Getting Paid and How it Affects Your Taxes
Who doesn’t love getting paid?! Isn’t that a big reason why we do the work that we do? Of course, as small business owners, we are passionate about what we do; but realistically if a business is not profitable, it likely will not survive. This blog article was prompted by a conversation I had recently with a new business owner, and I felt that a lot of other small business owners might be able to benefit from this information. Here are some things to think about regarding getting paid as a small business owner and how it affects your taxes.
What Forms of Payment Do You Accept?
I’m sure most of you have heard the old saying “cash is king”. However, when it comes to getting paid for the goods and services you sell within your business, I tend to disagree. I’d probably change the saying to “cash equivalents are king”. Cash, as in paper currency, does not always provide the best record of what revenue has come in and what expenses have gone out. Transacting primarily with paper currency can be very problematic in proving your income to third parties (i.e. to obtain a business loan, rent an apartment, or secure a mortgage), preparing your taxes, or achieving a favorable outcome in a tax audit. Many small business owners leave deductions on the table simply by not tracking what they spend, and oftentimes that causes them to file taxes late or not at all. Electronic forms of payment provide the benefits of a paper trail, proof of your income and deductions, additional resources for clients to pay you, generally more safety and security for the funds you receive, and almost always more responsible spending. Of course, electronic forms of payment are accompanied by fees, and this is a concern that is oftentimes raised by small business owners. Definitely research the amount and types of fees involved in setting up merchant accounts and engaging in electronic forms of payment, but in most cases, with a good electronic payment solution, the benefits far exceed the costs.
Cash, of course, is still legal tender. If that is the only way you can get paid, then by all means get paid how you can. But in today’s times, most clients and customers have the ability to pay via PayPal, Venmo, Zelle, debit and credit cards, Apple Pay, Samsung Pay, or other methods that are more effective for tracking and reporting your income properly as a business owner.
Cash or Accrual?
For a first-year business, one of the most important considerations in reporting income is whether you will report your income and file taxes on a cash or accrual basis. Even if you are not an accountant, it is important to know what this means as it will affect the amount of taxes you pay. If you report your income on a cash basis, this means that you record income when you are actually paid and expenses once you actually pay them. Easy enough, and this is why the overwhelming majority of businesses report their income and expenses on the cash basis of accounting. However, this may not be the most beneficial method for you. Accrual accounting involves reporting income when earned and expenses when incurred, even if you haven’t been paid by the customer yet or you haven’t paid the expense yet.
Here is an example- Sarah paints houses. She collects a 50% deposit upfront before the work is performed so that she’s able to purchase the job supplies she needs and pay contractors that she may use for the job. If she is on a cash basis, even before she paints the house, the money she collects is reportable as income. If she is on an accrual basis, she doesn’t report the income until she actually performs the work and the income is effectively earned.
Why does this matter? The bigger the numbers are with respect to upfront payments and on the other end of the spectrum, expenses you incur that will need to be paid, the more the decision of whether to report on a cash or accrual basis can affect your taxes. Sometimes as companies grow, it may make sense to reevaluate whether cash basis makes sense anymore. Another reason accrual may make sense is because it can give you more reliable data with respect to business performance and decision-making. If you receive the funds in one month (or year) and pay the related expenses to that job the next month (or year), being on the cash basis of accounting will throw off your profitability for the month or year (and probably unintentionally).
The discussion of whether to report income on a cash or accrual basis is definitely a discussion that each client should have with his or her accountant. This is especially true if your business is new or if it has grown significantly over time.
Whose Income Is It?
If at all possible, try to avoid depositing nominee income into your business accounts and accepting payments for the benefit of others. Nominee income is essentially someone else’s income deposited into your account. At first glance, this may seem like something a business owner obviously would not do, but you would probably be surprised at how common this is. Unfortunately, I see small business owners make this mistake all the time and have to warn clients of the tax implications as well as other potential legal hazards down the road.
One common example results from the inadequate separation of business and personal income, such as depositing your personal tax refund in your business account. If your business is ever audited, the taxing authority will want proof of why the total deposits in your account are not reflected on your return. Because your personal tax refund is not income for your business, it creates an unnecessary conversation and hurdle for you with the IRS or state department of revenue. Another common example is depositing the payment for one business that you own into the bank account for another business that you own. This scenario creates the same problem as the previous example, but also may jeopardize limited liability protection your business may have established under state law if these transactions are significant. A third example is collecting money on behalf of another business, depositing it into your account, and paying that business the difference. Everything that gets deposited into your business account must be accounted for, so if it is not your income, it should not be reflected in your accounts.
An additional consideration with getting paid as a small business owner is that the IRS increases third-party reporting requirements each year with respect to payments and transfers of funds. Chances are, the IRS will know about a large portion of the revenue that your business receives. However, regardless of what is reported to the IRS, as a business owner you have a responsibility to keep accurate books so that you can effectively track all of your income and deductions. In the event that you are audited by the IRS or a state department of revenue, failure to keep accurate books and records will result in assessments of additional tax with penalties and interest tacked on years down the road.
If you have a new or established small business and would like to set up a consultation engagement to discuss your business or accounting practices, I would enjoy assisting you! Feel free to contact me using the form below.