Introduction: About Thad Eichhorn
I’m here today with Thad Eichhorn from Eichorn tax and financial. He’s a CPA here in Plain City in Madison County, Ohio. He works with a lot of small businesses and we just appreciate you taking the time to do an interview with us today, to answer some questions that many of us have as small business owners as we begin our businesses or when we’re thinking through taxes for a business. So Thad, can you just tell us a little bit about yourself and what your business does?
Sure, yeah! I appreciate the opportunity to speak to your members in this way. My name is Thad Eichhorn. My practice name is Eichhorn Tax Financial and my specialty is working with small businesses especially their tax needs and working with their accounting and also helping small business owners with their financial planning and needs and golds.
Why Understanding Taxes and Tax Planning is Important
So right off the bat, can you just help us understand for a small business why tax planning, accounting, bookkeeping is — why this is all — this is so important for their business?
Sure! yeah! So accounting is the language of business and it is how you communicate to yourself, to your creditors, to your investors, and also to the government taxing authorities what happened in your business? So, therefore, accounting is very important because otherwise, you might not know the numbers. Small business owners very often know a lot of details about their business and they know it intuitively but how you communicate that to the people around you who are interested.
Another reason it’s important is, taxes are one of the biggest expenses for most households. It follows only housing and transportation in a lot of cases. So this is an area where you can reduce your cost of living. And for instance, taxes are a hard expense to realize the benefit from. If you overpay on tax, it’s hard to see how that benefited. Say if you overspend on a house or car– well, at least you get to enjoy a nicer house or car, but with taxes, it’s not so much. So, taxes are a good place to try to optimize and not pay more than what you need to.
Best Tax Practices to Apply in your Business
So what are some of the best practices and things that a small business person can do right out of the gate as they’re thinking it through, how to apply these for their business when they’re getting started, or even if they’re already launched their business?
One of the best things that you can do is to stay current. This helps you work on transactions in your history that are fresh in your mind. It’s hard to remember something that happened over a year ago. This includes for instance reconciling your accounts on a monthly basis and reviewing your reports constantly. Another best practice in reviewing your report is, try to pull conclusions out of those reports. Try to understand why that number is like that?. When you look at a report, you may think: “that doesn’t seem right”, and maybe it is, maybe it isn’t. Digging into that is how you learn. For one, improve your accounting, if there was a mistake and you caught it like that; Or if the numbers prove you wrong, you learn something about your business.
Organizing your Business Accounting Systems and History
So, it seems like right from the very beginning as you’re trying to get your business going or you have a small business, just really working with a professional to set up your chart of accounts and then making sure that at the end of every month every expense paid or revenue earned is properly posted into those accounts. Is that something that would typically help a small business setup?
Yes! absolutely, and a very important thing is setting up things right. Accounting is an information system and you need to set up a system in order for a system to work. So in a lot of cases, it may be a retroactive thing where you go back and handle history– deal with history. But the more you can do to look for proactively and get things, set up systems in place, you can save yourself a lot of time and effort.
I’ve seen a lot with some small businesses that we work with at Cultivate, it can be so daunting to really just begin that process but really those that just take a little bit of time and maybe a few hundred dollars early on to get that chart of accounts set up properly too, have some training on how to categorize some of these revenues and expenses, it just saves so much time on the back end when it’s the time at the end of the year, or the end of the month to see how much money you’ve earned or help calculate your tax liability, whereas people that maybe don’t take that extra time right upfront at the beginning may post things incorrectly, not really have things categorized right, or they just are delaying things — leaving all their receipts in a shoebox or their check ledger and then it just makes it so much harder as you get further into the year, or at the end when it’s time to do your tax preparation.
And here’s a great place to say that accounting is one of those things where an ounce of prevention is worth a pound of cure and I get it, when you start a new business, there’s a lot of things going on and it’s difficult, you know, to get into that — to get into accounting because it doesn’t drive your profitability necessarily, and that’s one of the reasons why it’s often overlooked. But it is still a great value in the future and eventually, eventually it’s gonna catch up with you. So, my advice is to be proactive in it.
Separating your Personal and Business Accounts
Are there any other best practices you’d like to share with our audience?
Yes, another very good one is to strictly observe the separation of business and personal bank and credit card accounts. It’s a simple step that you can sort your transactions from the beginning and it saves work later weeding out personal vs business transactions.
So right from the beginning, set up a separate business checking account and get a separate credit card that you can make any of those purchases for that is not commingled with your personal transactions.
So as I’m getting ready for starting a new business, what are some of the tax implications that I have to be aware of and start thinking about?
First off the biggest thing that most new small business owners encounter is, the first time that they’re paying self-employment tax and that feels very different from paying taxes as an employee. Self-employment taxes attach on top of income tax and it is paid for social security medicare. Normally, when you’re an employee, that’s withheld. Your employer pays half, you pay half.
When you’re self-employed, you pay both. Nobody’s withholding it and you have to pay that as an estimated tax. You estimate it when you do your taxes at the end of the year and it hits a whole lot harder than income tax in the lower brackets. For instance, if you’re single, the first $12,000 that you earn as an employee is tax-free, you get a standard deduction for that. The next $12,000 or $10,000 is taxed 10%, and the next $30,000 is taxed 12%. So, you can get up to $52,000 and it’s only tax at the max rate of 12%.
Self-employment tax, the first dollar is taxed at approximately 15%, and it actually goes the other way. Once you have broken the level of $137,000 then you quit paying self-employment tax whereas income tax, the rate starts getting progressively higher as you’re in more income. So, this self-employment tax hits harder and as well — for instance, self-employment tax is one of the biggest things that I do in tax planning and entity selection– that’s the main tax actually that we’re looking to optimize and avoid legally.
Reducing Tax Liability and the Three Business Entities
So thinking about ways we can reduce our tax liability brought up the entity selection. How we elect to be taxed is an important thing to consider. Can help us better understand what some of those options are?
Sure! So you have essentially, three options when you start a new business. You have a sole proprietorship, that’s one where it’s just you and business, and that income shows up on your personal tax return.
If you have partners, a partnership return is going to be pretty well the same thing. It’s just that it files a separate tax return. It acts very similarly to your personal tax return as it flows through.
Then as far as avoiding self-employment tax, an S corporation is often a very good way to do this. In an S corporation, you have to pay yourself a reasonable wage — In essence, you become your own employer formally. You’re not self-employed anymore, you are employed by your own corporation and there you have to pay yourself a reasonable wage. So, if you could hire somebody to do the work that you do, what would you pay them? What do people in your experience level role, your industry make and this is often a very, very gray area as to what exactly it is but, in essence, it needs to be reasonable? You need to be able to look somebody in the eye and say this is reasonable for the work that I do.
And then, whatever your business makes on top of that is not taxed for self-employment. So, for example, say that you are a sole proprietor and your business makes $100,000 in one year and your reasonable wage is $50,000 for the work that you’ve done. For the sole proprietor, that whole $100,000 is going to be taxed for self-employment.
In an S corporation, only the $50,000 wage that you paid yourself is going to be taxed for FICA taxes, which is the employer version of self-employment taxes. And since it’s your corporation, you’re playing both sides anyway so nothing changes on the $50,000 wage. But on the $50,000 net profit, no self-employment tax. And the reason you’re allowed to do this is that the S corporation earned that, not you. That’s why you know, you have to pay yourself a reasonable wage. But if you are in a position where that is a reasonable tax position to take, that can save you a lot.
Another option would be a C corporation, there are other tax implications that go into that. A couple of things that drive that, it acts very similarly to the S Corporation as far as a reasonable wage goes but then the C corporation pays tax on its own profits rather than passing them through to the individual that owns it.
So if you’re in a case where the owner shareholder has a very high marginal tax rate, they have lots of income elsewhere and the C corporation will not — that may be a case where the C corporation rate is lower than the individuals’ rate and that can make sense.
The thing is with a C corporation as well, you may have to take dividends out of that. And the dividends were taxed twice. That’s not for the wise. The corporations are not used for small businesses because they will want to take most of the cash out either for wages or for just living expenses and the tax that twice, you end up usually paying more tax than C corporation, but in certain cases, that the C Corporation can work as well.
Taxes for LLC Business Structures
So I just have a couple of follow-up questions on those selections. So, most of the small businesses that we work with, initially set up the legal structure of their business as an LLC, whether it says still a sole proprietor or a partnership but, they are an LLC. Do they still have the option to elect to be taxed as an S corporation, even though they are legally an LLC?
Yes, so an LLC is, that is purely a legal designation. So, for legal purposes, you do that for limited liability and you know, you don’t have to be an LLC to be taxed as a sole proprietorship. But the LLC is popular for a reason, they’re simple to set up and simple to maintain, and so that’s why a lot of small businesses choose them. So the LLC has the option to be taxed however it wants. It can be taxed as a sole proprietorship, that’s actually the default.
This is called a disregarded entity. If the LLC has more than one partner, the default is a partnership, because you need to report income and split it between two or more partners. But it can also be elected and also elect to be taxed as an S corporation or C corporation. This is done by a special election filed with the IRS and it can elect and be taxed in any way it wants. In fact, you actually have to be an LLC in order to be an S corporation or C corporation. If you don’t have a legal entity, you can’t elect to be an S corporation or C corporation.
Now, is that election something that has to be done once like at the beginning of the business or can that be changed year to year based on what’s most advantageous to the owner?
That election can be made from the start when you first apply for your EIN, your employer identification number. You can say that you’re a single-member wanting to be taxed as an S corporation immediately. Usually how I see developed though is — especially, if it’s one owner business — it doesn’t make sense to be an S corporation right away because of the extra cost associated with running payroll, with filing a separate tax return, and additional reporting requirements to go in. But as the business grows and has more income as you can start to show income beyond what you would pay the owner, then the S corporation may come to play in, and at that point, you filed that election. For the S corporation, it’s due by March 15th of the year that you want to be an S corporation. So if you want to make the 2021 S Corporation election, that’s due March 15th of 2021.
So if I decide to be taxed as an S corporation, I have to pay myself as the owner as like a W2 employee through the whole year. Is that how I do that?
So the other follow-up question I have on that, it would seem that if the reasonable salary that I pay myself as the owner of an S corporation, if that reasonable salary is pretty close to the profit that the business made anyway, then there maybe wouldn’t be a big tax advantage for being taxed as an S corp versus if we had substantial net profit to the business that went above and beyond what that reasonable salary was, that’s where the tax-saving comes into play. Am I understanding that correctly?
Yes. My rule of thumb actually is, if you can see about $20,000 of net profit after you pay the owner, the shareholder-employee a reasonable salary, that’s when I start saying like: “You need to think about this. This is probably going to work out well for you.”
Okay, so when they first start a business and you’re not making a lot of money in the early days of your business, it may not be super important to have that S corp election, but as the business gains momentum and has more profits that are $20,000 or greater maybe than the owner salary. At that point, that’s where you would really want to start thinking about choosing that option?
Yes, and a couple of other factors go into that. For instance, If you already have employees, you don’t have much incremental expense to add the shareholder as an employee but if you’re the only employee of the company, now you have to go through all the extra set up and running payroll. There’s a certain amount of cost for that.
The other thing is filing for a separate tax return. If you’re a sole proprietor, it goes right on your personal tax return, you file one tax return. But, an S corporation makes you file a personal return and an S corporation return — that’s two returns. For instance, if you were a partnership, you’re already filing a second return, then that lowers the bar a little bit for an S corporation election because you don’t have much incremental cost and much additional cost to do that. So yeah, every situation is different and you have a $20,000 rule of thumb. That’s a rule of thumb, situations can be different. But I would definitely say– if you’re at that point, that would be a good thing to look at.
Risk Areas and Pitfalls for Small Business Owners
So, as a small business owner or we’re busy running our business trying to keep track of all these expenses and revenues, what are some of those higher risk areas that often– may be a pitfall for a small business owner?
Travel and Business Meals
The first one I would say is deductions around meals and at travel and operating vehicles. These expenses– are deductible, it’s not that you’re pushing the limits as to what you’re allowed to deduct but they have fairly strict substantiation requirements. And what that means is you have to have good records backing up to those deductions. Otherwise if audited, they may be disallowed.
The reason for that is, meals and travel can contain a significant element of personal enjoyment. You don’t generally drive a lot of personal enjoyment from buying copy paper for your business to print documents. But you could very well get a certain amount of enjoyment from traveling to a nice location even if you’re going there primarily for business. So, the reason that there are strict substantiation requirements around that is to make sure that it is indeed for business and that you’re not taking a personal trip and just kind of making it into being a business trip or a meal for instance.
Is it really a business meal? One thing for meals — there are a number of points that you should be keeping track of. It’s who, what, when and why?
So, who were you with? When did you do it — and that’s the date to keep the receipt, you got it.
Why did you have to have this meal, for a friend? For instance, I could say, if I take a potential client out for coffee to get to know them and discuss with them, I would write on my receipt: Discussed new client options with Joe Smith. And that would satisfy that who, what, when, where, and why all that on the receipt.
Employees and Subcontractors
Another area is classifying your workers or subcontractors. This Is another one of those grey areas. It’s hard to get an exact read on but if you are challenged by the IRS or some other taxing authority, it can be very, very expensive and very, very painful to deal with.
When you have employees, you get to tell them where to show up, you provide their equipment. You have more control over what an employee does. A true subcontractor, you tell them what you want to be done and maybe when you want it done by. But they pretty well take it from there and they provide their own equipment. They set their own schedule and they also have the ability to work for other people. That’s a big difference between employees vs. subcontractors. Employees generally don’t have the right to work for a lot of other people whereas a subcontractor, they are in business to do what they’re doing.
And the reason that it can be costly when you have a subcontractor you write them a check. You pay with a credit card, they handle their taxes. If someone is your employee, you are now liable to collect FICA taxes, federal unemployment, state unemployment, and you’re also required in Ohio to have workers compensation insurance through the Ohio Bureau of Workers compensation. And for some industries, that can actually be fairly costly.
So, if you are improperly classifying an employee as a subcontractor and that is now overturned— now, these governing authorities can come after the business owner for all those taxes that I listed, and that’s often a large amount. Very often, payments to employees or subcontractors is a large expense in a business. So, to have that changed and get charged taxes for that can be very costly.
Thad, is there a limit to how far they can look back and kind of clawback all those taxes that are due ‘cause we meet small businesses that sometimes for years will have an assistant or a person coming into their office, designated hours, using their equipment, doing specific tasks and just the way they operate for years, can they go back to the beginning of when that started?
Generally, statutes of limitations expire within three years, specifically for income tax. I am not an expert in employment tax and employment law so, I’m not sure. But for income tax, you can actually go back 10 years if it’s due to fraud– usually, the statute of limitations is 3. So, in this case, I would think at least 3 years if it is overturned or it is audited and looked at. And again, that the thing to remember here is it is a gray area. It can be argued one way or the other, but what I would counsel my clients is, you don’t need to be taking undue risk. It does cost a little bit to have employees. And the fact is that these rules are not followed to a T very often, but you do open yourself up to a small risk of very big pain. So, that’s why I counsel clients to look into that and to maintain good employment practices that don’t open themselves up to that.
When follow-up question that comes to my mind which we seen a few business owners get themselves into the situation where they get to the tax time and they haven’t really set aside enough money for their taxes or in the case of an employee where they are doing withholdings of their taxes, then they actually spend that money that they withheld for their employees instead of keeping it aside to send in on behalf of those withholdings and then they find themselves in a situation where they have a pretty big tax bill at the dead and they don’t have the money to pay. What kind of flexibility do you usually see with either the federal government and state to work out some of those kinds of things with a small business owner in what are kind of some of the limits of how far they’re willing to go to help you work that out?
The most important thing to say here is as if you don’t have the money to pay, still file. Please, please file. The penalties are way worse for not filing than not paying. If you owe tax that you do not have the money to pay, the first thing to take care of is any employment taxes, any withholdings. ‘Cause that is the most — the penalties for that are the meanest and they have the most power to come after those because it’s really not your money — It’s not your tax liability, it’s something that was withheld from an employee and in that case those taxes can be assessed through two owners, through limited liability companies, they can be assessed to officers of companies, and responsible parties. So employment taxes, that’s the last place you want to skim.
If you owe income taxes and you don’t have the money to pay, you can always set up a payment plan. They will still charge you some penalties and interest but at least, if you are on record with a payment plan, the taxing authorities won’t come after you and looking to file liens and too and take assets that you have and miss. If you get into a really bad situation where you don’t have the money at all and you owe a big tax burden sometimes you can have some of that tax forgiven through an offer in a compromise situation.
That’s specifically with the IRS that works out where if you really if the value of all your assets can’t and even if you sold everything you own minus your basic your living things the house on the car and only the feed and clothe yourself and your family if you’re down to that you may actually be eligible for an offer in compromise and tap some of that tax. I forgiven may see what you’re saying the IRS is if you want some at least take anyone any but take this and that’s all I got. That’s, that is for a very dire situation, but there are right there are ways to read that is an option. If you are in that bad of it and that difficult of a situation. But again, but the important thing there is to say if you don’t even if you don’t have the money you need to file that. Not filing is.. Is worse than not paying in most cases as far as penalties go.
Decreasing Tax Liability
So as a small business owner, what are some of the things that we can do to decrease our tax liability?
Especially when you’re starting out or if you have variable business income, you can engage in tax planning around those swings and income. If you know you’re going to have a high-income next year, you can try to shift some income into this year’s resident, in a receiving deposit or something like that early. Or if you have a big liability this year, you can try to decrease by purchasing equipment and investing an expense again immediately when you know the next year’s going to be down. In other things, major life events, you may be moving from a city or not, you can see into and out of cities, you can maybe see I’m not safe and taxes around, around changes. That’s a big thing. Big life change or big swings in business income, think of an opportunity to plan.
Another thing you can do is to employ your children in your business and the parameters for this are basically kind of similar to a reasonable wage that we were talking about earlier. What your children are doing in your business needs to be reasonable for them. You can claim your six-year-old as your CFO and pay them a salary commend, commend of a CFO but you know, they can maybe help with filing them. They can maybe help clean your office.
There’s a number of things that they can do. So ask to be reasonable about what they’re doing and you have to be paying them a reasonable amount for what they’re doing, and of course, reporting their pay as wages for payroll. But the reason this is great is that a child when you pay the wages, you deduct the wages. They get that as income. You still claim them, but they get that $12,000 standard deduction. So they pay zero income tax on the first twelve thousand. So if you can, obviously not every business lends itself very well to this, but if that is the case, that can be great. And you can pay this child to have their own bank account.
You can use it to pay for their living expenses. You can maybe do it instead of an allowance. If they do work, they get this pay, they can pick up some of their own expenses. And when they’re under the age of 18, if they’re employed by their parents, and this is being the case of a sole proprietor, neither of you pays any FICA taxes. So that’s also a way to save on taxes, get a tax deduction and tax-free income for your child. And then another thing to add on top of that if the child has earned income they can set up a Roth IRA and contribute to a Roth IRA. And if you start at one of those accounts early, they grow tax-free for their whole life and they can even be used in some cases to pay for college education and a first-time home buyer, paying for a downpayment for a house.
So this is one of those super-charged attack strategies. Speaking of contributing to retirement plans, another thing that you can do to save on tax is to set up an IRA or in some cases even a 401k Simple Plan or SAP for contributing to your retirement and reducing your tax liability in the current year. There’s a lot of different options and as you continue generating business income, this is a good way to defer tax liability or save in a tax-efficient way.
Due to the COVID-19 pandemic a lot of us are working from home and if you are a small business owner and your primary place of business is your home, you can claim a home office deduction and this can be a valuable deduction as it offset your business net income, reduces for both income, regular income tax, and self-employment tax. There are some record-keeping requirements, there are maybe a little bit complicated to claim it, but especially now this is something that you should look at. If you are working from home due to the pandemic.
Things we should be looking for in a financial professional
So Thad, to wrap things up, help us understand some of the things that we should be looking for in a financial professional to help us with our business.
Sure, so when you ask that question, one thing that I think about is something that Dave Ramsey says about looking for financial professionals to help you is, look for someone with the heart of a teacher. Someone who will explain to you what is going on with your books, with your tax return, with your finances and a person who will teach you and help you be a better business person.
You don’t have to be a technical expert at any of these things. That’s why you hired a professional but at the end of the day, they are your books and it is your tax return, it is your business. When things go wrong, it will come back to you ultimately but when things go right, it also is yours. So it’s important that you work with professionals who have an outlook of helping you with your business.
Something else down the line of looking for professionals, look for a local person who understands your business climate and your immediate area. Things like understanding what’s going on in your community and what some challenges that you might be facing that they can identify with. Something else to look for with a local person is someone who understands. Ohio State and Local and Municipal Tax Laws are a little bit odd in comparison with some other places for state and local and municipal income-tax, and you want someone that understands that.