No one likes to pay more in income tax than they have to, but it happens all the time thanks to inadequate record keeping.
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If a business owner doesn’t understand the accounting process and the basic skeleton of a good set of books, costly errors can go undetected. Business income is a common area to make mistakes, so here are a few tips designed to eliminate potential problems.
Sales are the primary source of taxable income for most small businesses, and this is the only income that should be shown at the top of the Profit and Loss Statement. Sales can be broken down into several line items if you wish. For example, a clothing store may break out sales numbers by broad categories of items, such as, women’s clothing, men’s clothing, accessories, jewelry, shoes, etc…
What I often find when drilling down into the gross sales reported on the profit and loss is income that is not taxable at all: loans, capital contributions, deposits of gifts from parents or loan repayments. If a tax pro uses the total reported on the profit and loss statement and the total contains these types of transactions, the business owner will pay more in taxes than required.
To prevent confusion, monies from sources other than sales when deposited into the business bank account must be classified according to the type of income they represent. Take a look at the chart of accounts on your accounting software. If you are using QuickBooks, go to the top ruler bar, click on lists, and chart of accounts. Note that all accounts are categorized on the right hand side by type of account: bank, assets, liabilities, equity, sales, expenses, other income and other expenses, etc. Whenever you post a transaction, QuickBooks will provide you with the name of the account as well as the type of account it is. Start paying attention to this feature.
Capital Contributions: Any time you transfer money from a personal account or deposit cash from your pocket into a business bank account, you have increased your equity position in the business. Therefore, the transaction should be classified as a capital contribution. On your chart of accounts under equity, you may see this listed under a similar name such as owner investments, paid in capital (corporation) or owner contributions.
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Owner Loans: If you are a sole proprietor, you are the business and don’t need to set up a liability account payable to yourself. Not only is this not the method to be used to record monies you “lend” to yourself, the business, but it will falsely decrease your equity position. Post these items as capital contributions.
However, if your legal form is corporate, you may wish to classify these transactions as loans. In this case, set up a liability account (short term – payable in one year or less or long term – payable in more than one year). Check with your tax pro to determine if it would be better to show the transaction as a loan or as paid in capital.
Bank Interest: When your business accounts earn interest, these amounts should be shown on the profit and loss statement but at the very bottom of that statement under Other Income. You are not required to pay self-employment tax on interest earned on business accounts, therefore do not report this income on your Schedule C. It belongs on Schedule B of the tax return.
Credit Card Cash Advances and Consumer Loans: I can’t believe how many times I’ve seen these transactions mixed up in sales. Not only might the business owner, who obviously needed a cash infusion to begin with, hurt himself further financially by paying taxes on nontaxable income, but he is losing a valuable interest deduction by not properly tracking the repayment of the loan or cash advance. Set up this account as a credit card liability. When the monthly statement arrives, record the interest expense as well as any new charges. It is best to have a credit card devoted 100% to business. But if personal charges occur then post them to your draw (also an equity account).
Reconcile the credit card or loan account monthly in the same way you would reconcile your checking account to ensure the correct balance is carried forward. QuickBooks allows the reconciliation of liability and credit card accounts including full reports.
- Say you have a vending machine on the premises that you cash out every couple of months, that income is taxable and should be recorded as “Other Income” at the bottom of the profit and loss statement.
- Or perhaps you receive a check from the insurance company for flood damage at your business, this reimbursement will be recorded as “Other Income” and included on your Schedule C. Of course, so will the offsetting expenses to clean up the damage. It’s usually a push.
- Rebates on equipment, business vehicles, etc. are not reported as income. Instead they reduce the basis of the item purchased. The rebate should be recorded as an asset in the same account that the purchase resides.
- Gifts from friends and family members can be attributed to your owner capital contribution account.
- Business loans from family members – see consumer loans above.
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 the owner of Taxpertise in Sonoma, CA and the author of 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 at BLTaxpertise or Facebook at http://www.facebook.com/taxpertise.bonnielee