent for self-employment tax to fund your social security. Ouch!

Since you are taking wages from the corporation, the 15.3 percent self-employment tax rate will be built in to your withholdings and the employer’s matching share, all classed as payroll taxes, which is a write off at the corporate level. When a sole proprietor pays the self-employment tax, she cannot write it off as a business deduction.

Obama’s tax plan and new tax rates on those making more than $250,000 per year will be affective in 2011. Using income-splitting techniques these higher tax rates can be minimized.

Protection from the IRS

If a C Corporation gets in income tax trouble, the IRS can only go after corporate assets. Like any litigator, they may attempt to pierce the corporate veil, and tap into your personal assets. So make sure you follow the rules.

“There is no personal liability for corporate income taxes unless there is a liquidating dividend or the shareholders fail to maintain clear delineation between corporate finances and personal finances,” says Robert McKenzie, tax attorney for Arnstein & Lehr LLP. He added that if the company is operated properly and not a single member LLC treated as a C Corporation for income tax purposes, there is no personal liability for corporate income taxes.

But look out! If the C Corporation has an unpaid payroll tax liability, the IRS can hold you personally liable.

Why is this so important? Because the “newer and friendlier IRS” has left the building. Obama sees the $400 billion tax gap–unpaid tax liabilities, projected lost tax revenue due to nonfilers, cheaters, and the underground economy–as a potential source of revenue. His mandate to IRS Commissioner Doug Shulman is to “Sic ‘em!” So the IRS is retraining their keypunch staff (don’t need all those clerk typists now that more than 70 percent of the nation is filing electronically) for enforcement positions. The IRS is also adding an additional 3,500 positions in all areas of enforcement from audit personnel to special agents.

With this rocky economy, it might be wise to have a suit of armor to protect your personal wealth.

Consider these factors along with all the issues that pertain to your individual situation. Then sit down with your tax pro and your attorney to determine if incorporating your business is a logical next step.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is also the author of Taxpertise: The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn’t Want You to Know, from Entrepreneur Press. Follow Bonnie Lee on Twitter @BLTaxpertise or email her at bonnie@taxpertise.com. Live stream her radio show every Tuesday at 1:00 PST by going to KSVY.org and clicking on Listen Now.

This article has been excerpted from Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn’t Want You To Know, available from Entrepreneurpress.com.

The IRS will never tell you why a particular tax return is under audit. However, there are certain factors that make it obvious why a tax return was selected.

What Triggers an Audit?

Following is a comprehensive list of things that can trigger an IRS audit:

Failure to include income that has been reported to the Internal Revenue Service

During the month of January, you receive tax documents in the mail declaring income and certain expenses that relate to your tax return. For example:

1099-INT declaring the amount of interest income you’ve received from various sources including banks and investment companies

1099-DIV declaring the amount of dividends you have been paid on your investments

1099-MISC for work as an independent contractor and for rental income from tenants of your commercial properties

W-2s and K-1s

The Internal Revenue Service receives this same information. When you file your tax return, the IRS plays a matching game to ensure that you have declared all of this income on your tax return. If you have not, the IRS will recalculate your tax liability and bill you accordingly. Also considered an audit, it’s basically a by-mail correction notice that is open to dispute.

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Severe departure from the national standards

The IRS has a construction of tables, available on its website at irs.gov, that indicate by income level and if self-employed, by industry, an average of deductions taken in any given tax year. If your numbers are significantly different than the national averages, you may find your tax return up for scrutiny. Red flags include vehicle expense; charitable contributions, especially noncash ones; meals, entertainment, and travel; and excessively high cost of goods sold.

Dramatic change in income and expenses from one year to the next

You may experience a financial downturn that throws you into a loss situation. The IRS may audit just because it is interested in what happened and whether or not you are hiding income. Or if your income suddenly increases, the IRS may be suspicious that you cheated in the past and are now coming clean.

Lifestyle

Lifestyle audits are supposedly a thing of the past. But come on, you know that lifestyle comes into play. I mean, if you are living in a Beverly Hills mansion, with mortgage interest of $200,000 per year, paying DMV fees on a Ferrari, and making charitable contributions of $50,000 each year, then your tax return had better show more than $36,000 of wages from Oil Changers, right? These incongruities will flag your tax return for audit.

Industry

Specific industry audits are a continuing IRS project. Every year the IRS selects a particular industry to audit. In recent history it has selected wage earners with a small Schedule C business (looking to blow hobby losses out of the water), attorneys incorporated as S corporations (looking at unreasonable compensation in order to add payroll tax liabilities), and trusts with offshore holdings (looking for tax fraud and unreported income).

Bonnie Lee is an Enrolled Agent (E.A.) admitted to practice at all levels within the IRS representing tax payers in all 50 states. She founded Symmetry Business Services to represent taxpayers in audits, offers in compromise, tax problem resolution and to help non-filers safely reenter the system. She has served as a champion to taxpayers for more than 25 years. She is the author of Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn’t Want You To Know, available from Entrepreneurpress.com

When you’re self-employed filing a Schedule C with your tax return, your chances of being audited are greater than if you were a wage earner. Why? Because the IRS suspects that you will attempt to either hide income or write off personal expenses as business deductions. So when they select tax returns to audit, they cast the net wider and rake in 1.5% of self-employed folks versus 1% of W2 employees.

Here’s how you can keep them off your back:

Use a professional software accounting system. Your credibility increases in the eyes of an IRS agent if your tax return is based on professionally prepared financial statements, especially if maintained by an outside firm. You can use the same software to track your personal income and expenses as well.

Document sources of all income. If you are audited, the first thing the IRS agent will do is add up all of the deposits from your personal and business bank accounts. If more money went into the bank than was declared on your tax return, the IRS will want to know where the money came from and whether or not the income is taxable. If you use QuickBooks for your personal and business books, you will automatically tie out this income. But you still need proof. If the income you record is not taxable, e.g. gifts, inheritances, loans, transfers from personal funds, then keep a copy of the check or document that accompanies the income.

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Let a professional prepare your income tax return. Self-prepared returns are more likely to be audited because the IRS believes that a nonprofessional has limited knowledge. Besides, you may find that the fee charged by an Enrolled Agent or CPA might be wiped out by the added deductions they spot for you. Tax law is complex. There are more than 14,000 pages of tax code. And if you are self-employed, no matter how small your business, your tax return is now a complex creature.

Rethink your legal form. Corporations, LLCs, and partnerships are less likely to be audited. But that should not be the sole reason to incorporate. Discuss this option with a tax professional and your attorney before deciding.

Document red flags. You are allowed to deduct all ordinary and necessary business expenses. Would you make this purchase if you didn’t have this business? If the answer is no, you probably have a deductible business expense. But it’s important to know the rules and to have proper documentation to justify the deduction. Some expenses receive considerably more scrutiny than others.

Automobile expense is a favorite area the IRS explores. Taxpayers are required to keep a mileage log, however, I have met only one client who ever did. There are ways to substantiate mileage deductions without presenting an auditor with a mileage log. Be sure to record your beginning and ending odometer reading in your appointment book on Jan 1 and again on Dec 31. If you use an appointment book or calendar, a mileage log can be reconstructed from those pages and total mileage for the year can be extrapolated from odometer readings recorded on vehicle repair receipts.

Travel, meals and entertainment are close runners up to automobile expense when it comes to scrutiny. Go to www.irs.gov and read publication 463 to determine what you can and can’t deduct. Then document the hell out of it.

Vacation destinations like Las Vegas or Hawaii should be documented with more than purchase receipts to prove business intent. Keep flyers advertising the trade show, the seminar or letters from prospective clients at that location on file to prove the validity of the deduction. If entertaining, make sure to make notes on receipts for meals and entertainment mark with name of the person entertained and a brief description of the business purpose.

More people telecommute and work from home offices than ever before. So while it has become the norm, the IRS still likes to pick this deduction apart. Take photographs of the house and the office area. This will serve two purposes: It will show the proportion of the business area versus the personal living area to substantiate the amount of space claimed and it will show that there is in fact a business area. The rule is that your home office must be your principal place of business, used exclusively and on a regular basis for business purposes.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. Lee founded Symmetry Business Services in 1982 to represent taxpayers in audits, offers in compromise, tax problem resolution, tax preparation, tax planning, and to help non-filers safely re-enter the tax system. As an outgrowth of her work with her growing clientele and her dedication to demystifying taxes for real people everywhere, Lee launched the Taxpertise ™ seminar program, her Taxpertise ™ radio show on KSVY radio in Sonoma County, California and her upcoming (July, 2009) Entrepreneur Press book, Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn’t Want You to Know. Follow Bonnie Lee on Twitter @BLTaxpertise or email her at bonnie@taxpertise.com . Live stream her radio show every Tuesday at 1:00 PST by going to KSVY.org and clicking on Listen Now.

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