The IRS. More than any other government agency, it strikes terror into the hearts of taxpayers nationwide. It silently sucks money from our pocketbooks and paychecks. It can destroy a business in a single audit.
You should be afraid. You should be very afraid-but you've got a business to run. You have employees to manage, products to ship, people to call, money to make. With so many ever-changing rules and regulations and so much time-consuming paperwork, it's no wonder small businesses can't keep up and are constantly getting into trouble with the IRS.
But help is out there. We've asked Michael Savage, a 30-year tax law veteran and author of Don't Let the IRS Destroy Your Small Business: 76 Mistakes to Avoid to highlight the biggest problems small businesses face when dealing with the IRS.
Entrepreneur.com: Of the 76 mistakes you detail in your book, what are the five most common tax mistakes you see small businesses making?
Michael Savage: The first is not thinking of the consequences. On a conceptual basis, the biggest problem is that business owners don't think about it. They don't stop and think, "What are the tax consequences of what I'm about to do?" And when they don't do that, they find out years later that there were tax consequences and they're now in trouble.
Another mistake is borrowing from trust fund taxes. Small businesspeople get in trouble a lot over payroll taxes. They see that large chunk of withheld social security and income taxes sitting in their accounts for anywhere from a few days to a couple of weeks before it gets sent in to the IRS. And they've got bills to pay. So they say, "Well, I'll just use that money to pay the bills. When it comes time to send it into the IRS, I'll have some more money in and then I'll send it in." And of course, when it comes time to send it in to the IRS, they don't have it.
The one thing the IRS makes very sure of and audits very carefully is the payment of trust fund taxes. And what many small businesspeople don't realize is that they're personally liable for those taxes, even if their company is a corporation. They, as the owners or as the COOs of the corporation, have personal responsibility to get those trust fund taxes paid. And if they don't, the IRS can come take their home and their car and their kids' college education money and anything else to get those taxes paid.
The third biggest mistake is treating employees as independent contractors. Small businesses do this so they don't have to pay payroll taxes on them, cover them in their pension plans or provide them with medical insurance. That's a problem the IRS doesn't pick up on quite so quickly. Sometimes it won't find out until it conducts a payroll tax audit, which it may never do. If you're filing your payroll tax returns and paying payroll taxes on time, you may never get a payroll tax audit. But if you do [and you misidentify employees as independent contractors], then you may have payroll taxes due for those people going back three years. It mounts up quickly, and you've got interest and penalties due as well. Before you decide to call somebody an independent contractor, you really ought to check with your accountant or tax lawyer and make sure there's some justification for doing it that way.
Another big problem for small businesses is expense accounts and perks. One of the problems is the record-keeping requirements are so extensive now for perks and business expenses that [many business owners] just can't be bothered with it. And you can't blame them. They're in business to make money, not to comply with tax laws. And you can spend an awful lot of time doing that, especially when it comes to travel and entertainment expenses.
Even though all your business expenses and entertainment expenses may be valid, you may still get those expenses disallowed because you haven't gathered or kept the documentation you need in order to demonstrate that they're valid. And most of this documentation has to be in writing. So you can't reconstruct it from memory two years later, even if it's a bonafide business expense.
For regular C corporations, reasonable compensation is also a big problem. There are probably more of these cases in tax court than any other kind of case, except possibly independent contractor cases. This is where the small-business owner pays himself a salary, say, of $200,000 during the year. Then he finds out he's got a $200,000 profit for the year, so he pays himself a $200,000 bonus. He pulls all his profits out of the company as salary. The reason he wants to do that is because his company gets a deduction for salary payments but doesn't get a deduction for dividend distributions. But the IRS will look at a company to see whether the amount of salary the owner pays himself is a reasonable salary given his business and the industry it's in, the amount of work he does, and the amount of money similar businesses make.
Entrepreneur.com: How can business owners avoid making costly tax mistakes?
Savage: It's nice if you can have a CFO or a very good accountant who is aware of all these problems and understands what has to be done to avoid them. But that can be an expensive undertaking for a small business.
So the only other thing you can do is become informed yourself by reading books like mine or other books that are on the market. Or at least sit down with your accountant once or twice a year, and go over what you're doing, what problems you're likely to run into, and what you can do to avoid them.
Entrepreneur.com: What advice do you have for small businesses when dealing with the IRS and taxes in general?
Savage: Be aware that taxes permeate every aspect of your business. Practically every decision you make or every business activity you engage in that involves more than a small amount of money may have tax ramifications. You have to at least stop and think, "Maybe this does [have tax ramifications.]" And if you don't know whether it does, then you ought to see somebody who does know.