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STARTING AND OPERATING A
BUSINESS IN THE U.S.


Copyright © 2013, Michael D. Jenkins
All Rights Reserved

Published in the United States of America

Dedicated, since our first edition in this series in 1980, to all the hard working small business people of America, who have risked everything to build enterprises that fulfill our many needs, employ millions, enrich our communities -- and sometimes make a profit.

"This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher and author are not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought." -- from a Declaration of Principles jointly adopted by a committee of the American Bar Association and a committee of publishers.


NOTE: THIS IS A SAMPLE OF ONE OF THE 50 STATE AND D.C. EDITIONS OF THE "STARTING AND OPERATING A BUSINESS" SERIES OF E-BOOKS, FOR THE STATE OF RHODE ISLAND. HOWEVER, ALL RHODE ISLAND INFORMATION HAS BEEN REMOVED FROM THIS SAMPLE, AS NOTED THROUGHOUT.

THERE IS NO "NATIONAL EDITION" OF THE SERIES AT THIS TIME. (THE PRINT EDITION OF "STARTING AND OPERATING A BUSINESS IN THE U.S.," WHOSE COVER IS SHOWN ABOVE, HAS BEEN OUT OF PRINT SINCE 2003.)

ALL OF THE CHAPTERS INCLUDED HEREIN HAVE BEEN UPDATED IN 2013, BUT THIS FREE ONLINE VERSION WILL NOT BE UPDATED AFTER 2013.

TO ORDER A STATE EDITION FOR YOUR STATE, CLICK HERE.

TABLE OF CONTENTS

PART I -- STARTING YOUR BUSINESS

Chapter 1: Deciding to Go into Business

1.1 - Taking the Plunge
1.2 - Advantages and Disadvantages of Owning a Business
1.3 - Characteristics of the Successful Entrepreneur
1.4 - Know the Business
1.5 - Know Your Market
1.6 - Know How Much Money You Need To Succeed
1.7 - Finding the Best Location
1.8 - Will You Hire Employees?
1.9 - Choosing Professional Advisers
1.10 - Small Business Start Up Checklist

Chapter 2: Choosing the Legal Form of the Business

2.1 - General Considerations - Federal and [STATE NAME] Aspects
2.2 - Advantages and Disadvantages of Sole Proprietorships
2.3 - Advantages and Disadvantages of Partnerships
2.4 - Advantages and Disadvantages of C Corporations
2.5 - Advantages and Disadvantages of S Corporations
2.6 - Advantages and Disadvantages of Limited Liability Companies
2.7 - Entity Choices for Specific Types of Businesses
2.8 - Should You Incorporate Outside Your Home State?

Chapter 3: Buying an Existing Business

3.1 - Buy vs. Build
3.2 - Finding a Business for Sale
3.3 - What to Look for Before You Leap
3.4 - Should You Consider a Franchise Operation?
3.5 - Negotiating the Purchase
3.6 - Closing the Deal

Chapter 4: Selecting the Right Location

4.1 - Location, Location, Location
4.2 - Steps in Selecting a Site for a Retail Business
4.3 - Site Selection Factors for a Non-Retail Business
4.4 - Assistance in Choosing a Location

PART II -- OPERATING YOUR BUSINESS

Chapter 5: A Trip through the Red Tape Jungle: Requirements That Apply to Nearly All New Businesses

5.1 - Choosing a Name for the Business
5.2 - Local Business Licenses
5.3 - [STATE NAME] Licenses
5.4 - Federal Licenses
5.5 - Income Taxes - Federal and [STATE NAME]
5.6 - Self-Employment Tax
5.7 - Miscellaneous Tax Information Returns
5.8 - [STATE NAME] Sales and Use Taxes
5.9 - Property Taxes
5.10 - Using a Fictitious or Assumed Business Name in [STATE NAME]
5.11 - Insurance - A Practical Necessity for Businesses
5.12 - Securities Laws
5.13 - Federal and [STATE NAME] Excise Taxes
5.14 - Requirements Specific to the Legal Form of the Business

Chapter 6: The Thicket Thickens: Additional Requirements for Businesses with Employees

6.1 - Social Security and Income Tax Withholding
6.2 - Unemployment Taxes - Federal
6.3 - Workers' Compensation Insurance in [STATE NAME]
6.4 - Compliance with ERISA - Employee Benefit Plans
6.5 - Employee Safety and Health Regulations
6.6 - Employee Wage-Hour and Child Labor Laws - Federal and [STATE NAME]
6.7 - Fair Employment Practices - Federal and [STATE NAME] Laws
6.8 - Immigration Law Restrictions on Hiring
6.9 - Restrictions on Layoffs of Employees - Federal and [STATE NAME]
6.10 - The Americans with Disabilities Act
6.11 - Mandatory Family and Medical Leave Requirements - Federal and [STATE NAME]
6.12 - Performance Evaluations - Your Legal Exposure as an Employer
6.13 - Employee or Independent Contractor?
6.14 - Reporting Newly Hired Employees
6.15 - Military Leave for Employees
6.16 - The "Union Shop" and Right-To-Work Laws
6.17 - Employee Polygraph Protection Act and Similar State Laws
6.18 - [STATE NAME] Wage Payment and Other Labor Laws
6.19 - Catch-22 for Employers: Giving References
6.20 - COBRA Requirements for Employers
6.21 - Health Care Reform Requirements for Employers

Chapter 7: Environmental Laws Affecting Your Business

7.1 - Liability under Environmental Clean-up Laws
7.2 - Community Right-To-Know Notification
7.3 - Water Pollution Laws
7.4 - Air Pollution Laws
7.5 - Toxic Substances Control Act
7.6 - Environmental Impact Statements
7.7 - Miscellaneous Environmental Regulations
7.8 - EPA Self-Evaluation Policy

Chapter 8: Technology and Your Business

8.1 - Technology -- A Revolution in Progress
8.2 - Using Universal Product Codes (UPC), RFID, and QR Codes or Windows Tags
8.3 - ISO-9000 Quality Standards and Certification
8.4 - Is Electronic Data Interchange (EDI) in Your Future?
8.5 - Internet Taxation and Regulation
8.6 - Telecommuting and Other Important Technologies and Trends To Watch

Chapter 9: Miscellaneous Business Problems and Pointers

9.1 - Protecting Your Assets from Creditors
9.2 - Protecting Trade Names, Trademarks and Intellectual Property
9.3 - Mail Order Sales and Telemarketing Regulations
9.4 - Consumer Credit Laws Affecting Your Business
9.5 - Multilevel Marketing Programs -- Look Before You Leap
9.6 - Reporting Foreign Investments in U.S. Businesses
9.7 - Exporting Your Product or Service
9.8 - Electronic Marketing Restrictions

PART III -- MONEY AND TAX MATTERS

Chapter 10: Financing Your Business

10.1 - Venture Capital (Equity) Financing
10.2 - Small Business Administration Loans
10.3 - Other Federal Loan Programs
10.4 - Small Business Investment Companies
10.5 - Business Development Corporations
10.6 - Contact Information -- Financing

Chapter 11: Accounting Basics

11.1 - Establishing Your Accounting System
11.2 - Depreciating Assets
11.3 - Selecting Tax Accounting Methods
11.4 - Cash-Flow Management
11.5 - Don't be a Victim of Accounting Fraud

Chapter 12: Employee Fringe Benefits and Stock Options

12.1 - Introduction
12.2 - Fringe Benefits
12.3 - Retirement Plans
12.4 - Stock Option Plans
12.5 - Nonqualified Deferred Compensation Plans
12.6 - Restricted Stock Plans
12.7 - Play or Pay -- Preparing for ObamaCare
12.8 - Overview of Fringe Benefits

Chapter 13: Business Expense Tax Deductions and Tax Credits

13.1 - Travel, Entertainment, and Meal Expenses
13.2 - Automobile Expenses
13.3 - Start Up Expenses Must Be Capitalized, But Some Now Deductible Immediately
13.4 - Office in the Home Expenses
13.5 - Business Tax Credits
13.6 - New Business Tax Deductions
13.7 - Small Business Tax Breaks for Hard Economic Times
13.8 - Federal Tax Changes for 2012 and 2013

Chapter 14: Additional Tax Savings Strategies

14.1 - Introduction
14.2 - Choosing the Best Taxable Year for a Corporation
14.3 - Using a Corporation as a Tax Shelter
14.4 - Tax Problems Unique to Corporations
14.5 - Planning for Withdrawal of Funds from a C Corporation at Minimum Tax Cost
14.6 - Post-Incorporation Planning
14.7 - Hiring Your Spouse or Child as an Employee
14.8 - How to Save on Unemployment Taxes
14.9 - Section 1244 Stock
14.10 - VEBA--The Ultimate Tax Shelter?
14.11 - Tax and Legal Implications of Doing Business in Other States
14.12 - Qualified Joint Ventures -- Husband and Wife (New Law)
14.13 - Escaping IRS Penalties -- First Time Offender?

Chapter 15: Excise and Other Taxes

15.1 - Introduction
15.2 - Federal Excise Taxes
15.3 - State Excise Taxes
15.4 - Federal Estate and Gift Taxes
15.5 - State Estate and Inheritance Taxes

Chapter 16: [STATE NAME] Laws and Taxes

[STATE LAWS CHAPTER FOR SPECIFIC STATE APPEARS HERE IN EACH STATE EDITION, BUT STATE LAWS NOT INCLUDED IN THIS SAMPLE "NATIONAL" EDITION]


APPENDICES

Appendix A: Start Up Checklist (Generic Version)
Appendix B: Business Plan Outline

Part I.     Starting Your Business

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Chapter 1

Deciding to Go Into Business


"Entrepreneurship is the last refuge of the troublemaking individual."
-- James K. Glassman
"We are surrounded by insurmountable opportunity."
-- Pogo Possum
"There's many a pessimist who got that way by financing an optimist."
-- Doc Snopes' Sixth Law of Business Survival


1.1 TAKING THE PLUNGE

(IN ALL STATE EDITIONS OF THIS SERIES, GENERAL COMMENTARY ON BUSINESS CONDITIONS IN THE PARTICULAR STATE IS INCLUDED HERE, SUCH AS A DISCUSSION OF THE TAX AND REGULATORY CLIMATE, ECONOMY, LINKS TO OFFICIAL STATE LAWS ONLINE, ETC.)

No book can tell you whether or not you should take the plunge and go into business for yourself. You alone must make that difficult decision. This series of self-help guides, which we have published annually since 1981, is not a rah-rah motivational publication. We figure that you need to supply that motivation yourself, and if you have already started the wheels turning to go into business for yourself, or are already are in business, you already have cleared that hurdle. Our goal in this book and our other other state guides is not to inspire you to charge into owning a business, nor to discourage you from doing so. However, we recognize that the number of taxes and government regulations we describe, as well as the many practical difficulties of operating a profitable business, can be daunting to contemplate, as you will see as you read through the next 500 or so electronic pages.

We have simply tried to present you with as much useful factual knowledge as you are likely to be able to absorb, as to what running a small business will entail. This includes a great deal of guidance on the mind-boggling array of federal tax and regulatory issues (AND STATE ISSUES, IN THE STATE-BY-STATE EDITIONS OF THIS SERIES) that you may have to deal with, including advice on many good ways to cope with or take full advantage of those groundrules.

We sincerely hope this all this detail doesn't overload your circuits and scare you out of starting a business. However, if you have been somewhat naive as to what challenges you will face as a business owner, and realize after going through this book that it is more than you had ever anticipated and a bit too much to bite off, perhaps we will have done you a service. In any case, we just present the cold, green facts, Ma'am.

Running a business can be exciting, rewarding, and fulfilling, but it also has its risks. High risks. Before you make the decision to start your own business, carefully consider your strengths as an entrepreneur and your commitment to your new venture. (If you have already started your business or have irrevocably made the decision to do so, you may want to skip this chapter and get into the many nitty-gritty details of operating a business, such as choice of legal entity, financing, accounting, site selection, technology choices and issues, and the seemingly endless number of federal and state tax and business laws and regulations with which you will have to comply.)

One of the first and most important points to consider when starting your business is the major financial risk you will be taking. Once you have committed yourself financially, it will not be simple or easy to change your mind and back out.

Remember also that even if you're an expert in your field, you will need strengths in other areas to be a success in business. Effective management includes experience and competence in three main areas:

Experience and knowledge in these areas increase your odds of success.

This chapter will engage you in the process of realistically evaluating your entrepreneurial strengths and weaknesses. It also will focus on some of the typical start up problems and choices you are likely to face and helps you deal effectively and rationally with those issues.

1.2 Advantages and Disadvantages of Owning a Business

Have you realistically considered the advantages and the disadvantages of owning and operating your own business? Owning a business is going to be very different from working for someone else. Before (not after!) you start up or buy an existing small business, consider some of the advantages and disadvantages of having your own business and decide for yourself if the pluses outweigh the minuses, based on your personal likes, dislikes, strengths, and weaknesses.

Advantages

Among the many advantages of owning your own business, you may gain the most satisfaction from being able to:

Disadvantages

Awareness of the potential disadvantages should not dissuade you from your goal of going into business for yourself if you have a strong commitment to that goal. However, do consider, before you take the plunge, that you may have to:

Carefully weigh these pros and cons of going into business for yourself, and consider your own qualifications as an entrepreneur.

1.3 Characteristics of the Successful Entrepreneur

A good deal is known about what it takes to be a successful entrepreneur. Many experts feel that the single most important factor is an overpowering need to achieve. In other words, a person's attitude seems to be the main determinant of success in business, rather than other such important factors as education, intelligence, physical attributes, or personality.

Key characteristics of the typical successful entrepreneur include:

How do your personal characteristics stack up against this profile of the successful entrepreneur? If you possess 8-10 of these qualities already, you're ready to explore some other aspects of starting and operating a business, including market research, financing, and business planning. But remember, running a business is not like working for someone else, who provides you with a steady paycheck. You, or your employees, must make things happen. This demands initiative, hard work, self-discipline, and resourcefulness. On the other hand, solving the problems that arise from day to day and making it all work out can be a source of immense satisfaction, as well as financial rewards.

[LINK TO Q & A, TO HELP DETERMINE IF YOU ARE SUITABLY EQUIPPED TO START YOUR OWN BUSINESS, DELETED FROM THIS "NATIONAL" EDITION]

1.4 Know the Business

What experience do you have in the type of business you plan to run? You can learn while doing, but it helps a great deal to know a business before you start. Often the most successful businesses are started by people who have worked in a particular line of business for years and who finally decide that they know the ropes well enough to leave their employer and start their own similar operation.

It helps to have experience in the particular business you propose to enter, but often your experience working in some other line of business will have considerable carryover value. If you have little business experience, you may find you have much to learn once you begin the business.

Your company's success depends on your ability to get the job done right, on time, and efficiently enough to charge a competitive price and still make a profit. For example, with the tremendous proliferation of personal computers, you may have decided to go into business repairing small computers. You may be absolutely right about the prospects for the business, but unless you have the technical capability to do such repairs, or the ability to properly select and hire employees who can do the job, you had better look for some other kind of business.

In many cases, if you know you lack the experience you need to open a particular kind of business, your best approach is to get a job in that industry and work for someone else for a few years until you learn what you need to know. This may require patience, but it is definitely preferable to getting into a business you do not know well and quickly and painfully losing your shirt in the process.

When choosing your type of business, keep these thoughts in mind:

An example of how observing social trends can translate into profits -- in this instance, stock market profits -- is the case of an investment analyst in the `60s who noticed the trend toward mini-skirts and correctly anticipated that rising hemlines would create a boom market for pantyhose. He made a killing by buying shares of pantyhose companies.

Another, rather cynical, example of investors looking for the silver lining in social trends, is the (possibly apocryphal) tale of a group of Wall Street investment types in the early '70s who were discussing investment ideas over lunch one day, when one mentioned he had read that heroin use in the U.S. was growing at 30% a year, and said he wished he could invest in a business with that kind of steady and rapid growth. One of his quick-thinking colleagues immediately asked the group, "Me, too. So who makes the hypodermic needles?"

While the big money may have already been made in the pantyhose and hypodermic needle businesses, the above examples suggest the kind of thought processes that can be useful to you in responding to recent social or economic changes, such as the trend towards two-earner households, which continues to spawn considerable growth in convenience businesses.

To succeed, you must find the right business opportunity. If you do not have a clear idea of what business to go into or where to operate it, you will need to do some intelligent investigation of all possible opportunities that might be suitable for you. If you already have a concept of what you want to do, you still need to do a great deal of investigating to make sure it is as good an opportunity as it appears to be. Much of the effort you put into researching your industry also involves researching the market.

1.5 Know Your Market

One of the most important questions you should ask yourself is whether you feel you know and understand the market for the particular kind of products or services you intend to sell. Do you know who your competition is and whether your target market is large enough for both you and the existing competition? Also, how will your products or services measure up against those of your competitors in terms of quality and price?

What social, economic, or technological trends are opening business opportunities today? The trend toward two-earner households continues to spawn growth in convenience businesses, like pizza delivery, pet sitting, and personal shopping services. Such services fill a need for busy couples or non-traditional families who spend most of their waking hours at work, and who don't have much time for doing the traditional household chores.

If your product or service is something new or unusual, you need to have a sense of whether you will be selling an item that is wanted and needed in the marketplace. Or, even if you intend to sell a product or service that you know there is a need for, you should be satisfied in your own mind that you are going to be making it available at the right place at the right time.

Determine Market Feasibility

To quote a well-known brokerage firm: "Investigate before you invest." This often entails doing your own market feasibility study before committing yourself to opening a new business.

A market feasibility study is a systematic analysis of the information you can obtain about the potential market for your product or service. This information can include the competition you face, the amount of sales you can reasonably expect in that particular market, at projected prices, and whether that level of sales will be adequate for your business to operate at a reasonable profit. For example, if you are planning to build homes in a small community where there is only a demand for five homes a year, and you need to build and sell ten homes a year to survive, doing a market feasibility study might help you realize your proposed business venture is not feasible, even if you were to be wildly successful and capture 100% of the local housing market.

Alternatively, if you have several thousand dollars to spend and a well-defined idea of what it is you want to do, you can hire a professional economist or marketing consultant to do a feasibility study. In almost every major city, there are one or more firms that can do a thorough marketing and demographic study for you. Such a market feasibility study can be quite valuable, but it will also be fairly expensive. Most people starting a new business tend to do their own market feasibility study, which is usually done very informally, if at all.

So how do you analyze the market for your product or service once you have focused on a particular business you might want to start? Completing Worksheet 2 [WORKSHEET AND LINK TO WORKSHEET DELETED HERE, ALONG WITH STATE-SPECIFIC INFORMATION] at the end of this chapter will help you to pinpoint the information you need to satisfy yourself that a good market exists for whatever it is you are planning to sell, products or services or both.

Doing a Business Plan

One exception to doing a market feasibility study is for people who take the time to create a formal, written business plan to obtain financing, for example. A thorough analysis of the market for a new business' product or service is always a key portion of any business plan. Included with the software version of this publication is an extensive outline of a business plan, roughly 100 pages of step-by-step instructions and suggestions as to how you should go about the process of creating one.

The outline is provided only with the Small Business Advisor software and "Starting and Operating a Business" books as a plain ASCII (text) file, named BIZPLAN.TXT, which you can load into any text editing software or word processor, such as Word Perfect ® or Microsoft Word. ® **

Readers of the e-book version of this publication can instead go to the author's Ronin Software website and download a free copy of the file, at the following URL:

Free downloadable business plan outline:
www.roninsoft.com/sbz/bizplan.htm

(The above web page can be saved as a file on your computer's hard drive by clicking on your browser's File/Save As... menu item while viewing the web page on-line; you can then open the saved file in your word processor, for viewing and editing.)

This lengthy text file provides you a skeletal outline, with extensive commentary following each segment (which should be deleted from the file when the business plan document is completed). To prepare your business plan, you need to load this file into your word processing software, and work through the file section by section, writing up the information that applies to your planned business, by following the instructions that follow or precede each section, then deleting the instructions or explanatory information from the file as you finish writing each part, or when you are ready to print out the finished business plan.

Even if you choose to use some type of business plan software to create a "canned" business plan, you may find it useful to read through the BIZPLAN.TXT (or BIZPLAN.HTM) file, as additional guidance, to help you avoid some of the common pitfalls and errors that are often made in creating such a plan; or, even if you do not intend to create a business plan, you may want to spend some time carefully reading and absorbing Section 15 [FILE NOT INCLUDED, AND LINK DELETED] of the BIZPLAN.TXT file, which gives examples of the three main types of financial statements -- income statement, cash flow statement, and balance sheet -- and gives you plain-English descriptions of what each line item means in each statement, line by line.

[** Microsoft Word is a registered trademark of the Microsoft Corporation.]

Creating a well thought-out business plan can be an important step in getting a new business off to a successful start. Don't be like some businesses that start off with little or no real plan, like the gnomes in a recent hilarious South Park episode who decided to steal underpants as part of their 3-part business plan, which consisted of the following:

Market Data Resources

Once you have identified your most likely potential customers, you then need to determine how to locate your business and/or how to direct your advertising and promotional efforts so that you most efficiently reach them. Fortunately, there is a great deal of published data you can use for this type of research and analysis. One of the best sources is Sales and Marketing Management Magazine, which publishes its Survey of Buying Power each year. This survey provides breakdowns of population, households, retail sales by type of business, and total purchasing dollars for each county in the United States and for cities with a population of more than 10,000.

Some of the printed sources of market information you can use in your research are:

Many of these items can be found in your local business or university library. The NTPA Directory can be ordered from:

National Trade and Professional Association Directory
Columbia Books

8120 Woodmont Ave., Suite 110
Bethesda, MD 20814
(202) 464-1662
(888) 265-0600 (Toll-free)

Various industry and government sources of information to consider are:

Another excellent source is U.S. Census data. Census data gives vast amounts of detailed information on the U.S. population and its buying habits by individual census tract. You may want to obtain a couple of useful pamphlets from your nearest U.S. Small Business Administration field office. Ask for the pamphlet entitled, Researching Your Market for guidance on how to do your own market research.

A mother lode of census demographic information is also available through the Census Bureau's home page on the Internet. A slick and easy-to-navigate series of screens with mouse-driven menus will allow you to pick a geographical area ranging from the entire country to a small town and review detailed demographic information about it. You can get a report on anything from commuting time to home values, and much more. The Census Bureau's web address is:

Census Bureau Website
www.census.gov

1.6 Know How Much Money You Need to Succeed

Can you afford to start a full-time business if it will mean giving up your current employment and income? Many small businesses never really have a chance to succeed because the owners run out of money before the business becomes a viable operation. As a result, the owners often wind up having to go back to work for someone else again, disappointed and broke.

Carefully calculating and scheduling out, in as much detail as possible, the income and expenses you can reasonably expect for at least the first year of operation, as well as your living expenses and a reserve for emergencies, is a helpful step when determining how much money it will take to start and maintain your business. Remember, you will have many one-time expenses when starting up almost any kind of business, and it is quite normal for most businesses to start out operating in the red for a time.

Consequently, you will want to budget and make projections of your start up income and expenses so you make it through any rough times and get your business to the point where it can support you and your family. To help you plan your cash flow for the crucial first year of business, complete Worksheets 3 through 5 [WORKSHEETS DELETED FROM THIS "NATIONAL" EDITION] at the end of this chapter. Use these cash flow worksheets at the end of this chapter to carefully calculate and schedule out, in as much detail as possible the income and expenses you can reasonably expect for at least the first year of operation, as well as your living expenses and a reserve for emergencies.

[ACCOUNTING/CASH FLOW WORKSHEETS 3 THROUGH 6 AND LINKS TO PRINTABLE VERSIONS DELETED HERE]

If, under your most realistic projections, you are still running a deficit in cash flow each month at the end of the first year, you may want to do a similar projection out into the second year of operation. Some businesses can withstand more than two years of financial losses before they finally become profitable, so you may need to extend your projections as far out as three years or more. If it appears you will need to borrow or raise money to keep the business operating until it gets into the black, find out well in advance how much you will be able to raise and whether or not you will be able to get that amount.

If you plan to borrow, do you know how to put together a strong financing proposal so the prospective lender understands how you will repay the loan? If not, see Chapter 10 for sources of information and help on obtaining financing and summaries of some of the main financial assistance programs for small business. Alternatively, you may want to prepare and submit a business plan that includes a financing proposal.

1.7 Finding the Best Location

Finding the best location is an important part of any business planning project. Depending on your type of business, you want to investigate future and current projections for city population, income trends, and economic outlooks. You may also be interested in information on available transportation and freight services, the local labor force, and public utilities in a particular area to ensure the location has the resources to meet your retail, service, or manufacturing needs. As part of your site selection process:

For a more detailed discussion of how to find the optimal location for your business, see Chapter 4 of this book.

Signing a Lease

If the location you have found for your business requires you to sign a lease, you need to consider several critical points before signing:

Remember: A lease is a binding legal contract, and if you agree to pay rent of $2,500 a month for two years, you are on the hook for $60,000, unless you can sublease or assign the lease to someone else, which could be difficult or impossible to do, depending on the terms of the lease.

1.8 Will You Hire Employees?

In certain kinds of businesses, during the initial start up phases -- and perhaps even afterwards -- you may be able to operate without employees by either doing all the work yourself, with the help of family members, or by contracting out certain functions to independent, outside contractors. To the extent you can do so, you may find your life is much simpler by doing it yourself or with independent contractors.

Once you hire even one employee, you take on a great many responsibilities as an employer, over and above meeting a payroll every week or two.

These responsibilities include paying and filing tax returns for federal and state unemployment taxes, Social Security taxes, and income tax withholding from wages. In addition, you will need to comply with workers' compensation laws, employee health and safety laws, anti-discrimination laws, U.S. immigration law restrictions on hiring, and a variety of other federal and state labor laws and regulations that may apply once you hire employees. These and other employer requirements are discussed in Chapter 6.

This section reviews some of the legal restrictions on your hiring practices and provides you with a working outline of what you will need to consider in the way of personnel policies once your business reaches the point where you will have to hire employees.

Hiring Practices

When hiring personnel, you need to be aware of the broad array of state and federal laws designed to prevent an employer from hiring on the basis of discriminatory factors, such as age, sex, race, disability, religion, sexual preference, or gender identity. Most of these laws affect all but the smallest employers, so you will have to be alert to most of these rules to avoid even the appearance of discrimination in your hiring practices.

While anti-discrimination rules apply to promotions, job assignments, firing, and other aspects of the employment relationship as well as to hiring, the focus here is mainly on hiring practices. This is the area where most small business owners are likely to stumble into trouble, even when they have no intention to discriminate.

Things Not to Do

All questions you ask or information you provide should relate to job qualifications only and not to extraneous factors, such as age, race, sex, or physical size or condition. If your business has special occupational requirements -- for example, hard physical labor that might preclude hiring certain disabled individuals -- be sure to document carefully such unusual situations or requirements.

A sample (printable) employment application form is provided for your review at the end of this chapter. If you wish to add additional questions to it, be careful not to request indirectly anything that would reflect on the applicant's race, religion, sex, age, marital status, national origin, or physical condition. In short, it is dangerous to ask for much more than "name, rank, and serial number." In most states, you need to also be cognizant of additional prohibitions under state anti-discrimination laws. However, in three states (Alabama, Arkansas and Mississippi), there are no such state laws -- those states rely on the federal EEOC and Justice Department to enforce federal civil rights laws in the state.

Because state anti-discrimination laws differ, check with your legal adviser or the state human rights agency or labor department in each state where you do business, before you prepare and use an employment application form. For example, in the states of Maryland and Massachusetts, all job application forms must include a statement regarding the applicant's right not to submit to a lie detector test.

For information on anti-discrimination laws and enforcement see Sections 6.7 and 6.10 regarding federal anti-discrimination laws. (LINKS TO STATE ANTI-DISCRIMINATION LAWS DISCUSSION APPEAR HERE IN EACH OF THE STATE EDITIONS OF THIS BOOK SERIES.)

With very few exceptions, you should never ask a job applicant to take a lie detector (polygraph) or test or any kind of similar test, in connection with employment. Both federal law and, in many states, state law, prohibit use of any such tests in hiring or otherwise in the employment relationship. For more on this prohibition, see Section 6.17 of Chapter 6.

Personnel Policies

Even before you hire your first employee, you will need to outline some basic personnel policies. If you write down your policies on matters such as hours, vacation time, and sick leave, and give these written policies to new employees, it will help clarify the employment relationship. Perhaps it will even prevent a misunderstanding that could lead to legal action by an employee against you.

Worksheet 7 [LINK TO DELETED WORKSHEET DELETED HERE] at the end of this chapter provides a series of questions that will help you focus on different personnel policies that are typical in a small to medium-sized business. For a more thorough treatment of this area, and if you wish to develop a personnel policy manual for your business, there are a number of useful books and software programs you can find at any good bookstore or office supply store, which will guide you through the process of creating such a policy manual. If possible, try to find one that deals with the specific employment laws of your state.

You will also find related information on hiring and personnel policies and anti-discrimination laws in Section 6.7 and Section 6.10 of Chapter 6.

1.9 Choosing Professional Advisers

At some phase of your starting and operating a business, you will need to rely on one or more professional advisors, whether it is an attorney to help you incorporate or draw up contracts, an accountant to assist you with taxes (this book can't do it all) and setting up your books, or bankers or consultants of various types, including benefit consultants. This section provides some real-world practical advice that should be helpful to you in choosing and using professional advisors.

Accountants

Select your accountant carefully. This is the one person outside your business who is most likely to be closely in touch with almost everything going on in your operation. Besides helping to set up your books and to establish systems for handling cash receipts and disbursements, a good accountant can provide a wealth of practical advice on a wide range of subjects that are important to your business, including planning for taxes, managing your money, obtaining financing, and evaluating business opportunities. Attorneys and bankers are often in a good position to recommend accountants.

If you have a problem with the IRS or a state or local tax agency, an accountant (especially a CPA or an Enrolled Agent) will often be the best person to help you handle the audit or other tax dispute or problem. An unlicensed bookkeeping service may be quite capable of doing your everyday accounting for your business, but they will not be able to represent you in a tax audit or tax case involving the IRS -- only an attorney (who may or may not know much about taxes), a CPA, or an Enrolled Agent can represent you in such cases. If you are involved in tax litigation, however, you will usually need to retain an experienced tax attorney to represent you in state courts for a state tax case or against the IRS in Tax Court, federal District Court, the Court of Federal Claims or federal appellate courts.

Attorneys

Unless you are starting out as a sole proprietor, you will usually need an attorney to prepare a partnership agreement or to set up a corporation or limited liability company. You will do well to consult an attorney anyway to make sure you are obtaining necessary licenses and permits or to help you obtain them. Most local bar associations have lawyer referral services that can put you in touch with attorneys in your area. In most cases, you will do better to ask an accountant or banker to recommend a good business lawyer. If you need highly specialized legal advice or representation, ask an attorney you know to recommend a specialist.

In many cases, such as for routine legal tasks such as setting up a corporation or LLC, you may prefer to use one of the many firms that specialize in setting up such business entities, which can usually do so efficiently and for much less than you would need to pay an attorney to do the same. However, it is usually a good idea to have an attorney involved before you enter into any kind of important lease or other contract. Also, if you are buying or selling a business, it is almost always a good idea to have an attorney represent and advise you in connection with the transaction.

Bankers

Establish a good relationship with officers of the bank branch where you open a business account. While you may find it tough to borrow from your banker when you first go into business, he or she will be interested in keeping an eye on your business to see how it develops. It pays to cultivate the relationship to create a good impression before you apply for a business loan from the bank.

Ask around before opening an account; find out if there is a bank in your area that is well known for lending to small businesses. Many of the large banks tend to be more interested in larger accounts, although different branch managers of the same bank may have different ideas about working with small businesses. Your banker can be a useful source of free financial advice and a good connection when wanting to meet other business owners in your community.

Benefit Consultants

If you intend to establish a corporate pension or profit-sharing plan or Keogh plan if you have a number of employees, you may want to seek out a benefit consulting firm to make a benefit plan proposal. Many of these firms are primarily engaged in selling insurance products, such as life insurance, annuities, and investment contracts designed for pension plans, so the plan these firms design for you will almost invariably involve selling you their products. Since an insured retirement plan may not necessarily make sense in your particular situation, ask your attorney or accountant to recommend a benefit consulting firm that does not have products to sell other than its consulting and plan administration services.

As a general rule, benefit consultants will be much more knowledgeable about the ins and outs of setting up and administering benefit plans than lawyers, accountants, or bankers, and even those benefit consulting firms that operate entirely on a fee-for-services basis (not selling insurance products) will usually tend to charge much less than a law firm or CPA firm would charge for a similar level of service.

However, not every business that wants to set up a retirement plan will need a "qualified" corporate or Keogh plan, and thus may not need the services of lawyers, accountants, or benefit consultants for the simpler types of plans (except, perhaps, at the planning stage). If not, there are various IRA-type plans, as discussed in Section 12.3 of Chapter 3, that may be all you need, and which can often be set up for minimal fees or no fees at all, if adopting a model plan (which can include a Keogh plan) of a bank, stock brokerage firm, or other financial services firm. The IRS even provides standard plans you can set up, such as a S.I.M.P.L.E. plan, using the IRS Form 5305-SIMPLE or Form 5304-SIMPLE.

1.10 Start Up Checklist

The Windows software program, "The Small Business Advisor" (Single-State Edition, $29.95 if purchased), published by the author of this book, will create a detailed Small Business Checklist, about 4 to 6 pages long, of federal and state tax and legal requirements that are likely to apply to your small business, based on your answer to a series of 15 to 20 questions the software asks you about your business. You may download a ("shareware") copy of this software free of charge or obligation, at www.roninsoft.com/sbz/smallbiz.exe. See Appendix A at the end of this book for details on the Small Business Checklist.

WORKSHEETS AND FORMS MENTIONED IN THIS CHAPTER

Sample Employment Application Form:

[EMPLOYMENT APPLICATION FORM AND 6 OTHE WORKSHEETS DELETED FROM THIS "NATIONAL EDITION," AND INCLUDED ONLY IN THE SPECIFIC STATE EDITIONS OF THIS BOOK SERIES.]


Chapter 2

Choosing the Legal Form of the Business

"Criminal: A person with predatory instincts who has
not sufficient capital to form a corporation."

-- Howard Scott

"A limited partnership is a business arrangement where,
at the outset, the limited partners have the money and
the general partners have the experience, and at the
end, the roles are reversed."

-- Professor William Hoffman


2.1 General Considerations -- Federal and State Aspects

A business venture can generally be structured into one of four legal forms: a sole proprietorship, partnership, limited liability company (LLC), or corporation. In addition, there are some odd ducks, business trusts, real estate investment trusts, and master limited partnerships, but we will stick to the four main types of legal entities in this book -- the entities that are used by nearly all small businesses.

There are also variations on the four basic legal forms, such as the S corporation, the limited partnership, the limited liability partnership (LLP), and, in several states the limited liability limited partnership (LLLP). The limited liability company (LLC) and limited liability partnership (LLP) are relatively new forms of business organization, which have gained legal status in all 50 states and the District of Columbia in recent years.

When deciding your business' legal form, consider the following questions:

Tax Election on Form 8832

Since a change in IRS regulations went into effect on January 1, 1997, the task of achieving the desired type of tax treatment of an entity, where you wish to avoid treatment as a corporation has been greatly simplified, and you now get to choose how your unincorporated business entity, such as a limited liability company, will be taxed -- as a corporation or not. The IRS "check-the-box" regulations provide for simplified default rules for domestic companies:

IMPORTANT NOTE:
However, note that, starting in 2009, federal tax regulations now consider all disregarded entities to be employers for purposes of federal withholding taxes. Thus, for example, a single-member LLC with employees is now required to file a Form SS-4 to obtain a Taxpayer Identification Number to use on payroll tax returns, beginning in 2009.

Under these default classification rules, it is no longer necessary, in the case of a limited partnership or limited liability company, to qualify under numerous complex rules regarding centralized management, transferability of interests, and the like, in order to avoid corporate tax classification. The IRS also provides a tax election form, Form 8832, Entity Classification Election, for certain foreign entities and for domestic entities that wish to elect tax treatment other than as provided under the default rules. In most cases, unless you wish to do something out of the ordinary, such as electing corporate tax treatment for an LLC, or changing the current tax classification of your business, it will not be necessary to make a Form 8832 election.

Changing the Legal Form of the Business

Before choosing the legal form of your business, you should realize you may need to change to a different form in the future. Changing legal forms is easier to do with some forms of business than with others. As a rule, it is simpler to change from a sole proprietorship to a partnership, or from a sole proprietorship or partnership to a corporation, than it is to move in the opposite direction. An LLC is usually treated like a partnership.

For example, converting a corporation into a sole proprietorship or partnership may result in substantial individual and corporate-level taxes when the corporation is liquidated. Terminating a partnership or LLC and distributing its assets to the partners may also have significant (and highly complex) tax consequences.

While some expenses and complications are almost always involved in changing the legal form of a business, such changes are quite routine transactions. Many businesses start off as sole proprietorships, develop into partnerships, and later incorporate for tax or other reasons. Your choice of legal form when you first start your business need not be final.

To give you a brief overview of the various legal forms of doing business, the rest of this chapter lists some of the key characteristics of sole proprietorships, partnerships, C corporations, S corporations, and limited liability companies. (The state-by-state editions in this book series also details the fees, legal requirements, and any special state taxes that apply to each type of business entity in the specific state.)

2.2 Advantages and Disadvantages of Sole Proprietorships

A sole proprietorship is one of the most common ways to organize a new start up. Many self-employed individuals, home-based businesses, and small cottage industries operate as sole proprietorships. As a sole proprietor, you are the sole owner of your business. If you are married, however, your spouse will usually have a one-half interest in the business if you live in a state that has community property laws. (The states that have community property laws are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.) A sole proprietorship is a simple, independent way to operate a business, with its own unique set of advantages and disadvantages.

Your income or loss from a business conducted as a sole proprietorship is fully reported on your individual federal income tax return, on Schedule C of Form 1040. With few exceptions, any net income from your sole proprietorship will be considered self-employment income, which is subject to federal self-employment tax, as well as federal income tax, and must be reported and the self-employment tax calculated, on Schedule SE of your Form 1040. For more information of self-employment tax, see Chapter 5, Section 5.6.

In 2013, federal individual income tax rates begin at 10% on the first $18,150 of taxable income for married couples, filing jointly ($9,075 for single filers), rising to 39.6% on taxable income in excess of $457,600 for married couples, or $406,750 for single filing status. The self-employment tax in 2013 applied at the rate of 15.3% on the first $113,700 of self-employment income, and 2.9% on the excess over $113,700. (The 2014 taxable wage base will be $117,000.) For 2011 and 2012, the self-employment tax rate was temporarily reduced by 2%, to 13.3%, but the 15.3% rate has returned in 2013 and thereafter.

The top income tax in 2013 and 2014 is 39.6%. In 2012, the top rate bracket was 35%.

Due to the passage of emergency "fiscal cliff" legislation on New Year's day, 2013, rates for 2013 generally remain the same in 2013 and 2014 as in 2012. That is, most of the "Bush tax cuts" were extended, except for a new 39.5% tax bracket for high-income individuals. Some of the main changes for 2013 and later are (bracket amounts indexed for inflation after 2013):

Where a business is owned solely by a husband and wife, and is not a corporation, LLC, limited partnership, or LLP, it was not always clear in the past whether it would be considered a partnership or simply reported as owned by one spouse or the other. However, federal tax legislation enacted in 2007 now allows the spouses who own such a business to elect to be treated as a "qualified joint venture," in which case they will each file as sole proprietors on separate Schedule C's, and no partnership returns will be required. For more on such "qualified joint ventures," see Chapter 14, Section 14.12.

State Requirements for Sole Proprietors

In general, sole proprietorships in all states can be established with no formalities. However, as discussed in [LINK DELETED], it will generally be necessary to obtain one or more local business licenses from cities or counties (or parishes, in Louisiana) in which you operate and, in some cases, state licenses, as well. In addition, if you sell any kind of tangible personal property at retail or provide certain types of services, you may be required to obtain a sales tax license and collect sales tax, as discussed in all but a few state.

(REMAINDER OF THIS SECTION, WHICH DISCUSSES STATE AND LOCAL REQUIREMENTS FOR A SOLE PROPRIETORSHIP IN EACH OF THE STATE EDITIONS OF THIS SERIES, IS DELETED FROM THIS FEDERAL-ONLY EDITION.)

Advantages

To give you a better perspective on why a sole proprietorship is a popular legal form of doing business, consider the benefits listed below. Not only is a sole proprietorship easy to start, but everyone likes the idea of receiving all the profits from the business, saving on unemployment taxes, and having more freedom to withdraw assets from the business.

Disadvantages

To make an informed decision, you must always look at the downside of a situation or opportunity. A sole proprietorship has several advantages, but be sure to consider also some of its important disadvantages.

2.3 Advantages and Disadvantages of Partnerships

In general, any two or more individuals or entities who agree to con­tribute money, labor, property, or skill to a business and who agree to share in its profits, losses, and management are considered to have a partnership. You can choose to have a general partnership or a limited partnership, or in almost all states, a limited liability partnership (New York and California only allow certain professionals to operate as a limited liability partnership).

Partnerships often start out with a great deal of trust but have a high break-up rate. Or, as our old tax professor used to put it, "Partnerships are a lot like a marriage -- easy to get into, hard to live with, and hell to get out of." Thus it is wise to consider the equivalent of a pre-nuptial agreement -- a partnership agreement that specifies, in writing, what the partners agree to.

Some of the advantages and disadvantages of the partnership form of doing business are spelled out in the following paragraphs.

Advantages

Some reasons a partnership can be advantageous include:

Disadvantages

Knowing some of the positive aspects of organizing a partnership gives you a chance to better weigh the disadvantages, such as:

State Partnership Requirements -- In General

(Legal requirements for partnerships, including general partnerships, limited partnerships, and limited liability partnerships, are summarized in this section, in each of the state-by-state editions of this book series, but all of the state-specific information is left out of this "national" edition.)

...[DELETED STATE INFORMATION ON PARTNERSHIPS...]

A partnership agreement, for any type of partnership, should spell out in considerable detail such matters as the following:

General Partnerships -- In General

Creating a general partnership can be a very simple matter in most states since state laws generally do not require any official written documents or other formalities for most partnerships. As a practical matter, however, it is a very sound business practice for partners to have a written agreement that, at a mini­mum, spells out basic issues, such as those described above.

A written partnership agreement should be prepared by an attorney and, if possible, should be reviewed by a tax accountant before it is put into effect.

State General Partnership Requirements

[STATE-SPECIFIC INFORMATION ON GENERAL PARTNERSHIPS DELETED HERE]

Limited Partnerships -- In General

In contrast to the general partnership, which has unlimited personal liability for all of its partners, the limited partnership allows investors who will not be actively involved in the partnership's operations to become partners without being exposed to unlimited liability for the business' debts.

A limited partner risks only his or her investment but must allow one or more general partners to exercise control over the business. In fact, if the limited partner becomes involved in the partnership's operations, he or she may lose his or her protected status as a limited partner, in many states.

The general partners in a limited partnership are fully liable for the partnership's debts. Every limited partnership must have one or more general partners, as well as one or more limited partners. Besides enjoying all the benefits derived from limited personal liability, a limited partner's share of the partnership's income is not subject to the self-employment tax, although he or she will usually be subject to self-employment tax on guaranteed payments from the partnership for services rendered, in addition to his or her distributive share of profits or losses.[5]

State laws generally require certain formalities in the case of a limited partnership that are not required for other partnerships. To qualify for their special status, limited partnerships must usually file a certificate of limited partnership with the secretary of state or other state and county offices and pay the applicable fees.

In every state, establishing a limited partnership also requires a written partnership agreement, which a general partnership does not, with few exceptions, and all states require a "foreign" limited partnership (one formed in another state) to obtain a certificate of authority to do business in the state, which invariably requires payment of fees to obtain such authority.

State Limited Partnership Requirements

[STATE-SPECIFIC INFORMATION ON LIMITED PARTNERSHIPS DELETED HERE]

Limited Liability Partnerships -- In General

All 50 states and the Washington, D.C. have now enacted limited liability company (LLC) laws as well as additional provisions for another new entity, the limited liability partnership (LLP). The LLP laws vary considerably from state to state, with some states granting more liability protection to the partners in an LLP than other states.

In general, the LLP is simply a regular general partnership that is granted some degree of limited liability -- much like a corporation or LLC -- if it files a required form or statement with the state. In some states (California and New York), LLP's are allowed only for certain professional service firms, as an alternative to professional corporations, while in other states an LLP may engage in almost any lawful business, other than certain highly regulated businesses such as banking.

In a number of states, an LLP does not provide the full liability protection afforded by a corporation or LLC, for most types of businesses. All state LLP laws do provide liability protection for certain defined types of misdeeds of another partner, such as malpractice, intentional misconduct, or negligence, and many states have amended their LLP laws in recent years to also provide protection to partners from general trade debts of the partnership.

However, in most states, no liability protection is provided under their LLP laws to an individual partner in an LLP for his or her own negligence or wrongdoing (such as malpractice), or (generally) for wrongdoing by a person who is under his or her supervision, and in some states, no protection is granted with regard to trade debts or other liabilities, except for liability arising from tortious acts committed by the other partners.

Accordingly, an LLP should not be considered the complete equivalent of a corporation or LLC with regard to limiting the liability of the owners of a business in every state. (... Except in the case of licensed professionals such as doctors, dentists, lawyers, or CPA's -- professional corporations and professional LLC's may provide liability protection that is no greater than under the LLP laws, in some states that allow all such entities to be formed by professional service firms.)

Be aware that some states may deny an LLP limited liability status if an LLP formed in your state does business in another state without first registering as a foreign LLP in such state. However, in most states a foreign LLP will simply be denied the right to start or maintain a lawsuit in the state's courts until the LLP has registered for a certificate of authority to do business in that state.

State Limited Liability Partnership Requirements

[STATE-SPECIFIC INFORMATION ON LIMITED LIABILITY PARTNERSHIPS DELETED HERE]

Note that one potential drawback of LLP's, if you will do business in other states besides your home state, is that you may not enjoy limited liability with regard to creditors of the LLP if you do business in some such states. Some states, like California and New York, only recognize certain types of professional partnerships as LLP's. Such other states may simply treat your LLP like an ordinary general partnership, with no limitation of liability.

Advantages of LLP's

While LLP's have not garnered the degree of attention recently focused on LLC's, they have a number of advantages over LLC's, corporations, or other partnerships.

Disadvantages of LLP's

Despite the obvious advantages of LLP's, do not be in too great a hurry to set up one. Keep in mind several disadvantages of operating your business as an LLP.

2.4 Advantages and Disadvantages of C Corporations

When you are considering which legal entity to choose for your business, you will want to carefully consider the pros and cons of the corporation. A corporation is unlike most other forms of doing business because it is considered by federal and state law to be an artificial legal entity that exists separately from the people who own, manage, control, and operate it. It can make contracts and pay taxes, and it is liable for debts. Corporations exist only because state statutory laws allow them to be created. Deciding whether to incorporate in your home state or elsewhere is dis­cussed in Section 2.8 of this chapter, below.

A business corporation issues shares of its stock, as evidence of ownership, to the person or persons who contribute the money or business assets that the corporation will use to conduct its business. Thus, the stockholders or shareholders are the owners of the corporation, and they are entitled to any dividends the corporation pays and to all corporation assets -- after all creditors have been paid -- if the corporation is liquidated.

Corporations can exist in many different forms. The regular C corporation is the main focus of this section; the personal service corporation is mentioned briefly at the end of this section; and the S corporation is dis­cussed in the next section.

Before getting into the general advantages and disadvantages of incorporating, you need to know that to set up a corporation, you must file articles of incorporation with the state office that grants and approves corporate charters.

Incorporation Fees and Requirements in Your State

[STATE-SPECIFIC INFORMATION ON CORPORATIONS DELETED HERE]

Corporate Taxes

Since many of the advantages associated with incorporating involve how a corporation is taxed on its income, you need to understand corporate tax rates and how your income from the corporation is viewed by the IRS. Corporations filing their income tax returns on Form 1120 will be taxed at different rates depending on the amount of their taxable income. The following table lists the current federal corporate income tax rates, which are 39% in the highest marginal bracket, but never exceed 35% of total taxable income.

Corporate federal income tax rates are as follows:

As a corporate shareholder/owner, you will be considered an employee and most likely draw a salary from your corporation. This salary will be subject to personal income tax (which the corporation must withhold from your pay), FICA (Social Security) taxes, and state and federal unemployment taxes. FICA taxes imposed on both the employee and the corporation and are generally the same (in total) on the wages of a corporate employee/owner as would be the self-employment tax on the same amount of business income if you were a sole proprietor or a partner.

State Tax Treatment of C Corporations

A C corporation is any corporation (other than a non-profit entity) that has not elected S corporation tax treatment. All but a few states impose state income or franchise taxes on the taxable income of a C corporation.

[STATE-SPECIFIC INFORMATION ON STATE CORPORATE INCOME TAXES DELETED HERE]

Advantages

Corporations have several advantages, including tax advantages, limited personal liability, and continuous existence.

Disadvantages

If the potential tax disadvantages of the C corporation make it an undesirable choice in your case, you have another option: the S corporation.

2.5 Advantages and Disadvantages of S Corporations

The first thing to understand about S corporations (formerly referred to as Subchapter S corporations or small business corporations), is that they are just like any other corporation in terms of corporate law requirements, limited liability of shareholders, and all other corporate aspects; however, they are treated differently when it comes to how they are taxed under the federal tax laws. In addition, most, but not all, states also allow this or some other type of special tax treatment for S corporations.

State Tax Treatment of S Corporations

An S corporation is simply a regular corporation that has elected, for federal or state income tax purposes, or for both, to be taxed somewhat like a partnership, with its income, losses and tax credits flowing through to its owners, who report such income, losses, or credits on their individual tax returns.

[STATE-SPECIFIC INFORMATION ON TAXATION OF S CORPORATIONS DELETED HERE]

S Corporation Requirements

To qualify for (federal) S corporation treatment, your corporation must meet all the following requirements:

Electing S Corporation Status

To become an S corporation, your company must meet the above requirements and file an election on Form 2553 with the IRS. The election must be signed by all of the corporation's shareholders, including your spouse, who may have a community property interest in stock that is in your name.[20] The S corporation election must be filed during the first two months and 15 days of the corporation's tax year for which the election is to go into effect or at any time during the preceding tax year.[21]

Since a newly formed corporation that wants to start out as an S corporation does not have a preceding tax year, it has to file an election in the two-month and 15-day period after it is considered to have begun its first tax year. Its first tax year is considered to start when it issues stock to shareholders, acquires assets, or begins to do business, whichever occurs first. Filing of articles of incorporation with the secretary of state (or similar state agency that supervises corporations) usually does not begin the first taxable year.

You should take care to file the election at the right time, which can be tricky, since it is sometimes difficult to determine when a corporation first begins to do business. There can be some rather horrendous tax consequences if you operate the corporation as though it were an S corporation, and the election is later determined to have been filed too early or too late. Thankfully, under a recent tax law change, if an attempt to elect S status for the current taxable year is filed too late, the election will apply to the following year. (Previously, a late election NEVER became effective, which was a very serious tax trap.)

You should also take extreme care if you elect to change your regular C corporation over to S corporation status; consult a competent tax adviser first. A regular corporation that elects to become an S corporation will generally be subject to an eventual corporate-level tax on any built-in gains on its assets -- assets with a value greater than their tax basis at the time it becomes an S corporation -- if the assets are sold for a gain within five years. Or, if the gain assets are sold after 2013, they must have been held for ten years to avoid the built-in gains tax.

One of the major tax traps when converting to S status is the problem of customer accounts receivable for a corporation that uses the cash method of accounting, since the receivables have a zero tax basis, so that when they are collected they are not only taxable (as part of the S corporation's distributable income) to the shareholders, but are also taxable to the S corporation itself under the built-in gains tax provisions.

An LLC that is treated as a corporation may also elect to be an S corporation, if the LLC meets all the other requirements of being an S corporation (number and types of owners, no preferred stock or equivalent, etc.). Formerly, if an LLC wished to become an S corporation, it first had to file Form 8832 to elect to be treated as a corporation, before it could file the S corporation election on Form 2553. Now, under new IRS regulations,[22] an LLC that files an S corporation election will automatically be treated as a corporation. When the Form 2553 is filed by an LLC by the 15th day of the third month of a taxable year, both the deemed election to be classified as a corporation and the S election are effective as of the first day of that year.

Federal Tax Treatment of S Corporations

Once a corporation has made an election with the IRS to be treated as an S corporation, its shareholders will generally report their share of the corporation's taxable income or loss on their individual tax returns. That is, the corporation "passes through" its income or loss and tax credits to the shareholders in proportion to their stock holdings in the corporation, much like a partnership.

The S corporation does not usually pay tax on any of its income. Any domestic S corporation, however, must file Form 1120S, U.S. Income Tax Return for an S Corporation, regardless of whether any tax is due. Form 1120S must be filed by March 15, if filing on a calendar-year basis, or the 15th day of the third month following the close of a fiscal year.

An S corporation must also furnish a copy of Schedule K-1, Shareholder's Share of Income, Credits, Deductions, to each shareholder.

Profits of an S corporation are deemed to be distributed to its shareholders on the last day of the corporation's tax year, whether or not the profits are actually distributed.[23] Thus, if profits of an S corporation are distributed as dividends, the distribution itself is ordinarily not taxable, so there is no double taxation of distributed profits.

UPDATE NOTE:
Beginning in 2013, under the Patient Protection and Affordable Care Act of 2010 ("Obamacare"), a new tax of 3.8% will apply to the LESSER of an individual's net investment income or the amount that adjusted gross income exceeds $200,000 for a single or head-of-household filer, or $250,000 for a married couple filing jointly.

Many S corporation owners are wondering if this new tax will apply to their share of the distributable net income of the S corporation. The answer is that the distributable profits of an S corporation will not be considered "investment income" for purposes of this tax if the shareholder who is taxable on such income is actively engaged in the S corporation's business. However, if the S corporation income is "passive income" with respect to that shareholder, it will be considered "investment income" to him or her and, therefore, potentially subject to the 3.8% Obamacare tax, if he or she is in a high enough income tax bracket.

Until the 1993 tax law changes, S corporations enjoyed a clear tax advantage over regular corporations because the maximum tax rate on S corporation income taxed to shareholders was significantly below the top regular corporation tax rate. However, now that the top individual rate is 39.6% (or perhaps 43.4%, if the Obamacare 3.8% tax applies) on S corporation shareholders, and the top corporation rate is generally 34% or 35%, S corporations don't necessarily offer a tax rate advantage over regular corporations.

Terminating an S Corporation Election

If it becomes desirable to revoke or terminate S corporation status after a few years, as is often the case, this can be done if shareholders owning more than half the stock sign and file a revocation form.[24] A revocation is effective for the tax year it is filed, but only if it is filed during the first two months and 15 days of that tax year.[25] If it is filed later in the year, it does not become effective until the next tax year, unless a specific date for termination (on or after the date of filing the revocation) is specified.[26]

Doing anything, however, that causes the corporation to cease to qualify as an S corporation -- such as selling stock to a corporate shareholder -- will also terminate the election, effective on the first day after the corporation ceases to qualify as an S corporation. In that case, the company must file two short-period tax returns for the year, the first -- up to the date it ceased to qualify -- as an S corporation, the second as a regular taxable corporation.

Where there is a mid-year termination of an S election, requiring two short period returns to be filed, both tax returns are due 2 1/2 months after the end of the full taxable year and all income and deductions are to be allocated on a pro rata basis between the two short periods, based on the number of days in each period, unless the corporation elects to have such items assigned to each short period based on when they were incurred, under normal accounting rules.

Once a corporation has terminated an S corporation election, it cannot reelect S corporation status for five years, unless it obtains the consent of the IRS, which is rarely given, unless the termination was caused by factors beyond the reasonable control of the corporation.[27]

Advantages

For a corporation, electing S corporation status can be very advantageous in some instances, and less so, or even disadvantageous in other situations. An S corporation election should not be made without the advice and assistance of a tax professional, since it is a very complex and technical area of the tax law.

Electing S corporation treatment for a corporation is usually most favor­able in these types of situations:

Disadvantages

While there are some significant advantages to operating as an S corporation, the S corporation election is frequently not advisable depending upon the circumstances. Some of the possible disadvantages or pitfalls of operating your business in the form of an S corporation are:

2.6 Advantages and Disadvantages of Limited Liability Companies

The S corporation and the limited partnership have lost some of their luster in recent years, due to the appearance of a relatively new form of legal entity that has a number of advantages over both and is proliferating across the country -- the limited liability company (LLC). An LLC closely resembles and is taxed as a partnership, but it offers the benefit of limited liability, just like corporations. It is also similar to a limited partnership, except that in an LLC, all the owners have the benefit of limited liability.

In 1988, the IRS concluded in Revenue Ruling 88-76 that a Wyoming limited liability company could be classified as a partnership for federal income tax purposes, despite its limited liability, because it lacked continuity of life (it was required to cease existence after 30 years, under Wyoming law).

This ruling was highly favorable, from a taxpayer's standpoint, because it held that an LLC, which offers the corporate benefits of limited liability, could qualify for the flexible flow-through tax treatment of a partnership. Because this favorable IRS ruling opened the floodgates, all of the other states and the District of Columbia have since followed Wyoming's lead in adopting similar LLC laws. (The IRS no longer requires that an LLC must cease to exist after a term of years.)

Fees and Other Requirements for LLC's in [STATE NAME]

[STATE NAME], like every other state in the U.S., has adopted a limited liability company (LLC) law. Thus, in addition to the traditional choices of a sole proprietorship, partnership, or corporation, a business that operates in [STATE NAME] may also choose to operate in the form of an LLC. LLC's are very attractive entities for many small businesses, in that they offer the same protection as a corporation from creditors for debts of the business, while offering much of the flexibility plus the flow-through tax treatment of a partnership for federal tax purposes, and in most states.

See [LINK DELETED] for a discussion of the income tax treatment of LLC's under [STATE NAME] tax laws. Also, see [LINK DELETED] regarding tax requirements for pass-through entities (such as LLC's). Such entities must withhold state income tax if they have nonresident owners, in many states.

[STATE-SPECIFIC INFORMATION ON FORMATION OF LLC'S DELETED HERE]

IMPORTANT NOTE RE LLC FORMATION:
If you need help setting up an LLC in any state, there are firms such as, for example, Northwest Registered Agent LLC, which will handle the entire process of creating an LLC for you very inexpensively, for a flat fee of $100. (Of course, you will still owe the required filing fees that are payable to the Secretary of State or other state agency when forming an LLC in [STATE NAME]. For details on this economical way of setting up an LLC and protecting yourself from unlimited liability, see www.roninsoft.com/LLC/nw_regagent.htm.

(Or, even if you draw up your own LLC documents, you may need a "registered agent" for your LLC in any state in which you do business but don't have offices. In that case, Northwest Registered Agent LLC will review your LLC documents at no charge before you file them, if you retain them as your registered agent, for $125 a year or less.)

[STATE-SPECIFIC INFORMATION ON ANNUAL REPORTS AND TAXATION OF LLC'S DELETED HERE]

Advantages

Doing business as an LLC has a number of benefits over any other form of business organization, which accounts for its recent popularity. Advantages of the LLC include the following:

Disadvantages

Despite the obvious advantages of LLC's, there are also some downside factors you should consider before you rush to set one up. Some of the disadvantages of operating your business as an LLC are as follows:

Regarding the self-employment tax status of LLC members, the IRS has proposed to treat certain members of an LLC like limited partners, thus exempting them from self-employment tax on their share of an LLC's earnings if certain conditions were met.

Many taxpayers complained that the IRS was seeking to overturn long-standing laws that have exempted all limited partners from self-employment tax on their earnings. Therefore, in 1997 Congress ordered the IRS to refrain from implementing the proposed regulations until July 1, 1998, while it sought to develop a legislative solution to this issue. To date, Congress still has not acted, the IRS has not finalized the regulations and the issue of self-employment taxation of LLC members remains somewhat muddled.

As a general rule, most tax practitioners believe that an LLC member is not subject to self-employment tax on his or her income if the member is not a manager of the LLC and, generally, 10% or less owners of an LLC are exempted from self-employment tax unless they receive a guaranteed payment (like a salary) from the LLC for services rendered, and not just a percentage share of the profits. However, there is no clear answer to this question at present, and the IRS may not necessarily agree if you treat your share of income from an LLC as exempt from self-employment tax.

One U.S. District Court case in 2000 that considered whether some LLC members could be treated like general partners, despite the fact that all members of an LLC have limited liability, concluded that members who actively participate in the business were similar to general partners, and thus their income or loss from the LLC was not "passive income or loss" under the passive activity tax rules. The IRS had argued in this Gregg case[37] that all the members of an LLC were similar to limited partners, due to their limited liability, and that their losses were thus "passive losses" that could not be deducted against other income. The same logic of the holding in the Gregg case was applied again in 2009 decisions by both the Tax Court[38] and the Court of Federal Claims.[39] (The Tax Court case ruled that LLP partners as well as LLC members could be treated like general partners for purposes of the passive activity loss rules.)

However, to date no court cases have considered the question of whether LLC members are subject to self-employment tax or, if so, which LLC members would be taxed. Since the IRS lost the Gregg case and subsequent similar cases, they might now try to use the logic of those court decisions, although they all dealt with passive loss rules rather than self-employment tax, to argue that some LLC members (or LLP partners) are also like general partners for purposes of the self-employment tax, and thus should be subject to self-employment tax.

CAUTION:
While it is probably safe to assume that a passive investor in an LLC, which is not a service business in one of the professions, performing arts, or consulting, would not be subject to self-employment tax on his or her distributive share of the LLC's income, or that an active managing member of an LLC would be subject to the tax, the self-employment tax treatment of members of an LLC is an area of the tax law that is very unsettled at the present time. Whether or not income from an LLC should be reported as self-employment income is a decision that should be made only after consultation with a competent tax professional, as this is a highly technical tax question and an area where experts (and the IRS) can and do disagree as to what the proper tax treatment should be.

Also, beware of much of the information on this question you will find on the Internet, much of which assumes that the IRS Proposed Regulations (of which Congress disapproved, but did not order the IRS to rescind, in the 1997 tax act) are the law. Sophisticated tax practitioners would beg to differ.

Converting to a Limited Liability Company

In Revenue Ruling 95-37, the IRS ruled favorably that an existing partnership may generally be converted, tax-free, to an LLC if the LLC qualifies for partnership tax treatment. In fact, this conversion can be done without terminating the partnership's taxable year -- the LLC is simply treated as a continuation partnership -- and without obtaining a new federal employer identification number for the LLC. Thus, converting your existing partnership to an LLC is fairly simple and relatively free of tax complications, at least under the federal tax laws.

In contrast, there is no easy, tax-free way to convert a corporation to an LLC. The conversion of an existing incorporated business to an LLC is likely to have severe tax consequences, including:

Accordingly, extreme caution is advised before converting a corporation to LLC status. Consult a good tax adviser before you consider setting up an LLC, despite its obvious attractions. See [LINK DELETED] of the state chapter for information on the taxation of LLC's in [STATE NAME].

Some States Now Allow "Series" LLC's

Individual entrepreneurs, corporations, or other entities have learned to utilize multiple LLC's, by putting separate business ventures in separate LLC's, which allows the owner to isolate the risks of each venture to the capital invested in that LLC. However, in many states, such as California, using multiple LLC's means incurring multiple taxes or other fees or administrative costs, particularly where the various LLC's have somewhat different members.

EXAMPLE:
ABC Restaurants, a restaurant chain, might set up a number of LLC's, one for each restaurant, perhaps with local partners in each city who own part of the LLC that operates the ABC Restaurant in that city. The bankruptcy of one of the LLC's will not affect the parent company or other owners of any of the other restaurants.

Now, some states, notably Delaware,[40] have amended their LLC laws to allow "series LLC's."

Other states that now permit formation of "series LLC's" include Illinois, Iowa, Kansas, Nevada, Oklahoma, Tennessee, Texas, and Utah, and more are likely to follow, once there is more certainty about the tax treatment of such entities.

The District of Columbia has also recently done so.

A series LLC is a single LLC that divides itself into a "series" of separate divisions, each of which must keep a separate set of books, but with each such division or series operating a separate business, with its own separate limited liability, so that if the business of one series goes bankrupt, the other series or divisions of the LLC are not liable for its losses. In effect, each such "series" of an LLC is like a separate legal entity, with regard to legal liability, but only one LLC exists, thus creating only one set of taxes, tax filings, etc. (Theoretically.)

Each "series" can even have different members, managers, and ownership percentages and can make distributions to its members while other members of the LLC receive none. However, legal experts are divided, so far, as to whether other states will respect such series LLC's established under the laws of, for instance, Delaware. (California's Franchise Tax Board has already announced that it will treat each such "series" as a separate LLC, subject to the state annual $800 minimum franchise tax.) Also, it is not yet clear whether the IRS will allow such an LLC to file a single partnership tax return, or will treat each separate series as a separate partnership, with tax returns required for each.

Thus, while this new legal development offers significant potential benefits, you may take significant risks if you are one of the pioneers who sets up a series LLC, before the tax and legal treatment of such entities has been sorted out by the courts, IRS, and state legislatures. The early bird may get the worm, but the second mouse gets the cheese from the mouse trap. (However, the IRS has indicated, in Proposed Regulations, that it will honor state law with regard to series LLCs, if a series LLC is established in a state whose law allows their formation.)

2.7 Entity Choices for Specific Types of Businesses

As this chapter has shown, the choice of legal entity for your business involves a great many factors, which you will have to weigh against each other. Thus, it is not possible to say that one type of legal entity is better than all others for all businesses. However, as a general rule, certain types of businesses may be better suited to using a particular type of legal entity; or at least should definitely AVOID certain legal entity choices, in most cases. This section discusses some general points to consider, based on the type of business (or profession) in which you are engaged.

Choice of Entity: Professional Service Businesses

For many years, C corporations (professional service corporations) were the legal vehicle of choice for most providers of professional services, as well as some entertainers and professional athletes. This was primarily to take advantage of qualified pension and profit sharing plans, tax deductible fringe benefits (medical insurance, group term life insurance, disability insurance, medical reimbursement plans, etc.), income deferral from using a fiscal tax year, and low tax rates on net income retained by the corporation. Even professional partnerships were often structured so that the partners in the partnership were mostly or entirely professional corporations set up by the individual professionals (primarily to take advantage of certain provisions of the tax laws regarding pension plans).

Most of these excellent reasons for operating as C corporations began to disappear in the 1980s. Since 1984, Keogh and S corporation pension and profit sharing plans have been given virtual parity with C corporation plans; the 1986 Act did away with fiscal years for most new personal service corporations and virtually prohibited the use of separate pension plans for each corporate partner in a partnership; and the Revenue Act of 1987 did away with graduated tax rates for certain personal service corporations, thus subjecting ALL taxable income of such corporations to a flat rate tax of 35%. (However, not all kinds of service businesses are subject to each of the above new restrictions on personal service corporations, since the definitions vary slightly in each instance.)

In addition, all C corporations are now subject to eventual double taxation on appreciated corporate assets when such corporations are eventually liquidated, and are potentially subject each year to alternative minimum tax where "adjusted current earnings" differ from regular taxable income for various corporate income and deduction items. Those corporations subject to the 35% flat tax rate must now also be very careful in paying out enough salary each year to zero out their taxable income, to avoid paying this high tax rate.

Also, where a new business is expected to operate at a loss for a year or more, such losses must be carried forward by a C corporation until the corporation generates enough income to use up the losses, or the carryovers expire. For an unincorporated service business or one operating as an S corporation (or as an LLC or LLP, in certain states), these early losses may be used by the individual owners immediately to offset their other income of any kind. (These would not ordinarily be considered passive losses, and thus should be immediately deductible, in full.)

IMPORTANT NOTE:
For shareholders of an S corporation to utilize losses, their losses may be claimed on their individual tax returns only to the extent of their tax basis in their S corporation stock, plus the amount of any loans they have made directly to the S corporation. (Simply agreeing to guarantee a loan made to the corporation by a lender will NOT give the shareholder any additional tax basis that can be written off.)

Personal service corporations that are C corporations still enjoy an advantage over S corporations and unincorporated businesses with regard to deductibility of fringe benefits for employee-owners, though. However, the rules prohibiting discrimination against rank-and-file employees in coverage and benefits under these benefit plans have gradually been tightened in recent years.

While it is not possible to make any blanket recommendation as to the legal form a new personal service business should adopt, most advisers today seem to agree that the typical professional service corporation should probably avoid C corporation status and should instead strongly consider becoming an S corporation or remaining unincorporated. The deck has simply become too heavily stacked against most kinds of personal service corporations (other than S corporations). Where limited liability is important, an S corporation will now often be preferable to operating as a proprietorship or general partnership. Note, however, that in all states, a "professional corporation" (medical, law, accountancy, etc.) does NOT confer limited liability on its shareholders for purposes of malpractice claims, for the employee-stockholder who is responsible for committing the malpractice or, in most states, for employees under the supervision of that shareholder.

A number of states now allow professionals to operate their practices in the form of a limited liability company (LLC). LLC laws have now been enacted in every state. However, many states still do not allow professionals to use the LLC form -- but almost all states now allow a similar type of organization, a limited liability partnership, or LLP. In states where professionals can operate in LLC or LLP format, they will benefit from some reduction in personal liability, but only to the same limited extent as with a professional corporation; that is, practitioners will still be personally liable for their own acts of professional malpractice, or for those of any employee whom they supervise. [LINK TO STATE INFORMATION ON LLC'S DELETED HERE]

An LLP or LLC for a professional is treated as a partnership for tax purposes (with the same advantages and disadvantages, as compared with a C corporation), but with the added benefit of SOME reduction of personal liability exposure, which is not provided by a regular general partnership or sole proprietorship. In addition, the IRS "check-the-box" regulations now allow one-owner LLC's to be treated as sole proprietorships for federal income tax purposes.

Choice of Entity: Capital-Intensive Businesses

In general, capital-intensive businesses, such as high-tech, wholesale, retail, and manufacturing firms, are still good candidates for incorporating as C corporations, for several major reasons:

C corporations will face the problem of double taxation when ultimately liquidated or sold, to the extent they retain income and to the extent they have assets that appreciate. However, the problem of appreciating assets can be controlled somewhat by keeping assets that are likely to appreciate greatly over time, such as real estate, out of the corporation (such as by having the owners buy such assets and lease them to the corporation). Double taxation on the retained income itself will not occur unless you sell your stock or liquidate the corporation during your lifetime, since the stock generally gets a step-up in basis if it is included in your estate when you die.

Choice of Entity: Real Estate Rental Businesses

For many years, small businesses investing in income property (real estate rental property) tended to avoid the corporate form, either using partnerships or holding such real estate in sole proprietorships. The main reasons for this tendency were that:

In recent years, most of these ground rules have changed, so that corporations, particularly S corporations, are now much better candidates for holding real estate. Since the passive loss rules now either prohibit passive losses (except to the extent of income from passive activities) or limit losses from rental real estate to $25,000 a year[42] for an individual (phasing out for persons with adjusted gross incomes between $100,000 and $150,000), the need for a lot of "tax basis" to support large real estate losses is much less of a problem, so an S corporation may be quite suitable, even though cumulative losses are still limited to a shareholder's basis for his or her stock plus loans made to the corporation by the shareholder.

Perhaps even more importantly, a C corporation (other than a personal service corporation) is either not subject to the passive loss limitations, or, in the case of a "closely held C corporation," can offset such losses against "net active income" (but not against portfolio income such as interest or dividends). Thus, where large tax losses are expected for a number of years, a C corporation may be able to take such losses as deductions where another entity could not (assuming the C corporation has "net active income" from other business operations that can be sheltered from tax).

However, a C corporation holding rental real estate still has some major disadvantages. One is that when the income property becomes profitable, the profit will be taxed at the corporate level and if the property appreciates in value, or even maintains a value beyond its (depreciated) tax basis, there will ultimately be additional tax to pay, if or when the corporation is liquidated someday in the future. This additional tax would include any capital gain on the stock you owned in the company at time of liquidation, plus capital gains on the appreciated real estate in the corporation, and ordinary income ("depreciation recapture") on depreciation deductions taken over a period of years by the company.

Another disadvantage of operating a rental real estate business as a C corporation is that the rental income may be considered "personal holding company" income, subject to a 15% penalty tax if not distributed, if the company has significant amounts of other "personal holding company income" of other types, such as dividends or interest. (If 50% or more of a company's "adjusted ordinary gross income" is considered "adjusted income from rents," the rental income itself won't cause a problem, but even in that case the corporation must distribute any other kinds of personal holding company income, such as interest or dividends, that exceed 10% of "ordinary gross income.")

(For more details on the personal holding company tax, see Chapter 14, Section 14.4.)

Thus, overall, it is now hard to make any blanket statement as to which type of entity is best for holding rental real estate. Using a corporation should no longer be ruled out under present law, especially an S corporation that elects S status in its first tax year and thus is exempt from the special tax on "excessive passive income." Holding rental real estate in a corporation may now make very good sense, depending upon your particular situation. This is a very complex decision that, in most cases, should be made only after consulting a competent tax accountant or tax attorney, however.

On balance, the author of this program is of the view that keeping real estate out of a C corporation will continue to be advisable in most situations, but that holding rental property in an S corporations is now virtually on a par with holding it individually or in a partnership, at least in the case of a new S corporation that is not subject to the special S corporation tax on "excessive net passive income."

Even more attractive for holding rental real estate, in many cases, is the limited liability company (LLC) entity, which offers partnership pass-through tax treatment, coupled with the limited liability benefits of a corporation. In addition, all states now allow partnerships to register to become limited liability partnerships (LLP's), which, like LLC's, are generally treated the same as regular partnerships for tax purposes -- although some states only allow certain types of businesses, such as professional service firms, to operate in LLP form.

While LLC's or LLP's can be very attractive entities for holding rental real estate, and also offer limited liability protection, there are a number of unresolved and complex tax issues having to do with deductibility of losses that may provide some uncertainty if an LLC or LLP is used to hold rental real estate, where tax losses are being generated. Because LLC's and LLP's are relatively new entities, not all of these tax wrinkles have been worked out yet.

General or limited partnerships are time-tested vehicles for holding real estate investments and continue to offer the most favorable tax treatment, but general partnerships offer no liability protection and limited partnerships only offer such protection to the limited partners, not the general partners. Where liability exposure is not considered to be a significant problem, general or limited partnerships may still be the optimal choice of entity for real estate holdings, however.

Choice of Entity: Authors, Software Developers and Others Who Earn Royalty Income

Authors, computer software developers and other persons earning significant royalties from the licensing of their "intellectual property" (such as copyrights or patents) will find to their serious dismay that the tax law provides some major DISincentives to incorporating those business activities, as outlined below.

In most cases, this writer is of the opinion that you will be better off receiving any software, book or patent royalties as a sole proprietor, or as an LLC, rather than incorporating. Since such income will ordinarily be "earned" income, you will have to pay self-employment tax on it, but you may also set up Keogh pension or profit sharing plans for yourself to shelter a healthy percentage of any such royalties from income tax. For example, with a simple Keogh profit sharing plan, you can set aside, with a current tax deduction, up to the lesser of $51,000 (in 2013) or 20% of your pre-tax earned income -- or potentially much more with a more complex "defined benefit plan".

CAUTION:
Be wary of incorporating if you are an individual writer, inventor, or software developer who will be receiving royalty income -- doing so can often be a serious tax trap, unless you elect S corporation status (and are able to avoid the 35% S corporation penalty tax on "excessive net passive income"). And with either type of corporation (C or S), you may incur a large taxable gain if you later try to remove the royalty rights from the corporation, by liquidating the corporation or otherwise distributing the rights back to your individual ownership.

2.8 Should You Incorporate Outside Your Home State?

For most small businesses, there is little reason to consider incorporating your business under the laws of some state other than where you live. In fact, there are several good reasons why you should not incorporate in a different state than where your business is based:

Don't fall into a trap and believe the newspaper ads that tell you to incorporate in wonderful, tax-free Nevada or Wyoming or some other low-tax state and avoid your state's corporation income or franchise taxes. It simply doesn't work, unless you are planning to commit tax fraud. (Not recommended.) If your corporation does business in your state, it generally pays the same taxes on its taxable income regardless of whether it is incorporated in [STATE NAME], some other state, or in the Grand Duchy of Luxembourg.

Perhaps the only valid reason why you might want to incorporate your business elsewhere would be to take advantage of some particular provision or flexibility that is available under the corporate laws of a particular state, such as Delaware.

For example, in some states, it is easier for a small shareholder or group of shareholders owning relatively few shares of the stock to disrupt the company's business by forcing a liquidation of the corporation. Thus, if that is a concern in your state, you might prefer to incorporate your business in a state whose corporate laws make it harder for owners of a minor percentage of the stock to force such a liquidation of the business.

If you own all the stock of your company, it is unlikely you would ever need to take advantage of any such corporate provisions, which are usually only of interest to publicly-owned companies or in private companies where an incumbent group is seeking to maintain control of a corporation's board of directors and prevent a dissident group of shareholders from taking control or dissolving the corporation.

The tax and legal implications of doing business in other states are dis­cussed further in Chapter 14, Section 14.11.

Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code.)

1. Inflation adjustments for tax brackets and other items are per Rev. Proc. 2013-35, 2013-47 I.R.B ___ (page number to be determined when I.R.B. 2013-47 is published), which modifies and supersedes Rev. Proc. 2013-15, 2013-5 I.R.B. ___.
1A.I.R.C. § 162(l).
2. I.R.C. § 1402(a)(1).
3. I.R.C. § 6050K.
4. I.R.C. §§ 444 and 7519.
5. I.R.C. § 1402(a)(13).
6. I.R.C. § 243(a).
7. I.R.C. § 1202.
8. I.R.C. § 1045.
9. I.R.C. §§ 11(b)(2) and IRC 448(d)(2).
10. I.R.C. § 1361(b).
11. I.R.C. § 1361(b)(1)(C).
12. I.R.C. § 1361(b)(1)(B).
13. I.R.C. § 1361(b)(1)(D).
14. I.R.C. § 1361(b)(1)(A).
15. I.R.C. § 1361(c).
16. I.R.C. § 1361(b)(2).
17. I.R.C. § 1362(d)(3).
18. I.R.C. § 1375(a).
19. I.R.C. § 1362(d)(3)(A)(i)(I).
20. I.R.C. § 1362(a)(2).
21. I.R.C. § 1362(b).
22. Treas. Regs. § 301.7701-3(c)(1)(v)(C).
23. I.R.C. § 1366.
24. I.R.C. § 1362(d)(1)(B).
25. I.R.C. § 1362(d)(1)(C)(i).
26. I.R.C. §§ 1362(d)(1)(C)(ii) and 1362(d)(1)(D).
27. I.R.C. § 1362(g).
28. I.R.C. § 4975(f)(6)(B)(iii).
29. I.R.C. § 1374(a).
30. Rev. Rul. 91-26, 1991-1 C.B. 184.
31. Id.
32. I.R.S. Ann. 92-16, 1992-5 I.R.B. 53.
33. I.R.C. § 1378(a).
34. I.R.C. § 736(b)(3).
35. Medical Practice Solutions, LLC, Carolyn Britton, Sole Member, Petitioner v. Commissioner, Dkt. No. 14668-07L, 132TC, No. 7 (3-31-09); S.P. McNamee v. IRS, CA-2, 2007-1 USTC; Frank A. Littriello v. US, 6th Cir, No. 05-6494, April 13, 2007.
36. I.R.C. § 1402(a)(13).
37. Steven A. Gregg, et ux. v. United States, 87 AFTR 2d Par. 2001-311, U.S. District Court, District of Oregon (November 29, 2000).
38. Garnett v. Commissioner, 131 T.C. No. 19 (2009).
39. Thompson v. United States, docket no. 06-211T (Fed Cl., 2009).
40. Delaware Code, Title 6, Subtitle II, § 18-215.
41. I.R.C. § 469(e)(2).
42. I.R.C. § 469(i).
43. I.R.C. § 543(d).


Chapter 3

Buying an Existing Business

"Trust everyone, but brand your cattle."
-- Hallie Stillwell

"You can never be too rich, too thin, or too paranoid."
-- Doc Snopes' Seventh Law of Business Survival

"If it's important, always get it in writing UP FRONT.
Your own mother will cheat you blind if you don't."

-- Doc Snopes' Tenth Law of Business Survival

3.1 Buy vs. Build

Rather than build your company from the ground up, you may find an appropriate existing business for sale. Buying an existing business can have considerable advantages over starting one from scratch, one of the most important of which is the chance to start out with an established customer base. It is also sometimes possible to have the seller stay on as an employee or consultant for a transitional period to help you become familiar with the operation of the business.

Other advantages of purchasing a going business include:

  • Drawing a regular salary right from the start if it is a profitable operation. This is usually not the case in a start up operation, which typically starts off losing money.
  • Slightly less risk.
  • You know that it has a viable market if the business is already profitable. Your main risk is that something would change after you acquire the business, such as new competition or product obsolescence. Another risk is that you will mismanage the business, destroying its value.
  • Getting started is simpler.
  • By buying an established business, you can focus your attention on giving good service and operating profitably. Since most facilities, operating systems, and employees will already be in place, your efforts will not be diluted by remodeling the premises, trying to hire employees, setting up accounting systems, acquiring initial inventory, and the like. In most cases, you should be able to step right into an operation that has already been established by someone else.

While there are some definite advantages to buying an established business, as compared to starting a new business, it can sometimes be much more complicated and involves many potential pitfalls you must avoid.

Because the process of buying and selling businesses is very complicated even for experts, do not attempt it without retaining the services of a reliable attorney and, usually, a good accountant. Even skilled professionals, however, can only protect you from certain legal, financial, or tax pitfalls that arise in connection with the purchase of a business. Most potential problems can only be spotted in advance, if at all, by the exercise of your good judgment and by doing the necessary homework. This chapter dis­cusses some of the important pitfalls you should look out for when buying an existing business.

3.2 Finding a Business for Sale

How do you go about finding a business for sale? You have a number of ways to approach the problem, none of which are ideal, so you will probably want to use two or more of the approaches discussed below to find and buy an existing business.

Advertisements

The business opportunities section of your local newspaper, regional magazine, or trade association journal can be a major source of leads to businesses for sale. These ads often do not tell you very much about the nature of the business, but at least they can be a starting point in your search. In many cases, the ads are placed by business brokers rather than owners. Business brokers represent people who are seeking to sell their businesses.

Business Brokers and Realtors

Business brokers and realtors can be excellent sources in your search for a business for sale. The main drawback of going through a business broker or realtor is that his or her fee (paid by the seller) is usually a percentage, often 10%, of the sales price of the business; so the broker or realtor, like the seller, is trying to get the highest possible price for the business. At the same time, the seller will usually want more than he or she would if the sale were made without a broker, since the broker will take a healthy com­mission out of the negotiated sales price.

Local Chambers of Commerce

Your local chamber of commerce can usually tell you a great deal about the local business community and also can sometimes provide you with leads to firms that are for sale.

Accountants, Attorneys, and Bankers

Professionals, such as accountants, attorneys, and bankers, can often pro­vide leads regarding good businesses even before they are on the market. Frequently, business clients tell their accountant, attorney, or banker that they are planning to sell out or retire, long before making any formal attempt to put the business up for sale. So, if you have friends who are accountants, attorneys, or bankers, take them to lunch and tell them what you have in mind. Typically, they will have a vested interest in finding a friendly buyer for a retiring client's business, since they may lose that account if the firm is sold to buyers who have their own professional advisers.

Certified public accountants (CPA's) can be excellent sources of leads. Not only will they usually not charge you any finder's fee, but they also know which of their clients' businesses are little gold mines. A CPA who has a very profitable client who wishes to sell out may even want to go into the business with you as a financial partner, leaving the day-to-day operations to you. In these cases, if the CPA is putting up his or her money, he or she has studied the client's business carefully and feels that it is a real moneymaker. In short, the CPA will have already done much of the pre-­screening and due diligence for you.

The Direct Approach

Often, if you see a small business you think you might like to buy, the simplest approach is to talk to the owner and see if he or she is interested in selling. While an owner may have had no serious thoughts about selling the business before, the appearance of an interested potential buyer is not only flattering, but may even cause him or her to decide to sell out to you. Many businesses are bought and sold by someone simply asking the right question at the right time.

3.3 What to Look for Before You Leap

Why Is the Business for Sale?

One of the first questions you may want to ask is: "Why are you selling your business?" Often, the response will be the owner wants to retire or is in poor health. While an explanation like this may be true in many cases, it could also be a well-rehearsed cover story. The real reason may be the business is in a declining neighborhood and the owner has been robbed several times recently and wants out, pronto. Or, the owners of a profitable little corner grocery store may be anxious to sell out while they can, because a Wal-Mart or major chain-store supermarket will be opening in the neighborhood in a few months. Another common reason behind a planned sale is that the business is either losing money or is not sufficiently profitable to make it worthwhile to continue in business.

Whatever the real reason behind the owner's attempt to sell the business, you are unlikely to discover it without rolling up your sleeves and doing some independent and in-depth investigation. The best way to find that needle in the haystack is to talk to other business people in the vicinity, particularly competitors in the same business. The business' suppliers can also be a source of important information.

Even if you are very diligent and thorough, you may not be able to dis­cover the hidden reason -- if there is one -- underlying an owner's desire to sell out. You may simply have to rely on your intuition in deciding whether the seller's reason for getting out of the business is the real reason. Just remember that in most cases a good and profitable small business is not something that most people walk away from, unless there is a darn good reason to do so, or the price offered is too good to turn down.

What Kind of Reputation Does the Business Have?

One of the great advantages of taking over an existing business can be the opportunity to enjoy the reputation and goodwill that the existing owner has built up with customers and suppliers over the years. On the other hand, you may be much better off starting your own business from scratch than acquiring a business that has a poor reputation because of inferior work or merchandise or inferior service. It could take you years of hard work and reduced profits to overcome a former owner's poor reputation.

Even if the present owner has an excellent business reputation, you will want to know whether or not that goodwill is based on personal relation­ships built up between the owner and customers. Those types of relation­ships aren't easily transferable. If the business relies heavily on a few key customers with whom the owner has very favorable business arrangements based on personal relationships, you may find those business arrangements could be lost when you attempt to take the owner's place. In short, satisfy yourself the goodwill you are buying is not based solely on personal relationships.

How Profitable Is the Business Now?

Unless you have some very good reasons to believe that you can operate the business more profitably than the current owner, you should not purchase a going business that does not produce a satisfactory profit under its current ownership. Thus, it is extremely important to find out how the business has fared financially for the last few years. This is where the services of a good accountant, who has knowledge of the particular type of business, is invaluable.

Insist on having the seller make the business' financial and business records available to your accountant. Be particularly wary of a business that keeps poor records. Often, the most reliable sources of financial information can be the owner's income tax and sales tax returns, since it is not very likely that a business owner will report more income than was actually earned for tax purposes. Be sure to ask the seller to have his or her outside accounting firm send you a copy of these tax returns, verifying they are true copies of the actual returns that were filed. Some unscrupulous sellers are not above filling out two tax returns -- one version showing low income to file with the taxing authorities and another showing much higher income to present to a potential buyer of their business.

PLANNING POINT:
If the owner is not willing to make financial records available, make it clear that you are not willing to negotiate any further.

Buying a business is much like buying a used car; you want to make sure it runs and kick the tires a bit before you put up a large sum of money.

Review the Assets

You will need to review both the tangible and intangible assets of the business to see if they are worth the price you will pay and also to deter­mine just what assets you will acquire under the sales agreement.

Personally inspect the business premises and look for things like obsolete or unsalable inventory, out-of-date or rundown equipment, or furniture or fixtures that you may have to repair or replace. Also, determine whether the business is able to expand at its present location or if it is already too cramped. You may need to buy or lease additional facilities if you wish to expand.

Review the terms of any leases. Some businesses close because of the imminent expiration of a favorable long-term lease or because the land­lord plans to either raise the rent drastically or not renew the lease at all when the current lease expires.

If you will be acquiring the accounts receivable of the business, review them in detail. An aging of the accounts should be performed to deter­mine how long various receivables have been outstanding. As a general rule, the longer a given receivable has been outstanding, the more likely it will prove to be uncollectible, but you may need the assistance of your accountant to do a proper aging analysis of the accounts receivable.

If a few large accounts of credit customers make up a significant portion of the receivables, you will want to focus particularly on those accounts and perhaps even have credit checks run on those customers. The bankruptcy of a major credit customer has been the ruin of many an otherwise highly successful business.

Part of your job in investigating a business is to find out what makes it tick -- and make sure you will be getting whatever that is. For example, a business that has well-developed customer or mailing lists should include those lists in the sales agreement. If there is a favorable lease, make sure it can and will be assigned to you. If patents, trademarks, trade names, or certain skilled employees are vital to the business, be sure that you will get them as part of the package.

Similarly, if there are special licenses the business needs to operate, you need to find out what they are and whether the transfer of the business will cause any such key licenses to terminate -- and if so, whether you are likely to have any problems re-acquiring such licenses once you become the new owner of the business.

You also need to be aware of potential problems with the government that the seller is experiencing or might experience in the near future, such as zoning problems or new environmental restrictions that may hamper the business' profitability of the business or even threaten its continued existence.

Liabilities

Once you have satisfied yourself as to what assets you will actually be get­ting if you buy the business, you must also determine what liabilities of the seller's business you will take on.

Hidden liabilities. Liabilities of the business may not always show up on its accounting records. There may be any number of hidden claims against the business, such as security agreements encumbering the accounts receivable, inventory, or equipment; unpaid back taxes of various kinds; undisclosed lawsuits or potential lawsuits; or simply unpaid bills.

If you are acquiring the stock of a corporation, you or your attorney should examine the corporate documents, including corporate minute books, looking for any kinds of improprieties or any mention of possible liability from lawsuits or other causes.

If you are going to assume the liabilities of the business, the written agreement of sale should specify exactly which liabilities are being assumed and the dollar amount of each.

Other examples of hidden liabilities include pension and vacation liabilities. As a successor employer, you may be taking on significant liabilities in the form of contributions to a pension fund or accrued but unpaid vacation leave of employees. These can represent significant hidden liabilities in some cases.

Environmental liabilities. A potentially disastrous hidden liability is the possibility of environmental contamination when purchasing real estate as part of a business. In many instances, environmental law imposes liability for past environmental abuses on current land owners or lessors. Many banks and savings and loans have learned about this the hard way, after having foreclosed on land which had been contaminated over the years by toxic substances, and being held liable for cleanup costs as the pre-existing contamination problems came to light.

Increasingly, in any purchase of a business that involves a transfer of real estate, a buyer must be extremely cautious about liability exposure under both federal and state environmental laws. It is not uncommon today for the purchasers of businesses to be held liable for the environmental problems created by their predecessors, even if they were unaware of them at the time of purchase. These laws can be brutal in their effect, as they are much less concerned with fairness than finding "deep pockets" of any person in the chain of title to a polluted property -- i.e., someone who can pay for the costs of remediation.

To protect yourself from such exposure, any purchase agreement you enter into when buying real estate, for business or other purposes, should contain environmental warranties from the seller that the condition of the property is in compliance with all applicable federal and state environ­mental laws, and you may want to hire your own environmental consultant to advise you if there is even a remote possibility of contamination.

Numerous federal and state environmental laws pertain to air, water, storage of hazardous materials -- including some very common household-type products -- waste disposal, and cleanup liability for contaminated ground water or soil, underground storage tanks, and other matters. These disposal or cleanup costs can sometimes exceed the cost of the property acquired. Even if no cleanup is required by the government, you may find the property has become nearly worthless or unsaleable if it is found to have any kind of environmental problem.

Environmental audits. You might consider an environmental "audit" of the property before you buy it, to determine its environmental condition. An audit is, at a minimum, a first-phase risk appraisal by an environmental consulting firm. At greater cost, but offering much more protection from liability, is a second-phase environmental audit, which typically includes soil and water tests. You do not gain absolute protection from environ­mental liability with an audit, but if a contamination problem that pre­dates your acquisition of the property is later discovered, and you have done an environmental audit before you bought the property, you are more likely to be considered an "innocent" purchaser of the property, and to avoid any cleanup liability. Otherwise, you are almost certainly on the hook for cleanup costs, even if it is clear that the property was already polluted when you acquired it.

Your business purchase agreement should contain detailed representations and warranties of the seller stating that:

  • The seller has not violated any environmental law or regulation; and
  • The seller will reimburse you for any cost or liability you incur for environmental damage that occurred before the acquisition.

Such representations and warranties by the seller may not offer you ironclad protection from environmental liabilities, (since the seller may die, disappear, or go broke by the time the problem comes to light, years later) but they are better than nothing.

See Chapter 7 of this book for a more detailed discussion of federal environmental laws.

Avoid Stock Purchases If the Seller Is a Corporation

If you intend to buy a company that is already incorporated, you are well advised to structure your purchase as buying the business assets rather than purchasing its existing stock. The former approach assures you only purchase the business' assets and any known liabilities you agree to acquire. The latter approach, on the other hand, results in purchasing the company's assets and all its hidden or contingent liabilities, whether or not you have agreed to pay for any liabilities that predated the sale.

One exception to this suggestion would be if the selling corporation was one that had substantial tax loss or tax credit carryovers that you might be able to use if you bought the stock of the corporation rather than the assets. Be aware, however, the tax law is a mine field when it comes to taking over someone else's tax loss or credit carryovers. So before you do so, seek good advice from a tax attorney or tax accountant. If you don't, you may find that the carryovers you thought you were acquiring have evaporated like a mirage.

The basic rule is that, in all cases, a change in ownership of more than 50% of the stock of a corporation in a three-year period will generally result in a severe restriction on the amount of its prior net operating losses that can be deducted in any subsequent taxable year.

In such a case, the prior net operating loss ("NOL") that can be used as a tax deduction in any subsequent year will be limited to an amount computed as follows: Multiply the value of the stock of the corporation immediately before the ownership change (typically, the buy-out price, if you are buying 100% of the stock) times the "long-term tax-exempt rate" in a period just before the change of ownership occurred.[1] The latter rate is essentially the interest rate on long-term tax-exempt bonds.

EXAMPLE:
You buy 100% of the stock of XYZ Corporation for $200,000. It has a $150,000 NOL carryover at the time and the "long-term tax-exempt rate" (as published by the IRS) is determined to be 5%. Thus, the maximum NOL deduction XYZ can claim to reduce its taxable income in any subsequent year is 5% of $200,000, or $10,000 per year, until the acquired NOL is used up or expires (expiration occurs 20 years after the losses for any given year were incurred).

Due Diligence Document Review Checklist

The following is a list of some of the key documents and possible problem areas you, and in some cases your professional advisers, should carefully investigate when are considering the purchase of an existing business:

  • Review Corporate Documents. If you are acquiring a corporation's stock for some reason (despite our advice above), obtain and review copies of the articles of incorporation, bylaws, and any shareholder agreements. Also review stock ledger records and verify the amount of outstanding stock or other securities. A review of all corporate minutes of board meetings and shareholder meetings should also be conducted, even if you are only buying the assets of the company, as the minutes may reveal important issues you may need to raise or investigate further.
  • Review Agreements To Which the Seller is a Party. These will include recent employment agreements and retirement or other benefit plan documents, as well as any noncompete agreements, equipment leases, and other agreements the selling business is a party to. Important legal documents involving patent rights, copyrights, or important licenses should be reviewed by your attorneys. Also pay particular attention to any receivables from or payables to the owners or other related parties, which may have onerous terms or, in the case of receivables, may prove difficult to collect in some instances.
  • Insurance. Review the insurance coverage of the selling business, including a review of all current insurance policies and any recent correspondence with the insurance companies or brokers. These would include a wide range of insurance policies, such as fire and casualty, property liability, business interruption, employee health insurance, group or key man life insurance, disability insurance, errors and omissions or malpractice insurance, as well as any other types of coverage carried by the seller.
  • Client List. Obtain a list of clients or major customers that have been lost in recent periods, such as the last 2 or 3 years. Also obtain a list, for such a recent period, of the top ten current clients or customers in terms of fees or sales billed to them and their current status, in terms of amounts of receivables from those clients or customers and the status of their accounts.
  • Real Estate Assets. Examine copies of all real estate deeds, mortgages, and title policies if you will be obtaining real estate in the transaction. Also examine any property leases on rented real estate.
  • UCC Search. It is important to know if there are any recorded security interests or liens against any of the assets of the business that would interfere with your receiving clear title to such assets. To check for such liens on property other than real estate, you or your attorney must do a search of the state records. Every state has enacted the Uniform Commercial Code and maintains a centralized record of recorded security interests on items of personal property.
  • Examine Credit Documents. Obtain and review copies of all loan agreements, bank lines of credit, and other credit agreements and debt obligations, including installment sale or capitalized leases, as well as loan guarantees or indemnity agreements. Finally, run credit checks on all of the principal owners.

3.4 Should You Consider a Franchise Operation?

Many small businesses, particularly fast food restaurants and print shops, are operated under franchises from a large national company (a franchisor). There can be substantial advantages to operating a franchised business, such as the benefits of national advertising, training programs, and assistance in setting up and running the business. In general, franchised businesses have a much lower failure rate than other small businesses.

If you are considering buying a franchise, investigate the franchise's reputation. Contact your local Better Business Bureau or an appropriate state agency to see if they have any information regarding the history, ethics, and reputation of the franchisor. You do not want to sign on with one of the less-than-reputable franchising operations that charges substantial franchising fees for very little in the way of useful services. With the advent of the Internet, digging out information about a franchisor has become much easier to do.

Also, if you are investigating buying a franchise as a transfer from the previous franchisee, determine whether the franchise can be transferred to you, and if so, you should provide for the transfer as part of the sale in the sales agreement.

Review the Franchise Agreement and Disclosures

Carefully review the franchise agreement with the help of your attorney to determine whether the franchisor must approve the transfer, what the costs of operating are under the franchise, and the other terms of the agreement.

Keep in mind, if you acquire a franchise, either from the franchisor or as a transfer from another franchisee, that you may be able to amortize (write off) the cost of acquiring the franchise, under certain circumstances, for federal income tax purposes. Consult your tax adviser as to whether or not this will be possible in your case. If it is amortizable, you may want to allocate a significant part of the purchase price for the business to the cost of the franchise, which could save you major tax dollars in the long run, since you will be able to write off the cost of the franchise over a 15-year period.

The Federal Trade Commission (FTC) and a number of states provide franchising laws and regulations that offer you some protection from scams.[2] These laws and regulations mandate the timing and content of the various disclosures that the franchisor must make to you, as the potential franchisee. Make sure you or your attorney asks for all of these disclosures on a timely basis, and be wary of any franchisor who does not provide these disclosures to you unless you ask for them. Be sure you have an attorney who is familiar with these requirements, if you are going to acquire a franchise.

More on Franchising

Once you have focused on a particular franchise opportunity, you will find the checklist located at the end of this chapter [LINK TO DELETED WORKSHEET DELETED], very useful for evaluating the franchise operation.

3.5 Negotiating the Purchase

The Purchase Price

No book can tell you how much you should pay for the business you are planning to buy. You are on your own on that one. If, however, you have done your homework thoroughly in investigating the business and have talked to bankers and other business people about what the normal purchase price for a business of that type and size should be, you will have a fairly good basis for determining whether the purchase price the seller is seeking to obtain is a reason­able one.

For example, you may find that small businesses of the type you are considering generally sell for about one and one-half times their annual gross sales. That could be very important to know if the seller is asking three times last year's gross sales.

There is no general rule of thumb as to how much you should pay for a business. Different types of businesses may sell for widely differing multiples of sales or earnings, depending on profit margins, growth potentials, stability of revenues, and other factors that may vary greatly, depending upon the industry and the location.

Even if you conclude the purchase price is a fair one, or even a bargain, you still must decide whether the price is one you can afford. Assuming that you can get the purchase price together, will it so deplete your liquid resources that you will not have enough working capital to make the business go, or put you in a bind if income from the business drops off while you are at the learning stage? Or, if you are financing a substantial part of the purchase price, will your operating budget be able to withstand the cost of making the payments on the debt and still leave enough for you to live on?

Remember, just because you can get the purchase price or down payment together does not necessarily mean that you can afford to buy a particular business even when the price is right.

Disclosure of Financial Information

At an early stage in the negotiations, specify that you want access to tax returns, books of account, and other financial records of the business, as well as the corporate minutes in the case of a corporation, and make it very clear that you have no interest in continuing the negotiations unless the seller cooperates fully in this respect.

Additionally, be sure this condition is expressed in any informal "memorandum of understanding" or letter of agreement between you and the seller that is written up before the final contract of sale.

Allocation of Purchase Price

One very important item that is often omitted in business sales agreements, perhaps because it is not absolutely necessary, is a provision in the agreement that shows how the parties agree to allocate the purchase price between the various assets that are being acquired. For tax purposes, how­ever, it is often very important to both you, as the purchaser, and the seller to have a written allocation agreement.

In most cases, whatever value of an asset you and the seller agree on is binding for tax purposes. So, it is very important from a tax standpoint to negotiate the best possible allocation of the purchase price among the assets you acquire and have that allocation reflected in the contract of sale.[3]

Since you and the seller usually have opposing interests in making an agreed allocation, the courts and IRS have generally been willing to accept any allocation agreement between the parties.

PLANNING POINT:
Both you and the seller will be required to file a tax form with the IRS, Form 8594, in which you report how the sales price was allocated to the various assets you acquired from the seller. (Obviously, if the allocation figures reported by you and the seller on Form 8594 are not the same, the IRS will take notice and want to know why.)

Revenue Reconciliation Act (Tax Law) Simplified Allocations

Breaking with Congress' long and hallowed tradition of enacting ever-more-complicated tax laws, the passage of the Revenue Reconciliation Act of 1993 actually did a great deal to simplify the allocation process and also made it easier, on an after-tax basis, to acquire a business when a significant portion of its assets are intangibles.[4]

Under the 1993 tax law, a broad new category of amortizable assets, called "Section 197 Intangibles," was created. Section 197 Intangibles may be amortized over a 15-year period. For the first time, this change in the tax law allowed goodwill and the going-concern value of a business to be amortized, as Section 197 Intangibles, over 15 years. Included in the definition of Section 197 Intangibles are:

  • Goodwill or going-concern value of an enterprise
  • Workforce in place
  • Information base
  • Any license, permit, or other right granted by a governmental unit or agency
  • Know-how, such as patents, copyrights, formulas, designs, patterns, or similar items -- special rules apply to computer software and interests in films, tapes, books, and videos
  • Any customer-based intangible, such as customer lists, depositor lists, subscribers, and insurance expirations
  • Any supplier-based intangible, such as favorable supplier contracts
  • Covenants not to compete
  • Any franchise, trademark, or trade name

Computer software is considered an intangible asset, but it is generally not subject to the 15-year amortization requirement of Section 197. Software that is readily available for purchase by the general public is not considered a Section 197 Intangible asset and can be amortized over 36 months.[5] Other computer software is a Section 197 Intangible asset only if acquired in a transaction that involves the purchase of a whole business or a substantial portion of a business.

TAX TIP:
During the years 2003-2013, off-the-shelf computer software can be expensed entirely as part of the allowable Section 179 expensing deduction that otherwise only applies to tangible personal property.[6]

Section 197 benefits most business buyers by preventing many disputes with the IRS regarding the purchase price of a business and by allowing amortization of the cost of intangible assets that were not deductible in the past. The law, however, is not entirely favorable. Previously, business buyers who were allowed to amortize certain intangibles were often able to do so over a period of only a few years, which was far better than the current 15-year amortization requirement.

Allocation Agreements Are Still Important

Do not assume that the 1993 tax law has made a purchase price allocation agreement unnecessary or unimportant. Certain assets that might be acquired in a business purchase, such as land, are still not depreciable or amortizable, so it will be advisable to try to allocate as little as possible to the cost of land or to buildings (which generally must be depreciated over 39 years) in a purchase price allocation agreement. Also, it will still be advantageous to allocate as much as possible of the purchase price to inventories or depreciable assets whose costs can be written off in a time frame much shorter than the 15-year amortization period for Section 197 Intangibles.

PLANNING POINT:
A tax deduction you can take today or in the near future is almost always worth more than a tax deduction fifteen years from now.

Non-Compete Covenants

In most states and for most kinds of businesses, it is possible to prevent the seller from competing against you for a reasonable period of time within specified geographic areas. (Your attorney will need to draft such a covenant and will know what limits state law places on such a non-compete agreement.) This can be an extremely important provision to negotiate for from the outset, for many types of businesses, to prevent the seller from starting up a new business just down the street to compete with the one you are buying from him or her for good money.

If your purchase agreement includes a covenant not to compete, note also that the cost of such a covenant is now generally deductible for the buyer (as paid, or by amortization), so it can also be advantageous to you, as the buyer, for income tax purposes, to allocate as much of the purchase price as possible to the covenant. Since the amounts received under the covenant by the seller are regular taxable income to him or her, rather than capital gains, it is disadvantageous to the seller to allocate a large part of the purchase price to a non-compete covenant. Because of the opposing interests of buyer and seller, the IRS will generally go along with whatever allocation to a non-compete covenant that the parties can agree to.

Sales and Use Tax Considerations

In some states that have sales taxes, the very act of selling a business may give rise to a sales or use tax on the purchase price, at least in part. Most states exempt such non-routine or "occasional" sales, but some do not, so you will need to factor that tax cost into the deal.

Even if it appears the purchase may be subject to sales or use tax, you may be able to structure the deal so more of the purchase price is allocated to assets that will not give rise to sales tax, such as inventory or stock in trade that is held for resale.

Thus, the legal form of the transaction can have major sales tax con­sequences, aside from income tax considerations.

3.6 Closing the Deal

The legal and recommended procedures involved in buying an existing business are rather complex. To ensure you are protected as fully as possible from liabilities you have not agreed to assume, first retain a lawyer, preferably one who specializes in business law practice. Also, obtain competent tax advice, either from your attorney or from an accountant, when negotiating and structuring aspects of the deal, such as the allocation of the purchase price and the disposition of any employee benefit plans carried on by the seller for the employees of the business. Then have your attorney take the steps described below.

File Bulk Transfer Notice in States Where Still Applicable

In the past, all states required that a purchaser of a retail or wholesale establishment or certain other types of businesses had to notify creditors of the bulk transfer, by one or more of several means, which varied from state to state.

If the proper notices were not given on a timely basis and in a specified manner, the seller's unsecured creditors could place a lien or security interest on the property that the purchaser thought he or she (or it) was buying free and clear. Laws requiring such notices, by filing, publication, or otherwise, are referred to as bulk sale or bulk transfer laws.

In 1988 and 1989, the National Conference of Commissioners on Uniform State Laws and the American Law Institute recommended that states abolish or repeal their bulk sale or bulk transfer laws. Both of these prestigious organizations concluded that bulk sale laws no longer serve any useful purpose, but are instead a significant burden upon persons buying existing businesses. Since these recommendations were made, most states have decided that such laws provided little real protection to the creditors of the selling businesses, but added significant legal and other costs for both buyer and seller in business sale transactions. Accordingly, all but a few states and D.C. have now repealed or else amended and simplified their bulk sale laws. This trend is likely to continue in the next few years.

Typical bulk sale laws require either publication of legal notices to all creditors in advance of the sale and recording of such notices in some cases, or maintenance of detailed lists of the property to be transferred, for inspection by the public.

[STATE-SPECIFIC INFORMATION ON THE DETAILS OF THE PARTICULAR STATE'S BULK SALE LAW, IF THE STATE STILL HAS ONE, APPEARS HERE IN EACH STATE EDITION OF THIS SERIES, WHERE APPLICABLE.]

Following Wisconsin's repeal of its bulk sale law in 2010 and the repeal of the Virginia bulk sale law in 2011, only 3 states and the District of Columbia still had bulk sale laws at the time of this writing:

  • California
  • District of Columbia
  • Georgia
  • Maryland

Check for Security Interests

Before closing the purchase, your attorney should check with the secretary of state or equivalent state office to determine whether anyone has recorded a security interest -- a lien or chattel mortgage -- against the personal property of the seller's business. Naturally, if the transaction involves a purchase of real property, you should also have a title search performed to see if the seller has good title and if there are any recorded mortgages or other claims against the property that the seller has not disclosed to you. For a fee, the secretary of state's office -- or its equivalent in your state -- will provide a listing of any security interests that have been recorded as a lien against the assets of the business you are buying.

Obtain [STATE NAME] Tax Releases

Another very important step you need to take when acquiring a business, in almost every state, is to obtain any necessary tax releases, or have the seller obtain such releases, as a condition of completing the sale.

When you acquire an existing business, you will want to make sure that you do not unwittingly become liable for any unpaid taxes owed by the seller. Typically, to protect yourself, you will need to receive a tax release or releases from various state taxing agencies, for such taxes as sales and use tax, income tax withholding, and state unemployment taxes, in each state in which the seller does business. If you fail to obtain such a release or written statement from the tax agency that the seller is not delinquent on any tax payments, you will be held responsible for such tax if it is not withheld from the purchase price proceeds and paid to the state at the time the sale of the business occurs.

In [STATE NAME], you should obtain [STATE-SPECIFIC REQUIREMENTS DELETED HERE].

Succeed To Seller's Unemployment Tax Rating

In most states, when you acquire an entire business or a business unit, with employees, you may automatically succeed to the seller's unemployment tax "experience rating," which may be beneficial, if you already own a business that pays a higher state unemployment tax rate. However, in some states, becoming a "successor employer" (inheriting the seller's tax experience rating for the seller's work force) may be optional, and if so you will need to make a timely application for a transfer of its rating to your company.

Even in a case where you already own a business, and the business you are acquiring to add to your operation has a tax rate that is the same or somewhat higher than yours, or where you have no existing business and the seller's tax rate is a bit higher than the rate for "new employers" (you would be a "new employer" if you do not already have employees and you don't become a "successor"), it will usually be beneficial to be treated as a "successor employer" with respect to the acquired employees, unless you are acquiring the business on January 1st, before any wages have been paid. That is true because an employer is only required to pay unemployment tax (state and federal) on each employee's annual wages up to a fixed dollar amount or "wage base" ($7,000 of wages each year, for federal unemployment tax purposes, or higher wage amounts for most states). Thus, any wages paid by the selling employer will have reduced the amount of wages on which you will have to pay tax for that employee during the rest of the year, if the employee earns wages for the whole year that exceed the wage base, as will be the case for most employees.

In addition to obtaining tax releases, you may find it advantageous to succeed to the seller's unemployment tax experience rating, if the seller has a tax rate lower than you would otherwise obtain as a new business. [STATE-SPECIFIC REQUIREMENTS FOR SUCCEEDING TO SELLER'S EXPERIENCE RATING DELETED HERE].
PLANNING POINT:
Besides possibly obtaining a lower unemployment tax rate and experience rating, another clear advantage of being treated as a successor employer is that you may take into account wages already paid to the acquired employees by the former employer during the year of the acquisition. Thus, you will not have to pay tax on the amount of wages paid to an employee in that year by the former employer, who will have already paid unemployment tax on such wages, for which you may take credit, in determining the amount of tax owed on total wages paid to that employee for the year.
EXAMPLE:
Employee X has already earned wages equal to or exceeding the current year taxable wage base amount, while employed by the former employer, on which the former employer has paid the unemployment tax. Thus, if you qualify as a successor employer, your business would not incur any unemployment tax on wages you pay to Employee X for the remainder of the year of the business acquisition.
For more information on unemployment tax rates and the taxable wage base in [STATE NAME], see the discussion of [STATE NAME] unemployment taxes in Section 6.2 of Chapter 6.

File Form 8594 with the IRS

Tax regulations require both you and the seller to file Form 8594 with the IRS any time a business is bought or sold.[7] Form 8594 is used to report certain information about the purchase price allocation and is due when your tax return is filed that covers the year in which the transaction occurred. Penalties for failure to file this form can be extremely large. Needless to say, the information on your Form 8594 and that filed by the seller should be identical, or you both will be inviting IRS audits.

Withhold Federal Income Tax If Buying Real Estate from a Foreign Person

When you purchase real estate, either as part of a business purchase or in a separate transaction, the seller may owe tax on his, her or its gain (if any) on the sale of the property. In certain situations, you may be required to withhold, from the purchase price you pay to the seller, federal or state taxes (or both) on behalf of the seller and pay such taxes over to the appropriate taxing authorities.

In any business purchase, if the purchase includes the acquisition of a "U.S. real property interest"[8] (real estate located in the United States or Virgin Islands, generally) from a "foreign person," you, as the buyer, must withhold 10% of the purchase price as income tax and pay it over to the Internal Revenue Service on behalf of the seller. [9] The amount to be withheld may be reduced if the seller applies in advance to the IRS for a determination that the amount of tax owed on the sale is zero, or less than 10% of the purchase price.[10]

UPDATE NOTE:
The IRS has had temporary authority to apply the withholding tax to gains on the disposition of U.S. real property interests by partnerships, trusts, or estates that are passed through to partners or beneficiaries that are foreign persons. The American Taxpayer Relief Act of 2012 has made this authority permanent and increased the amount of tax that may be withheld to 20% of the gains.

Generally, a U.S. real property interest can mean real estate you purchase directly, or an indirect interest in property, where you acquire an option to buy such property. It can also be an indirect purchase, if you acquire stock in a U.S. corporation that holds such property, if the stock is owned or controlled by foreign persons.

No withholding is required if the seller is not a foreign person. "Foreign person" means, generally, a nonresident alien individual, or a foreign corporation, foreign partnership, foreign trust, or foreign estate. A resident alien individual is NOT a "foreign person" for purposes of this withholding requirement.[11]

A nonresident alien individual is defined as a person who is neither a U.S. citizen nor a resident of the United States. The tax code bases this on two tests: a "green card" test and a "substantial presence" test.

  • Green card test -- Once an individual receives their green card, allowing them legally work in the United States, they are deemed to be a resident of the United States and will be taxed on their worldwide income, like a U.S. citizen.
  • Substantial presence test -- A foreign individual is considered to be a resident for U.S. federal tax purposes if he or she is physically present in the U.S. for 183 days or more during the current calendar year.

As part of your acquisition of the real estate, you should obtain an affidavit of non-foreign status from the seller, or if you are acquiring stock of a corporation, you should obtain a statement, issued by the corporation pursuant to section Income Tax Regs. Section 1.897-2(h), certifying that the interest is not a U.S. real property interest.[12]

Withhold State Taxes If Buying Real Estate, in Some States

In some states that have income taxes, you may also be required to withhold state income or other tax on the real estate purchase if the seller is a nonresident of the state where the property is located and or is an entity that is not qualified to do business in the state. Some states, such as California, even require withholding where the seller is a resident of the state where the property is located.

States that require state income or other state taxes to be withheld by the buyer from sales proceeds of some real estate transactions include the following:

  • Alabama
  • California
  • Colorado
  • Delaware
  • Georgia
  • Hawaii
  • Maine
  • Maryland
  • Mississippi
  • New Jersey
  • New York
  • Oregon (since 2008)
  • Rhode Island
  • South Carolina
  • Vermont
  • West Virginia (since 2008)

[LINK TO STATE CHAPTER DISCUSSING THE STATE REQUIREMENTS FOR WITHHOLDING ON REAL ESTATE PURCHASES DELETED HERE.]

CAUTION:
If federal or state tax, or both federal and state taxes must be withheld on an acquisition of a real property interest, you, as the buyer, may be held liable for any tax you were required to withhold, but did not!

Use an Escrow

In general, both you and the seller will be protected -- from the time the sales agreement is signed until the deal closes -- if an escrow is used to handle the sale of the business. The escrow holder, which is usually an escrow company or escrow department of a financial institution, will hold the agreement, escrow instructions, funds, and important documents until all conditions for closing the deal or releasing the funds or documents are fulfilled and should make sure that any taxes that must be withheld have been withheld and are paid over to the federal or state governments.

When the deal closes, the escrow holder will disburse the funds to the seller and deliver the documents of title to you. If the deal is not completed, the escrow instructions will specify how the items held in escrow are to be distributed to the parties. Your attorney or the seller's attorney may also act as escrow holder, but you probably will not want the seller's attorney to act in that role in most cases, for obvious reasons.

Build Holdbacks into the Agreement

If the seller has made misrepresentations to you in the contract of sale regarding assets that do not exist, or the like, you may always seek satisfaction by suing for damages. In view of the cost, delay, and uncertainty in bringing a lawsuit, however, you are far better off if you structure the deal so part of the purchase price is held back for some period, say a year, just in case such a contingency arises. Discuss with your attorney the possibilities of structuring the transaction so you either:

  • Give the seller a note as part of the purchase price, with a right to reduce the principal amount of the note if certain contingencies occur; or
  • Have part of the cash payment price held in escrow for six months or more after the sale occurs.

Then, if you discover false representations as to assets or liabilities, it will be relatively simple -- compared to bringing a lawsuit against a seller who may have skipped town -- to have your claim deducted from the amount held back.

Below is a checklist, Worksheet 8, at the end of this chapter, to help you investigate, negotiate, and close the sale of an existing business, as well as a checklist for evaluating a franchise [LINK TO WORKSHEET DELETED], below).

Avoiding State Taxes, if You Are the SELLER

If you are selling a business you own that is located in a high-tax state, and plan to retire in a low-tax or no-income-tax state, it may be critically important for you to take up residence in the low-tax state before you even put the business up for sale. If you are able to do so, and are no longer a resident of the high-tax state when the business is sold, your sale of the corporate stock (if the business is incorporated) will ordinarily not be taxable in the state that you have exited, even if the business of the corporation is located there. This assumes that you sell the stock of the corporation, rather than having it sell its assets and then liquidate.

The result would generally be the same if the business were a partnership or LLC and you sold your partnership or LLC interest, rather than having the partnership/LLC sell the business and distribute the proceeds to the partners or members. That is because shares of stock or interests in a partnership or LLC are intangible property, and thus any gain on the sale of such intangible assets should only be taxable to you, for state income tax purposes, in the state where you are a resident. If that state happens to be one like Alaska, Florida, Nevada, New Hampshire, Tennessee, Texas, Washington, or Wyoming, with no general individual income tax, you would be home free, escaping state income taxes on the sale entirely.

If, however, your business were a sole proprietorship, located in a high-tax state like California or New York, it would do you no good if you had moved to a low-tax state before selling it, as you would still be taxable on most, if not all, of the gain in the high-tax state, where the assets were located.

CAUTION:
While the above strategy, when selling your business, should work if you are able to effectively change your state of residence to a low-tax or no-income-tax state, be forewarned that some states like California and New York, in particular, are very aggressive in trying to tax former residents, treating them as though are still residents. Thus, it will be necessary for you to consult a tax professional and take all necessary steps they advise, in order to sever all your ties with the high-tax state where you were doing business, before you try to sell the business.

Simply moving to another state and taking a few steps like registering to vote there will often be insufficient to free you from the long-arm of the tax authorities of the state whose high taxes you are fleeing, unless you are able to defeat them in court. That can be expensive.



Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code, C.F.R. to the Code of Federal Regulations.)

1. I.R.C. § 382(b)(1)(B).
2. 16 C.F.R. §§ 436.1 and 436.2.
3. I.R.C. § 1060(a).
4. I.R.C. § 197.
5. I.R.C. § 167(f)(1).
6. I.R.C. § 179(d)(1)(A)(ii).
7. Treas. Regs. § 1.1060-1(e)(1)(ii)(A).
8. I.R.C. § 897(c).
9. I.R.C. § 1445(a).
10. I.R.C. § 1445(c)(1).
11. Treas. Regs. § 1.1445-2(b)(2)(i).
12. Treas. Regs. § 1.1445-2(c)(3).


Chapter 4

Selecting the Right Location

"There will be no nuclear war. There's too much real estate involved."
-- Frank Zappa

"To the child and the stockbroker, all things are possible."
-- Eric Hoffer

4.1 Location, Location, Location

There's an old saying in the real estate business that the three most important things to consider in buying a piece of real estate are location, location, and location.

There is a lot of truth in that assertion, and it tends to be especially true when selecting the site where you will locate your business, as even the best run retail business can fail if it is in a poor location. The process of selecting a good location for your particular type of business is largely a matter of common sense. Nonetheless, whether buying or leasing the property, carefully weigh the many complex factors involved before you decide on a location for your business.

Enough time, energy and study has been devoted to this subject over the years to turn the process of site selection into a science. While we can't turn you into a "location specialist" or real estate expert in one easy lesson, the background information and suggestions below will give you a number of things to consider and look into before you sign on the bot­tom line and buy or rent a location for your business.

Importance of Site Selection for Retail Businesses

Site selection tends to be more critical in the success or survival of the typical small retail business than for a wholesaler, service firm, manufacturer, or Internet business. Therefore, most of this chapter focuses on retail location, and only the last section discusses location considerations for non-retail types of businesses, since location can be important in some cases for those kinds of businesses, as well.

If yours is a retail business, much of your success will depend on those people who happen to pass by your site, notice your signs, and decide your business is convenient and looks inviting enough for them to stop in. You may still be able to attract people based on your advertising and promotional activities, but you will usually have a very hard time surviving if your location is poorly chosen.

The rest of this chapter gives you a general framework for conducting a location analysis for your business. It also offers hints and suggestions of things to look for, or to avoid, as you go through the process. If yours is not a retailing business, the next section, Section 4.2, may not be particularly relevant reading for you, so you may want to skip ahead now to Section 4.3, which covers location factors for certain types of non-retail businesses.

4.2 Steps in Selecting a Site for a Retail Business

Step 1: Market Research

Begin your site selection process by doing a market study to make sure the general area in which you are locating will support the type of retail business you plan to open or acquire. While this phase of your study will not point you to a specific site, it should give you some assurance that the geographic area offers the potential for success. Then you can begin to focus on specific streets, shopping centers, or individual sites.

Some of the key components of a market survey require you to:

  • Calculate how far your target customers will travel to obtain your product or service. The typical retail customer will drive 15 minutes or less, but this also depends on your region -- many shoppers in Los Angeles expect long drives, while shoppers in New York City or Philadelphia calculate walking, subway, or taxi time.
  • Identify the retail trading zone from which you will draw most of your customers. Draw it on a city or county map. Measure the distance from your customer base to your store not in miles but in minutes by car (or by foot or public transportation if applicable). For example, if there is only one major east-west arterial street or highway that runs through your targeted area, with good traffic flows at high speed, your retail trading zone will probably be an elongated elliptical area, running east to west, if there are no similar north-south arteries. If you will attract customers who are within a 15 minute drive, this may mean people 10 or 12 miles east or west of your location, who live near the major east-west road, will be in your trading area, but people who live only 5 or 6 miles to the north or south, who must take slow or congested side streets to reach you, may be outside your retail trading zone.
  • Study demographics, population trends, and growth prospects for your retail trading zone. Make sure there is a good market for your retail product or service operation. You can use Census Tract data on income levels, age and ethnic distribution, and other demographic factors that may be relevant to your particular type of retail business, all of which is available from the U.S. Census Bureau. You can also make informal observations on your own, such as of local supermarkets, to determine income levels in your trading area. If they are busy, clean, and well-maintained, with high-quality meats, seafood, fresh fruits, and vegetables, you are in a relatively affluent neighborhood.
  • Identify your competition. Generally, look for areas with minimal competition, but don't necessarily be scared off by a lot of competition. An area with several good restaurants set up shoulder to shoulder can become known as a good spot to eat out, with numerous dining choices, so you may actually benefit from the presence of the other restaurants, provided you offer food, service, and atmosphere that is fully competitive with the neighboring eateries.
Step 2: Traffic Patterns

Research traffic patterns in your city or other selling area until you feel you have a good understanding of how, when, and in what directions the major traffic flows occur. Identify the major arterials, radial roads, and other major thoroughfares that carry most traffic to and from various nodes, such as between residential districts and office or industrial employment centers. Find out which way the traffic flows on major streets where you might locate, at different hours of the day.

Look for the three main types of traffic:

  • Local traffic, which consists mostly of very short trips by people to the grocery store, to pick up a paper or other items at a convenience store, or to get their hair cut, or the like;
  • Commuter traffic to and from work; and
  • Long-distance traffic from other cities or from out of state.

In general, you will pay more for a site that is located on a main artery that carries a lot of commuter and local traffic. You will pay even more if an interstate or other major highway passes through the area, with long-distance traffic either being forced to use the artery or else, if it is a restricted-access freeway, if it has off-ramps that dump off substantial traffic onto the local streets.

The most desirable sites are those that carry all three kinds of traffic, local, commuter, and long-distance. While you will have to pay higher rent for these sites, it will be more than worth it for most kinds of retail businesses.

Other considerations as you do your traffic study include:

  • Time of day your target customers are likely to shop. If you are opening a Mexican restaurant or a steak house on a major commute route, you want to locate on the side of the road most accessible to evening commuters. Conversely, you want to locate on the other side of the road if you are opening a donut shop, which is likely to appeal to the morning com­muter.
  • Traffic count information and projections from city or county officials. The local planning department or city traffic engineer's office compiles such information and can also alert you to future developments in the area, such as future street improvements that will improve access, or a long construction period that could negatively impact your business.
  • The speed of traffic in the area. Merely locating on a high-volume street will not necessarily be good for your business. If you are on a stretch where traffic goes by at 50 miles an hour much of the day, or crawls by during long congested periods each day, it may be difficult to attract much business. You may not attract fast-moving traffic unless you have a very wide entry and can post large, visible signs far enough ahead to give drivers time to slow down and safely turn into your driveway. By the same token, if traffic is terribly congested, it will tend to discourage anyone other than commuters who are inching by to come to your location, and many com­muters who might want to stop at your store may be unwilling to exit and later re-enter the heavily congested street or highway.

Step 3: Focus on Possible Sites

Once you have done your market analysis and study of local traffic pat­terns, you can begin to focus on specific streets or shopping centers. As you do so, consider the following:

  • Dead-end streets. Avoid locations on dead-end streets, roads that parallel railroad tracks, or freeway frontage roads, in general. Even a street that soon ends at a T-type intersection should generally be considered a dead-end, for this purpose. Avoid other low-traffic minor roads or streets, even though rents might be temptingly low.
  • One-way streets or odd intersections. Avoid one-way streets, or intersections with one-way streets, or odd, triangular 3-way intersections, in most cases. Remember that if a driver has to go to any trouble to get to your store, he or she is likely to pass you by and look for a more easily accessible alternative.
  • Focus on a few sites. Narrow down your site selections to just a few.
  • Malls and shopping centers. Your best choice will usually be in a large regional mall, if that is a realistic possibility, where there is a great deal of "foot traffic." Often, however, such a location in a regional shopping mall may only be available to bigger businesses having widespread name recognition. Thus, many small businesses frequently have to settle at first for some sort of compromise. Often that means locating at first in an active neighborhood shopping center or strip mall, or acquiring a free-standing site.
  • Far corner sites. The best type of free-standing site is one located on a "far corner" of an intersection, on the right hand side, on a major street. Ideally, it should be at an intersection of two major thoroughfares, but a location on the far corner of a busy street where it intersects with a less busy street can also be quite a good location. (The "far corner" site is the corner on the right, across the cross street, which you will be able to see as you wait at the red light, if any. See the examples in the diagram below.)
  • Adjacent sites. A second-best choice is an "adjacent" site just behind a far corner site, if your site has good visibility, room for two entrances (each two cars wide, so that cars can be entering and leaving each such entrance comfortably, at the same time). It will be an even better site if your property wraps around the corner site so that your business also has good access to the side street, as well as the main road.
  • Near corner sites. Avoid the "near corner" in most cases, unless it has exceptionally large frontage on the main drag. Otherwise, most cars speeding up to get through the intersection will not have time to slow down and turn into your driveway after they see your signage. Also, cars leaving your site and trying to get back onto the street will find it difficult to do so, if traffic backs up at the light, past your driveway -- which will normally be the case with a near corner lot.

Corner Location
Diagram (16,452 bytes)

Step 4: Traps to Avoid

Once you have found a site that seems to meet all your criteria, it is time to begin looking for the fly in the ointment, if any. That is, you need to beware of certain serious traps in the site selection process. Buying or leasing a business location is a major financial commitment, and you definitely don't want to learn afterwards that there is some serious drawback to your site you hadn't originally noticed or fully appreciated.

Some sites that seem to be ideal in many ways may nevertheless have certain flaws that can be fatal to your business if you fail to identify them. Be particularly wary of any of the following possible problems, once you have narrowed your search down to a few (apparently) choice locations:

  • Median dividers or other obstacles which prevent cars coming from one direct­ion or the other from turning easily into your driveway. This is often a problem at an intersection of two major roads. A much more ideal road layout, from a retailer's point of view, is one where the major street is either two or four lanes, with an additional center turning lane running down the block from the intersection, marked only with yellow lines. With that street lay­out, drivers wanting to turn across traffic to get to your store can easily pull into the center lane and await a break in the traffic. Also, drivers pulling out of your lot who wish to go left can easily do so by first pulling into the center lane. Without the center lane, most drivers will be fearful, in heavy traffic, of trying to time their left turn. Or, if there is a center divider, they may not patronize your business if they know they will have to turn right when they exit and then make a number of further convoluted turns, if they want to go back in the other direction.
  • Inadequate parking! Even the best site can be crippled by a lack of parking, or even by a shortage of convenient parking. The author can speak from very personal experience in this regard, having paid heavy "tuition" to learn this lesson early in life. During this author's misspent youth, he and several associates from a real estate economics/consulting firm for whom he worked started an upscale, award-winning restaurant in Southern California, located in an exclusive, very dynamic office/shopping center complex. Parking was allowed on the side streets of the development and we were told that patrons would be able to park on a street behind the restaurant, but were not able to get that promise in writing from the developer or the city. When the restaurant opened to large crowds and rave reviews, the large developer who controlled the office/shopping center decided the on-street parking was a nuisance to other tenants and banned it. Our sales immediately dropped by almost 50% when the on-street parking was banned, since most Southern Californians at the time did not like to park in an upstairs parking garage, even though we gave free (validated) parking to our customers. Our restaurant finally went out of business two years later, after incurring huge financial losses. Lesson learned.

    Unless you will have your own parking lot for customers, you need to carefully focus on whether there is enough free or inexpensive metered street parking available, or adequate common parking if you are in a shopping center, at the times of day when you expect your business to peak. Lack of convenient and free (or cheap) parking has been the death of many a small business.

  • The rent asked seems too low. If the rent seems too low, or the location seems too good to be true for the asking price, there is probably a good reason. While the site might look ideal, you had better do some more research. There may be a zoning change or street layout change looming on the horizon that can negatively impact the prospects for business at the site. Start by asking questions of neighboring business owners until you find out the missing piece of the puzzle. When you do, you will probably understand why the rent for the property is so cheap.

4.3 Site Selection Factors for a Non-Retail Business

As a success factor, location is most essential for a retailing firm. However, location can also be important for some kinds of manufacturing and service businesses. As a rule, look for places that present you to the most customers at the lowest cost.

Businesses that cater to the same class of customer will often tend to increase sales of neigh­boring businesses. service business, consider a location in an office or professional building. For example, if you are a lawyer, you may do well if you locate in an office building that is largely filled with accounting firms, and vice versa if you are an accountant. In either case, you won't help yourself very much by locating in an industrial park, in the midst of various types of manufacturing businesses, except to the limited extent you may be able to attract a few of those nearby businesses as clients.

While rent is an important cost factor for a professional service firm, there are two schools of thought on whether you should seek costly "prestige" offices, or economize by seeking something that is clean and presentable, but much less expensive, and perhaps not in a major office center. One line of thought is that, for a new professional firm in particular, it is very important to convey an impression of being successful, by maintaining prestigious offices in a centrally-located, top-of-the-line office building. The other view is that many clients may be "turned off" by such fancy surroundings, assuming that your fees will have to be very steep in order to pay for such lavish offices, and such clients may thus prefer to go to a professional who runs a leaner, less-pretentious, "no-frills" operation.

There is a lot of truth in both arguments, and the answer as to which approach is best for your professional firm is likely to depend upon the type of clientele you will attract -- the more upscale, rich client who expects his or her professional service providers to have lavish offices, or the more practical, frugal business types who aren't interested in such "showy" surroundings. Obviously, if you run a tax preparation firm where you charge low fees to do "small" tax returns, you want inexpensive office space in a strip shopping center or comparable location, not lavish offices in a pricey downtown office tower. If you are a high-priced lawyer or investment counselor, on the other hand, you might prefer the more prestigious location.

Some types of businesses, like small manufacturing companies, or even some retail firms like those doing mail-order or Internet sales, will be somewhat less concerned about a specific location within a geographic area. If yours is such a business, consider whether the site is in an area where employees will feel safe coming to work, and whether it is also reasonably accessible to freeways or other major roads or transportation lines. Consider, also, whether the area offers enough qualified workers for your business. If you are in a rural, agricultural area, far from major cultural centers such as New York or San Francisco, for instance, you may find it difficult to attract qualified people to staff a high-technology firm.

While the immediate area may have low taxes, a thriving economy, good roads, and a good workforce to draw from, if you are a manufacturer, it may simply be too far from the major cities to which you will have to ship your product. In that case, if your product is bulky and expensive to ship over long distances, you may be at a serious cost disadvantage com­pared to your competitors.

In some locations, "incubator" space is available for many kinds of non­retail businesses. Incubator space offers low rent and shared services, such as telephone answering, receptionists, conference rooms and copy machines, which your small firm might not be able to afford if you "go it alone." Contact the SCORE (Service Corps of Retired Executives) chapter at your local U.S. Small Business Administration (SBA) office, or the nearest Small Business Development Center.

A number of Small Business Development Centers (SBDCs) are located throughout [STATE NAME] to assist you. These centers, usually located on college campuses, provide a wealth of start-up information and sponsor frequent business-oriented seminars. Contact the lead office below for information, or for the location of other SBDCs nearer to you.

[ADDRESS AND PHONE NUMBERS FOR LEAD SBDC CENTER IN YOUR STATE DELETED HERE]

4.4 Assistance in Choosing a Location

Now you can do much of your demographic research and site location analysis on the Internet. The Pitney-Bowes Predictive Analytics website allows you to:

  • Enter your city and view maps with up to three drive-time rings, from a given location, such as 15 minutes, 30 minutes and 45 minutes;
  • Create Median Household Income maps for your target areas, showing the highest income areas in darker shades of green;
  • Get pop-up spreadsheets showing a number of different types of demographic reports, such as breakdowns of household size and composition; and
  • View maps that show locations of all major shopping centers or malls in a given area with a map width of 25 miles or less.

The SBA also has a useful publication for locating a retail business, Choosing a Retail Location. Contact:

SBA Answer Desk
(800) 827-5722

For more assistance in choosing a location, try these websites. They have directories, phone numbers, FAQs (answers to Frequently Asked Questions), and other helpful information.

SBA Online
www.sbaonline.sba.gov

Association of SBDCs
www.asbdc-us.org

SCORE Online
www.score.org

Lastly, don't forget the important financial and legal considerations of signing a lease discussed in Chapter 1, Section 1.7. A lease is a binding legal contract. Get your business' needs in writing, including parking, signage, and building improvement needs.

Now that we have covered some of the basics of choosing a legal entity and finding a suitable location for your business, let's continue on to Chapter 5 for a discussion of federal and state tax laws and regulations and other requirements that may apply to your business.

Part II.     Operating Your Business

horiyell.gif (1505 bytes)

Chapter 5

A Trip through the Red Tape Jungle: Requirements that Apply to Nearly All New Businesses



"If you're going to sin, sin against God, not the bureaucracy.
God will forgive you, but the bureaucracy won't."

-- Admiral Hyman G. Rickover

"The law, in its majestic equality, forbids the rich as well as the poor
to sleep under bridges, to beg in the streets, and to steal bread."

-- Anatole France

"Remember that the bureaucrat who smiles when something goes
seriously wrong has already found someone to blame it on."

-- Doc Snopes' Ninth Law of Business Survival

INTRODUCTION

This chapter outlines the most common governmental requirements and other red tape that virtually everyone starting a new business or buying an existing business must attend to. Specifically, this chapter focuses on the important tax and legal requirements that apply to nearly all businesses, whether or not they have employees. If you expect to have one or more employees, a large number of additional legal requirements will affect your business. Chapter 6 covers the additional requirements that apply to businesses that have employees.

This chapter provides only limited information on the special licenses that many types of businesses must have, as the number of possible license requirements, at all levels of government, approaches infinity. If you do not know whether your business requires a special license from state or local government agencies, refer to the state chapter ([LINK DELETED]) for [STATE NAME], which provides contact information for major [STATE NAME] licensing and other agencies. Section 5.4 of this chapter summarizes the various types of federal licenses that a business may require, Section 5.3 discusses some of the main [STATE NAME] licensing and registration requirements, and Section 5.2 provides general information on the types of local licenses that may be required.

5.1 Choosing a Name for the Business

The name you choose for your business can be important from a business image standpoint and also for communicating to the public what you have to offer. Most small businesses should select a name that, at least in part, clearly describes the product or service provided. If you ignore this basic common-sense rule, you run the risk of losing many potential customers for the simple reason they will pass right by without realizing what you do. A fanciful or whimsical name is fine from an image standpoint, but it should also give the public a clear idea of what goods or services your business provides. For example, if you call your restaurant, "The Comestible Emporium," a lot of hungry people will probably drive right by without realizing that you serve food.

However, to protect your business' name as a trademark or service mark under federal and state laws, it makes sense for you to adopt a name that is partly arbitrary or non-descriptive. Names that are merely descriptive of the goods or services sold cannot be legally protected from use by others, unless you can prove that the name has acquired a secondary meaning -- which is very difficult for a new or small business to establish.[1] A name like "21 Club Restaurant" serves both purposes -- it describes the service (restaurant) and the atmosphere (club-like), and does so in a creative, trademarkable way.

Think carefully before using your own name as part of your business name. If you use your own name and the business closes, as some new businesses do, many people in the community will automatically associate your name with the defunct or bankrupt business. This may make it very difficult to start another business or obtain credit in the same community in the future. Consider using a fictitious name (see Section 5.10 below) for your business, rather than your own name. There is nothing illegal or shady about using a fictitious business name.

Once you have settled on a name for your business, you (or preferably your attorney) should find out whether the same name, or a confusingly similar name, has already been preempted by someone else. In many states, this involves making an inquiry with the secretary of state's office (or similar state office) to find out whether the name is already being used in the state. However, business name registration procedures (when required) vary greatly from state to state. In some states, you may need to inquire at the county clerk or similar office in each county where you will do business to see if another business is already using the same or a confusingly similar name and has filed a fictitious business name statement or other name registration of some type. If so, you may have to choose a different name. See Section 9.2 of Chapter 9 for more information on trademark protection. See Section IV(g) [LINK DELETED] of the [STATE NAME] chapter for registration requirements, if any, for businesses that use fictitious or trade names, and guidance as to where in [STATE NAME] you should inquire to find out if the name you have chosen for your business is already in use.

(Note that not all states have counties; Louisiana has parishes and Alaska has boroughs, which are the functional equivalents of counties in those states.)

5.2 Local Business Licenses

Nearly any business, operated anywhere in the United States, will have to have at least one government license of some kind. In most cases, this will be a local license, issued by your city or county government, although some businesses may require a state license (see Section 5.3) or even a federal license (see Section 5.4) to operate.

Before you open your business in [STATE NAME] or any state, contact the local city or county government and find out if your particular business needs one or more local licenses. Most kinds of local business licenses are granted upon payment of a fee, with no further requirements, except possibly for annual or other periodic renewal fees. Failure to obtain a license when you start a business will usually result in a penalty or fine when the local government eventually catches up with you; there­fore, obtaining the necessary licenses should be among the first steps taken when you start a business.

However, if you are engaging in any kind of food business, you will usually need to also obtain a health department permit and show that you are in compliance with health department food-handling requirements. In addition, be sure to check with an attorney or local government zoning or planning department officials to determine if your business will be in compliance with all local zoning restrictions and any local ordinances regarding hazardous activities. You may be required to obtain a use permit from the local planning commission for many types of businesses.

If you own or rent any type of facility, you will generally need fire department permits, showing that you meet fire safety codes and any construction or improvements to an existing structure will usually require you to obtain a building permit. Most local governments throughout the nation require permits for both new construction and remodeling.

If you intend to simply operate your business from your home, you may be in violation of local zoning requirements, but this is less likely to be a concern if you don't have clients, customers, delivery trucks, suppliers, or employees coming to your house on business, on a regular basis.

Cities and counties in some states impose gross receipts, income, or payroll taxes on businesses. In addition, in some states that have local sales taxes, the local sales taxes in some of the localities may be locally administered, which usually means you will have to register for a sales tax license with each local government for the local sales taxes, in areas where your business operates.

In several states, some cities or counties administer their own sales taxes, while other cities allow the state governments to collect and administer their local sales taxes -- such as, for example, in Arizona, where some of the larger cities like Phoenix and Tucson administer their sales taxes themselves, most smaller cities and counties in Arizona allow the state to collect their tax for them, along with the state sales tax. Similarly, in Alabama, which has hundreds of local sales tax jurisdictions and rates, only about 2/3 of the localities' sales taxes can be filed and paid with the state of Alabama -- businesses must file separately with each of the rest, if making taxable sales in those localities.

[LINK TO STATE CHAPTER FOR STATE-SPECIFIC INFORMATION ON LICENSING HAS BEEN DELETED HERE.]

5.3 State Licenses

All states and the District of Columbia impose license fees or taxes on a wide range of businesses, occupations, and professions that operate within their jurisdiction. The fees often vary widely among the different types of businesses and occupations, ranging from relatively nominal to substantial amounts, depending upon the activity.

Since you may not legally operate any of these regulated businesses or professions without being licensed, you should find out whether there is a state licensing requirement for the particular business you currently are operating or plan to start. If so, deter­mine whether and how you will be able to comply with the licensing requirements.

[STATE NAME] Licensing and Business Registration

[STATE-SPECIFIC INFORMATION ON LICENSING AND LINKS TO STATE LICENSING WEBSITES ARE DELETED HERE.]

5.4 Federal Licenses

If you are starting a small business, it is relatively unlikely that you will need any type of license or permit from the federal government; however, the following is a list of the federal licensing requirements you might possibly encounter and the federal agencies that issue such licenses:

FEDERAL LICENSING REQUIREMENTS

  • Rendering investment advice (Securities and Exchange Commission)
  • Providing ground transportation as a common carrier (Interstate Commerce Commission)
  • Preparation of meat products production of drugs or biological products (Food and Drug Administration)
  • Making tobacco products or alcohol; making or dealing in firearms (Treasury Department, Bureau of Alcohol, Tobacco, and Firearms)
  • Radio or television broadcasting (Federal Communications Commission)

If you wish to engage in any of the foregoing activities, all of which are heavily regulated, consult an attorney regarding regulatory requirements well in advance.

5.5 Income Taxes -- Federal and [STATE NAME]

Individual Income Tax -- Federal

It will come as no surprise to anyone that your income from an unincorporated business (sole proprietorship, partnership, or limited liability company) or from an S corporation will be subject to federal income tax, at rates that are as high as 35% in the highest bracket.

In addition, income from many types of businesses, if unincorporated, will be subject to federal self-employment tax, which is described at Section 5.6 of this chapter.

Individual income taxes are reported and paid on federal income tax Form 1040, and income from a business is shown on or more of the following schedules, which you attach to the Form 1040, depending on the type or source of the business income:

  • Form 1040, Schedule C -- Income or loss from a sole proprietorship;
  • Form 1040, Schedule E -- Your share of income or loss from from a partnership, limited liability company, or S corporation;
  • Form 1040, Schedule F -- Income or loss from farming activities; and
  • Form 1040, Schedule SE -- Self-employment income, if any, from an unincorporated business. (This will generally be the same income reported on Schedules C, E, and F.)

Form 1040 must be filed each year by April 15th of the following year.

Alternative Minimum Tax (AMT) -- Federal

In addition to paying "regular income tax," more and more taxpayers are becoming subject to the Alternative Minimum Tax (AMT), which can apply if a taxpayer has significant amounts of certain "tax preference" items, such as rapid depreciation write-offs or interest on tax-exempt private activity bonds, or where the taxpayer has large deductions for certain items that are not deductible at all in computing the AMT, such as state and local taxes, personal exemptions, and dependents' exemptions.

While the AMT calculations can be very complex, one simple way to understand this tax is to look at it as though you are filing a second, alternative tax return -- one in which many of your deductions are disallowed and in which some items that are not taxable for "regular" tax purposes are fully taxable for AMT purposes. The result is an "Alternative Minimum Taxable Income" (usually greater than your regular taxable income) on which the AMT is computed, at a tax rate of up to 28% (after allowing an AMT exemption). If the AMT as computed on the Alternative Minimum Taxable Income is greater than your "regular" income tax, you must pay the difference, as an additional AMT tax.

EXAMPLE:
Your regular income tax for the year is $50,000. However, the tax computed under the AMT is $57,000. Thus you would pay the $50,000 regular tax plus $7,000 of AMT, or a total tax for the year of $57,000 (disregarding any self-employment tax, which is not considered part of the "regular tax").

Because of its complexity, the AMT often catches taxpayers by surprise, when they learn on April 15th or shortly before that a large amount of AMT must be paid, in addition to the regular tax they were expecting to pay. While the AMT is a bit too complex to be calculated by most civilians -- and even most tax professionals tend to rely on their tax software to compute it -- the IRS has recently posted a handy "AMT Assistant" on the IRS website, at: http://apps.irs.gov/businesses/small/article/0,,id=150703,00.html. It will help you determine if you need to file Form 6251 to calculate your AMT liability, if any, though it will not do the actual calculation for you. At least it can sometimes assure you that you do not have an AMT liability, if you enter your information correctly.

You will probably need to call your accountant or rely on tax-preparation software like Turbo-Tax or Tax-Cut to do the calculation if it appears you may be subject to AMT, unless you want to try to tackle completion of a Form 6251 on your own. (Good luck!)

PLANNING POINT:
Note that where you incur the AMT on account of timing differences (such as from having too much accelerated depreciation expense), you may generate an AMT tax credit that can be used to offset part of your tax liability in future years when, for example, you are not subject to the AMT. No such credit arises from tax preferences that are not timing differences, such as items that are only deductible for regular income tax purposes, such as state income taxes.

Under 2006 tax legislation,[2] as amended through 2009, individuals with certain "long-term unused minimum tax credits" (those carried over for more than three years) may be able to claim a refundable tax credit equal 50% of such unused credits or the amount of such AMT refundable credit so computed for the preceding taxable year. The 2009 amendments increased the limitation on the credit from 20% to 50% of the unused credits and did away with a phase-out of the credit above certain high income levels, for the years 2008 through 2012.

In calculating whether or not the AMT applies, or the amount of the AMT if it does apply, taxpayers have been allowed a rather modest exemption from alternative minimum taxable income. Because the exemption was so small, many millions of middle-class taxpayers would be subject to AMT, often just because they lived in a high-tax state like California, and claimed large deductions for state income tax, which deductions are not allowed in computing AMT. To prevent this widespread imposition of the AMT on millions of taxpayers, Congress has regularly enacted an "AMT patch" every tax year for a number of years, significantly increasing the AMT exemption on a temporary basis. This patch expired on December 31, 2011, so that in 2012 it was expected that the AMT would apply to about 31 million taxpayers, instead of about 4 million.

Fortunately for many taxpayers, the American Taxpayer Relief Act of 2012, enacted in January, 2013, has re-enacted the patch, retroactive to January 1, 2012, and made it permanent. For 2012, the exemption amounts are $78,750 for married taxpayers filing jointly and $50,600 for single filers, and these amounts, as indexed for inflation in 2013, are $80,800 and $51,900, respectively.

Individual Estimated Income Tax -- Federal

As a sole proprietor or partner in a partnership, or a member of an LLC, or shareholder in an S corporation, a business owner will have to make advance payments of estimated federal -- and possibly state -- income taxes and federal self-employment tax once the business begins to turn a taxable profit. Individual estimated tax payments are due in four annual installments on April 15, June 15, September 15, and January 15 of the following year for an individual whose tax year is the calendar year. Any remaining unpaid federal tax is due with your tax return on April 15 of the following year -- which is also the date when the first estimated tax installment is due for that year. You will file Form 1040-ES with your federal estimated tax payments. For each taxable year, you must make estimated tax payments equal to 90% of the current year's tax or 100% of the prior year's tax, whichever is less.

Certain high-income taxpayers -- those with more than $150,000 of adjusted gross income in the prior year -- are not allowed to base their estimated tax payments on 100% the prior year's tax. However, they may instead base their payments on 110% of the previous year's tax.[3]

Individual Income Tax -- [STATE NAME]

The great majority of the states impose some sort of income tax on the income of an individual from a business. The only states which do not impose a general income tax on the income of an individual from a business (sole proprietorship, partnership, limited liability company or S corporation) are:

  • Alaska
  • District of Columbia (but D.C. taxes the income of any corporation or unincorporated business at the entity level, although the individual sole proprietor, partner, member of an LLC, or S corporation shareholder is not required to pay tax on his or individual D.C. income tax return on the income of the business, generally, except on earnings from outside the District that are not taxable at the business entity level)
  • Florida
  • Kansas (which has enacted a law that went into effect in 2013, exempting individual taxpayers from tax on their income from a business, either from a sole proprietorship or as a share of the business income from a pass-through entity, such as a partnership, LLC taxed like a partnership, or an S Corporation. While business income is no longer taxable to individual taxpayers, the Kansas state income tax will continue to apply to other types of income, however, such as interest, dividends, wages, pensions, and capital gains.)
  • Nevada
  • New Hampshire (although there is no New Hampshire individual income tax except on dividends and interest, all businesses, including corporations and unincorporated businesses, must pay the Business Profits Tax on their taxable income)
  • South Dakota
  • Tennessee (but Tennessee taxes all limited liability entities in the same manner as corporations, under its corporate excise tax on income)
  • Texas (although there is no Texas individual income tax, Texas imposes its corporate franchise tax on LLC's and on all business corporations, including S corporations, at the entity level, and since 2007 it also taxes limited partnerships and LLP's; however, the new franchise tax is more like a gross receipts tax than a net income tax and all small businesses with gross receipts below specified levels are exempted)
  • Washington state (although Washington imposes a gross receipts tax on nearly all businesses, whether or not incorporated), and
  • Wyoming

[LINK TO STATE-SPECIFIC DISCUSSION OF STATE INCOME TAX DELETED HERE.]

Individual Estimated Income Tax -- [STATE NAME]

With the exceptions of Utah, Idaho and Tennessee, all states that impose any kind of individual income tax require individual taxpayers to make prepayments of estimated tax during the year. For a discussion estimated tax payment requirements, if any, in [STATE NAME], see [LINK TO STATE INFORMATION CHAPTER DELETED HERE].

Corporation Income Tax -- Federal

Businesses conducted in the form of a C corporation (which is any corporation that has not made an S corporation election) are subject to a federal corporate income tax, at tax rates of up to 35% of taxable income. Marginal corporate tax rates are as high as 39% at some levels, but the total federal tax bite never exceeds 35% of total taxable income, unless the corporate Alternative Minimum Tax applies. See the schedule of corporate tax rates in Chapter 2, Section 2.4.

C corporations are required to file corporate income tax return Form 1120 each year, by the 15th day of the third month after the end of the corporation's taxable year (by March 15th, for example, if the taxable year ends on December 31st).

Corporate Estimated Income Tax -- Federal

If your business is incorporated, the corporation will generally have to make corporate estimated tax payments as early as the fourth month of its first tax year if it has a tax liability of $500 or more.[4] Your corporation must pay estimated tax equal to 100% of its current year tax or 100% of its tax for the prior year, whichever is less. A large corporation -- one which had one million dollars or more of taxable income in one of the three preceding years -- may not base its estimates on the prior year's tax. Estimated tax payments are due on April 15, June 15, September 15, and December 15, for a corporation using a calendar year for its taxable year.

Federal estimated tax payments should be computed on Form 1120-W -- which can be obtained, along with other federal tax forms, from any IRS office. The corporate estimated tax payments must generally be paid electronically, by electronic funds transfer.

Refer to Section IV(c) [LINK DELETED]of the state chapter for [STATE NAME], regarding state filing requirements for [LINK DELETED]individual and [LINK DELETED] corporate estimated income taxes.

Large companies making substantial payments of federal withholding and payroll taxes have long been required to pay such taxes by means of electronic funds transfers (EFT), rather than making tax deposits. See Section 6.1 of Chapter 6 regarding EFT payment requirements for employers. In addition, more and more states are requiring various types of taxes to be paid by EFT when the tax payments are larger than certain threshold amounts.

UPDATE NOTE:
Beginning in 2011, only very small employers, those with no more than $2,500 of quarterly federal employment taxes, are allowed to make payments other then by EFT. All larger employers now are required to make their tax deposits electronically by EFT.

Corporate Income or Franchise Tax -- [STATE NAME]

In addition to federal corporate income taxes, most states also impose corporation income taxes or corporate franchise taxes that, in some cases, are based wholly or in part on taxable income of the corporation. The only states that do not impose a tax on the net income of corporations are Ohio, Nevada, South Dakota, Washington state, and Wyoming (although South Dakota does tax banks and certain other financial corporations). The Texas franchise tax on corporations’ net income has been replaced with a new franchise tax that is more like a tax on gross income, rather than on net income, although it exempts small businesses.

[LINK TO STATE TAX DISCUSSION OF STATE'S CORPORATE TAXES DELETED HERE.]

Corporate Estimated Income or Franchise Tax -- [STATE NAME]

Corporations are generally required to make payments of state estimated income or franchise taxes in states that impose such taxes. For more information on corporate taxes and any corporate estimated tax requirements in [STATE NAME], see Section IV(c) [LINK DELETED] of the [STATE NAME] chapter.

5.6 Self-Employment Tax

The average self-employed American now pays more self-employment tax than federal income tax, the news media tell us. This should come as no surprise, as any small business person who is not incorporated is likely to pay a lot of this ubiquitous tax. While the tax rate is only 15.3%, this tax applies to a lot more of your income than the income tax, for many people, since there are many deductions from taxable income, but only business deductions reduce your self-employment income, in general.

The self-employment tax is a Social Security tax on self-employed people, and consists of two parts, the OASDI (Old Age Survivor and Disability Insurance) portion, usually imposed at 12.4%, but only imposed on the first $117,000 of self-employment income in 2014, and the Medicare portion of the tax, imposed at the rate of 2.9% on ALL self-employment income. Thus, the tax rate is 15.3% on the first $117,000 of self-employment income and 2.9% on the excess over $117,000. (A lower OASDI rate of 10.4% applied in 2011 and 2012, and the taxable wage base was $113,700 in 2013.)

The total tax is identical to the Social Security (FICA) tax on employers and employees, except that the FICA tax is split in half between employer and employee. (When you are an employee and also own the corporation, you are paying both halves of the FICA tax, in effect, which is the same as for a self-employed person.)

UPDATE NOTE:
Under the 2010 Tax Relief Act, which extended the Bush tax cuts two more years, Congress also enacted a 2% FICA and self-employment tax cut for the year 2011, so that in 2011 the self-employment tax rate was reduced from 15.3% in total to 13.3% and the OASDI portion of the employee's FICA tax was reduced from 6.2% to 4.2% (the employer's share of the FICA tax was not reduced). This 2% rate reduction was extended through December 31, 2012, but expired in 2013.

For 2014, the taxable wage base for the OASDI portion of the self-employment tax (and FICA) is increased to $117,000, up from $113,700 in 2013.

There are very few deductions from self-employment income, other than business deductions. For example, even though they are business-related deductions, and are allowed as adjustments to taxable income for income tax purposes, none of the three following important deductions are allowed against your self-employment income:

  • Deductions for (income) tax-deductible contributions to Keogh pension or profit sharing plans;
  • Self-employed persons' health insurance deductions (except that such a deduction was allowed in the year 2010 only); and
  • The Domestic Production Activities deduction, enacted in 2004, which has gradually been phased in, starting at 3% of income, and finally was fully phased in as a deduction equal to as much as 9% of net pre-tax income from manufacturing or other production activities carried on in the United States.

For the first taxable year (only) that begins after December 31, 2009 (that is, 2010), a deduction for a self-employed person's health insurance was allowed in computing the self-employment tax, as well as for income tax purposes, under recent tax legislation.

Note also that the IRS has quietly (on its 2010 Form 1040 income tax instructions) changed its view on deductibility of Medicare Part B premiums as self-employed health insurance for income tax purposes. While there have never been any official IRS announcements on this issue, tax form instructions prior to the 2010 returns said that such premiums were not deductible (except, possibly, as an itemized medical expense deduction), but the 2010 instructions said that the Medicare premiums can be deducted as self-employed health insurance and the same was true on the 2011 tax form instructions.

Also, in an e-mail to Spidell Publishing, a major California tax publisher, the IRS confirmed in 2011 that Medicare Part B premiums may also be treated as self-employed health insurance for the one-time (2010 only) deduction of health insurance premiums in computing the self-employment tax, as well as for income tax purposes. (Arguably, Medicare Part D drug insurance premiums should also be deductible as self-employed health insurance, for income tax purposes, and in 2010 for self-employment tax, as well.)

UPDATE NOTE:
On July 13, 2012, the IRS Chief Counsel released a memorandum, Chief Counsel Advice (CCA) #201228037, that explains and clarifies the IRS change of position that heretofore had only appeared in the 2010 and 2011 instructions for Form 1040. The CCA memorandum makes it clear that all Medicare premiums, not just Part B premiums, are a form of health insurance, and thus are deductible as self-employed health insurance by self-employed individuals, for income tax purposes. (However, Medicare premiums would still not be deductible in computing self-employment tax, for which no deduction is allowed for health insurance premiums, except for the year 2010, under a special temporary provision in the tax law that applied only for that one year.)

One deduction that is allowed is for any FICA wages you may have earned during the year, although that only reduces the OASDI portion if the tax, if your combined FICA wages and self-employment income exceed $117,000 in 2014. This is allowed because both the self-employment tax and the FICA tax are simply the two different forms of Social Security taxes, and the total of the two (for the OASDI portion) is only imposed on your first $117,000 of earned income in 2014, whether that income is from wages or from self-employment. The example below shows how this works. (We have used the 2005 taxable wage base of $90,000 in this example, since it was a nice round number to work with.)

EXAMPLE:
You had $70,000 in self-employment income in 2005, but also worked for an employer, and earned $50,000 of taxable FICA wages. Thus, since your combined self-employment income and FICA wages exceeded the $90,000 OASDI taxable wage base limit for 2005, you would subtract the $50,000 of taxable FICA wages from the $90,000 ceiling, and thus would have only $40,000 of self-employment income that is subject to the OASDI (12.4%) tax. Therefore, $30,000 of your self-employment income would escape the OASDI tax. However, all of your self-employment income would be subject to the 2.9% Medicare tax, on which there is no income ceiling, unlike the $90,000 (in 2005) OASDI wage base limit ($117,000 in 2014).

The other non-income tax deduction from self-employment income is one-half of the self-employment tax itself, or 7.65% of your self-employment income, as computed before this deduction. The reason you are allowed this deduction for half the tax it to roughly equalize the treatment of incorporated and unincorporated businesses, since a corporation paying you a salary gets an income tax deduction for one-half of the FICA tax -- the half it pays.

Thus, after computing your self-employment income initially (reduced in some cases, as in the above example, by some or all of your FICA wages), you then simply compute the tax on 92.35% of the remaining balance of self-employment income. As a result, in reality, the true self-employment tax rate is not 15.3%, but is 15.3% x .9235, or approximately 14.13% of your net earned (non-wage) income in years other than 2011 and 2012 (or 12.28% in 2011 and 2012).

In addition to deducting this amount from your self-employment income when computing your self-employment tax, you are also allowed to take an income tax deduction for one-half of the actual self-employment tax you owe for the year, which softens the blow a bit more. (Or deduct 57.51% of the actual self-employment tax you owe in the tax years 2011 and 2012.)

Not all types of income earned by an unincorporated entrepreneur are subject to self-employment tax, however. Major exceptions are for rental income from real estate, and on interest or dividends earned, although any of those income items can become self-employment income if you are a dealer, such as someone who is a dealer in real estate, or a securities dealer who maintains an inventory of stocks or bonds, but earns some rent or dividends or interest on some of the inventory assets while holding them for sale.

In addition, a limited partner's share of the distributive income of a limited partnership is not subject to the self-employment tax. However, if a partnership has self-employment income, any partner (if not considered a limited partner), including one who does not participate in the operations of the partnership's business, will be subject to self-employment tax on his or her distributive share of the partnership income. Whether or not a person is a passive partner is irrelevant for purposes of the self-employment tax, if he or she is not a limited partner!

Because the self-employment tax is often difficult to avoid for sole proprietors, partners in partnerships, and members of limited liability companies, many small business people in recent years have attempted to avoid it by incorporating and making an S corporation election. The idea behind this approach is to pay out only a small fraction of the S corporation's earnings in the form of compensation to the owner or owners, while paying out the rest of the profits as dividends. Thus, only a small salary is usually taken, often much less than the $117,000 OASDI wage base on which the full FICA tax would apply in 2014.

EXAMPLE:
Let's say a business, set up as an S corporation, earns $120,000 in 2014, before payment of salary to the sole stockholder. All $120,000 of profit would be self-employment income subject to the 2.9% Medicare tax if the business were not incorporated, and $117,000 -- the limit on the amount subject to OASDI tax in 2014 was $117,000 -- would be subject to the 12.4% OASDI tax.

But instead of taking most or all of the $120,000 out of the S corporation as salary, the owner might instead take a salary of only, say, $30,000, resulting in a large profit ($90,000) that the S corporation reports. While both the salary and the $90,000 of profit are taxable to the owner for income tax purposes, the corporation and owner only have to pay the combined 15.3% FICA taxes on the $30,000 of salary, while the $90,000 of profit is distributed as a nontaxable S corporation dividend -- which is not subject to either self-employment tax or FICA taxes.

Either way, incorporated or unincorporated, the individual taxpayer has $120,000 of taxable income (ignoring the income tax deduction the corporation gets for its half of the FICA tax on the $30,000 of wages, or 7.65% x $30,000=$2,295, and the expense it incurs for unemployment taxes, federal and state, which offsets some or all of the benefit of that deduction, but is also deductible). But the Social Security 15.3% tax is only owed on $30,000 of wages, rather than paying self-employment tax on $117,000 for the 12.4% OASDI tax and the 2.9% Medicare tax on $120,000 of self-employment income.

This may be a bit hard to follow, but the net result is a small payment of FICA taxes, slightly over $2,000, instead of a very large amount (over $16,000) of self-employment tax.

Does this sound too good to be true? Possibly. At least, the IRS takes a dim view of this strategy. But it can be a good strategy, if one pays out a reasonable amount as salary. For more on this tax strategy, and the IRS's response, see Chapter 14, Section 14.4.

Regarding the self-employment tax status of LLC members, the IRS has proposed to treat certain members of an LLC like limited partners, thus exempting them from self-employment tax on their share of an LLC's earnings if certain conditions were met, but also changing the definition of "limited partner" for self-employment tax purposes, to exclude any partner who materially participates in the business for more than 500 hours during the taxable year from the limited partner exemption from self-employment tax. Under the proposed regulations, any owner of a service business, such as law, medical, accounting, architecture, performing arts, engineering, actuarial science, or consulting firms, would be subject to self-employment tax, even if he or she is a member of an LLC or is a limited partner in a limited partnership.

However, many taxpayers and tax practitioners complained that this proposal was a "stealth tax" and that the IRS was seeking to overturn long-standing laws and rulings that have exempted limited partners from self-employment tax on their earnings. Therefore, Congress in 1997 ordered the IRS to refrain from implementing the proposed regulations until July 1, 1998, while it sought to develop a legislative solution to this issue. To date, Congress has not acted, the IRS has not finalized or withdrawn the regulations, and the issue of self-employment taxation of LLC members remains somewhat muddled, although the American Institute of Certified Public Accountants and the American Bar Association have put forward suggested definitions they hoped Congress (or the IRS) would eventually adopt.

As a general rule, many tax practitioners believe that an LLC member is not subject to self-employment tax on his or her income if the member is not a manager of the LLC and, generally, 10% or less owners of an LLC should be exempted from self-employment tax unless they receive a guaranteed payment (like a salary) from the LLC for services rendered, and not just a percentage share of the profits. However, there is no clear answer to this question at present, and the IRS may not necessarily agree if you treat your share of income from an LLC as exempt from self-employment tax.

One court case in 2000 that considered whether some LLC members could be treated like general partners, despite the fact that all members of an LLC have limited liability, concluded that members who actively participate in the business were similar to general partners, and thus their income or loss from the LLC was not "passive income or loss" under the passive activity tax rules. Steven A. Gregg, et ux. v. United States, 87 AFTR 2d Par. 2001-311, U.S. District Court, District of Oregon (November 29, 2000). The IRS had argued in this case that all the members were similar to limited partners, due to their limited liability, and that their losses were thus "passive losses" that could not be deducted against other income.

However, to date no court cases have considered the question of whether LLC members are subject to self-employment tax or, if so, which LLC members would be taxed. Since the IRS lost the Gregg case, they might now try to use that court decision to argue that some LLC members are also like general partners for purposes of the self-employment tax.

CAUTION:
While it is probably safe to assume that a passive investor in an LLC, which is not a service business in one of the professions, performing arts, or consulting, would not be subject to self-employment tax on his or her distributive share of the LLC's income, or that an active managing member of an LLC would be subject to the tax, the self-employment tax treatment of members of an LLC is an area of the tax law that is very unsettled at the present time. Whether or not income from an LLC should be reported as self-employment income is a decision that should be made only after consultation with a competent tax professional, as this is a highly technical tax question and an area where experts (and the IRS) can and do disagree as to what the proper tax treatment should be.

Also, beware of much of the information on this question you will find on the Internet, much of which assumes that the IRS Proposed Regulations (of which Congress disapproved, but did not order the IRS to rescind, in the 1997 tax act) are the law. Sophisticated tax practitioners would beg to differ.

5.7 Miscellaneous Tax Information Returns

Reporting Payments to Individuals

As a general rule, every person engaged in a trade or business must report to the IRS any payments of $600 or more made to any person during the calendar year, for items such as compensation for services, rent, commissions, interest, and annuities, plus other items of fixed or determinable income.[5] To make these filings, you will use a series of 1099 forms. A number of additional tax reporting requirements are listed below. Be aware that there are stiff penalties for failure to comply with them.

1099 Forms

You must file a Form 1099-MISC for each individual non-employee -- including independent contractors -- to whom you have paid $600 or more in any calendar year, or $10 or more in royalty payments.[6] Send a duplicate to the payee by January 31 and to the IRS by February 28 of the following year. In addition, you must prepare and file a Form 1096 return summarizing all the information on the 1099-MISC forms and on the other forms in the 1099 series.

In addition to the requirement that you file 1099s with the IRS, you may have to file similar forms with some or all states where you do business.

Instructions for Form 1099 say that, if the recipient of the Form 1099 is a sole proprietor, you should use the recipient's personal Social Security number rather than their employer identification number on the form. Putting down the wrong taxpayer identification number will subject you to a penalty.

Obtaining Social Security Numbers

It is necessary to obtain the name and Social Security number or other tax identification number of any person to whom you make payments of $600 or more. There is a $50 penalty for failure to obtain their tax identification number -- unless you have a reasonable excuse, such as their refusal to give you the number.[7] If they do refuse to give you the number, you must withhold a specified percentage of whatever amount you owe them and deposit it with the IRS, or you will be subject to a penalty for failure to withhold.[8] The percentage to be withheld is at the fourth-lowest individual tax bracket, or 28% at present (2005 through 2012).

Reporting Sales to Direct Sellers

In addition, you must report sales of $5,000 or more of consumer products to any individual who is engaged in direct selling -- that is, selling in any way other than through a permanent retail establishment.[9] This will mainly apply to sales made to people in direct sales organizations, such as Tupperware, Amway, or Shaklee. It would also apply in many other situations, such as where the person you sell to resells the goods by mail order. Use Form 1099-MISC to report these sales.

New 1099 Reporting under Health Care Reform Law

Under the massive health care reform law enacted in 2010, there was an unrelated new tax provision that was to go into effect in 2012, requiring businesses to report all payments to ANY payee (including corporations) on a 1099 return if making over $600 of payments during the year to that payee.

Thus, for example, if you bought over $600 of office supplies during the year from the Office Depot, you were to obtain their tax identification number and at the end of the year send both the Internal Revenue Service and Office Depot 1099 forms, reporting the total of such payments. It is unclear how or if this additional reporting would have aided the government, if at all, in its tax collections from large corporations, but it would have imposed a huge and costly paperwork burden on all businesses, large and small.

UPDATE NOTE:
Fortunately for small businesses, this part of the health care reform law regarding expanded 1099 reporting was repealed by Congress in 2011.

New 1099 Reporting Requirement for Rental Property Expenses (Also Repealed)

In addition, under the Small Business Jobs and Credit Act of 2010, persons who receive rental income from real property were to be required to file information returns with the Internal Revenue Service and with a copy to service providers, reporting payments of $600 or more for rental property expenses. This new requirement was to go into effect for payments made in 2011 and thereafter.

UPDATE NOTE:
On April 14, 2011, President Obama signed into law a retroactive repeal of the above expanded 1099 reporting requirement for persons who incur expenses in connection with real estate rental properties.

New Form 1099-K Reporting Requirement for Credit Card Sales

While your business will probably never have to file a Form 1099-K, most businesses that make credit card sales in 2011 or later will receive a Form 1099-K from payment settlement entities such as Visa, Mastercard, American Express, or Paypal, for amounts they remit to your business for credit card sales.[10] Not only will you receive such statements, but you must begin reporting credit card sales separately on Line 1, "Gross receipts or sales," on page 1 of Forms 1065, 1120, 1120S, and Schedule C of Form 1040.

This new, more detailed requirement for reporting gross sales may require many businesses to make changes to their chart of accounts and accounting systems to keep track of credit card sales separately from cash or checks received. However, the instructions for 2011 tax forms said that you could insert "-0-" on the line for credit card receipts. In addition, in a letter to the National Federation of Independent Business in 2012, IRS Deputy Commissioner Steven Miller wrote that "there will be no reconciliation required on the 2012 form, nor do we intend to require reconciliation in future years." (Having to reconcile 1099-K's would be an accounting nightmare, where tips, sales tax, and cash back amounts are included on the 1099-K's.)

Thus, the Form 1099-K information reporting will, for now, mainly be used in audits where IRS agents are analyzing gross receipts for possible fraud, where there are gross discrepancies.

Penalties for Not Filing

There are stiff IRS penalties for not filing the above 1099 forms. The penalty for not filing or not giving a 1099 to a payee is $50 per failure. Since there is a separate penalty for not giving a copy of the 1099 to the payee, as well as for not filing a copy with the IRS, it can cost you $100 for each person for whom you fail to prepare l099s.[11] In cases of intentional violations, both $50 penalties will be doubled. The $50 penalty for late-filed 1099s and certain other information returns can be reduced to $30 if you file more than 30 days late but before August 1 of the year the filing is due. Or, if you file within 30 days after the due date, the penalty can be reduced to only $15.

UPDATE NOTE:
The above penalties were all increased substantially under the Small Business Jobs Act of 2010, effective in 2011. The $15 first-tier penalty is increased to $30; the second-tier penalty from $30 to $60; and the third-tier penalty from $50 to $100. In the case of intentional non-filing the previous $100 penalty is increased to $250. The new law also repealed the reduced penalties for small businesses that fail to file 1099s.

In addition, if you erroneously, but in good faith, treat a person as an independent contractor, and it is later shown that the person was actually an employee, you will only be liable as an employer for 20% of the employee's Social Security tax that should have been withheld. You will also be held liable for income tax withholding equal to 1.5% of what you paid the individual, provided that you properly filed Form 1099-MISC with the IRS.[12] If you failed to file Form 1099-MISC for that person, the amount of withholding tax you are liable for is doubled.[13]

Exemptions From 1099 Filing Requirements

Fortunately, a number of important exemptions from the 1099 filing requirements will eliminate most of the people or companies to whom you are likely to make payments of $600 or more. You do not have to report:

  • Payments to corporations -- except certain corporations in the medical field and for gross amounts paid to law corporations for legal services (under the health care reform law, this exemption was to disappear in 2012 and later, but that provision has been repealed);[14]
  • Payments of compensation to employees that are already reported on their W-2s;[15]
  • Payments of bills for merchandise, telegrams, telephone, freight, storage, and similar charges;[16]
  • Payments of rent made to real estate agents;[17]
  • Expense advances or reimbursements to employees that the employees must account to you (the employer) for;[18] and
  • Payments to a governmental unit.[19]

Reporting Dividends and Interest

If your business is incorporated, your corporation will have to file a Form 1099-DIV for each person to whom it pays dividends of $10 or more each year.[20] You must also file Form 1099-INT for each person to whom you pay $10 or more in interest on bonds, debentures, or notes issued by the corporation in registered form.[21] However, interest paid by a natural person is not reportable by the payor unless at least $600 is paid during the year to a payee.[22]

Form 1099-DIV or Form 1099-INT is also required for any other payment of dividends or interest on which you are required to withhold tax. Payments reported on Form 1099-DIV and Form 1099-INT must also be reported on the Form 1096 summary. Form 1099-S must be given to recipients of the proceeds from the sales of real estate, in general.

Reporting Large Cash Transactions

Any business that receives a payment of more than $10,000 in cash, in cash equivalents -- such as cashier's checks or traveler's checks -- or in foreign currency in one transaction, or in two or more related transactions, is required to report the details of the transactions within 15 days to the IRS.[23] In addition, the business must furnish a similar statement to the payor by January 31 of the following year.[24] Form 8300 is used for reporting such "suitcase" transactions.

The penalties for noncompliance are generally the same as for not filing 1099s, except that in cases of intentional failure to file, there is an additional penalty equal to the higher of $25,000 or the amount of the cash or cash equivalent received in the transaction, up to $100,000.[25]

Reporting Mortgage Interest Received

Federal law requires that you give Form 1098 to any individual from whom you receive $600 or more in mortgage interest during the year, in the course of your trade or business. Form 1098 has the same filing requirements as Form 1099.[26]

1099 Reporting on Magnetic Media

The IRS now permits you to file Form 1098 and Form 1099, as well as certain other information returns, electronically rather than filing the actual paper forms. The IRS requires that most information returns be filed electronically or on magnetic media if your business files 250 or more such returns for a calendar year. (This 250 forms requirement applies to each individual form, not to the total number of information returns you must file.) The forms that must be filed electronically if filing 250 or more include:

  • 1098
  • 1098-C
  • 1098-E
  • 1098-T
  • 1099-A
  • 1099-B
  • 1099-C
  • 1099-CAP
  • 1099-DIV
  • 1099-G
  • 1099-H
  • 1099-INT
  • 1099-LTC
  • 1099-MISC
  • 1099-OID
  • 1099-PATR
  • 1099-Q
  • 1099-R
  • 1099-S
  • 1099-SA
  • 3921 (new requirement since 2009)
  • 3922 (new requirement since 2009)
  • 5498
  • 5498-ESA
  • 5498-SA
  • W-2G
[27]

A "hardship waiver" to excuse you from having to file in electronic or magnetic media format may be granted under certain circumstances if you file a request on Form 8508 at least 90 days in advance of the due date.

Failure to file an information return electronically or on magnetic media -- or on a machine-readable form where magnetic media filing is not required -- when required to do so is treated as a failure to file and can result in penalties, as noted earlier.

If your business finds it will be required to file information returns electronically or on magnetic media, you can use a data processing firm or computer program to encode the data for you, at a relatively small cost, in a way that meets the IRS's highly technical specifications.

5.8 [STATE NAME] Sales and Use Taxes

Sales and Use Tax Requirements in [STATE NAME]

[STATE NAME] sales and use or gross receipts taxes are discussed in Chapter 16, [LINK DELETED].

Making Sales in Other States

With a limited number of exceptions, every business that sells tangible personal property, such as merchandise, to customers must obtain a seller's permit from the state sales tax agency in each state where it does business, if the seller has a physical presence in that state. Usually, a separate permit must be obtained for each place of business where property subject to tax is sold. Certain sales of services or of intangible personal property may also be subject to tax, although the extent to which such items are taxable varies very widely from state to state, with some states like Hawaii and New Mexico taxing nearly all services and sales of intangible property (such as computer software or data, or even real estate rentals), while some states' sales and use tax laws exempt almost all services and sales of intangible items.

Sellers are generally not required to obtain permits or collect sales or use tax on sales made to states where the seller has no activity other than, for instance, mail order sales. However, this may change, now that the Streamlined Sales Tax Agreement (described below) has been implemented by a number of the states, and if Congress or the U.S. Supreme Court respond by overturning the Supreme Court's decision in Quill v. North Dakota, (1992) 504 U.S. 298. That court decision currently forbids states from requiring out-of-state sellers to collect sales or use tax unless the seller has a physical presence of some kind in the state.

Three states, Delaware, Hawaii, and New Mexico, impose a gross receipts tax on the seller, rather than a sales tax. Washington (state) imposes both a sales tax on buyers and a separate gross receipts tax on sellers of goods or services. Only a few states (Alaska, Montana, New Hampshire, and Oregon), have neither a sales tax nor a gross receipts tax.

In general, as a wholesaler or manufacturer, you will not have to collect sales tax on goods you sell to a retailer for resale if the retailer holds a valid seller's permit and provides you with a resale certificate in connection with the transaction. Likewise, if your business, as a retailer, buys goods for resale, you need not pay sales tax to the wholesalers if you provide them with resale certificates.

The form of resale certificates varies widely from state to state; thus, there is no universal form of resale exemption certificate that can be used in all states. Fortunately, the MultiState Tax Commission has developed a single resale exemption certificate form that can be used (subject to various conditions and restrictions) in 36 states and the District of Columbia, all of which have approved this form. It will only be useful to you if your company does business in one or more of the 36 states (or D.C.) listed on the form.

This resale certificate is not valid in any of the following 14 states:

  • Alaska (has no state sales tax)
  • Delaware (has no sales tax)
  • Indiana
  • Louisiana
  • Massachusetts
  • Mississippi
  • Montana (has no sales tax)
  • New Hampshire (has no sales tax)
  • New York
  • Oregon (has no sales tax)
  • Virginia
  • Washington (After 12-31-2009, after which date Washington instead issues resale permits to wholesalers.)
  • West Virginia
  • Wyoming

The multistate resale certificate form can be freely downloaded at the website of the Multistate Tax Commission:

Multistate Tax Commission
www.mtc.gov/

The sales and use tax laws typically require a business that sells or leases tangible personal property to keep complete records of the gross receipts from sales or rentals, whether or not the receipts are believed to be tax­able. You must also keep adequate and complete records to substantiate all deductions claimed on sales and use tax returns and of the total purchase price of all tangible personal property bought for sale, lease, or consumption in the state.

Streamlined Sales and Use Tax Agreement

Nearly all of the states that impose sales tax have now adopted implementing legislation as part of the Streamlined Sales Tax Project, whereby they would agree to certain changes and simplifications in their sales and use tax laws, under the Streamlined Sales and Use Tax Agreement that state governments have entered into or soon will enter into with each other. Once adopted, the Streamlined Agreement is intended to provide tax law simplifications, more effective administrative procedures, and emerging technologies designed to substantially reduce the burden of sales and use tax collection. The Streamlined Sales and Use Tax Agreement went into effect on October 1, 2005, for the first group of states that adopted the Agreement, consisting of 13 states. The states that had become full members, as of March, 2012, are:

  • Arkansas
  • Georgia
  • Indiana
  • Iowa
  • Kansas
  • Kentucky
  • Michigan
  • Minnesota
  • Nebraska
  • Nevada
  • New Jersey
  • North Carolina
  • North Dakota
  • Oklahoma
  • Rhode Island
  • South Dakota
  • Vermont
  • Washington
  • West Virginia
  • Wisconsin
  • Wyoming

Three other states (Ohio, Tennessee, and Utah) have "associate member" status; these states either have enacted the provisions required to be in compliance with the SSUTA, but legislation enacting the required changes is not yet effective.

The Project is a response to the loss of sales tax revenues by state governments, due to the rise of the Internet and the rapid growth of commerce conducted over the Internet. Many of such Internet sales, or mail order sales, do not generate sales or use taxes, since interstate sales of goods are often exempt from sales tax, and vendors are not required to collect the use tax that purchasers are supposed to pay on such purchases, unless the vendor has a physical presence in the state where the goods are delivered.

Since it is generally impractical for states to track down consumers who buy goods from out-of-state vendors and collect the use tax from them, and since relatively few such consumers volunteer to pay those taxes, a great many such Internet or mail order transactions escape taxation entirely, although they are technically subject to state use taxes.

The main features of the Streamlined Agreement include the following:

  • Uniform sales and use tax law definitions. Each state determines what is or is not taxable within their state, but participating states use common definitions for key items in the tax base and cannot deviate from the definitions;
  • Rate simplification. Each state is allowed one state rate and a second state rate (such as for food and drugs) in limited circumstances; each local jurisdiction is allowed one local rate. State and local governments are to be responsible for notice of rate and boundary changes at restricted times. States must provide an on-line rate/jurisdiction database which sellers may access to simplify tax rate determinations for sales made in each participating state.
  • State level tax administration of all state and local sales and use taxes. Each state will be required to provide a central administration point for all state and local sales and use taxes and the distribution of the local taxes to the local governments, so that sellers do not have to deal with dozens of different taxing jurisdictions in each state. A state and its local governments are to use common tax bases.
  • Uniform sourcing rules. The states must have uniform and simple rules for how they will source transactions to state and local governments. The uniform rules must be destination/delivery based and uniform for tangible personal property, digital property, and services. Special sourcing rules are to be developed for unique industries. (However, a number of states were unable or unwilling to go along with destination-based sourcing, and changes in the SSUTA rules have been developed to allow some states to retain origin-based sourcing, at least for intrastate sales.)
  • Simplified exemption administration for use-based and entity-based exemptions. Sellers are relieved of "good faith" requirements, and will not be liable for any uncollected tax where relying on exemptions claims improperly put forth by purchasers, such as false resale exemption certificates. Purchasers are responsible for paying the tax, interest and penalties for claiming incorrect exemptions. States must have a uniform exemption certificate in both paper and electronic form.
  • Uniform audit procedures. Sellers who participate in one of the certified Streamlined Sales Tax System technology models will either not be audited or will have limited scope audits, depending on the technology model used. States may conduct joint audits of large multi-state businesses.
  • State funding of the system. In order to reduce the financial burdens on sellers, states will assume responsibility for funding some of the technology models.

Thus far, many states have been unwilling to sign on to SSUTA because they are unwilling or unable to change from origin to destination sourcing of sales and as a result the Streamlined Sales Tax Project Governing Board finally reversed course in December, 2007, voting to admit states that retain origin sourcing for intrastate (but not interstate) sales.

Under SSUTA, sellers are able to use one of three technology models:

  • Model 1. A Certified Service Provider compensated by the state will perform all of the seller's sales tax functions.
  • Model 2. A seller will have a Certified Automated System perform only the tax calculation function.
  • Model 3. A larger seller with nationwide sales that has developed its own proprietary sales tax software will be able to use Model 3 and have its own system certified by the states collectively.

Sellers can also choose to continue to use their current systems.

"Certified Service Providers" are entities that are to be agents who are certified by the states to perform all of a seller's sales tax functions, using a Certified Automatic System of software which will calculate the tax due on a transaction. Under the Streamlined Agreement, a Certified Service Provider would contract with and be an agent of the seller for the collection and remittance of sales and use taxes. As the seller's agent the Certified Service Provider would be liable for the sales and use tax due each state on all transactions that it processes for the seller; the seller would not be liable for the tax due on transactions processed by the provider, unless the seller has committed fraud or has misrepresented the type of items that it sells.

The Streamlined Sales Tax Project proposes that states change their sales and use tax laws to conform with the simplifications as proposed by the Project. Thus, the simplifications would apply to all sellers, once enacted.

Initially, collections by sellers of sales and use taxes on remote sales (in states where the sellers have no physical presence) will continue to be voluntary. Registration by sellers to voluntarily collect sales and use tax will not mean that the business must also pay business activity taxes in a state, such as corporate franchise tax or state income tax.

It is widely expected that, once the Streamlined Agreement is fully in place, Congress will enact legislation that overrules the U.S. Supreme Court's Quill decision, thus allowing states to force out-of-state sellers with no physical presence in the state to collect and pay over sales and use taxes on sales made to customers in participating states. Such legislation, in various forms, has already been introduced in Congress. One such bill proposed in 2007, H.R. 3396, would give SSUTA member states the authority to force out-of-state sellers to collect sales and use taxes on interstate sales. A similar Senate bill that has been proposed is essentially identical, but also would allow Indian tribes to be treated like states by signing onto SSUTA.

IMPORTANT NOTE:
In most states, at present, delivery and shipping charges on sales of taxable items, if separately stated, are not subject to sales tax. However, once the Streamlined Agreement goes into effect, note that sales tax WILL apply to all delivery and shipping charges, whether or not they are separately stated. However, there are indications that this SSUTA standard may also be watered down somewhat, due to objections by a number of potential member states.

Small businesses can only hope that there will eventually be some kind of exemption for small business like the $5 million exemption that was initially set forth in some proposed bills in Congress. Otherwise, if you are a small business, selling just a few items a year in each of the "remote" states (those outside of your home state, where you have no physical presence), you are likely to incur sales tax compliance costs for filing in all of those remote states that could far exceed the dollar amount of your sales in such states, bringing your out-of-state sales to a screeching halt.

5.9 Property Taxes

Real Estate Taxes

As a rule, you do not need to worry about contacting the tax assessor's office regarding payment of any real property taxes on real property acquired for your business. In most states where you may own property, the local county assessors will usually contact you by mailing a property tax bill to the owner of record of the property.

Personal Property Taxes

Nearly all states also tax tangible personal property owned by businesses, such as machinery, equipment, office furniture, and goods inventories, although most states now exempt business inventories. ("Personal property" is any kind of property that is not real estate.) However, a few states do not generally tax personal property, tangible or intangible:

  • New York
  • North Dakota
  • Delaware
  • Hawaii
  • Illinois
  • Iowa
  • Minnesota
  • Ohio
  • Pennsylvania (taxes intangible personal property only)
  • South Dakota

Ohio has long taxed tangible personal property, although this tax was phased out entirely by 2009.

Various types of intangible personal property, such as cash, stocks, bonds, promissory notes, or accounts receivable are also subject to property tax at either the state or local level, or both, in the following states:

  • Alabama
  • Connecticut (most kinds of intangibles are specifically exempted, including cash on hand, stocks of corporations whose property is taxable, and computer software)
  • Florida (but the annual Florida taxes on intangibles were repealed, as of January 1, 2007)
  • Kansas (local taxes on only the gross earnings from intangibles)
  • Mississippi (limited primarily to a tax on cash on hand)
  • Pennsylvania

Until recently, property taxes in Montana and Kentucky applied to most intangible property, but intangible property is now generally exempted in both of those states.

Property Taxes in [STATE NAME]

[DISCUSSION OF TAXES ON REAL ESTATE AND PERSONAL PROPERTY IN SPECIFIC STATE DELETED HERE.]

Withhold Federal Income Tax If Buying Real Estate from a Foreign Person

In addition to local property taxes, U.S. citizens and residents who acquire U.S. real estate from foreign persons -- including partnership interests or stock in certain firms owning U.S. real property -- must withhold federal income tax of up to 10% of the purchase price and remit it to the IRS under the Foreign Investment in Real Property Tax Act (FIRPTA).[28] If you fail to withhold the tax, you are liable for it. This is a potentially dangerous tax trap for unsuspecting American buyers of real estate, since it is often difficult to determine whether a seller is a foreign person.

UPDATE NOTE:
The IRS has had temporary authority to apply the withholding tax to gains on the disposition of U.S. real property interests by partnerships, trusts, or estates that are passed through to partners or beneficiaries that are foreign persons. The American Taxpayer Relief Act of 2012 has made this authority permanent and increased the amount of tax that may be withheld to 20% of the gains.
PLANNING POINT:
While there is an exception for residences costing $300,000 or less -- if you will live in it for at least 50% of the time for two years -- it is far safer to obtain a certificate of nonforeign status from the seller if there is any possibility that the seller is a nonresident alien or a foreign company.

To protect yourself when purchasing real estate -- or your client if you are in the real estate business -- you should require, as a condition of closing the transaction, that the seller provide you with an affidavit certifying whether or not the seller is a nonresident alien or a foreign company. If the seller refuses to sign the affidavit and provide the required information, you should withhold 10% of the gross purchase price and transmit it to the IRS within ten days of the sale along with IRS Form 8288 and Form 8288-A. This can be a real problem in a highly leveraged deal where less than 10% of the purchase price is paid in cash at the closing.

A nonresident alien individual is defined as a person who is neither a U.S. citizen nor a resident of the United States. The tax code bases this on two tests: a "green card" test and a "substantial presence" test.

  • Green card test -- Once an individual receives their green card, allowing them legally work in the United States, they are deemed to be a resident of the United States and will be taxed on their worldwide income, like a U.S. citizen.
  • Substantial presence test -- A foreign individual is considered to be a resident for U.S. federal tax purposes if he or she is physically present in the U.S. for 183 days or more during the current calendar year.

In short, if the seller is a foreign person, you will owe the IRS 10% of the purchase price if you fail to withhold the tax, unless you received a certificate of nonforeign status from the seller, or unless the seller has little or no tax liability on the transaction and applied to the IRS in advance for zero or reduced withholding tax on the transaction.

Withhold State Taxes If Buying Real Estate, in Some States

In some states that have income taxes, you may also be required to withhold state income or other tax on the real estate purchase if the seller is a nonresident of the state where the property is located or is an entity that is not qualified to do business in that state. Some states, such as California, even require withholding where the seller is a resident of the state where the property is located.

For more on state income tax withholding requirements when purchasing real estate from nonresidents, see Section 3.6 of Chapter 3.

5.10 Using a Fictitious or Assumed Business Name

There are various reasons why you might want to conduct your business under a name other than your own -- a trade name, or sometimes called a fictitious business name or assumed name. These reasons can range from simply wanting to use a fanciful name, such as "The Clip Joint" for a hair salon, to not wanting your name to be associated with a risky business, in the event it fails. Or, if your business is incorporated or is an LLC, for example, its actual legal name may be a name that is already reserved or taken by some other company or person when you seek to begin business in a particular state, so that you have to adopt an assumed name for your corporation or LLC to operate under in that state.

Most states and the District of Columbia have laws that require any person -- including a partnership, LLC, or corporation -- who regularly transacts business in the state for profit under a fictitious or assumed business name to file or register that fictitious or assumed business name. The filing is usually done with either the state or county offices, or both.

There is nothing illegal or unethical about using a fictitious name, as long as you register it and -- if required by state law -- publish it. In fact, you may sometimes have no choice but to use a fictitious name if you wish to do business in another state and the real name of your business is already being used by someone else in that state.

In most states, the only penalty for not registering a fictitious business name is that you can't start a lawsuit in the state courts until you file the fictitious name statement or registration, although a few states do impose fines or other severe penalties, such as imprisonment. (Doing business under an unregistered assumed name can land you in jail in some states -- such as Delaware, Rhode Island, West Virginia, or Wisconsin.)

PLANNING POINT:
A more practical reason to register or file your fictitious business name is that most banks will not let you open a business account with them until you show them proof you have done so, in states where registration of fictitious names is required.

Even in a state where registration of the fictitious name is not required, most states allow you to voluntarily register the trade name, usually for a small fee, in order to secure the use of that name for your business and prevent any other firm from using it.

For a sole proprietorship or partnership, a business name is generally considered fictitious unless it contains the surname of the owner or all of the general partners and does not suggest the existence of additional owners. Use of a name that includes words like "company," "associates," "group," "brothers," or "sons" will suggest additional owners and will make it necessary for a business to file (and in some cases also publish) a fictitious business name statement, in all but a few states where you may do business. For an entity such as a corporation or limited liability company, the use of any name other than its name as shown on its articles of incorporation or articles or organization will be considered to be the use of a fictitious name.

Putting a name that would be considered fictitious on your company letterhead, on your business cards, in advertising, or on your products will be considered a use of the name.

Fictitious name registration requirements vary widely from state to state. Some states require such registration by any legal entity using a fictitious or assumed name; others require certain types of business entities, but not others, to register; while a few states (Alabama, Kansas, New Mexico and Wyoming) do not require any businesses to register fictitious names. A few states also require publication of the fictitious name for a specified period in a newspaper. Some newspapers will provide the form for filing, publish the notice, and file the required affidavit, in those states where publication of a fictitious name notice is required.

For more on registration of trade names in [STATE NAME], see Section IV(g) [LINK DELETED] of the [STATE NAME] laws chapter.

5.11 Insurance -- A Practical Necessity for Businesses

Insurance, like death and taxes, is an inevitable necessity for the owner of any small business. Almost any business, even one that has no employees, should consider insurance coverage for general liability, product liability; fire and similar disasters, robbery, theft, and interruption of business.

If your business will have employees, workers' compensation insurance is usually mandatory under state law. Employee life, health, and disability insurance have also become virtual necessities in many businesses and professions if you wish to be competitive with other firms in hiring and retaining capable employees.

Fidelity bonding should be considered for employees who will have access to the cash receipts or other funds of the business. If you have an employee pension or profit-sharing plan subject to the Employee Retirement Income Security Act of 1974 (ERISA), employees involved in administering the plan or handling its funds are required to be covered by a fidelity bond.[29] See Section 6.4 of Chapter 6 for further information.

Insurance Agents

Since it isn't realistic to expect you to become a sophisticated comparison shopper for insurance while you are trying to get a business off the ground, seek out a good insurance agent whom you can trust and rely upon to give you good advice. There is no easy way to find such an agent, just as there is no sure way of finding a good lawyer or accountant. In general, the best approach is to ask friends, lawyers, accountants, or other business people you know to refer you to a topflight insurance agent.

Agents who have earned the Chartered Life Underwriter (CLU) designation will, as a rule, be more experienced and capable than those without the CLU credential. This can be an additional factor to consider when selecting your insurance agent. Agents who deal primarily in property and casualty insurance will not usually have CLU on their business cards. Instead, they may have the initials CPCU -- Chartered Property/Casualty Underwriter -- after their name, which is a similar mark of distinction in the field of property/casualty insurance.

Insurance Consultants

If you cannot find an agent with whom you feel comfortable, call an insurance consultant. Be sure the consultant is a member of the Society of Risk Management Consultants. To belong to the group, the individual or firm cannot be an insurance broker. These consultants are insurance experts and can give you an objective analysis on risk management and insurance.

Society of Risk Management Consultants
330 S. Executive Drive, Suite 301
Brookfield, WI 53005
(800) 765-SRMC (Nationwide)


SRMC Web Site
www.srmcsociety.org/content/

The usual hourly fees of these consultants may seem high, but most new businesses probably will not need an excessive amount of time. Most will bill in quarter-hour increments. You will probably recoup the consultant's fee several times over in premium savings in just the first year alone.

Be wary, however, of a consultant who wants to increase the number of hours by offering to create specifications and provide additional services. Once you have met with an independent consultant and know what is needed, shop for the insurance you need from insurance brokers. Don't let them bid up the amount of coverage or add on additional types of insurance.

5.12 Securities Laws

If you are going to raise money for your business by selling stock or LLC or limited partnership interests, you will need to know something about securities law -- or hire someone who does. Corporate stock and LLC and limited partnership interests generally are considered securities, and even a general partnership interest can be a security in certain circumstances, as can some types of debt instruments. Because of the potentially dire consequences of violating federal or state securities laws, consult with your attorney as early as possible when considering issuing or transferring a security.

Registration of Securities

Since the Securities Act of 1933, federal law has required registration with the Securities and Exchange Commission (SEC) as a prior condition to the issuance or transfer of securities. The law exempts various types of securities and certain types of transactions. The most important of these exemptions for small businesses have been the exemptions for securities sold to persons residing within a single state and of transactions by an issuer that are not deemed to involve any public offering. In addition, the SEC from time to time has issued regulations exempting small securities issues, attempting to balance the needs of small businesses to raise capital against the public policy of protecting investors. In 1982, the commission adopted Regulation D as its primary method of regulation of securities offerings by small businesses, although not to the exclusion of other exemptions that might apply. The Regulation D and various other exemptions under the Securities Act are discussed below, in the remainder of this section.

Rule 504 Exemption

If your company's issuance of stock or other securities meets the requirements of Rule 504 under Regulation D, you will be exempted from having to register the offering of securities with the SEC.[30] This exemption is available to any company that offers its securities for sale if the total offering price of all the exempt securities sold by the company during a twelve-month period is one million dollars or less -- but remember that no more than $500,000 of securities can be sold without registration under the state securities laws in a number of states.

The shares of stock or other securities you may sell under this exemption cannot be offered or sold by any form of public solicitation or general advertising, and no one who buys the securities can resell them without registration, unless they also qualify for an exemption from registration.

Rule 504 does not require that you give any specific information to the purchasers of the securities; however, since the anti-fraud provisions of the securities laws apply even to a transaction that is exempt from registration, it is advisable and customary to give purchasers a written summary of material information about the offering. In addition, Rule 504 may not apply unless the securities are registered with at least one state, unless exempted under state law where the securities are offered to "accredited investors."

Rule 505 Exemption

Rule 505 exempts offers and sales of securities from registration if the total price of all exempt securities your company sold over a twelve-month period is five million dollars or less.[31] While this exemption allows you to do larger offerings, in dollar terms, than under the Rule 504 exemption, there is an additional restriction: you must not issue the securities to more than 35 purchasers. However, any sales of securities to sophisticated "accredited investors" need not be counted when determining whether you have sold to more than 35 investors.[32]

Examples of accredited investors include banks, insurance companies, an individual whose net worth at the time of purchase exceeds one mil­lion dollars, or an individual who has individual income in excess of $200,000 -- or $300,000 jointly with a spouse -- in each of the two most recent years and expects the same in the current year.

UPDATE NOTES:
The SEC has adopted new regulations in 2012 to implement Section 413(a) of the Dodd-Frank Act, which requires the exclusion of the value of one's primary residence in determining whether an "accredited investor" has a net worth of one million dollars. Under the SEC's proposed new net worth standard, both the value of the primary residence and mortgages on such residence would be ignored in computing a person's net worth. However, if mortgages exceed the value of a residence, the excess must be taken into account in computing net worth.[33]

In addition, Congress has enacted the JOBS Act of 2012, which, among other things, has raised the $5 million limit for exempt security offerings under Rule 505 to $50 million. The new law also lifts the ban on "general solicitation" and advertising by small companies in certain kinds of private placement offerings of securities and is expected to make it much easier for small companies to raise start-up capital from investors.

Exceptions are also made for certain large investors, including corporations, partnerships, or business trusts with total assets in excess of five million dollars, unless formed for the specific purpose of acquiring the securities.

For purposes of Rule 505, the issuer must furnish extensive information and certified financial statements to the investors, unless securities were sold only to accredited investors. The prohibition against advertising and solicitation applies to this rule, as do the anti-fraud provisions of the securities laws.

Rule 506 Exemption

The main difference between Rule 505 and Rule 506 is that there is no five million dollar or other maximum size limitation on the amount of securities that can be issued in a Rule 506 offering. In addition, under the JOBS Act of 2012 securities law amendments, general solicitation or advertising is now allowed in Rule 506 offerings, provided the only purchasers are accredited investors. Final Rule 506 Regulations to implement this new standard were issued by the S.E.C. on July 10, 2013.

Rule 506 provides exemptions similar to those under Rule 505, including the 35-purchaser limitation, with the same exception for accredited investors described above.[34] However, Rule 506 requires that an issuer of securities must reasonably believe, immediately before making a sale to a nonaccredited investor, that the investor is sufficiently knowledgeable to adequately evaluate the merits and risks of the investment. Alternatively, the issuer can rely on the knowledge and experience of a person who represents the investor.

Regulation D Filing Requirement

Issuers using any of the above exemptions must file Form D with the SEC generally no later than 15 days after the first sale of securities and at other specified times thereafter. Rule 507 disqualifies any issuer found to have violated the Form D filing requirement from future use of the Regulation D exemptions if the issuer has been enjoined by a court for violating the notice filing requirement -- but this does not disqualify prior issuances of securities merely due to failure to file Form D.[35]

The exemptions available under the federal securities laws are more liberal than those available under the securities laws of many states. In connection with any issuance or transfer of securities, it is necessary to consider the possible application of securities laws in the state where the business entity is established or operates, and, if different, the states where purchasers of the securities live.

Rule 147 -- Intrastate Offering Exemption

Rule 147, under the Securities Act of 1933, exempts from registration a sale of securities solely to persons resident in one state, where the issuer has at least 80% of its assets in that state, and uses at least 80% of the proceeds of the sale within the state.[36] Resales of such securities may be made only to persons within the state during the period of the offering and for nine months thereafter. No SEC filing is required under a Rule 147 offering.

Regulation A Exemption

Yet another possible exemption is under Regulation A, which allows an issuer that is not a "public" company immediately before the offering to sell up to $5 million of securities within a one-year period without registration.[37] No limits are placed on the number of offerees, or their degree of financial sophistication. However, purchasers must be given an offering circular, and a copy of the offering circular must also be filed with the SEC. Financial statements included in the offering circular need not be audited statements. In addition, no more than $1,500,000 of the offering can be of shares owned by existing holders, and no resales of shares or interests by "affiliates" may be made unless the company has had net income from continuing operations in at least one of its two preceding years.

A Form 1-A offering statement must be filed with the SEC, followed by a 20-day waiting period, before sales may commence.

Public Companies: Securities and Exchange Act Requirements

While your company's issuance of securities may qualify for one of the above exemptions from the Securities Act of 1933 and will generally not be subject to the Securities and Exchange Act of 1934, a company whose equity securities are considered to be publicly traded must be registered with the SEC under the Securities Exchange Act of 1934. Issuers who must register their securities under the 1934 Act include:

  • A company that has any security (stock, bonds, or other) that is traded on a national security exchange; or
  • A company with total assets in excess of $10 million if it has a class of equity securities held by 500 or more shareholders and is traded in interstate commerce.

Any such "public" companies are subject to a host of costly reporting requirements, including:

  • Filing an annual report, Form 10-K, which includes audited financial statements;
  • Filing quarterly (unaudited) Form 10-Q reports; and
  • Filing Form 8-K monthly reports, which must be filed whenever a "material event" occurs.

In addition, Congress reacted strongly in response to massive securities frauds or scandals that occurred in the 1990s by passing the Sarbanes-Oxley Act of 2002.[38] This law, while it may help to cut down on securities fraud and phony or misleading financial reporting by public companies, also imposes heavy new financial burdens on reporting companies, as well as potential criminal penalties on corporate chief executives and chief financial officers, who must now "sign off" on the company's audited financial statements, attesting to their validity.[39]

Public companies subject to Sarbanes-Oxley are now required to retain staggering amounts of records of all types, including the archiving of every e-mail received or sent. Companies subject to these added record keeping requirements estimate that their information technology ("IT") costs for maintaining such information in accessible electronic formats will often triple a company's total IT costs, resulting in a heavy financial drain on such publicly-traded companies.

In the spring of 2004, the Public Company Accounting Oversight Board ("PCAOB") filed a massive rule with the SEC, for review, entitled "Auditing Standard No. 2, an Audit of Internal Control over Financial Reporting in Conjunction with an Audit of Financial Statements," which was modified later that year, on September 15, 2004.[40] These rules impose stringent new auditing standards (for internal control procedures) on auditors of public companies, which adds considerably to the ongoing audit fees and operating costs of any company that has "gone public."

Intended to clean up Wall Street, the steep cost of compliance with Sarbanes-Oxley for small companies has had an unwelcome side effect -- public offerings of securities by small companies in the U.S. have nearly dried up, with many small companies now choosing to list their stocks on the London or Shanghai stock exchanges, where they will be "SarbOx-free," as the terminology goes. In addition, many small U.S. companies are now "going private" to get out from under continuing costs and headaches of compliance with Sarbanes-Oxley, according to a May, 2006 report by the Government Accountability Office (GAO).

Finally, the 2010 financial regulatory reform law (the "Dodd-Frank Act") provided major relief from the onerous Sarbanes-Oxley audit provisions for approximately 5,000 smaller public companies. A 2007 study showed that the average "accredited filer" incurred outside audit and legal fees associated with Sarbanes-Oxley compliance of $846,000. Under the Dodd-Frank Act, public companies with less than $75 million of market capitalization (non-accredited filers) are no longer subject to the Sarbanes-Oxley requirements.

UPDATE NOTE:
Sarbanes-Oxley provisions have been further softened for small and startup businesses by enactment of the Jumpstart Our Business Startups Act (JOBS Act) of 2012. The new law relieves certain "emerging growth companies" from certain disclosure and regulatory requirements when they go public, and for a period of five years (previously two years) after that. For example, under Rule 506 and Rule 144A offerings, general solicitation or advertising will now be allowed, provided sales are made only to accredited investors in the case of Rule 506 or to qualified institutional buyers in Rule 144A offerings, under SEC final regulations issued in July, 2013.[41]

In addition, the JOBS Act increases the number of shareholders a company may have before it is required to register its stock with the SEC and become a reporting company. Existing laws required such registration when a company had $10 million in assets and 500 shareholders. Under the new law, the threshold will be reached only when a company has 500 "unaccredited" shareholders or 2,000 total shareholders. "Accredited" shareholders, as discussed in this chapter, are individuals with high incomes or high net worth or certain entities such as banks, insurance companies, or other large organizations.

State Blue Sky Laws

In addition to federal regulations, each state has its own set of securities laws, generally referred to as "blue sky" laws. In the early 20th century con men peddling stocks in nonexistent companies were so successful they were said to be able to sell the "clear blue sky" to gullible investors. States stepped in to regulate these sales, and state regulations are generally less liberal than the exemptions available under federal securities laws.

Even where a federal securities law exemption applies in the issuance or transfer of securities, you need to consider which securities laws apply in the state where your business is established or operates. If potential purchasers of the securities live in other states, you also need to review the securities laws of those states. State requirements range from extensive registration procedures to simple notice filings, where a business is only required to file a notice and pay a fee to the state agency that regulates securities.

Although most state blue sky laws are based on the Uniform Securities Act, the laws of each state -- even the interpretation from state to state of identical state laws -- can differ. Fortunately, many states have adopted the SEC regulations and rely on the SEC to enforce their securities laws. For example, many states provide for transactional exemptions for Regulation D securities offerings if there is full compliance with SEC Rules 501 through 503. Transactions in exchange-listed securities are also exempt under state laws.

To facilitate small business capital formation, the North American Securities Administrators Association, or NASAA, in conjunction with the American Bar Association, developed the Small Company Offering Registration, also known as SCOR. SCOR is a simplified "question and answer" registration form that companies also can use as the disclosure document for investors. SCOR was primarily designed for state registration of small business securities offerings conducted under the SEC's Rule 504, for sale of securities up to $1,000,000.

Currently, over 45 states recognize SCOR. To assist small business issuers in completing the SCOR Form, NASAA has developed a detailed "Issuer's Manual." This manual is available through NASAA's Web site at http://www.nasaa.org In addition, a small company can use the SCOR Form, called Form U-7, to satisfy many of the filing requirements of the SEC's Regulation A exemption, for sales of securities of up to $5,000,000, since the company may file it with the SEC as part of the Regulation A offering statement.

To assist small businesses offering in several states, many states coordinate SCOR or Regulation A filings through a program called regional review. Regional reviews are available in the New England, Mid-Atlantic, Midwest and Western regions. Companies seeking additional information on SCOR, regional reviews, or the "Issuer's Manual" should contact NASAA.

Federal Preemption of Blue Sky Laws

The National Securities Markets Improvement Act [42] enacted in 1996 preempted many state security registration and qualification requirements. Most small businesses, however, must still observe state securities regulations because the states retain the right to regulate penny stocks, certain small and intrastate offerings, and some offerings of securities exempt under federal laws. While the federal preemption of state laws simplifies securities law compliance requirements for many companies, its benefits for small companies that are not publicly traded are minimal or nonexistent. Consult a business attorney who is familiar with the blue sky law requirements of your state or any other states in which you operate, before you issue any stock or other securities.

The analysis of specific state blue sky laws is beyond the scope of this publication. [ALTERNATE: DISCUSSION OF STATE SECURITIES REGISTRATION (BLUE SKY) LAWS FOR SMALL BUSINESSES APPEARS HERE IN SOME STATE EDITIONS, SUCH AS CALIFORNIA AND ALASKA]


5.13 Federal and [STATE NAME] Excise Taxes

Depending upon the type of business in which you are engaged or the types of products your business may make, sell, or use, you may be subject to one or more of the many different kinds of federal or state excise taxes that are imposed by the federal government and by each and every state government. For a discussion of the various types of federal and [STATE NAME] excise taxes that may apply to your business, see Chapter 15 of this publication.

5.14 Requirements Specific to the Legal Form of the Business

Each legal form of business has its own set of requirements. This section briefly mentions them to help you understand your new business' potential "to-do" list. To make this list more complete, see [LINKS TO STATE-SPECIFIC INFORMATION IN STATE LAWS CHAPTER DELETED HERE].

Sole Proprietorships

No significant government regulatory requirements apply specifically to sole proprietorships, although, as a sole proprietor of a business, you will need to attach a form Schedule C to your individual federal tax return, on which you will report the income or loss from your business. A sole proprietor is not required to apply a federal Employer Identification Number, unless the owner has employees or a qualified retirement plan or is required to file federal excise, alcohol, tobacco, or firearms tax returns.

If your sole proprietorship shows a profit, you will usually have to pay a federal self-employment tax on your net self-employment income from the business, which is in addition to any federal income tax on the same income.

The self-employment tax is a Social Security and Medicare tax for those who work for themselves. The tax is computed on Schedule SE, which must also be attached to your federal income tax return. For more details on the self-employment tax, see Section 5.6 of this chapter. For individual federal income tax rates and self-employment tax rates, see Chapter 2, Section 2.2.

For more information on the [STATE NAME] treatment of sole proprietorships, see [LINKS DELETED.]

Partnerships

Like a sole proprietor, as a partner, you will have to pay a self-employment tax on your share of your partnership's net self-employment income. Net self-employment income usually includes all partnership income less all partnership deductions allowed for income tax purposes. Some types of income, such as rentals or interest income, may or may not be considered self-employment income.

The source of your income and your involvement in the activity from which your income is received will determine whether it is self-employment income. Limited partners in a limited partnership are generally not subject to the self-employment tax.

If your earnings from self-employment are $400 or more for the year, you will have to figure self-employment tax on Schedule SE of your federal Form 1040. Schedule E deals with your personal income tax and includes various other types of taxable income, such as royalties, rentals, and inter­est. You report your share of partnership ordinary income or loss on Schedule E.

In addition, your partnership must file a partnership information return, federal Form 1065, reporting the partnership's income and, on Schedule K-1, each partner's share of income and other items. The partnership must also file Form SS­-4 with the IRS to obtain a federal employer identification number, even if it has no employees.

When a partner buys, sells, or exchanges a partnership interest, the partnership must file Form 8308, which is a special information return, if the partnership's assets include unrealized receivables or substantially appreciated inventory that might cause the seller to have ordinary gain, rather rather than all capital gain, on the sale or exchange.[43] Statements also have to be sent to the partners involved in the transaction.[44]

A limited partnership, to qualify as such, is usually required to file a certificate of limited partnership with the secretary of state or a similar state agency. In some states, a limited partnership should also file certified copies in each county where it does business or owns real estate.

Limited partnerships or limited liability partnerships (LLP's) that operate in other states outside of your home state will have to obtain a certificate of authority from the secretary of state or similar government office in each such other state, in order to transact business as a "foreign limited partnership" or "foreign LLP" in those states. A general partnership is not usually required to obtain a certificate of authority to do business, however -- in most states.

For more information on the [STATE NAME] legal and tax requirements for partnerships, see [LINKS DELETED].

Corporations

As mentioned in Section 2.4 of Chapter 2, corporations are a more complicated form of doing business, and as a result, have several requirements specific only to that form. A short list of some of these requirements would include:

  • Filing articles of incorporation with the appropriate state agency;
  • Adopting a set of bylaws;
  • Observing necessary corporate formalities on a regular basis;
  • Filing federal income tax returns on Form 1120 -- or Form 1120-S for an S corporation -- within 2 1/2 months after the end of the taxable year; filing state income or franchise tax returns in most states where they do business; and filing quarterly estimated tax payments of federal and possibly state corporate income taxes and/or state franchise taxes;
  • Reporting certain information relating to the tax-free transfer of property to the corporation under Internal Revenue Code Section 351 on the corporation's income tax return for the year of the transfer and on the tax return of each "significant transferor" who transferred property to the corporation and owned 1% or more of its stock (5% if publicly traded) immediately after the transfer;[45]
  • Filing Form SS-4 with the IRS to obtain an employer identification number, even if there are no employees; and
  • Qualifying with the secretary of state or corporations commission (or other similar agency) to do business in your state, if the corporation was organized under the laws of another state, plus qualifying the corporation in each other state where it is "doing business," as a "foreign corporation" in such other states.

For more information on the [STATE NAME] treatment of corporations, see Chapter 2, Section 2.4, and [LINK DELETED] of the [STATE NAME] laws chapter.

Limited Liability Companies

A limited liability company (LLC) must file articles of organization -- similar to articles of incorporation -- with the secretary of state or other appropriate state agency, and pay any applicable filing fees. See [LINK DELETED] for information on filing fees and other requirements for organizing an LLC (or registering a foreign LLC to do business) in [STATE NAME].

Tax treatment of an LLC will generally be the same as a partnership or, if the LLC has only one owner, it will be treated as a sole proprietorship (that is, its existence will be disregarded for tax purposes). Or, should you so choose, an LLC can elect to be taxed like a corporation by filing Form 8832 with the IRS.

An LLC that is taxable as a partnership for federal tax purposes must file an annual partnership tax information return each year, on Form 1065, reporting its income or loss for the year and the distributive share of profits, losses, tax credits and other items for each member (owner) of the LLC. Form 1065 is due by the 15th day of the fourth month after the end of the tax year (April 15th, for a calendar-year LLC). If an LLC has elected on Form 8832 to be taxed as a corporation, it is subject to federal corporate taxes and must file an annual corporation income tax return, Form 1120, by the 15th day of the third month after the end of the tax year (March 15th, for a calendar-year taxpayer).

An LLC must obtain a federal employer identification number by filing Form SS-4, even if it has no employees, if it will elect corporation status or be taxed as a partnership for federal income tax purposes. If it has only one member, it is generally not required to file an SS-4 unless it will have employees, in which case the SS-4 should be filed in the name of the LLC, rather than the name of the owner, beginning in 2009.

The state tax treatment of LLC's varies widely from state to state. Most states follow the federal tax treatment of an LLC, but others impose corporate income or franchise taxes on some or all LLC's, or impose various annual fees or taxes on LLC's. For more information on the [STATE NAME] treatment of LLC's, see [LINKS DELETED] of the [STATE NAME] laws chapter.

An LLC that does business in a state other than the state where it filed its articles of organization will be considered a "foreign LLC" in any such state and will have to obtain a certificate of authority to do business in those states where it has a significant business presence, such as offices.

See Section 14.11 of Chapter 14 for an analysis of when a company is considered to be "doing business" in a state other than its home state, for purposes of various taxes.

Checklist of Requirements for New or Existing Businesses

This is a "generic version" of this book. If you were using the author's "Small Business Advisor" ([STATE NAME] edition) Windows software program to assemble this book, you could use the software's interview feature to enter data about your business, which the software would then use to assemble a "customized" version of the e-book, instead of this "generic" version. See www.roninsoft.com/advisor.htm for more information on the "Small Business Advisor" software, which was used to assemble this e-book, and which has editions for all 50 states and D.C.

However, since this is a "generic" edition, no customized start up checklist has been generated that reflects your specific business circumstances and the tax/legal requirements imposed on your specific business by [STATE NAME].

If your business has or will have employees, prepare to journey further, as the thicket of red tape thickens in Chapter 6, which describes additional requirements for businesses with employees. If you have no employees, you may want to instead skip ahead to Chapter 7.



[WORKSHEET DELETED HERE]

Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code, C.F.R. to the Code of Federal Regulations.)

1.Armstrong Paint and Varnish Works v. New and U-Enamel Corp., 305 U.S. 315 (1938); Carter-Wallace, Inc. v. Procter and Gamble Co., 434 F.2d 794 (9th Cir. 1970).
2. I.R.C. § 53(e)(2)(A).
3. I.R.C. § 6654(d)(1)(C)(i).
4. I.R.C. § 6655(f).
5. I.R.C. § 6041(a).
6. I.R.C. § 6050N(a).
7. I.R.C. § 6724(d)(3).
8. I.R.C. § 3406(a)(1).
9. I.R.C. § 6041A(b).
10. I.R.C. § 6050W.
11. I.R.C. §§ 6721-6722.
12. I.R.C. § 3509(a).
13. I.R.C. § 3509(b).
14. I.R.C. § 6045(f) and § 1021(b) of the Taxpayer Relief Act of 1997; and Treas. Regs. § 1.6045-5(d)(1) (providing that payments to law corporations are not exempted from reporting requirement).
15. Treas. Regs. § 1.6041-3(a).
16. Treas. Regs. § 1.6041-3(c).
17. Treas. Regs. § 1.6041-3(d).
18. Treas. Regs. § 1.6041-3(h).
19. I.R.C. § 6041(a) requires filing of information returns for payments made to another "person." Person, as defined in I.R.C. § 7701(a)(1), does not include governmental bodies.
20. I.R.C. § 6042(a).
21. I.R.C. § 6049(a).
22. I.R.C. § 6049(b)(2)(A) and Treas. Reg. § 1.6049-5(b)(1).
23. Treas. Reg. § 1.6050I-1(e).
24. I.R.C. § 6050I(e).
25. I.R.C. § 6721(e)(2)(C).
26. I.R.C. § 6050H.
27. Rev. Proc. 2009-30, 2009-27 I.R.B. 27.
28. I.R.C. § 1445(a).
29. 29 U.S.C. § 1112 (§ 412 of ERISA).
30. 17 C.F.R. § 230.504.
31. 17 C.F.R. § 230.505.
32. 17 C.F.R. § 230.501(e)(1)(iv).
33. 17 C.F.R. § 230.501(a)(5) and 17 C.F.R. § 230.215(e), as amended by S.E.C. Release No. 33-9287, eff. February 27, 2012.
34. 17 C.F.R. § 230.506.
35. Rule 507, as interpreted in Securities Act Release No.6825, March 14, 1989 (17 C.F.R. § 230.507).
36. 17 C.F.R. § 230.147.
37. 17 C.F.R. § 230.251, et seq.
38. 15 U.S.C. §§ 7201, et seq.
39. 15 U.S.C. § 7241.
40. S.E.C. Release No. 34-49544A, 69 F.R. 20955 and S.E.C. Release No. 34-50495 (9/15/2004).
41. § 201(a) of the Jumpstart Our Business Startups Act, Pub. L. No. 112-106; S.E.C. Release No. 33-9415; and 17 C.F.R. § 230.506(c).
42. 15 U.S.C. § 77r.
43. I.R.C. § 6050K(a).
44. I.R.C. § 6050K(b).
45. Treas. Regs. § 1.351-3.


Chapter 6

The Thicket Thickens:
Additional Requirements for Businesses with Employees



"Laws are like sausages. It is better not to see them being made."
-- Count Otto von Bismarck

"The natural progress of things is for liberty to
yield and government to gain ground."

-- Thomas Jefferson

"Anything that is not prohibited, is mandatory."
-- Bureaucrats' Credo

"Government's view of the economy could be summed up in a few short phrases:
If it moves, tax it. If it keeps moving, regulate it.
And if it stops moving, subsidize it."

-- Ronald Reagan (1986)

INTRODUCTION

As the previous chapter indicated, a considerable amount of governmental red tape is involved in starting a new business. If your business will have any employees -- even if it is incorporated and you are the only employee -- the level of government regulation and red tape with which you must cope will increase by several orders of magnitude. Your life suddenly gets a great deal more complicated the moment you hire your first employee.

Having employees imposes a host of new legal responsibilities upon you (depending on how many employees you have, in some cases), including:

  • Income and social security tax withholding;
  • Workers' compensation insurance requirements;
  • Payment of unemployment and social security taxes;
  • OSHA safety rules and recordkeeping;
  • ERISA employee benefit rules, including a vast array of reporting and disclosure requirements;
  • Compliance with fair employment (non-discrimination) laws;
  • Compliance with immigration law requirements when hiring;
  • Minimum wage and hour requirements;
  • Child labor law restrictions on hiring, working conditions and working hours;
  • Providing health care coverage, once it is required under the Patient Protection and Affordable Health Care Act of 2010 (health care reform law, or "ObamaCare");
  • Family and medical leave requirements;
  • Reporting newly hired employees to state child support enforcement agencies and, if ordered to do so, garnishing the wages of some employees;
  • "COBRA" requirements allowing former employees to maintain their medical insurance coverage for a period of time after they leave your employment;
  • Compliance with upcoming implementation of health care reform legislation in the coming years;
  • Compliance with labor relations laws; and
  • Miscellaneous other state and federal labor laws of many kinds, such as federal "prevailing wage" and affirmative action requirements if you work on federal government contracts, plus state laws on various labor matters, such as regarding frequency of paydays and when terminated employees must be paid their final wages, or differing minimum wage, overtime, child labor, or family leave laws.
PLANNING POINT:
Think twice before you hire additional employees. While politicians endlessly proclaim that they are all in favor of jobs, jobs, jobs, the reality is that all levels of government tend to penalize the small business that creates jobs, by adding on additional taxes and other burdens every time you hire a few more employees.

This chapter outlines the main tax and regulatory bases you must cover, in addition to those described in Chapter 5, for a business that has employees.

6.1 Social Security and Income Tax Withholding

Once you go into business and begin paying salary or wages to employees, you will find that you have been appointed, as an agent of the government, to collect taxes from your employees. In addition to paying various payroll taxes, you must also collect income taxes and Social Security (FICA) tax, which includes the Medicare tax, from employees' wages.

Employer Identification Number

The first order of business is to apply for a federal employer identification number (EIN) with the IRS. This number will be used to identify your business on payroll and income tax returns and for most other federal tax purposes. To apply for an EIN, file a completed Form SS-4 at the earliest possible time, especially if you have employees.

Corporations, limited liability companies, and partnerships must generally file Form SS-4 even if they have no employees. (However, a single-owner limited liability company with no employees will usually not be required to obtain an EIN.) Any business that will have an employee retirement plan is generally required to obtain an EIN.)

The IRS can provide you with Circular E, Employer's Tax Guide, an IRS publication that explains federal income tax withholding and Social Security tax requirements for employers. Circular E contains up-to-date withholding tables to determine how much federal income tax and Social Security tax to withhold from each employee's pay­check in each pay period.

Employer Social Security Tax

In addition to withholding Social Security tax from an employee's pay­check -- at the rate of 7.65% on gross wages up to $117,000, 1.45% on wages in excess of $117,000 in 2014, the employer must also pay an employer's share of Social Security tax. The withheld federal income tax, withheld employee Social Security tax, and employer's Social Security tax are lumped together and paid to the IRS at the same time. In some cases, these taxes can simply be mailed in with your payroll tax return (Form 941 series) at the end of the calendar quarter or year; how­ever, if you have significant amounts of these taxes to pay, you will generally be required to make payments by electronic funds transfer, and as a rule, the greater the amount of taxes due, the sooner they must be paid.

UPDATE NOTE:
In the past, the employer and employee have usually been subject to equal amounts of FICA tax. However, for wages paid for periods between March 19, 2010 and December 31, 2010, employers were forgiven the 6.2% OASDI portion of the FICA tax (but not the 1.45% Medicare tax portion) on wages paid to certain newly hired employees.

In addition, when Congress extended the Bush tax cuts in December, 2010, it also provided a 2% reduction in the FICA tax on employees for the full year 2011. That reduced the employee's tax rate for the OASDI portion of the FICA tax from 6.2% to 4.2%. Employers continued to pay the usual 6.2% OASDI rate on the first $106,800 of wages paid to an employee in 2011. The 1.45% Medicare tax portion of the FICA tax that is imposed on both employer and employee, on ALL of the employee's wages, was not affected.

For 2012, the taxable wage base increased to $110,100, and both employer and employee were to be subject to the former 6.2% tax rate on the taxable wage base, and 1.45% rate (Medicare tax) on all taxable wages. However, in late 2011, Congress briefly extended the 2% rate reduction for employees through February 29, 2012. Then, on February 17, 2012, Congress extended the 2% rate reduction through the end of 2012. However, in 2013, the 2% rate reduction has expired, and the taxable wage base increased to $113,700, and to $117,000 in 2014.

The health care reform law enacted in 2010 will, beginning in 2013, impose a new 0.9% Medicare tax on FICA wages exceeding $250,000 on joint returns, $125,000 on married filing separate returns, and $200,000 for other individuals (single or head of household filing status). This additional tax is imposed only on the employee, with no corresponding tax increase on the employer.[1] Since the employer may not know and is not required to determine the amount of wages being paid to an employee's spouse, an employer will only have to withhold the additional tax on wages in excess of $200,000 paid to an employee and any additional tax owed will have to be paid by the employee on his or her return or on a joint return.

The complex tax deposit deadlines of previous years have been totally revised and considerably simplified under recent IRS regulations. Rules for how and when withheld federal income taxes and Social Security taxes are to be mailed in or deposited are summarized briefly as follows:

 
 

2013 FEDERAL EMPLOYMENT TAX DEPOSIT SUMMARY

  • VERY SMALL ANNUAL (FORM 944 PROGRAM) DEPOSITORS -- An employer that has been notified by the IRS that it must file Form 944 annually, in lieu of quarterly filings of Form 941. Pay by EFT or mail in payment of employment taxes for the prior year by January 31 of the next year (if less than $2,500).[1]
  • SMALL DEPOSITOR -- An employer (one that is not in the Form 944 Program) with less than $2,500 of employment taxes for the current calendar quarter. Pay (by EFT) by last day of month following the end of the quarter, or mail with Form 941 return by then.[2]
  • MONTHLY DEPOSITOR -- An employer who, for the 12-month period ending June 30th of the preceding calendar year, reported $50,000 or less of employment taxes. Pay (by EFT) by 15th day of the following month.[3]
  • SEMI-WEEKLY DEPOSITOR -- All other employers: [4] For Wednesday-Friday semi-weekly period: Pay (by EFT) on or before next Wednesday.
    For Saturday-Tuesday semi-weekly period: Pay (by EFT) on or before next Friday.

Some exceptions to the above tax deposit schedules do exist. For example, any employer with $100,000 of employment taxes accumulated at the end of any day -- for the current month or semi-weekly period only, whichever applies -- must deposit those taxes in an authorized bank by the end of the next banking day, subsequently becoming a semi-weekly depositor.[5] Shortfalls in required deposits will result in underpayment penalties. No penalty, however, will be imposed if the shortfall does not exceed 2% of the required deposit (or $100, if greater) provided the shortfall is made up within specified periods.

New employers, since their tax withheld during the "lookback period" ending June 30th of the prior calendar year is always zero, are always monthly depositors during their first calendar year, unless they have $100,000 or more of undeposited employment taxes accumulated at any point in time, as noted in the preceding paragraph.

In January 1, 2006, the IRS issued new Temporary and Proposed Regulations to implement its new Form 944 Program. Under this program, the IRS will notify in writing certain small employers, whose employment taxes for the year are $1,000 or less, that they must, for the next year, file an ANNUAL Form 944 payroll tax return (a new form) instead of quarterly filings of Form 941. Employers in the Form 944 Program will generally not be required to make a tax payment of the taxes until January 31 of the following year, and will have an additional 10 days in which to prepare and file the Form 944.

However, if an employer in the Form 944 Program has $2,500 or more of undeposited employment taxes at any time during the year, a tax deposit may be required under the normal rules for tax deposits, as in the above table.

Employers who are notified that they are in the Form 944 Program may, if they choose to, elect to continue filing Form 941, but only if they notify the IRS on a timely basis that they will be filing 941's electronically on a quarterly basis or that they expect to have more than $1,000 of employment taxes to pay over for the year. Otherwise, an employer in the Form 944 Program will remain in the program until notified by the IRS that it must begin filing 941's in the following year.

For a more detailed explanation of federal tax payments, see IRS Publication 15 (Circular E).

UPDATE NOTE:
Effective since Jan. 31, 2011, using Federal Payroll Tax Deposit coupons F8109 or F8109B is no longer a deposit option. Federal tax deposits must be made electronically. Payments mailed to the Federal Tax Deposit mailbox in St. Louis are being returned.[6]

To make sure you have the latest IRS pronouncements on any of the above tax payment deadlines, obtain a copy of IRS Publication 509, Tax Calendar for 2013 (or for the current year).

Electronic Funds Transfers

The IRS has gradually shifted over to electronic funds transfers (EFTs) as a mode of payment, in place of the tax deposit system described above. Taxpayers will eventually be required to remit withholding, payroll, excise, corporate income, and certain other taxes by EFT payment, either directly, or by means of an intermediary, third-party bulk data processor. The EFT payment requirements began phasing in on January 1, 1995 for large employers. In 1999, only very large employers with at least $47 million a year in combined FICA and federal income tax withholding had to make EFT payments.

Since January 1, 2000, smaller employers with as little as $200,000 a year of employment and other federal taxes, combined, in the 1998 calendar year "lookback period" have had to use EFT.[7] A one year grace period was allowed after an employer first reached the $200,000 a year threshold, so that, for example, if your business first had $200,000 of federal employment and other tax payments in 2008, the EFT payment requirement did not apply to you until 2010.

Smaller employers, who are not yet required to make EFT remittances, can make EFT payments if they desire.

Employers with less than $200,000 of annual FICA and federal income tax wage withholding and other federal employment taxes were not, until recently, required to make EFT payments, under IRS regulations. However, beginning in 2011, only very small employers, with no more than $2,500 of quarterly employment tax deposits, are exempt from having to make payroll deposits by EFT. All other employers are required to make EFT payments of such federal payroll taxes. [7A]

To implement the EFT system, the IRS has developed the Electronic Funds Transfer Payment System (EFTPS), which uses the same Automated Clearing House (ACH) network that was already in place for such items as Social Security and veterans' benefits payments and automatic loan payments.[8]

Businesses or individual taxpayers can use the EFTPS system to pay all their federal taxes electronically, 24 hours a day, 7 days a week. Visit the EFTPS website at:

EFTPS Website
https://www.eftps.com/eftps/

Or call EFTPS Customer Service at: 1-800-555-4477

EFTPS permits you to make EFT tax payments directly from your business' bank account to the U.S. Treasury's general account, electronically. EFTPS payments must be made one day before the tax payment due date. You will need to arrange with your bank or other financial institution to initiate EFTPS payments to the IRS.

You have two options for enrolling in EFTPS, both of which are free. you can enroll online at EFTPS.gov or by calling the IRS at the following toll-free number, Monday through Friday, 9:00 a.m. to 6:00 p.m. ET, to request an enrollment form:

Internal Revenue Service
(888) 725-7879
You will generally receive a "PIN" number within about seven days after your completed enrollment form is received by EFTPS. See IRS Publication 966 (03/2012 revision) instructions.

As soon as you receive your PIN, you can begin scheduling tax payments. If you use EFTPS.gov, follow the online prompts to set your Internet password. If you wish to schedule payments by phone, call 1-800-555-3453.

To avoid penalties, be sure to make your EFTPS payment by 8:00 p.m. ET the day before the tax payment is due. Remember to record the EFT Acknowledgement number you will receive when you make your payment and always be sure you have sufficient funds in your bank account to make the payment.

Year-End Reporting

By January 31 of each year, you must furnish each employee with copies of Form W-2, Annual Wage and Tax Statement, showing the taxable wages paid to an employee during the preceding calendar year and the taxes withheld, including state income tax. By February 28, the original of Form W-2 and a summary form, Form W-3, should be filed with the IRS.

New Employees

When a new employee is hired, give the employee a federal Form W-4. He or she must then complete and return the form to you. When completed, Form W-4 provides the employee's Social Security number and the number of withholding exemptions the employee is claiming.

The number of exemptions is used to determine how much income tax you must withhold from his or her wages. You keep Form W-4. Neither it nor the information on it is filed with the IRS, generally.

In the past, the IRS required employers to report a Form W-4 in the case of an employee who claimed more than ten withholding exemptions or who claimed complete exemption from income tax withholding.

However, in 2005, the IRS said "We'll do it ourselves," which means less paperwork for employers. Now the rule is that employers can accept an employee's W-4 as the basis for computing withholding, unless the IRS sends you a "lock-in" letter, telling you to ignore the employee's withholding exemptions claimed on the W-4 and to withhold tax on that employee on a specified basis.

Reporting New Hires or Contractors

Part of the federal welfare reform law requires employers in each of the states to report all newly hired employees, with their name, address, social security number, and other information, to an appropriate state agency (usually the same agency that administers state unemployment taxes, or a child support enforcement agency), generally within 20 days after an employee is hired (or rehired), although several states require reports to be filed in less than 20 days.

UPDATE NOTE:
On December 8, 2010, President Obama signed the Claims Resolution Act into law. This law amends section 453A of the Social Security Act and redefines an employee's Date of Hire as "the date services for remuneration were first performed by the employee", that is, the date the employee first performs services for pay. The law requires that employers report this Date of Hire to the State Directory of New Hires (SDNH) either on the employee's W-4 form or an equivalent form. The new SDNH reporting requirement went into effect June 8, 2011.

In addition, Section 453A of the Social Security Act was amended again on October 21, 2011, by the Trade Assistance Extension Act of 2011, so that, effective as of April 21, 2012, an employee who separates from employment for at least 60 consecutive days but is rehired must be reported as a "new hire."

Employers reporting electronically may have to file reports twice a month (if needed), on dates not less than 12 days nor more than 16 days apart, in most states.

Several states also require reporting of newly retained independent contractors who perform services for a business:

  • California
  • Connecticut
  • Iowa
  • Massachusetts
  • New Hampshire
  • Ohio
See Section 6.14 for more information on reporting new hires in [STATE NAME] or on multi-state reporting.

Nonpayroll Withholding

In addition to FICA and income tax withholding from wages that are required of employers, businesses are sometimes required to withhold income taxes with regard to nonpayroll payments, such as:

  • Withholding on certain gambling winnings;
  • Withholding on annuities, pensions, IRAs, and certain other payments of deferred income; and
  • Backup withholding on certain reportable payments, when required by the IRS for a particular taxpayer.[9]

The time for depositing these taxes is based on your status as a monthly or semi-weekly depositor under the payroll tax rules. However, a "small depositor" for payroll taxes is treated as a monthly depositor for nonpayroll taxes withheld. Deposits of nonpayroll taxes are generally required to be made by electronic funds transfer (EFT) unless the total Form 945 taxes withheld for the year are less than $2,500.

Taxpayers required to withhold nonpayroll income taxes must report this withholding on IRS Form 945, Annual Return of Withheld Income Tax, rather than on the Form 941 or Form 944 that is used to report payroll tax with­holding.

Withholding On Payments to Government Contractors

Under withholding provisions of the Internal Revenue Code that were enacted in 2005, federal, state, and local governments that make single payments to businesses or individuals of $10,000 or more for goods or services were required to withhold federal income tax at the rate of 3%, beginning January 1, 2013 (2011 originally, before Congress extended the effective date by a year, twice).

UPDATE NOTE:
The above withholding rules did not go into effect on January 1, 2013, due to the complete repeal of this provision in November of 2011.[9B]

Withholding Various State and Local Taxes

Most states and many localities have their own withholding tax requirements, in addition to any federal withholding that may be required of a business. A business, with or without employees, may be required to withhold state income taxes in the following situations:

  • Withholding tax from employees' wages is required in every state that has a general income tax on individuals;
  • A large and growing number of states now also require withholding by pass-through entities (partnerships, LLC's, and S corporations) on taxable income paid or allocable to nonresident partners, members, or shareholders;
  • Several states now require income tax to be withheld from the sales proceeds of real estate if the seller is a nonresident of the state and California even requires such withholding on resident sellers; and
  • A few states have recently begun to require withholding on payments to certain nonresident (or in some cases, resident) independent contractors.

In some states, various local governments may also impose city, county, or transit district income or wage taxes, which employers are generally required to withhold from employees' wages.

For information on the wage and other with­holding tax requirements for states in which your employees perform services or your business otherwise operates, consult your accountant or other tax adviser; or see the relevant state edition of this e-book series for each such state for a general overview of each state's withholding requirements, if any. (Not all states have individual income taxes that apply to wages or salaries.)

[STATE NAME] Employer Withholding Requirements

See summary of [STATE NAME] employer withholding requirements in Chapter 16, [LINK TO STATE LAWS CHAPTER REMOVED HERE].

Independent Contractors

A person who performs services for your business does not necessarily have to be your employee. In many cases, you can structure your legal relationships with persons who provide services to you so they are considered independent contractors. From an employer's standpoint, it is prefer­able to treat someone as an independent contractor rather than as an employee because you do not have to pay Social Security tax or federal or state unemployment taxes on his or her compensation. An independent contractor is considered to be self-employed for tax purposes and pays his or her own income tax and self-employment tax.

In addition, you don't have to withhold federal income or payroll taxes from compensation paid to independent contractors or file payroll tax returns with respect to their compensation generally. Nor, in most states, are you required to withhold tax on payments to independent contractors.

(California, Colorado, and North Carolina are exceptions. For more information on when such withholding on payments to independent contractors may be required, see the segment immediately above regarding [STATE NAME] withholding.)

You must, however, file a Form 1099-MISC with the IRS for each independent contractor to whom you make payments of $600 or more during a calendar year (with certain exceptions) or, in the case of a direct seller of consumer goods, as in a multi-level marketing arrangement, for each such direct seller to whom you sell $5,000 of goods during a year.

Because of the obvious advantages employers obtain by treating their employees as independent contractors, the IRS has been very aggressive in attempting to reclassify so-called independent contractors as employees where they perform functions in a manner that is more typical of an employer/employee relationship. Requiring businesses to file Form 1099-MISC is one way in which the IRS seeks to identify those businesses that may be improperly treating employees as independent contractors.

Before you decide to treat anyone who works for you as an independent contractor, consult your tax adviser, because there can be serious consequences if those individuals are reclassified as employees by the IRS, and the determination of who is or is not an independent contractor is highly technical and often very unclear. See Section 6.13 of this chapter, "Employee or Independent Contractor?" for a discussion of the risks involved.

6.2 Unemployment Taxes - Federal and [STATE NAME]

With relatively few exceptions, all businesses with employees must pay federal unemployment tax on the employees' wages. Each state also imposes an unemployment tax that meshes closely with the federal unemployment tax.

These taxes are imposed entirely on you, the employer. Theoretically, the federal unemployment tax is 6.0% of the first $7,000 of annual wages per employee. [10] However, employers are usually allowed a 5.4% FUTA tax credit if they pay their state unemployment tax on time, so that the net FUTA tax rate is only 0.6% in most cases. (The FUTA tax rate was 6.2% prior to July 1, 2011, but a "temporary" 0.2% surtax was finally allowed to expire on that date, after a mere 35 years.)

The state unemployment tax rate for an employer can be either more or less than the state's standard new employer rate, depending upon the amount of unemployment claims by former employees. The more unemployment benefits your former employees claim, the higher your unemployment tax rate will be, within certain limits.

Federal Unemployment Tax

Your business is required to pay federal unemployment tax (FUTA) for any calendar year in which it pays wages of $1,500 or more [11] or if it has one or more employees for at least a portion of the day during any 20 calendar weeks during the year.[12] Needless to say, this will cover almost any business that has one employee, even if that employee is part-time.

The FUTA tax is imposed at a nominal 6.0% tax rate on the first $7,000 of wages per employee. We say "nominal 6.0% tax rate" because a tax credit of 5.4% is ordinarily allowed to employers who pay their state unemployment taxes on a timely basis, resulting in a net FUTA liability of only 0.6% of the taxable wages, or a maximum annual tax of $42 for each employee.[13]

However, where a state's unemployment tax trust fund has a deficit on January 1 of two successive years, it will have to borrow from the federal unemployment tax fund, and the employers in that state will have their FUTA credit reduced from 5.4% of taxable wages by 0.3% each year the deficit continues.

Because a number of state unemployment tax funds have had deficits on January 1 of at least two successive years, employers in those states no longer received the full 5.4% tax credit against the 6.0% FUTA (federal unemployment) tax in 2012. Instead, the credit was reduced by 0.3% to 5.1% of FUTA wages (or reduced more in states that had a credit reduction in 2011 that had not yet repaid their loans from the federal unemployment tax fund), so that the actual net FUTA liability for employers in most credit reduction states in 2012 increased from the usual 0.6% tax rate to 0.9% (or more in several states). If a state continues to have a deficit on January 1 of future years, the FUTA credit will decrease by an additional 0.3% each year until the state repays the advances and interest owed to the federal unemployment tax program.

UPDATE NOTE:
For 2012, states with credit reductions were:
  • 0.9% reduction: Indiana
  • 0.6% reduction:
    • Arkansas
    • California
    • Connecticut
    • Florida
    • Georgia
    • Kentucky
    • Missouri
    • North Carolina
    • New Jersey
    • Nevada
    • New York
    • Ohio
    • Rhode Island
    • Wisconsin
  • 0.3% reduction:
    • Arizona
    • Delaware
    • Vermont
States that repaid their federal advances and were no longer "credit reduction states" for 2012 were:
  • Illinois
  • Michigan
  • Minnesota
  • Pennsylvania
  • South Carolina
  • Virginia

If the FUTA tax liability is more than $500 for the calendar year, you must deposit at least one quarterly payment. (Since January 31, 2011, you may no longer make federal tax deposits with a federal tax deposit coupon, Form 8109, but must make your "deposit" by electronic funds transfer.) Make your payment (by EFTPS -- see EFTPS payment information in Section 6.1, regarding withholding taxes) during the month following the end of the quarter if you have over $500 of undeposited tax at the end of the quarter. If the tax is $500 or less, you are not required to make a deposit, but you must add it to the taxes for the next quarter.

For the fourth quarter, if the total FUTA tax for the year is more than $500, pay any unpaid FUTA tax by EFT payment by January 31, 2013 (for 2012). If the total FUTA tax for the year is $500 or less, either pay by EFT or mail the payment to the IRS with your federal unemployment tax return, Form 940, by January 31. Form 940 is not due until February 10 if all of the FUTA tax for the prior year has already been paid when due. Otherwise, the 940 is due by January 31. [Per Form 940 Instructions, 2011]

[STATE NAME] Unemployment Tax

[SECTION ON STATE UNEMPLOYMENT TAXES IN THE SPECIFIC STATE DELETED HERE]

SUTA Dumping Is No Longer Legal

In earlier (print) editions of this book series, we suggested for several years that one means of reducing your state unemployment tax rate, if your business had an unfavorable experience rating, was to transfer your employees to a new or affiliated business entity that had a better tax rate. Some employers used other, even more creative tactics. For instance, a construction company with a very high tax rate would buy some business with a good rating that was about to go out of business, such as a flower shop, and transfer its construction employees to the payroll of the acquired entity, to utilize its low tax rate.

This "SUTA dumping" tactic (SUTA being a generic term for State Unemployment Tax Acts) is no longer legal, as the federal government finally wised up and required states to enact anti-SUTA dumping unemployment tax law amendments in 2005. Accordingly, now, if one business acquires another and the two are under a significant degree of common control or common ownership, the state can require the acquiring employer to succeed to the experience rating of the seller, or prohibit it from doing so, if it appears that the transaction was designed to reduce unemployment taxes. (Good-bye, tax loophole.)

6.3 [STATE NAME] Workers' Compensation Insurance

A business may be required by state law to obtain workers' compensation insurance for its employees, although some large firms may be allowed to self-insure. This means that you, as a small business employer, may have to immediately seek out and obtain a workers' compensation insurance policy covering all your employees, or you will be subject to possible legal sanctions, not to mention open-ended liability if a worker is injured on the job. Workers' compensation insurance coverage provides various benefits to an employee who suffers a job-related injury or illness.

CAUTION:
A number of states exempt small employers of varying sizes from mandatory workers' compensation coverage, and Texas exempts almost all employers. However, due to the legal liability risks from lawsuits by injured employees, it rarely makes sense for a small employer to take advantage of any such exemptions.

Many insurance companies offer workers' compensation coverage, though some may be reluctant to write a policy that covers only one or a few employees, unless it is tied to other types of insurance policies. Some states require all employers to purchase their workers' compensation insurance from a single state fund or state-run insurance company, though most states now allow businesses to choose between a number of private insurers.

The state of [STATE NAME] requires [STATE-SPECIFIC DISCUSSION OF WORKERS' COMPENSATION LAW REQUIREMENTS IN THE PARTICULAR STATE AND TEMPORARY DISABILITY INSURANCE IN SOME STATES, DELETED HERE.]

6.4 Compliance with ERISA -- Employee Benefit Plans

If you have employees and provide them with fringe benefits, such as group insurance -- other than workers' compensation -- or other types of employee welfare plan benefits, or if you adopt a pension or profit-sharing retirement plan, you will almost certainly have to comply with at least some aspects of the Employee Retirement Income Security Act of 1974 (ERISA). There are criminal penalties for willful failure to comply with two types of ERISA requirements:

  • Reporting to government agencies and
  • Disclosure to employees.
These criminal penalties can be quite severe. In 2002, Congress increased the maximum prison term for ERISA criminal violations from one year to ten years, and increased the maximum civil penalty (fine) from $5,000 to $100,000 for an individual and from $100,000 to $500,000 for an entity. [14]

There is a $25 per day penalty for late filing of any of the Form 5500 series Annual Reports required of pension plans (and some welfare plans). In addition, a number of different types of civil penalties apply, which are exceptionally numerous and complex, for unintentional failures to comply with ERISA requirements.[15] In short, compliance with ERISA is not for the faint of heart and is not a simple matter, for most employers.

This section lays down some relatively simple and straightforward guide­lines you can follow in trying to recognize when you might have an ERISA compliance obligation. If you recognize your need to be in compliance, call your attorney, accountant, or benefit consultant for help.

ERISA deals with two kinds of employee benefit plans: pension plans and welfare plans. Each is described below, along with basic ERISA reporting requirements for each type of plan.

Pension Plans

Pension plans under ERISA are what you might expect -- tax qualified retirement plans, including both pension and profit-sharing plans (including Keogh plans), plus other types of benefit programs that defer payments until after employment has terminated.[16]

Because these compliance requirements are so very complex and are constantly in a state of flux, no attempt to spell them out in detail is made here. Instead, the basic ERISA compliance requirements for most pension and profit-sharing plans are summarized in the following table.

[WORKSHEET FILE NOT INCLUDED IN THIS "NATIONAL" EDITION]

If your business maintains a pension or profit-sharing plan, it should be obvious from this summary of basic ERISA compliance requirements that you need some expert help from an attorney, accountant, or pension consulting firm -- or all of the above -- if you are going to be able to properly comply with the requirements of ERISA and avoid potential fines and other civil and criminal penalties.

Welfare Plans

Welfare plans under ERISA include most other types of employee benefit plans that are not considered pension plans.[17] These include typical fringe benefit plans adopted by small firms, such as health insurance, long-term disability, group-term life insurance, and accidental death insurance plans. ERISA compliance for welfare plans is usually less of a burden than for pension plans, but is required for almost every business that provides any kind of benefits for employees of the type mentioned above.

A number of so-called fringe benefits related to payroll practices, such as paid holidays, vacation pay, bonuses, or overtime premium pay, are usually not considered to be either pension or welfare plans under ERISA.[18] Thus, these kinds of pay­roll practices are not subject to ERISA at all. The various types of compliance requirements for reporting and disclosure under ERISA are briefly discussed below.

The Department of Labor has ruled that employer contributions to a Health Savings Account (HSA) of an employee will not be subject to ERISA regulations, so long as the HSA was established voluntarily and the employer's involvement in the HSA is minimal, other than making contributions to it. (DOL Field Bulletin 2004-1, April 7, 2004.)

Summary Plan Descriptions

The one ERISA compliance requirement that applies to most small businesses is the requirement for you to prepare a summary plan description (SPD) for distribution to all employees covered by any type of welfare plan you sponsor, such as typical health, accident, life, or disability insurance plans.[19] An SPD must contain more than twenty specific items of information listed in the U.S. Department of Labor Regulations, including an ERISA rights statement, which should be copied more or less verbatim from the regulations.[20]

An SPD must be prepared for each plan and distributed to covered employees within 120 days after the plan is first adopted.[21] Each new employee must be given a copy of the SPD within 90 days after becoming a participant in the plan.[22] Since an SPD must be prepared for each employee plan subject to ERISA, even a very small business may find that it has to produce three or four of these documents, each of which must meet very detailed technical requirements.

PLANNING POINT:
When you take out insurance coverage for employees, get a firm commitment from the insurance company or brokers that they will prepare the necessary SPDs for the insurance plans they sell you. Otherwise, you may need to have your attorney or benefit consultant prepare the SPDs, which can result in substantial professional fees.

Other than the need to prepare SPDs and distribute them to employees, there are no significant ERISA requirements that apply to most insured-type or unfunded employee welfare plans covering fewer than 100 employees.[23] You must, how­ever, make available the insurance policies and other plan documents for inspection by your employees and furnish copies to them upon request.[24]

Additional ERISA Requirements

If your business should grow to have 100 or more employees who are covered by a plan, or if you adopt any type of uninsured funded welfare plan, you will suddenly become subject to a whole array of additional ERISA requirements, including:
  • Providing to the U.S. Department of Labor, upon request within 30 days, a copy of the SPD and, if any, a summary of material modifications to the plan (the filing requirement for both have been repealed after August 5, 1997);[25]
  • Filing an annual return/report or registration (Form 5500 series) with the IRS each year;[26]
  • Preparing and distributing a summary annual report to covered employees each year;[27]
  • Preparing a summary of material modifications of the plan if necessary, and distributing it to covered employees;[28] and
  • Filing a terminal report if the plan is terminated.[29]

A "funded" plan is one where the employer sets aside money in a trust (or similar arrangement) to pay benefits under the plan. If benefits are to be paid by an insurance company, or paid only from the general assets of the employer, as a simple promise to pay by the employer, the plan will generally be considered "unfunded" and thus exempted from most ERISA compliance requirements.

Under the Pension Protection Act of 2006, defined benefit pension plans must now provide additional information in their annual report forms regarding "funding target attainment percentages" of the plan,[29A] but defined benefit plans will no longer be required to provide summary annual reports.[29B] Also, the new Pension Protection Act provisions provide that plans that have fewer than 25 participants will be allowed to file simplified annual reports with the IRS and, where applicable, with the Pension Benefit Guaranty Corporation, for plan years beginning after December 31, 2006. [29C] The new pension law also exempts one-participant plans with assets of $250,000 (previously $100,000) or less from having to file Form 5500-EZ annual reports, for plan years beginning January 1, 2007 or later.[29D]

Bonding and Withholding Requirements

Besides the ERISA reporting and disclosure requirements listed in the summary at the end of this chapter, you should be aware of two other points regarding ERISA: the bonding requirement and withholding requirements on pension or profit-sharing plan distributions. If any of your employees are deemed to handle assets of an employee benefit plan that is subject to ERISA, they must be covered by a fidelity bond.[30] Consult your attorney or benefit consultant to determine if you must cover your employees with a fidelity bond in regard to any benefit plans you maintain for your employees. This is particularly important if you have a pension or profit-sharing plan.

Withholding is mandatory on distributions of pension and profit-sharing plan benefits.[31] However, there is an exception for certain periodic distributions on which the recipient elects, in advance, not to have any tax withheld, or for any other distribution where the recipient elects, for that specific distribution, not to have tax withheld.

In addition to reporting and disclosure requirements under ERISA, there are other federal reporting and recordkeeping requirements for certain types of fringe benefit plans.[32] For example, employers maintaining educational assistance programs, adoption assistance plans, and so-called cafeteria plans have been required to file annual report forms (Form 5500 series) with the IRS and, if needed, to maintain records to show that those plans qualified for tax purposes for each year after 1984. However, the IRS has temporarily suspended the filing requirement for those plans since 2002.[33]

ERISA Pre-emption of State Laws

As complex and difficult to comprehend as the ERISA statute is, it is one area of the labor law where you do not generally have to be concerned with differing state and federal laws. That is because ERISA broadly pre-empts any state laws that would attempt to regulate employee benefit plans, thus eliminating one source of complexity, and creating a great deal of uniformity, nationwide -- for which employers can be thankful. A number of state laws that attempted to regulate or tax employee benefit plans have been voided in recent years, under the ERISA pre-emption provisions.

6.5 Employee Safety and Health Regulations

In addition to state laws in every state but Texas that require employers to carry workers' compensation insurance for the protection of employees, comprehensive and far-reaching federal laws set safety standards designed to prevent injuries arising from unsafe or unhealthy working conditions. The primary federal law regulating job safety, the Occupational Safety and Health Act of 1970 (OSHA), imposes several reporting and record-keeping obligations for employers.

Federal OSHA

Most small business owners tend to groan and say "Oh shhhh....ucks!" when they receive an unexpected surprise visit from "OSHA," the acronym for the much-feared federal Occupational Safety and Health Administration. That is because OSHA and its state counterparts in 22 states and territories are the government agencies that enforce the thousands of pages of complex job safety and health regulations in the private sector workplace and because many small employers find it costly and difficult to stay abreast of this multitude of safety rules and procedures they must adopt and observe under OSHA. Nearly half of the states have their own OSHA-type agencies that enforce OSHA safety and health standards at private workplaces in such states; the remaining states and the District of Columbia rely instead on the federal OSHA agency for enforcement.

Over the years, OSHA has issued reams of regulations and standards for workplace safety. If you have employees, you will need to consult an attorney, preferably one with OSHA expertise, to determine what, if any, steps you must take to comply with federal and state safety standards at your place of business.

Otherwise, you may be subject to fines and other legal sanctions if any employee is injured on the job or OSHA inspectors find that you are not in compliance with applicable safety standards at your place of business.

OSHA has recently begun sending out mandatory employer surveys to help target high-risk employers for inspections.

You can contact the nearest regional U.S. Department of Labor­/OSHA office to request information on any free consultative services or publications the office may have available. State occupational safety and health agencies provide confidential, on-site consultations for no charge. These consultations point out state compliance issues at your place of business without fining or penalizing you for any discovered violations. You may also request a federal OSHA consultation, but you will be cited for any violations that are found.

Notice to Employees

One of the first OSHA requirements is that you post a permanent notice to employees regarding job safety.[34]

Recordkeeping Requirements

Next, under OSHA, you are required to keep a log of industrial injuries and illnesses.[35] You can use records maintained under an approved state OSHA plan to satisfy this federal requirement. The information in the log must also be summarized and posted prominently in your workplace[36] from February 1 to April 30.[37] This requirement has been eliminated for most retail, financial, insurance, real estate, and service firms,[38] but not for businesses that sell building materials, garden supplies, general merchandise, or food, or for hotels and other lodging places, repair, amusement, and recreation services, and health services. Form 300 is the OSHA form used to log workplace injuries.[39] For a detailed list of exempt industries, see the OSHA website, at http://www.osha.gov/recordkeeping/ppt1/RK1exempttable.html.

You must also prepare a supplementary federal Form 301 or any approved state form within 7 days after a recordable injury or illness occurs.[40] You don't need to file them with the government, but you do need to keep them available for inspection for five years.[41] In addition, special recordkeeping requirements generally apply if your employees are exposed to toxic substances, asbestos, radiation, or carcinogens on the job.

You can obtain more detailed information on OSHA recordkeeping requirements by calling the nearest OSHA office -- usually listed in the phone book under U.S. Government, Department of Labor, and asking for the booklet entitled, Recordkeeping Requirements for Occupational Injuries and Illnesses.

Small Employer Exemption from Recordkeeping

OSHA exempts any employer with ten or fewer employees from most of its reporting and recordkeeping requirements; however, these small employers are not exempt from reporting job-related fatalities and multiple injuries.[42]

Reporting Requirements

The Bureau of Labor Statistics may nevertheless require certain selected employers, including small employers, to report certain summary information on job-related injuries and illnesses annually on an occupational injuries and illness survey form, [43] and OSHA may send you an annual survey form in some cases, even if you have ten or fewer employees.

In the event of a fatality or an accident resulting in the hospitalization of three or more employees, you must notify the area OSHA director within eight hours, describing the circumstances of the accident, the extent of any injuries, the number of fatalities, and other information.[44] If the OSHA area office is closed, you should report using the 800 number (1-800-321-OSHA, or 1-800-321-6742). There are serious penalties in the event you fail to give notice as required.

OSHA Hazard Assessment Regulations

For years, OSHA regulations have spelled out a number of requirements regarding the use of personal protective equipment ("PPE") by their employees. PPE includes such equipment as safety helmets, special safety goggles, gloves, protective face shields, and other such items that must be worn by employees for their own protection against physical hazards they might encounter on the job. These regulations apply primarily to indus­trial workers, but not exclusively so, since many workers in, for example, wholesale and retail firms, may also be exposed to danger when working on loading docks, in warehouses, and similar situations where special protective gear (such as safety shoes) is needed to prevent injuries. [45]

In 1994, OSHA updated existing standards regarding protection of a worker's head, eyes, face, and feet and expanded coverage to include hand protection. In addition, PPE purchased after July 5, 1994 must meet standards for safety equipment that have been adopted by the independent American National Standards Institute ("ANSI") that were incorporated into the OSHA regulations.

However, the main new thrust of the PPE regulations is to require all employers to perform their own hazards assessment. Employers must identify hazards that would necessitate the use of personal protective equipment by their workers, and then:

  • Select, and have each affected employee use, the types of PPE that will protect them from the hazards identified in the hazard assessment;
  • Communicate the selection decisions to each affected employee; and
  • Select protective gear that properly fits each affected employee.

The regulation also requires that an employer verify that the workplace hazard assessment has been performed through a written certification that identifies:

  • The workplace that was evaluated;
  • The person certifying that the evaluation has been performed; and
  • The date of the hazard assessment.

In addition, the certification document must specifically be identified as a certification of hazard assessment, and it must be available for OSHA inspectors. Employers must also train employees as to the proper use of the protective gear and put the training requirements in certified (written) form. This involves teaching each affected employee when PPE is necessary; what type of PPE is needed; how to don, doff, adjust, and wear PPE; the limitations of the gear; and the proper care, maintenance, useful life and disposal of the PPE.

Employers, take heed. As with most OSHA regulations, this one has teeth -- employers who fail to comply with these regulations can be fined up to $70,000 for each willful violation, so these are not rules any employer can simply shrug off, or "put on the back burner."

For more information, consult your attorney or your local OSHA office or state OSHA equivalent in [STATE NAME]. You may also contact the OSHA general office at:

OSHA General Industry Compliance Assistance Office
(202) 219-8031

You can also send for a free copy of the personal protective equipment rules (a reprint of the regulation, with official commentary, as printed in the Federal Register), by calling or faxing:

OSHA Publications Office
(202) 219-4667
(202) 219-9266 (fax)

OSHA's website contains useful information and publications, including a search feature and contact information by state:

OSHA Website
www.osha.gov
www.osha.gov/fso/osp/index.html (state directory)

[STATE NAME] Safety and Health Regulations

Employers in [STATE NAME] must comply with state and federal job safety laws designed to prevent injuries resulting from unsafe or unhealthy conditions in the workplace.

[DISCUSSION OF STATE-SPECIFIC WORKPLACE SAFETY LAWS DELETED HERE.]

6.6 Employee Wage-Hour and Child Labor Laws - Federal and [STATE NAME]

Not all businesses nor all employees of a given business are covered by federal and state wage-hour and child labor laws. The coverage of these laws is a crazy quilt patchwork of exceptions and exceptions to exceptions. Thus, there is no simple way to tell you whether your business will be subject to one or more of the federal and state laws relating to minimum wage, overtime pay, and child labor, or, if it is, which employees are covered and which are not.

Below is a description of the major federal and [STATE NAME] laws. To find out which of these laws, if any, apply to your business, contact your attorney or the local wage-hour office. However, it is a rather rare situation when the federal wage-hour and child labor laws do NOT apply, so, unless otherwise advised, you should generally assume that all of the laws discussed in this section will apply to some or all of the people you may hire as employees in your business.

The Federal Fair Labor Standards Act (FLSA) includes a number of requirements regarding compensation of employees covered under the act. There are three major requirements you need to know about -- the minimum wage and overtime pay requirements and child labor law restrictions on working conditions and hours that children may work.

While the FLSA, by its terms, applies only to certain fairly large employers with $500,000 or more of annual gross sales or to employees who are considered to be "engaged in interstate commerce," as a practical matter it applies to even the smallest employers, since almost any employee who is a human being that draws breath is considered to be engaged in activities that affects interstate commerce in some way and thus is covered by the FLSA requirements.

Minimum Wage Requirement

The minimum wage provisions of the FLSA set an hourly minimum wage that you must pay to an employee. The federal minimum wage has recently been increased, effective July 24, 2007, from $5.15 to $5.85 an hour and to $6.55 an hour on July 24, 2008. It increased again to $7.25 an hour on July 24, 2009, where it remains in 2013. An employer may pay new employees under age 20 at a reduced rate of $4.25 an hour for the first 90 days of employment.[46]

Congress increases the minimum wage from time to time, so check with an attorney or with the Department of Labor for the current minimum wage before setting new wage levels.

Certain states provide for a minimum wage in excess of the federal requirement while other states have a minimum wage rate that is the same as the federal standard. Only Georgia, Arkansas, Minnesota, and Wyoming have a state minimum wage that is lower than the federal minimum wage. Exemptions vary from state to state.

Several states have no state minimum wage law. Florida and Arizona also had no state minimum wage laws until recently, but voters in those states enacted minimum wage laws, effective on May 2, 2005 in Florida and January 1, 2007 in Arizona, each of which was initially higher than the federal minimum wage and is indexed for inflation on each subsequent January 1. States that still have no minimum wage law are:

  • Alabama
  • Louisiana
  • Mississippi
  • South Carolina
  • Tennessee

Although there is no state minimum wage requirement in any of the above states, most businesses with employees in any of those states will still be subject to the federal minimum wage law.

Overtime Pay Requirement

The overtime pay requirement rule states you must pay a covered employee at one and one-half times the employee's regular hourly rate for any hours worked in excess of 40 in a week.[47] The regular hourly rate can­not be less than the minimum wage. For the overtime pay requirement, the FLSA takes a single workweek as its measuring period and does not permit averaging of hours over two or more weeks. For example, if an employee works 20 hours one week and 50 hours during the next, he or she must receive overtime compensation (time and one-half) for the 10 overtime hours worked in the second week, even though the average number of hours worked during each of the two weeks is only 35 hours per week.

Note that the FLSA only requires overtime pay based on the number of hours worked during a week and not just for working long hours on a particular day, unlike some state laws, such as in California, Alaska, and Nevada.

The above rules generally apply to salaried workers as well as to those paid on an hourly basis. To determine the regular hourly rate for a salaried employee, it is necessary to divide the employee's weekly salary by the number of hours in his or her regular workweek (40 or less).

U.S. Department of Labor regulations require that all workers earning under $455 a week ($23,660 a year) must be paid time-and-a-half for overtime hours worked. Workers who earn more may also be entitled to overtime premium pay, or may be exempt from such requirements, as discussed in the following paragraphs.

Employee Exemptions

Executives, administrators, professionals, and outside salespeople are generally not covered by federal wage-hour laws and thus are not entitled by law to a minimum wage or to any pay for overtime hours worked, if they earn at least $455 a week. A 1996 law has also exempted certain skilled computer workers, including systems analysts, programmers, and software engineers. [48] The theory behind these exemptions is apparently the view that these types of employees are independent and sophisticated enough to take care of themselves and do not need to be protected by the government from possible exploitation by their employers.

Revised Department of Labor overtime pay regulations, which became effective in 2004, [49] have attempted to draw clearer lines between covered employees and exempt employees for purposes of determining who must be paid time-and-a-half for overtime, but the new regulations are also quite complex. These exemption provisions can be summarized as follows:

Executive Exemption

To qualify for the executive employee exemption, all of the following tests must be met:

  • The employee must be compensated on a salary basis (as defined in the regulations) at a rate not less than $455 per week;
  • The employee's primary duty must be managing the enterprise, or managing a customarily recognized department or subdivision of the enterprise;
  • The employee must customarily and regularly direct the work of at least two or more other full-time employees or their equivalent; and
  • The employee must have the authority to hire or fire other employees, or the employee's suggestions and recommendations as to the hiring, firing, advancement, promotion or any other change of status of other employees must be given particular weight.

Administrative Exemption

To qualify for the administrative employee exemption, all of the following tests must be met:

  • The employee must be compensated on a salary or fee basis (as defined in the regulations) at a rate not less than $455 per week;
  • The employee's primary duty must be the performance of office or non-manual work directly related to the management or general business operations of the employer or the employer's customers; and
  • The employee's primary duty includes the exercise of discretion and independent judgment with respect to matters of significance.

Professional Exemption

To qualify for the learned professional employee exemption, all of the following tests must be met:

  • The employee must be compensated on a salary or fee basis (as defined in the regulations) at a rate not less than $455 per week;
  • The employee's primary duty must be the performance of work requiring advanced knowledge, defined as work which is predominantly intellectual in character and which includes work requiring the consistent exercise of discretion and judgment;
  • The advanced knowledge must be in a field of science or learning; and
  • The advanced knowledge must be customarily acquired by a prolonged course of specialized intellectual instruction.

To qualify for the creative professional employee exemption, all of the following tests must be met:

  • The employee must be compensated on a salary or fee basis (as defined in the regulations) at a rate not less than $455 per week;
  • The employee's primary duty must be the performance of work requiring invention, imagination, originality or talent in a recognized field of artistic or creative endeavor.

Computer Employee Exemption

To qualify for the computer employee exemption, the following tests must be met:

  • The employee must be compensated either on a salary or fee basis (as defined in the regulations) at a rate not less than $455 per week or, if compensated on an hourly basis, at a rate not less than $27.63 an hour;
  • The employee must be employed as a computer systems analyst, computer programmer, software engineer or other similarly skilled worker in the computer field performing the duties described below;
  • The employee's primary duty must consist of:
    • The application of systems analysis techniques and procedures, including consulting with users, to determine hardware, software or system functional specifications;
    • The design, development, documentation, analysis, creation, testing or modification of computer systems or programs, including prototypes, based on and related to user or system design specifications;
    • The design, documentation, testing, creation or modification of computer programs related to machine operating systems; or
    • A combination of the aforementioned duties, the performance of which requires the same level of skills.

Outside Sales Exemption

To qualify for the outside sales employee exemption, all of the following tests must be met:

  • The employee's primary duty must be making sales (as defined in the FLSA), or obtaining orders or contracts for services or for the use of facilities for which a consideration will be paid by the client or customer; and
  • The employee must be customarily and regularly engaged away from the employer's place or places of business.

Highly Compensated Employees

Highly compensated employees performing office or non-manual work and paid total annual compensation of $100,000 or more (which must include at least $455 per week paid on a salary or fee basis) are exempt from the FLSA if they customarily and regularly perform at least one of the duties of an exempt executive, administrative or professional employee identified in the standard tests for exemption.

Blue Collar Workers

The exemptions provided apply only to "white collar" employees who meet the salary and duties tests set forth in the regulations. The exemptions do not apply to manual laborers or other "blue collar" workers who perform work involving repetitive operations with their hands, physical skill and energy. FLSA-covered, non-management employees in production, maintenance, construction and similar occupations such as carpenters, electricians, mechanics, plumbers, iron workers, craftsmen, operating engineers, longshoremen, construction workers and laborers are entitled to minimum wage and overtime premium pay under the FLSA, and are not exempt under the DOL regulations no matter how highly paid they might be.

Covered Employees and Businesses

The coverage of the federal wage-hour laws, as interpreted by the Department of Labor and the courts, is very broad. Employees who are considered to be engaged in interstate "commerce," except for exempted classes of employees such as executives and administrators, will be subject to the minimum wage and overtime requirements, even if employed by the smallest of firms and, in many cases, even if engaged in what you might consider to be purely local activities.

Thus, in most cases, all of your employees except the exempted classes are subject to the federal wage-hour laws, although it is possible that some will be covered and others will not. In rare cases, none of your employees will be covered.

The legal niceties of whether a particular employee is engaged in work that affects interstate commerce are, unfortunately, too technical to explain here in a meaningful way. The language of the law is generally interpreted such that if your firm does a half million or more in sales a year, then all but the exempted classes of employees are covered by the wage-hour laws, even if only one or a few employees actually engage in interstate commerce.[50] The courts have tended to bend over back­wards in wage-hour cases to find that an employee or firm is engaged in activities that affect interstate commerce and thus are covered by the FLSA wage-hour laws.

Even if it is determined that your employees are not engaged in interstate commerce and they are not subject to the FLSA wage-hour rules, state wage-hour laws may apply. State requirements may be more stringent than federal laws and may apply to small employers or employees who are not covered by the federal FLSA.

Numerous other exemptions from the wage-hour laws are based on the type of business, the nature of the work performed by the employee, where the work is done, and other factors.[51] Before you assume your employees are covered by the FLSA, consult your attorney, or at least call the local wage-hour office and ask for an informal and nonbinding opinion over the phone.

Detailed Records Required

Possibly the most important thing you should be aware of if you have employees subject to FLSA standards is the need to keep detailed records of hours worked, the type of work, and wages or salary paid.

Under the law, if an employee files a claim against you for alleged failure to pay required wages in the past, you will need to produce proof that you met the statutory requirements. Keeping detailed pay and work records for each employee is the only way to protect yourself against such claims for back pay. In addition, the FLSA requires employers to preserve these records for up to three years.

Poster Requirement

If you have employees whose wages, hours, and working conditions are subject to FLSA regulations, you will need to post the official wage-hour poster that is provided by the U.S. Department of Labor.

[STATE NAME] Wage-Hour Laws

[DISCUSSION OF STATE-SPECIFIC MINIMUM WAGE AND OVERTIME LAWS DELETED HERE.]

Child Labor Laws

Both the FLSA and various state laws regulate or prohibit the employment of children in businesses, with very few exceptions. If you intend to hire children to work in your business -- other than hiring your own children, which is usually permitted, except in hazardous situations -- you need to be aware of the following basic child labor law provisions, starting with the FLSA requirements.

Under the FLSA federal child labor laws, all children under the age of 18 are excluded from working in certain occupations that are designated as hazardous by the Secretary of Labor.[52] Children under 16 years of age cannot be hired under any of the following circumstances, according to a Labor Department regulation: [53]

  • To work in any workplace where mining, manufacturing, or processing operations take place;
  • To operate power machinery, other than office equipment;
  • To operate or serve as a helper on motor vehicles;
  • To work in public messenger services; or
  • To work in transportation, warehousing or storage, communications or public utilities, or construction -- except in sales or office work.
UPDATE NOTE:
The U.S. Department of Labor modified the above regulation, effective July 19, 2010, expanding upon the foregoing list of hazardous activities for children under the age of 16. The new restrictions prohibit outside window washing that involves working from window sills and all types of work requiring the use of ladders or scaffolds. Also newly prohibited are most types of work in connection with preparation of meats for sale, including work in coolers or meat lockers, and the revised regulation adds a broad new prohibition on "youth peddling" where such peddling (or supporting activities) are conducted away from the employer's establishment. Children under 16 also may not wear costumes, hold, wear, or wave signs or placards in order to attract potential customers, unless done inside of, or directly in front of, the employer's business establishment.

Children 14 or 15 years of age can be hired in occupations other than those listed above, but there are numerous limitations on the hours and times when they may work, particularly when schools are in session. In general, they may only work outside school hours, a maximum of 3 hours a day or 18 hours a week when school is in session; or, on a non-school, day 8 hours a day; in a non-school week, 40 hours. They may not work before 7:00 a.m. or 7:00 p.m., except that from June 1 through Labor Day they may work as late as 9:00 p.m.

A few occupations, such as delivering newspapers and doing theatrical work, are exempt from the federal child labor laws, even for children under 14 years of age.[54]

Provisions effective after October 31, 1998 prohibit the employment of a child under the age of 17 to drive a truck or an automobile and only allows 17-year-olds to drive if all of the following conditions are met:

  • Driving is restricted to daylight hours;
  • The minor holds a state license valid for the type of driving involved in the job performed and has no moving violations at the time of hire;
  • The employee has completed a state-approved driver education course;
  • The car or truck driven does not exceed 6,000 pounds gross weight and is equipped with seat belts;
  • The driving does not involve carrying goods or carrying more than three passengers at a time, route distribution or route sales, towing of vehicles, or urgent, time-sensitive deliveries;
  • The driving takes place within a 30 mile radius of the minor's place of employment; and
  • The driving is only occasional and incidental to the employee's job, as specified in very great detail by the law.[54A]

Note that the federal child labor law regulations require employers to keep a record of the date of birth of any employee who is younger than 19 years of age.

Most states also strictly regulate the employment of children. Thus, if you intend to employ children under 18 years of age in a business, you will probably need legal guidance as to the conditions under which they may work, if at all, under federal and state child labor laws, and may need to contact your state labor agency or local superintendent of schools to obtain a state child labor work permit for any children to be hired. The following segment provides a brief summary of child labor law restrictions currently in effect in [STATE NAME].

[STATE NAME] Child Labor Laws

In addition to wage-hour laws, most businesses are subject to federal child labor laws, which put numerous restrictions on the working hours and kinds of work in which minors under the age of 18 may engage. Your business must also be cognizant of similar state child labor laws, in [STATE NAME].

[DISCUSSION OF STATE-SPECIFIC CHILD LABOR LAWS REGARDING MAXIMUM HOURS, CHILD LABOR PERMITS, BREAKS, AND OTHER WORKING CONDITIONS, DELETED HERE]

6.7 Fair Employment Practices - Federal and [STATE NAME] Laws

As an employer, you will also need to be alert to your obligations under a number of federal and state laws that prohibit discrimination in employment on the basis of sex, age, race, color, national origin, religion, or on account of mental or physical disabilities. The District of Columbia and the following states also prohibit discrimination based on sexual orientation or sexual preference:

  • California
  • Colorado
  • Connecticut
  • Delaware
  • Hawaii
  • Illinois
  • Iowa
  • Maine
  • Maryland
  • Massachusetts
  • Minnesota
  • Nevada
  • New Hampshire
  • New Jersey
  • New Mexico
  • New York
  • Oregon
  • Rhode Island
  • Vermont
  • Washington
  • Wisconsin

These anti-discrimination laws are not just limited to hiring practices -- but relate to almost every aspect of the relationship between an employer and employee, including compensation, promotions, type of work assigned, and working conditions. In addition to outlawing discrimination in employment, companies contracting for business with the federal government may, in some instances, be required to adopt affirmative action programs in the employment of minorities, women, people with disabilities, and veterans.

Federal Anti-Discrimination Laws

If your small business employs fewer than 15 employees and does not work on government contracts or subcontracts, the federal anti-discrimination laws listed below will generally not apply to you. The exceptions are the Equal Pay Act of 1963, which requires equal pay for equal work for women and men and the Veterans Reemployment Act of 1994. The Equal Pay Act applies to employers with two or more employees and the Veterans Reemployment Act applies to all employers, of any size.

Employers violating any of the laws below may be sued by either the complaining individuals, by various government enforcement agencies, or both.

Employers violating any of the laws listed below may be sued by either the complaining individuals, by various government enforcement agencies, or both, unless the employer is exempted under one of the various small employer exemptions noted in the table below. The following table summarizes the main federal anti-discrimination laws, as they apply to employers:

[WORKSHEET TABLE DELETED HERE]

UPDATE NOTE:
Title II of the Genetic Information Nondiscrimination Act of 2008 (GINA), which prohibits genetic information discrimination in employment, took effect on November 21, 2009. Under Title II of GINA, it is illegal to discriminate against employees or applicants because of genetic information. Title II of GINA prohibits the use of genetic information in making employment decisions, restricts acquisition of genetic information by employers and other entities covered by Title II, and strictly limits the disclosure of genetic information.

Genetic information includes information about an individual’s genetic tests and the genetic tests of an individual’s family members, as well as information about any disease, disorder, or condition of an individual’s family members (i.e. an individual’s family medical history). Family medical history is included in the definition of genetic information because it is often used to determine whether someone has an increased risk of getting a disease, disorder, or condition in the future.

CAUTION:
Employers should tell health care providers who conduct post-offer, pre-hire medical exams to be careful not to disclose to the employer the results of any family medical history or other genetic information regarding the job applicant.

Veterans Reemployment Rights Act

The Veterans Reemployment Rights Act, which went into effect in October 1994, prohibits employment discrimination against any person who serves in or applies to serve in the uniformed military services.

The law also requires you, in most cases, to reemploy anyone who leaves your employ to serve in the military, unless they are absent on account of military service for more than five years. In many cases, you are not only required to rehire returning reservists and veterans, but also to reinstate them at the job level, pay status, and seniority they would have attained if they had remained in your employ.

In addition, you may also be responsible for having to offer job training or retraining to the returning reservist and to make reasonable efforts for two years to accommodate the returning former employee who has been disabled as a result of military service.

Also, an employer must continue a reservist's health insurance during deployments of less than 31 days and give the reservist the option to continue coverage at his or her own cost for up to 24 months.[56]

For a more detailed discussion of reemployment rights of veterans and members of the uniformed services, see Section 6.15.

Formal Compliance Requirements

Small businesses are not required to do great amounts of paperwork or filling out of forms when it comes to federal anti-discrimination laws. An employer with 100 or more employees, however, must file Form EEO-1 with the Equal Employment Opportunity Commission (EEOC) each year.[57]

As an employer, you are required to keep detailed records (and should do so, for your own protection) as to the reasons for hiring or not hiring, promoting or not promoting, any employee or job applicant. In the event it is ever necessary to demonstrate that your firm has not discriminated against any group or individual member of a group in violation of federal laws, these records will provide the needed documentation.

Besides the requirements already mentioned, you may need to post a number of official posters in your place of business. The table below describes which posters meet EEOC requirements. To obtain these posters, contact each of the appropriate federal agencies and request a copy of their required poster.

[WORKSHEET LISTING REQUIRED EEOC POSTERS DELETED HERE]

Sexual Harassment Is Also Discrimination

You also need to be keenly aware of your potential liability for sexual harassment in the workplace, another increasingly significant area of the anti-discrimination laws under Title VII of the Civil Rights Act. While the federal Civil Rights Act does not specifically refer to sexual harassment as a form of discrimination, the courts and the EEOC have long accepted it as such, as do a number of states' laws.

There are two types of sexual harassment under Title VII, as it has been interpreted over the years:

  • One type of sexual harassment is where tangible job benefits are granted or withheld based on an employee's receptiveness to unwelcome requests or conduct. For example, a male supervisor tells a female employee to meet him in the hot tub of his mountain chalet on a Saturday afternoon to discuss a business contract. She refuses to meet him at his place and later receives a bad rating from him for a "poor attitude and unwillingness to work overtime," which costs her a raise or promotion. The female employee in such a case has been denied a tangible job benefit due to sexual harassment.
  • The second type of sexual harassment involves a hostile work environment -- that is, a situation in which the work environment is oppressive and hostile to members of one sex. This occurs when the harassment either unreasonably interferes with the individual's work performance or creates an intimidating, hostile, or offensive environment. This type of harassment may not have any economic effects on the individual, and management or supervisory personnel may not be involved. Nevertheless, an employer who allows a hostile environment to persist may still be liable, especially if the employer was aware of the harassment by co-workers -- or even by customers -- and failed to take appropriate actions to remedy the situation.

Merely having a company policy that prohibits sexual harassment at your company won't automatically stop the behavior or protect the firm from liability if harassment occurs. But the absence of a sexual harassment policy tends to strengthen an employee's claim against you if your firm is sued for allowing sexual harassment to occur. Adopt a sexual harassment policy that not only prohibits such conduct, but that also sets up a grievance mechanism for employees who are victims of any harassment, and communicate this company policy strongly and clearly to your employees.

For guidance, go to the EEOC website to request a copy of the June 21, 1999 EEOC guidelines for employers on vicarious employer liability for sexual harassment by supervisory employees, or the shorter summary geared to small employers.

EEOC Website
www.eeoc.gov

In addition to federal civil rights case law, the statutes of many states, or the regulations of many state civil rights commissions, now specifically prohibit sexual harassment in the workplace. Some of these laws go well beyond the protections afforded under federal law. For information about anti-discrimination laws in [STATE NAME], refer to [LINK DELETED] of the state chapter [NOT INCLUDED IN THIS "NATIONAL" EDITION] or the last part of this Section 6.7.

Federal Age Discrimination Law Expanded

The definition of age discrimination has been expanded and clarified by a 1996 decision of the U.S Supreme Court. The age discrimination law specifically protects all workers at least 40 years of age. But in the unanimous decision, the court ruled that the relative ages of employees are what must be considered, not whether or not both are members of the protected class.

Until this Supreme Court decision, many employers had felt safe dismissing an over-40 employee if they replaced him or her with another over-40 employee. But now, firing a 56-year-old and replacing that worker with a 40-year-old is considered age discrimination, even though both workers are within the protected class of older workers. By the same token, the decision suggests that replacing a 40-year-old (protected) with a 38-year-old (non-protected) may not necessarily be considered age discrimination, where there is such a minor age difference.

More recently, in 2005, another U.S. Supreme Court decision (Smith v. City of Jackson, Mississippi, et al, No. 03-1160, March 30, 2005) further expanded the reach of the age discrimination law, by holding that employers can be held liable for actions that have a disproportionately unfavorable effect on older workers than on younger workers, even where no actual intent to discriminate can be shown. This could mean, for instance, that an action like converting a defined benefit pension plan to a 401K type of defined contribution plan, which would have more of a negative impact on older workers, or doing layoffs that disproportionately affected older workers, might be the basis for an age discrimination lawsuit by the over-40 employees. A statistical inference could be drawn to establish that there has been illegal age discrimination, even where there is no proof whatsoever of such an intention.

[STATE NAME] Anti-Discrimination Laws

State laws in some states may be more restrictive than federal law with regard to discrimination, and may apply to smaller businesses that are exempted under the federal civil rights laws, so you must comply with whichever standards are more prohibitive.

In addition to compliance with federal anti-discrimination laws, employers must also be aware of and comply with state civil rights laws in [STATE NAME], and [DISCUSSION OF STATE-SPECIFIC ANTI-DISCRIMINATION LAWS AND LINKS TO CONTACT INFORMATION FOR STATE CIVIL RIGHTS AGENCY DELETED HERE]

6.8 Immigration Law Restrictions on Hiring

The Immigration Reform and Control Act of 1986 introduced major new governmental requirements regarding the relationship between an employer and employee.[60] Under this law, you are prohibited from hiring illegal aliens, and depending on the number of any prior violations, you are subject to fines of $250 to $20,000 for each illegal alien hired after November 6, 1986. At the same time, the act makes compliance a tricky balancing act for the employer, since it also prohibits employment discrimination on the basis of citizenship status and national origin; you may not fire or fail to hire anyone on the basis of foreign appearance, language, or name.

When hiring employees, you are required to verify their eligibility for employment within three business days of each new hire. As an employer, you will need to fill out and retain Form I-9. The employee fills out the top portion of the form, indicating whether he or she is a citizen or national of the United States; an alien lawfully admitted for permanent residence; or an alien authorized by the U.S. Citizenship and Immigration Service (USCIS) to work in the United States. (Note: The USCIS was formerly known, until recently, as the U.S. Immigration and Naturalization Service (INS), so you may not recognize the name of this federal agency.)

On the back portion of Form I-9, there are three separate lists of identification and employment eligibility documents the employee must provide for you. In Section 2 of the form, you must record the documents you have examined, such as a passport or certificate of naturalization. These papers must include either one document in List A or one each in lists B and C. Both you and the employee must sign the form under penalty of perjury, and you must retain the completed form and make it available if the USCIS or U.S. Department of Labor requests it during an inspection.

Obtain copies of Form I-9 and a related "Employer's Handbook" from the nearest office of the U.S. Citizenship and Immigration Service.

For more information on employer responsibilities, call the USCIS toll-free at 1-800/375-5283.

U.S. Citizenship and Immigration Service
(800) 375-5283 (Nationwide)


USCIS Website
www.uscis.gov

The U.S. Department of Justice also has a hotline number you can call to hear prerecorded taped messages regarding the type of documents you can request to establish identity and work eligibility. The messages also offer tips on how to avoid discrimination when completing Form I-9. To hear these messages, call:

Office of Special Counsel for Immigration-Related Unfair Employment Practices (OSC)
U.S. Department of Justice Employer Hotline
(800) 255-8155 (Nationwide)

HOW TO CHECK FOR BOGUS SOCIAL SECURITY NUMBERS

It is common for illegal aliens to submit a false Social Security Number (SSN) when applying for a job in the U.S. Indeed, in some cases there have been thousands of individuals who obtained phony I.D. documents from the same place, all of which included the same fake SSN!

To help prevent that kind of fraud, the Social Security Administration has now made it easy for employers to verify that the SSN and the name submitted by an employee match up with Social Security records. Using the Internet, you can verify a new or prospective employee's SSN on the Social Security Administration website, if you go to the following link:

Social Security Website -- SSN Verification
www.socialsecurity.gov/employer/ssnv.htm

In addition to the above site, the Department of Homeland Security and the Social Security Administration are developing the "E-Verify" program and web site. A new Photo Screening Tool biometric feature will allow an employer to check the photo on his or her new hire's Employment Authorization Document (EAD) or Permanent Resident Card ("Green Card") against the millions of images stored in DHS immigration databases, to verify that a job applicant is who he or she claims to be.

UPDATE NOTE:
The continued existence of above verification sites is uncertain, as national policies on immigration are changing rapidly, so that much of the above information may be out of date by the time you read this.

For now, however, four states, Louisiana, Georgia, Tennessee and South Carolina, began requiring employers, starting in 2012, to use E-Verify to determine eligibility of new employees to work in the United States. On the other hand, a new California law, also effective in 2012, prohibits state or local government agencies in that state from requiring employers to use E-Verify.

State Restrictions on Hiring Illegal Immigrants

A number of states also impose various types of penalties on employers who hire employees who are not legally authorized to work in the United States. These range from fines to loss of business licenses to denial of tax deductions for wages paid to such individuals. States currently imposing such restrictions include:

  • Arizona
  • Colorado
  • Florida
  • Georgia
  • Maine
  • Massachusetts
  • Missouri
  • Montana
  • Nevada
  • Oklahoma
  • South Carolina
  • Tennessee
  • Vermont

6.9 Restrictions on Layoffs of Employees - Federal and [STATE NAME]

Federal law and some state laws require most large employers to notify various government agencies in the event the employer lays off specified large numbers of employees in a short period of time -- a so-called "mass layoff." Some state laws impose other requirements, such as posting notices in the workplace (Wisconsin), paying severance pay (Maine), or making payments of back pay where the notice of mass layoffs is not given on a timely basis (Wisconsin).

Federal W.A.R.N. Act Mass Layoff Notification Requirements

If your business grows to where you have 100 or more full-time employees (or the equivalent, based on 40-hour workweeks) at a single location, you may be subject to the provisions of the plant closing law called the Worker Adjustment and Retraining Notification Act, or WARN Act.[61] This act affects you if you lay off 50 or more employees, or one-third of the workforce, in a 30-day period. It applies to virtually any plant closing or major layoff for any reason, with a few obvious exceptions, such as due to an earthquake or flood, or due to a labor dispute, such as a strike or lockout, for which no notice need be given. A "layoff" under this act includes any of the following:

  • A permanent termination of employment;
  • A layoff of an employee for more than six months; or
  • A loss of half the employees' working hours for six consecutive months.

In case of any major layoff or shutdown, the law requires you to give at least 60 days advance notice. If you give less than that, you are required to pay the laid-off workers for 60 days minus the actual number of days' notice you gave. The law requires you to notify the labor union that represents the employees, or, if none, the individual employees by mailing the notice to their last known address or including it in their pay envelope. You must also notify the local city or county government and state labor agency of the planned shutdown or cutback, whichever agency is designated by the state to respond to such situations. If no such government agency or unit has been designated, notice must be given to the local government unit to which you pay the largest amount of taxes. (Your business is worth more to them alive than dead, for obvious reasons.)

The WARN Act generally does not prohibit a company from making layoffs or shutting down a money-losing plant, but it makes it more costly for the employer to do so, and also gives local unions and politicians time to find some way to attempt to keep a company from discontinuing or downsizing its operations.

State Mass Layoff Notification and/or Related Requirements

Several states impose notification requirements that are somewhat similar to the federal W.A.R.N. Act requirements and some such states also impose other requirements in the event of mass layoffs by an employer. States that impose various requirements in connection with mass layoffs include Georgia, Hawaii, Illinois, Maine, Maryland, New Hampshire, New Jersey, Ohio, Tennessee, and Wisconsin. See [LINK DELETES] of the state laws chapter for any of those states for more information on reporting and any other requirements in the event of mass layoffs.

6.10 The Americans with Disabilities Act

In 1990, Congress enacted the Americans with Disabilities Act (ADA), which is designed to make both the workplace and most public facilities much more accessible to disabled individuals.

The ADA and related regulations are having a significant impact on a great many businesses, both in terms of employment practices and in terms of removing architectural barriers and other physical features that have limiting effects on the lives of disabled persons.[62]

Anti-Discrimination Rules for People with Disabilities

Title I of the ADA prohibits discrimination against any "qualified individual with a disability" in all aspects of employment, including hiring and discharging of workers, compensation, and benefits. Employers are also prohibited from discriminating against any individual based on the individual's "association" with another person or persons with a disability (such as refusing to hire someone because their spouse is an invalid with some type of severe disability).

Title I applies to employers who employ 15 or more employees during 20 weeks of any calendar year. In addition, you must reasonably accommodate employees' or applicants' disabilities, which may mean modifying facilities, restructuring work schedules, or transferring disabled workers to vacant positions for which they are qualified, in appropriate circumstances. You are not required to accommodate a disabled worker, however, if doing so would impose an "undue hardship" on your business.

Employers considering job applicants are placed in a very difficult position, and must be extremely careful not to ask improper questions regarding a disability of a job applicant. Asking the wrong question can lead to a lawsuit against you for discrimination under the ADA. The set of guidelines listed below regarding questions you may or may not ask has been provided by the Equal Employment Opportunity Commission (EEOC).

[WORKSHEET LINK DELETED HERE]

UPDATE: You should no longer ask even the "safe" version of the last question, about alcohol usage, since an applicant may be a recovering alcoholic and treatment of alcoholism is protected under the ADA. Thus, you should no longer ask any questions about drinking habits. Similarly, you should not ask about past drug addiction, so you should not ask a question such as:

"When was the last time you used illegal drugs?"
An acceptable alternative might be to ask:
"Do you currently use illegal drugs? What illegal drugs have you used in the last six months?"
Other questions an employer should avoid in a job interview as possibly being discriminatory (not related to disability) would include:
  • "Have you ever been arrested?"
  • "Are you married?"
  • "Do you have children?"
  • "What kind of discharge did you receive from the military?"
  • "How long have you been working? When were you born? What year did you graduate from high school (or college)?"
  • "Is English your first language?"
  • "What country are you from?"
  • "Do you have any debts?"
  • "What religious holidays do you observe?"

What Constitutes a Disability?

The EEOC, in order to assist its staff in making determinations of what constitutes disability under the ADA and applicable regulations and court decisions, has created an internal manual for use by EEOC personnel.

Under the EEOC guidelines interpreting the ADA, a disabled person is one who:

  • Has an actual physical or mental impairment that substantially limits one or more major life activities;
  • Has record of such an impairment; or
  • Is regarded as having such an impairment that is not both transitory and minor.

A "disability" can include an impairment that is episodic or in remission, but which could substantially limit a major life activity when active.

The EEOC guide goes on to define each element of this definition of a disability. "Impairment" means a physiological disorder affecting one or more body systems or a mental or psychological disorder. Excluded from this definition are environmental, cultural, and economic disadvantages; homosexuality or bisexuality; physical characteristics; pregnancy; common personality traits; and normal deviations in height, weight or strength.

According to the Technical Assistance Manual on ADA issued by the EEOC, the ADA also does not protect current illegal use of illegal or legal drugs; transvestitism; transsexualism; pedophilia; exhibitionism; voyeurism; gender identity disorders not resulting from physical impairments; compulsive gambling; kleptomania; pyromania; or psychoactive substance abuse disorders, where the person is currently using such illegal substances.

UPDATE NOTE:
Under new regulations of the EEOC, an impairment that is episodic or in remission meets the definition of disability if it would substantially limit a major life activity when active. The Proposed Regulation says that examples of impairments that are episodic include epilepsy, hypertension, multiple sclerosis, asthma, diabetes, major depression, bipolar disorder, and schizophrenia. The new regulations were implemented in response to the ADA Amendments Act of 2008 (ADAAA), which overruled various Supreme Court interpretations of the ADA and generally broadened the possibilities of a person qualifying as "disabled" under the ADA statute.

"Substantially limited," as the EEOC guide defines it, means prohibiting or significantly restricting a person's ability to perform (1) a major life activity as compared with an average person's ability to do so, or (2) a class of jobs or a broad range of jobs in varying classes.

Temporary impairments that take significantly longer than normal to heal, and long-term (or potentially long-term) impairments of indefinite, but not permanent, duration may also be considered disabilities.

"Major life activities," as described in the guide and the regulations, include caring for oneself, performing manual tasks, walking, seeing, hearing, speaking, breathing, learning, working, sitting, standing, lifting, thinking, concentrating, and interacting with others. Other portions of the guide point out that even a person who has an impairment that does not substantially limit a major life activity may be considered disabled if treated as having such a limitation by an employer, or if the person is so limited only because of the attitudes of others toward the impairment.

As you may have already realized, these are extremely broad interpretations of what constitutes a disability. And because, as with any new law, the courts continue to interpret and reinterpret it, consult your attorney in employment cases in which you are unsure how the law affects you.

Medical Screening Tests

One area that is now significantly affected in the hiring process is the limitation on medical screening of applicants. Under the ADA, companies can no longer screen out prospective employees with disabilities because the applicant has an elevated risk of an on-the-job injury or a medical condition that might be aggravated because of job demands. The law specifically bans questions about a job applicant's physical or mental condition either on an employment application form or during a job interview. This includes general questions such as, "Do you have any mental or physical conditions that would prevent you from performing your job functions?" What is permissible, prior to employment or making an offer of employment, is to ask an applicant to describe or demonstrate how, with or without reasonable accommodation, the applicant will be able to perform job-related functions.[63]

Medical exams are still allowed, but they are greatly restricted. Pre-offer exams are prohibited, but an offer may be conditioned upon the satisfactory results of a medical examination. Results, however, cannot be used to withdraw an offer, unless they show that the individual in question is not able to perform the tasks required by the position.

The definition of "disabled" under the ADA includes people with AIDS, those who test positive for the HIV virus, and rehabilitated drug abusers and alcoholics; however, the ADA does not:

  • Prohibit voluntary tests, such as employer-sponsored cholesterol or blood pressure tests; or
  • Require employers to hire persons who are drug users or who have contagious diseases.

The ADA is neutral on the issue of drug testing of employees, in effect leaving that issue up to regulation by the states.

Workers with Mental Disabilities

Recently, the EEOC issued guidance on how employers must deal with mentally ill workers. If certain conditions are caused by a mental disability, you may have to provide accommodations. However, the EEOC guidance provides some relief for the employer, stating that a company is not required to accommodate an employee, unless the employee:

  • Informs the company that he or she is disabled; and
  • Requests that an accommodation be made.

The employee does not have to use the term "reasonable accommodation," however. It is sufficient if the employee simply makes a "plain English" statement such as, for example, requesting time off because he or she claims to be "depressed and stressed."

When an employee makes such a statement, it can put you, as an employer, in a no-win situation. If the employee complains of suffering from stress and depression, and it turns out the employee is actually disabled, you can be sued if you have not taken necessary steps to accommodate him or her (such as hiring another employee to assist the disabled employee to cope with job stresses). On the other hand, if in determining whether an accommodation is necessary, you cannot ask if the employee has a disability -- if you do, you could be sued for asking a question that is prohibited by the ADA. As interpreted by the EEOC, if an employee is mentally disabled, you must make accommodations under ADA, but you must not ask if the employee has a disability, or, if he or she does, mention such fact to other employees. Welcome to the Catch-22 world of employment law in the 21st century....

Perhaps the best way to address an employee making such complaints, who has been showing up late, or been too distracted to perform his or her duties, is simply to ask if there is anything that the company can do to help the employee successfully perform the job, without directly raising the issues of disability or accommodation.

Accommodations for People with Disabilities

Title III of the ADA requires practically all businesses to make their facilities accessible to disabled employees and customers. Examples of accessibility requirements in public accommodations include:

  • Specified numbers of designated parking spaces for the disabled, based on the total number of parking spaces;
  • A specified percentage of hotel and motel rooms accessible to wheelchairs, and other rooms equipped with devices to assist those with disabilities, such as visual alarms for the hearing-impaired;
  • Access ramps in place where the floor level changes more than certain specified amounts;
  • Elevators provided in three-story or taller buildings and in those with more than 3,000 square feet per story;
  • In retail or grocery stores, checkout aisles wide enough for wheelchairs; and
  • Specified numbers of wheelchair spaces dispersed throughout the seating area in theaters and similar places of assembly.

ADA Recordkeeping Requirements

The Americans with Disabilities Act requires that private employers with 15 or more employees retain personnel records for at least one year from:

  • the date of making the record or
  • the date of the personnel action involved,
whichever is the later.[64] For instance, this could include job applications and requests for reasonable accommodation from a disabled person.

Tax Incentives

Companies spending money to remove architectural and transportation barriers to the disabled can deduct up to $15,000 a year of such expenses.[65] In addition, small firms -- those who had fewer than 30 full-time employees in the preceding taxable year or whose annual gross receipts did not exceed one million dollars in the preceding taxable year -- who incur expenditures to provide access for the disabled, can claim a tax credit for up to 50% of the cost of such expenditures that exceed $250, up to a maximum annual credit of $5,000.[66] (Thus, if a qualifying small firm spends $10,250, it will be entitled to the full $5,000 credit.)

Taxpayers claiming the credit for removal of barriers cannot also claim a deduction for the same expenditures.

For more information on the ADA, contact the EEOC or Civil Rights Division of the Department of Justice, at:

Equal Employment Opportunity Commission
131 M Street, NE
Washington, DC 20507
(202) 663-4900
(800) 669-4000 (Information line)
(800) 669-3362 (Publications)


EEOC Website
www.eeoc.gov


Civil Rights Division, Disability Rights Section
U.S. Department of Justice

(800) 514-0301 (Nationwide)

6.11 Mandatory Family and Medical Leave Requirements - Federal and [STATE NAME]

The Family and Medical Leave Act of 1993 (FMLA) applies to all companies -- as well as nonprofit entities -- that have 50 or more employees, during 20 or more calendar workweeks during the current or preceding calendar year.[67] As a result, many companies are subject to the family leave law, which requires employers to:

  • Offer employees twelve weeks of unpaid leave after the birth or adoption of a child; to care for a seriously ill child, spouse, or parent; or for an employee's own serious illness;
  • Maintain a written family leave policy;
  • Give employees a handout, explaining their rights;
  • Maintain pre-existing health care coverage for an employee who is on a leave of absence as described above;
  • Guarantee that employees will be able to return to either the same job or to a comparable position after the leave; and
  • Post a notice, which may be obtained from the U.S. Department of Labor -- Wage and Hour Division, explaining the rights of employees under the Family and Medical Leave Act of 1993.[68]

Where a husband and wife work for the same employer, and take leave for a birth, adoption, foster care, or to care for a parent with a serious health condition, the 12 weeks of annual leave must be shared by the couple.

A serious illness must be verified by a physician's certification, and as the employer, you may require a second medical opinion if desired. An employee is required to provide you with 30 days notice for foreseeable leaves of absence for a birth, adoption, or planned medical treatment.

One major exception to the law's coverage is a provision that exempts certain "key employees" from coverage if their leave of absence would cause "substantial and grievous" economic harm to the employer. "Key employees" are defined as the highest-paid 10% of the employer's workforce (within a 75-mile radius of a worksite).[69]

In addition, the law specifies eligibility requirements for employees of a covered employer. For an employee to be eligible for family leave, he or she must meet all three of the following requirements. He or she:

  • Must have been employed by the employer for at least 12 months;
  • Must have been employed for at least 1,250 hours of service during the one year period immediately preceding the date leave is to begin; and
  • Must be employed at a worksite where 50 or more employees are employed by the employer within 75 miles of that worksite.

An employer is given the option of substituting an employee's accrued paid leave, if any, for any part of the twelve-week period of family leave.

Several states and the District of Columbia have also enacted similar family leave laws, which vary in scope and coverage. Some such state laws may apply to small employers that are exempt from the FMLA requirements. In addition to the District of Columbia, states that have some kind of family or medical leave laws include:

  • California
  • Connecticut
  • Louisiana (maternity leave only)
  • Maine
  • Maryland
  • Massachusetts
  • Minnesota
  • New Hampshire
  • New Jersey
  • North Carolina
  • Oregon
  • Rhode Island
  • Tennessee (maternity leave only)
  • Vermont
  • Washington
  • Wisconsin

Alaska has a Family Leave Act, but it only applies to public employers.

See [LINK DELETED] of the state chapter of any state edition of this series for a summary of miscellaneous labor laws in that state, including family leave requirements, if any.

6.12 Performance Evaluations -- Your Legal Exposure as an Employer

For both large and small businesses with employees, conducting regular performance evaluations of your staff and management people can be an excellent management tool. Not only does it allow you, as the employer, to identify your staff's strengths and weaknesses, but if used properly can be a morale booster for employees and provide them with much-needed feedback and guidance in their individual career development. Performance evaluations can increase employee productivity and your business' profitability, and can help you identify problem employees, employees who need special assistance, training, or education, and talented employees who can progress to more responsible positions in the company.

A potential downside to employee performance reviews is that if they are not done properly you may open yourself up to employee lawsuits. On the other hand, properly handled, regular, objective, and well-documented performance reviews may actually prevent possible lawsuit exposure from non-performing employees whom you decide to terminate. Regular performance reviews allow you to inform employees that they are not meeting required or expected job performance levels for specified reasons. They may still sue you, but they will have a much weaker legal position if their performance reviews show that they were not getting the job done at the competence level required, and they were informed of necessary steps to improve performance.

In doing performance evaluations, keep in mind some of the following pointers, which will tend to make such evaluations more effective and useful, and should also help to reduce possible liability exposure for your company:

  • Do not take a "Mary Poppins" approach, being overly reluctant to tell employees that they are not making the grade, simply because you want to make everyone happy. That approach often backfires when it becomes necessary to fire an employee, and the employee can point to a succession of favorable performance reviews in a wrongful termination lawsuit against you. Be objective and honest in your evaluations, even if doing so may sometimes hurt the feelings of some employees. Even strong criticisms can usually be expressed in constructive terms, with concrete suggestions as to how the employee's performance shortcomings can be remedied in the future.
  • Have a well-thought out and fully-documented, written evaluation program, one that spells out the timing and frequency of performance reviews, who will conduct them, and the procedures that will be followed in the review process. This will usually include evaluation forms to be filled out by the managers who do the evaluations.
  • Before putting your performance evaluation program into effect, have an attorney knowledgeable in employment matters review your program and policies on performance evaluations, including all written evaluation forms you will use. This "ounce of prevention" will cost you some legal fees today, but may save you from incurring much larger legal fees, or even legal damages later.
  • In filling out an evaluation form for an employee, the reviewer should type in all information or comments (or print out the form on a computer); do not make handwritten remarks in the margin and especially do not write anything in pencil. The only things handwritten on the form should be the signatures or initials of the reviewer and the employee being evaluated.
  • Communicate the results of the evaluation to the employee clearly and fully, at the time the evaluation is completed. Most attorneys suggest that you have the employee sign off on the evaluation form after you have completed it and met with the employee to discuss the evaluation. This serves as proof that the results of the evaluation have been fully and contemporaneously communicated to the employee.
  • Do not go back later and change the evaluation or amend the personnel file, without first informing the employee as to the changes and why they are being made. For example, if an employee initially got high marks in his or her performance review for getting an important project completed well ahead of schedule, and it later turned out that the employee "cut corners" to do so, with a shoddy end result, you might have to retroactively change his or her most recent evaluation to reflect the newly discovered facts. If you do, be sure to immediately inform the employee of the changes and the reasons for them.
  • Be careful in evaluations never to include any comments regarding the physical appearance, physical limitations, race, color, sex, or religion of the employee, for obvious reasons. Stick to performance-related issues: did the employee get the job done on time, and in a proper manner, consistently?
  • Finally, make sure that the comments in the personnel file reflect the feedback given to the employee during the review, oral or written. Don't praise the employee's performance during the review, while putting negative remarks in his or her personnel file when filling out the evaluation form.

Adhering to the foregoing suggestions in your performance evaluation program will not necessarily keep you from being sued by disgruntled employees or ex-employees. However, if you adhere to the above guidelines consistently, you should be in a much better negotiating position if a lawsuit is brought against your company.

6.13 Employee or Independent Contractor?

As was pointed out earlier in this chapter, in Section 6.1, hiring independent contractors rather than employees to work in your business has some major advantages. Not only do you gain considerable payroll tax savings by retaining independent contractors, but you have far fewer administrative headaches.

Unfortunately, just because you hire someone and you agree that he or she will be an independent contractor does not necessarily make it so for tax and legal purposes. So before you hire anyone to work for you as an independent contractor, take a hard look at whether the IRS or a court of law would consider that person to be your employee rather than an independent contractor.

While the IRS uses a 20-factor test to evaluate whether a person is or is not an employee, the courts have often rejected that formula. Instead, a few major warning flags will indicate to you that the person is your employee rather than a contractor:

  • The person works mostly or only for your firm -- that is, the person is not like a lawyer, for example, who has a number of clients besides you that he or she works for.
  • The worker is subject to your control, and you have the right to direct how the work is done, not just to demand a particular result.
  • The person works in your office or establishment and does not have his or her own place of business, business cards, or business name.
  • The kind of work the person does for you is normally done by employees, such as secretarial work.
  • The person is not a licensed professional of any type.

Unless you are quite clear that the work relationship will not be considered that of employer/employee, be very careful about hiring someone as a so-called independent contractor. The consequences of being wrong can be severe. Here are just a few of the things that can happen (none of them good) if your "independent contractor" is determined to be an employee by the IRS in a tax audit:

  • You are liable not only for the employer payroll taxes you failed to pay, but also for a portion of the employee taxes you failed to withhold, for example, income taxes and FICA tax.
  • If you treat someone as an independent contractor and report payments of $600 or more a year to that person on IRS Form 1099-MISC, and the IRS later determines the person was really an employee, the back taxes you are liable for are limited to the employer payroll taxes, 20% of the employee's FICA tax you failed to withhold, and income tax withholding equal to only 1.5% of the wages you paid the person.[70]
  • However, if you do not file Form 1099-MISC and the person is reclassified as an employee, you are liable for 40% of the employee's FICA tax and income tax withholding equal to 3% of the wages -- twice as much as if you had filed Form 1099-MISC.[71] Furthermore, there is a $100 penalty for failure to file Form 1099-MISC, and you will owe interest on the taxes due, which can be substantial.
  • You may also be assessed other penalties if you did not have a reasonable basis for treating the person as a non-employee and may be liable for up to 100% of the employee's FICA and income tax that you failed to withhold.
  • If the person is hurt on the job and you have not provided workers' compensation insurance coverage, you will he liable for extensive legal damages.
  • If your business has a qualified retirement plan and you have not contributed to the plan on behalf of the person because he or she was not thought to be an employee at the time, the retirement plan could be disqualified for tax purposes for failing to cover the employee in question.
PLANNING POINT:
Beware of playing the independent contractor game, simply because your friends and business associates tell you how simple it is to avoid all those payroll taxes. In addition to these federal rules regarding independent contractors, many states take an even more restrictive view than the IRS on the employee versus independent contractor issue.

Independent Contractor Treatment Tips

You can take a number of steps to strengthen your case that someone who works for you is an independent contractor. Not all of the steps will be feasible for you, and many of them may require some significant changes in the way you do business. But if you can follow most of the suggestions below with regard to a given worker, you will improve your odds against having the IRS reclassify that worker as an employee.

  • Have a written agreement, signed by both parties, that makes it clear the company doesn't have the right to control the methods or procedures for the worker to accomplish the work contracted for. Include language in the agreement that states it is the worker's obligation to pay income and self-employment taxes on amounts earned, and that he or she will receive a Form 1099-MISC reflecting amounts earned if the amount earned is $600 or more.
  • Try to avoid setting working hours by hour or week. It is all right to specify start and completion dates for the work.
  • Make it clear that if additional workers are needed to help, the contractor will hire and pay them.
  • The arrangement should make it clear that the contractor is not limited to working exclusively for you, but is free to take on other work from other customers.
  • Base compensation on what work is performed rather than the time spent to do it. This may require careful estimates so that the worker is fairly paid for the work done.
  • Avoid providing office space to the contractor on a regular basis.
  • Let the workers be responsible for their own training if that is possible.
  • Advise each worker, in writing, to provide for their own liability, workers compensation, health, and disability insurance coverage.
  • Build costs such as meals, transportation, and clothing into the contract price of the job, rather than being billed directly to your account.
  • Specify in your agreement with the worker that he or she can't be fired and can't quit. The worker's job is to fulfill a given work contract.
  • Don't give the worker other work to fill in during down time. This may mean, of course, that you will have to pay the worker somewhat more for the work done than you otherwise would if you wish to keep him or her happy.
  • Don't pay bonuses to a person you treat as an independent contractor.

Hiring individuals as your own employees or treating them as independent contractors depends on the nature of the work and of your relationship to the worker. You do, however, have other available options. You could hire temporary employees from a temporary help agency or, in some instances, lease employees from an employee leasing company.

CAUTION:
Beware of IRS Form 8919, Uncollected Social Security and Medicare Tax on Wages. Workers can now file this relatively new (released December 20, 2007) form if they believe their employer incorrectly treated them as an independent contractor. The form requests that the IRS collect social security taxes from you, as an employer. This, of course, is attractive to the worker, since it relieves him or her of the burden of paying self-employment tax if you are determined by the IRS (or the courts) to have an employer-employee relationship with the worker. Expect a lot of "independent contractors" to file this form.
Note that if you cannot justify classifying a worker as an independent contractor under any of the above tests, you may be able to qualify for the "safe harbor" Congress enacted as Section 530 of the Revenue Act of 1978. Under that law, before IRS auditors can re-classify your independent contractors as employees, they must first notify you that you may be eligible for relief under the Section 530 "safe harbor." Generally, as initial requirements for Section 530 relief, you must have:
  • consistently filed Form 1099 for the workers you have treated as independent contractors, and
  • consistently treated all workers holding a substantially similar position in the business (since December 31, 1978) the same (as either employee or independent contractor). This also means that you must not have treated the workers in question as employees for any period, for employment tax purposes.
If those two conditions are satisfied, then you may have a shot at qualifying for the Section 530 safe harbor, if one of several additional requirements is met, establishing that you had a reasonable basis for treating the workers as independent contractors (such as where doing so is an industry-wide practice in the taxpayer's industry). These requirements can be quite technical, so you will need the help of an attorney or other tax professional in such an audit.

Hiring "Temps"

Hiring temporary workers, or "temps," is usually quite straightforward, at least for many kinds of positions. However, it may cost you a bit more than straight hiring. A temporary help agency has to charge you enough to make a profit, as well as pay for any benefits it provides to the temps, who are the agency's employees -- not yours. One benefit to you, other than the simplicity of having someone else handle payroll, benefits, workers' compensation, and other costs of retaining such workers is that you can send temporary workers home the moment you no longer need them, with no adverse consequences.

Of even greater importance to many companies is the opportunity to try out temps and offer permanent jobs to those whose performance they like. In effect, you get to test out individuals for as long as you wish, before deciding if you want to offer them employment as your own employee, not the agency's, which is exactly what many temps are seeking.

Leasing temporary workers from an agency is not a panacea, however. If you lease employees for any significant length of time, you may run afoul of IRS attempts to treat them as your employees, rather than as employees of the leasing agency, especially if you are using leased workers so you won't have to make contributions on their behalf to pension or profit-sharing plans you provide to employees. If you plan to lease temps for anything other than short, fixed assignments, be sure to first consult your tax adviser as to whether you may be creating a major tax headache for your business.

6.14 Reporting Newly Hired Employees in [STATE NAME]

All states require every employer to report each newly hired (or rehired) employee to an appropriate state agency shortly after the date of hiring or rehiring. In addition, some states require businesses to make similar reports for some independent contractors, as well as for newly hired employees. This reporting requirement is intended to help states more effectively enforce their child support laws. The information provided by the employer on the new hire report is fed into a national registry data bank to make sure that the approximately 70,000 persons in the U.S. who are failing to pay required child support cannot beat the system by simply changing jobs. Reports are generally due within 20 days after the date of hire, unless you are reporting electronically.

Most states allow reporting of the required information (name, address, social security number, date of birth, and date of hire) electronically. Generally, an employer reporting electronically or by magnetic medium must submit two transmissions each month (if necessary, based on the volume of hiring) not less than 12 days nor more than 16 days apart. Many of the major payroll services will do the new hire reporting for you, filing such reports electronically.

Single-State New Hire Reporting in [STATE NAME]

[DISCUSSION OF STATE NEW HIRE REPORTING LAW DELETED HERE] See the contact information for the State Directory of New Hires in [LINK DELETED].

Simplified Multi-State Reporting by Employers

If you have employees in more than one state and transmit reports of new hires electronically, you may report all new hires to one state, instead of to each of the states where you hire employees, if you:

  • Notify the United States Secretary of Health and Human Services, in writing, of the state to which you will report all new hires in the United States (see contact information below); and
  • Transmit your reports to the state you have selected, in accordance with federal and state laws.

Notify the federal government of your request to transmit new hire reports to one state at the following address:

Department of Health and Human Services
Administration for Children and Families
Office of Child Support Enforcement
Multistate Employer Registration
Post Office Box 509
Randallstown, MD 21133
(410) 277-9470
(410) 277-9325 (FAX)
PLANNING POINT:
If you select the multi-state reporting option, you are required to follow the new hire regulations of only the state you have selected to receive your new hire reports. Employers choosing this method can save time and money by consolidating their new hire reports and electronically submitting them to a single state.

6.15 Military Leave for Employees

The federal Uniformed Services Employment and Re-employment Rights Act (USERRA)[72] provides a number of employment rights for employees who have to leave work to serve in the armed forces of the United States, including the four major branches of the military, as well as the Coast Guard, Army National Guard, Air National Guard and the Commissioned Corps of the Public Health Service.

As an employer, you need to be aware of your obligations in the event any of your employees have to temporarily report for duty in any of the uniformed services. While you are not required to continue paying compensation to an employee who is on leave for military service, you are required to provide a number of benefits during the leave and re-employment rights upon return of the employee. These obligations can be summarized briefly as follows:

  • You must provide an unpaid leave of absence for a period of up to five years;
  • Health insurance must be continued while the employee is on leave, for up to 24 months, although you can require the employee to pay up to 102% of the premium cost for coverage, if the employee's military leave is for longer than 30 days;[73]
  • Vacation and sick pay do not have to accrue during the leave, but when the employee returns from leave, both such benefits must accrue at the rate at which they would have accrued if the employee had never taken the leave of absence;
  • Pension plan contributions need not be made during the employee's absence, but the leave cannot be considered a break in service under the pension plan;[74]
  • Upon return from leave, the employee's job must, if possible, be reinstated, in the position he or she would have been in if the employee had not been absent, or in a comparable position, so long as the employee is qualified or can become qualified for the position;
  • When the employee returns from duty, you must make reasonable efforts to provide refresher courses or any other training necessary to update the returning employee's skills, in situations where the employee is no longer qualified for a suitable position with your company; and
  • An employer may not discriminate against the returning employee by discharging the employee without cause within a year after his or her return, where the leave period was for 181 days or more (or within 180 days of returning, if the leave was for between 30 and 180 days duration). [75]

There are a few limited exceptions to the employer's above reinstatement obligations:

  • No reinstatement is required if the employer's circumstances have changed so greatly that re-employment would be "impossible or unreasonable" (such as where the employee's position was eliminated due to a reduction in force during the leave, and the employee would have been terminated had he or she still been actively employed at the time);[76]
  • Seasonal or temporary employees do not generally have a right to be reinstated upon returning from military leave; and
  • An employee need not be reinstated by the employer if he or she failed to complete military service under honorable conditions.

Note that under the Veterans Benefits Improvement Act of 2004, signed into law on December 10, 2004, all employers are required to post a notice of USERRA rights and duties in their workplace, beginning March 10, 2005. A copy of the poster may be obtained from the U.S. Department of Labor, or downloaded from their website.

U.S. Dept. of Labor Website -- Downloadable USERRA Poster
www.dol.gov/vets/programs/userra/USERRA_Private.pdf

6.16 The "Union Shop" and Right-To-Work Laws

The National Labor Relations Act (NLRA), a federal law that has governed labor union/management disputes since the days of FDR and the New Deal, generally makes it illegal for a company to require that a person be a member of a labor union before he or she can be hired as an employee. Thus, the so-called "closed shop" has been illegal under federal law for many years.

However, a "union shop" contract between a company and a union is still permitted under the NLRA. A "union shop" is, in simple terms, a situation where a person can be hired by a company without first being a union member, but is required, under the collective bargaining agreement between the company and the union, to become a member of the union (usually within 30 days after becoming employed), in order to remain an employee. A similar arrangement that is also acceptable under the NLRA is an "agency shop" agreement, which provides that an employee need not join the union, but still must pay dues to the union in order to remain an employee.

However, the NLRA provides that a state, if it wishes to provide stricter limitations on mandatory union membership and mandatory union dues payments, may prohibit such "union shop" or "agency shop" agreements, as a matter of state law. To date, 24 states have enacted such "right-to-work" laws, which all guarantee, at a minimum, that no person may be denied employment for either being a union member or for refusal to join a union. A number of such laws also prohibit mandatory payment of union dues by non-union workers in order to retain employment (banning the so-called "agency shop," as well as the "union shop").

Many employers consider states which have "right-to-work" laws to be advantageous places to locate businesses, since unions have a much tougher time organizing workers where they are prohibited from creating "union shop" situations that force workers to join the union.

Thus, in recent years, many firms have relocated in states that have such right-to-work laws, which tend to be Sunbelt states in the South and the West or Midwest. It is no accident that most of the fastest growing states in the U.S. in recent decades, such as Nevada, Florida, Texas, Utah, North Carolina and Arizona, are all "right-to-work" states, and thus very attractive to industry. Other states with right-to-work laws are:

  • Alabama
  • Arkansas
  • Georgia
  • Idaho
  • Indiana (enacted in 2012)
  • Iowa
  • Kansas
  • Louisiana
  • Michigan (enacted in 2012)
  • Mississippi
  • Nebraska
  • North Dakota
  • Oklahoma
  • South Carolina
  • South Dakota
  • Tennessee
  • Virginia
  • Wyoming

None of the larger, heavily industrialized and unionized states had right-to-work laws until 2012, when Indiana and Michigan both enacted such laws.

6.17 Employee Polygraph Protection Act and Similar State Laws

A federal law, the Employee Polygraph Protection Act,[77] makes it illegal for nearly all private employers to require employees to submit to polygraph (lie detector) tests as a condition of gaining or retaining a job, and also prohibits any kind of discrimination on the job -- such as denying promotions -- against employees who refuse to take such tests.[78] While this law does not impose any burdensome obligations on employers (other than preventing your use of such tests, unless employees agree to submit to them), all employers are required to display a government Employee Polygraph Protection Act poster in the workplace, obtainable from the U.S. Department of Labor. [79]

Employers who violate this act are subject to serious penalties, including civil damage suits by employees and/or civil penalties (fines) of up to $10,000.[80]

Very few private employers are exempt from this law. The only exceptions are:

  • Defense contractors, where employees are engaged in sensitive work, with national security implications;
  • Security firms or armored car services which are engaged in protecting vital facilities such as power plants, water supply, or public transportation, or protecting currency, negotiable instruments, precious commodities or instruments, or proprietary information;
  • Employees at firms that are authorized to manufacture, distribute or dispense controlled substances, where such employees have access or control over such drugs; and
  • In connection with ongoing investigations, such as where a theft, embezzlement, or unlawful industrial espionage or sabotage has occurred or is believed to have occurred. [81]

A number of states and the District of Columbia have also enacted laws that restrict the use of polygraph tests or other lie detector tests in the workplace, some of which laws are more restrictive than the federal law.

6.18 Wage Payment and Other [STATE NAME] Labor Laws

This section briefly covers wage payment requirements under [STATE NAME] laws, and links to the section of the state chapter that contains information on miscellaneous other [STATE NAME] labor laws.

[STATE NAME] Wage Payment and Miscellaneous Labor Laws

State law in [STATE NAME] requires employers to pay wages each [STATE-SPECIFIC DISCUSSION OF REQUIRED WAGE PAYMENT FREQUENCY DELETED HERE].

When an employee's employment is terminated, final wages are usually due [STATE-SPECIFIC DISCUSSION OF WHEN FINAL WAGES MUST BE PAID TO TERMINATED EMPLOYEE, OR ONE WHO QUITS, DELETED HERE].

6.19 Catch-22 for Employers: Giving References

As an employer, you may find yourself between a rock and a hard place when a former employee lists your firm as an employment reference, especially if you have had a negative employment relationship with the former employee. Because most employers are quite aware of the risks of getting sued by the ex-employee if they pass along negative information to his or her prospective new employer, many firms take a "name, rank and serial number only" approach to this risky situation, divulging only job titles and dates of employment.

There have also been lawsuits in recent years by employers against the former employer of a troublesome worker, for failure to divulge information, such as a suit against Allstate Insurance by a company that hired a former Allstate employee, claiming that Allstate had concealed the violent nature of the former employee, and alleging that Allstate had written a misleading letter, stating that the employee had been let go as part of a general corporate restructuring, without mentioning the employee had been fired after coming to work with a gun. The employee wound up shooting five co-workers in the company cafeteria of the his employer, Fireman's Fund, which brought the suit against the former employer, Allstate.

Thus, as an employer, be aware that you will have to walk a very narrow line when asked for a job reference. If you divulge negative information that can be questioned by the employee, the employee may sue you; if you conceal such facts, the new employer may sue you.

Fortunately, about half the states have, in recent years, enacted various forms of legislation that now give employers more protection against employee lawsuits for divulging damaging information or providing unflattering job references.

6.20 COBRA Requirements for Employers

Since it was enacted in 1986, the Consolidated Omnibus Budget Reconciliation Act (COBRA)[82] has provided certain former employees, retirees and others, including spouses, former spouses and dependent children, the right to temporary continuation (up to 18 months) of health care coverage at group rates, provided that they, rather than the employer, pay for such continued coverage. The individuals who are given this COBRA benefit are those who lose, or would lose, their coverage due to certain specified events, such as layoffs, involuntary terminations, or involuntary reductions in work hours.

The COBRA regulations apply to employers with 20 or more employees on 50% or more of the working days in the previous calendar year and which have a group health plan for employees.

For many employees, especially in the current harsh economic environment, paying these expensive health insurance premiums themselves comes as a shock and is too costly to consider.

Thus, under new tax law provisions in the American Recovery and Reinvestment Act of 2009, COBRA participants were only required to pay 35% of the health plan premiums if they were involuntarily terminated from their employment between the dates of September 1, 2008 and December 31, 2009. Employers had to pay the other 65%, which they could later recover as a payroll tax credit against employee income tax withholding or FICA taxes.[83]

Note, however, that this new law only applied when employees lost their jobs, not when their hours were reduced. Also, ex-employees were only eligible if their "modified adjusted gross income" was less than $145,000 ($290,000, if married and filing jointly) in the year benefits are received. Individuals with incomes of less than those amounts but more than $125,000 ($250,000 for couples) had their subsidy reduced and phased out until complete phase-out occurred at or above $145,000 (or $290,000) of modified adjusted gross income.

While COBRA benefits last for up to 18 months generally, the new subsidy was only for the first 9 months after an employee's job is lost. The premium reduction period ends if the individual becomes eligible for coverage under any other group health plan or for Medicare benefits.[84]

UPDATE NOTE:
The subsidy was due to expire December 31, 2009, but recent legislation extended it to cover an employee who is involuntarily terminated on or before March 31, 2010.[85] Also, the new law extends the subsidy period by six months -- from 9 months to 15 months. Subsequently, the Continuing Extension Act of 2010 (CEA) amended the law to further extend the period to qualify for the COBRA premium reduction until May 31, 2010.[86] No further extension of this subsidy has been enacted for periods after May 31, 2010.

6.21 Health Care Reform Requirements for Employers

The Patient Protection and Affordable Health Care Act[87] and the ensuing Health Care and Education Reconciliation Act of 2010,[88] generally referred to together as the Health Care Reform law, impose a number of new requirements and taxes on businesses but also provide some tax benefits to small employers, as the new laws become effective over a number of years, from 2010 through 2018. This section summarizes some of the key provisions of which you need to be aware.

  • 2010. Contrary to what some may have believed, health care coverage was not immediately mandatory. Mandatory coverage and penalties for non-compliance do not become effective until 2014. However, beginning immediately in 2010, new health insurance policies or renewed policies had to include provisions such as covering children with pre-existing conditions and covering preventive checkups without requiring employee copays. The policies may no longer kick employees out of the plan if they become sick or place any lifetime dollar limits on coverage. These new provisions will obviously make health insurance much more costly, to the extent insurers are allowed to pass along their increased costs to employers. If insurers are not allowed to pass along their cost increases, they will either go out of business or cease writing health insurance policies, so that ultimately the government will become the single payer in that event.

    Certain small employers may claim an income tax credit of 35% of the cost of employee health care coverage if they have 10 or fewer employees and pay average wages of less than $25,000, during the years 2010 through 2013. Somewhat larger employers, with up to 25 employees earning average wages of no more than $50,000, may qualify for a smaller tax credit, which phases out where the number of employees exceeds 10 and/or the average wage per full-time equivalent employee exceeds $25,000.[89] For 2014, the $25,000 amount, as indexed for inflation, is $25,400, and the $50,000 ceiling is $50,800.

    The number of full-time employees is calculated by dividing the total number of hours worked by employees by 2080 (but only counting a maximum of 2080 hours for any one employee). When calculating the number of "full-time employees" and their wages, the term "employees" excludes seasonal workers (working no more than 120 days during the year). In addition, the term "employees" excludes the following: a self-employed individual, a 2% shareholder in an S corporation, a 5% owner of an eligible small business, or someone who is related to or a dependent of any of those people. Thus, as an example, a business will not receive a credit for health care coverage provided to small business owners or their family members.

  • 2011. Small businesses were first allowed to offer tax-free SIMPLE (Savings Incentive Match Plan for Employees) employee benefit Cafeteria Plans for their employees.
  • 2012. Businesses, including all corporations, were to have been required to file information returns reporting more types of business-to-business payments of more than $600, which would have resulted in massive additional recordkeeping and administrative costs for most businesses.[90] Fortunately, Congress repealed this requirement shortly after convening in 2011, before it could go into effect in 2012.
  • 2013. A new Medicare tax of 0.9% now applies to employees with FICA wages of over $250,000 (joint returns), $125,000 (married filing separate) or $200,000 (single or head of household status) beginning in 2013. No additional tax is imposed on the employer and the employer is only required to withhold tax if paying over $200,000 of FICA wages to an employee.[91] A similar added tax will apply to self-employed persons, increasing their self-employment tax, if self-employment income exceeds the above levels.[92]

    Under prior law, taxpayers who itemize deductions could deduct their medical expenses that exceeded 7.5% of their adjusted gross income (AGI). Under the new law, only expenses in excess of 10% of AGI will be allowed as itemized deductions in 2013 and later, although the 7.5% limit will still apply to persons 65 or older through 2016.

    A new 3.8% income tax is imposed on the LESSER of the taxpayer's net investment income or the excess of the taxpayer's modified AGI over certain threshold amounts ($250,000 for joint returns, $125,000 for married filing separate, $200,000 for all others).[93] This will substantially increase the tax rate on unearned income, such as dividends from a C corporation or capital gains on sale of a business or of stock. This tax may also apply to a shareholder's taxable distributable net income from an S corporation, if the S corporation income is considered passive with regard to that shareholder, but not if the shareholder actively participates in the business.

  • 2014. Mandated coverage begins. Self-employed persons and other individuals who do not receive health coverage from their employers will be required to obtain individual health care policies, or pay a penalty of the greater of $95 or 1% of their household income in excess of certain specified levels. Employers with 50 or more employees will be subject to a $2,000 per employee penalty for each employee for whom they do not provide health care coverage (over a threshold of 30 employees). However, the 35% small business tax credit for health care coverage costs described above (for 2010) will increase to 50%.
  • 2015. The individual penalty for not having health care coverage will increase to the larger of $325 or 2% of specified household income levels.
  • 2016. The individual penalty for not having health care coverage will increase to the larger of $695 or 2.5% of specified household income levels.
  • 2017. For years after 2016, the 2016 penalty levels for individuals who fail to obtain coverage will be indexed for inflation. Persons 65 or older will only be able to claim an itemized deduction for medical expenses that exceed 10% of AGI.
  • 2018. Beginning in 2018, employers who provide "Cadillac plans" (costing more than $10,200 a year for single coverage, or over $27,500 for family coverage) with more generous benefits than are generally allowed will be subject to a 40% EXCISE TAX ON THE EXCESS COST OF SUCH PLANS OVER CERTAIN THRESHOLD AMOUNTS.[94] (OUCH!)


Now that we have briefly covered your obligations as an employer, please continue on to Chapter 7 for a discussion of environmental laws and regulations that may apply to your business.

Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code, C.F.R. to the Code of Federal Regulations, U.S.C. to the United States Code.)

1. I.R.C. §§ 1401(b)(2) and 3101(b)(2), both effective on and after January 1, 2013.
1A. Treas. Decision 9440, 73 F.R. 79354-79361, December 29, 2008; Temp. Regs. 31.6011(a)-4T and 31.6302-1T.
2. Treas. Regs. § 31.6302-1(f)(4).
3. Treas. Regs. § 31.6302-1(b)(2).
4. Treas. Regs. § 31.6302-1(b)(3).
5. Treas. Regs. § 31.6302-1(c)(3).
6. I.R.S. e-News for Tax Professionals, Issue Number 2011-39; and I.R.S. Publication 966, "The Secure Way to Pay Your Federal Taxes for Businesses and Individuals."
7. Treas. Regs. § 31.6302-1(h)(2)(ii).
7A. Treas. Regs. § 31.6302-1(f)(4).
8. Rev. Proc. 97-33, 1997-2 C.B. 371, as modified by Rev. Proc. 98-32, 1998-1 C.B. 935.
9. Treas. Regs. § 31.6302-4.
10. I.R.C. §§ 3301(l) and 3306(b)(1).
11. I.R.C. § 3306(a)(1)(A).
12. I.R.C. § 3306(a)(1)(B).
13. I.R.C. §§ 3301(l) and 3302(b).
14. 29 U.S.C. § 1131.
15. 29 U.S.C. § 1132; I.R.C. §§ Sections 4971, 4975, 6057-6059, and 6652(e).
16. 29 U.S.C. § 1002(2); 29 C.F.R. § 2510.3-2.
17. 29 U.S.C. § 1002(1); 29 C.F.R. § 2510.3-1.
18. 29 C.F.R. § 2510.3-1(b); 29 C.F.R. § 2510.3-2(b).
19. 29 C.F.R. § 2520.104b-2.
20. 29 C.F.R. § 2520.102-3.
21. 29 C.F.R. § 2520.104b-2(a)(2).
22. 29 C.F.R. § 2520.104b-2(a)(1).
23. 29 C.F.R. § 2520.104-20.
24. 29 U.S.C. § 1024(b)(4); 29 C.F.R. § 2520.104b-1.
25. 29 U.S.C. § 1024(a)(6) and 29 C.F.R. § 104a-8
26. 29 C.F.R. § 2520.104a-5.
27. 29 C.F.R. § 2520.104b-10.
28. 29 C.F.R. § 2520.104b-3.
29. 29 U.S.C. § 1021(c).
29A. ERISA § 303(d)(2).
29B. ERISA § 104(b)(3).
29C. § 1103(b), Pension Protection Act of 2006.
29D. § 1103(a), Pension Protection Act of 2006.
30. 29 U.S.C. § 1112.
31. I.R.C. § 3405(a).
32. I.R.C. § 6039D.
33. Announcement 86-20, 1986-87 I.R.B. 34, as modified by Notice 2002-24, 2002-1 C.B. 785.
34. 29 C.F.R. § 1903.2.
35. 29 C.F.R. § 1904.
36. 29 C.F.R. § 1904.32.
37. 29 C.F.R. § 1904.32(b)(6).
38. 29 C.F.R. § 1904.2.
39. 29 C.F.R. § 1904.29(a).
40. 29 C.F.R. § 1904.29(b)(2) and (3).
41. 29 C.F.R. § 1904.33.
42. 29 C.F.R. § 1904.1.
43. 29 C.F.R. §§ 1904.41 and 1904.42.
44. 29 C.F.R. § 1904.39.
45. 29 C.F.R. § 1926.95-.107; 29 C.F.R. § 1910.132.
46. 29 U.S.C. §§ 206(a)(1) and 206(g).
47. 29 U.S.C. § 207(a)(1).
48. 29 U.S.C. § 213(a)(1).
49. 29 C.F.R. §§ 541.0-541.710.
50. 29 U.S.C. § 203(s) and 29 U.S.C. § 207(a)(1).
51. 29 U.S.C. § 213.
52. 29 C.F.R. §§ 570.5-570.72.
53. 29 U.S.C. § 213(c)(6) and 29 C.F.R. § 570.33.
54. 29 U.S.C. § 213(c)(3) and (d).
54A. 29 U.S.C. § 213(c)(6).
55. 38 U.S.C. §§ 4301, et seq.
56. 38 U.S.C. § 4317(A).
57. 29 C.F.R. § 1602.7.
58. 29 C.F.R. § 1601.30.
59. 29 U.S.C. § 627 and 29 C.F.R 1627.10.
60. 8 U.S.C. §§ 1324a(b) and 1324b(a)(1).
61. 29 U.S.C. § 2101-2109.
62. 42 U.S.C. §§ 12101 et seq. and 29 C.F.R. § 1630.
63. 29 C.F.R. § 1630.14.
64. 29 C.F.R. § 1602.14.
65. I.R.C. § 190.
66. I.R.C. § 44.
67. Public Law 103-3, 29 U.S.C. §§ 2601, et seq., and 29 C.F.R. § 825.104(a).
68. 29 C.F.R. § 825.300(a).
69. 29 C.F.R. §§ 825.217 and 825.218.
70. I.R.C. § 3509(a).
71. I.R.C. § 3509(b).
72. 38 U.S.C. §§ 4301, et seq.
73. 38 U.S.C. § 4317(a).
74. 38 U.S.C. § 4318.
75. 38 U.S.C. § 4316(c).
76. 38 U.S.C. § 4312(d).
77. 29 U.S.C. §§ 2001-2009.
78. 29 U.S.C. § 2002.
79. 29 U.S.C. § 2003.
80. 29 U.S.C. § 2005.
81. 29 U.S.C. § 2006.
82. Title X of COBRA, Pub. L. 99-272.
83. Section 3001 of title III of div. B of Pub. L. 111-5; I.R.C. § 6432.
84. Notice 2009-27, 2009-16 I.R.B. 838.
85. HR 3326, the Department of Defense Appropriations Act of 2010.
86. Pub. Law 111-157 and IR-2010-52, April 26, 2010.
87. Pub. Law 111-148.
88. Pub. Law 111-152.
89. I.R.C. § 45R; Rev. Proc. 2013-35, 2013-47 I.R.B. ____ (page not yet determined).
90. I.R.C. § 6041(a), as effective in 2012.
91. I.R.C. §§ 3101(b)(2) and 3102(f)(1), effective in 2013.
92. I.R.C. § 1401(b)(2), effective in 2013.
93. I.R.C. § 1411, effective in 2013.
94. I.R.C. § 4980I, effective in 2018.


Chapter 7

Environmental Laws Affecting Your Business


"We are all caught in an inescapable network of mutuality tied to a single
moment of destiny, and what directly affects one indirectly affects us all."

-- Rev. Dr. Martin Luther King, Jr.

"The L.A. basin is God's idea of a place to stub his cigarettes."
-- Dennis Miller

"We treat this planet like a bunch of freakin' college kids treat a frat house
-- we all say we love the place, but then we p___ on the stairs."

-- Dennis Miller

"Fall is my favorite season in Los Angeles, watching the birds change
color and fall from the trees."

-- David Letterman

The damaging effects on the environment of two centuries of industrial development have resulted in spirited attempts to remedy these problems. A flood of environmental legislation, regulations, and litigation has come out of state and federal governments and courts in recent decades. For small businesses without in-house legal staffs or funds to pay for professional guidance through this maze of regulations, the effect of the growing body of environmental laws can be especially dizzying.

While this book, in one chapter, can only scratch the surface of the environmental law complexities most businesses face, the discussion below will familiarize you with some key problem areas and should at least make you aware of the potential liability that exists.

7.1 Liability under Environmental Clean-up Laws

The most pervasive of the environmental laws, with the most devastating potential consequences for the unwary, are the environmental clean-up laws, and the legal liability these laws attach to real estate that has been contaminated by hazardous substances. The main laws that apply in this area are the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA),[1] also known as the Superfund law, and the Resource Conservation and Recovery Act (RCRA).[2]

CERCLA and RCRA apply to virtually every real estate transaction. While RCRA applies primarily to currently generated hazardous waste, including limits on creation of waste and requirements for disposing of it, CERCLA is more focused on cleaning up hazardous substances that have been spilled or dumped in the past.

CERCLA (Superfund) Liability

CERCLA deals with all kinds of pollution: air; surface water, ground water, and soil. It covers virtually every type of hazardous substance, as defined under CERCLA, the Clean Water Act, the Clean Air Act, or the Toxic Substances Control Act. There are, however, major exceptions for petroleum and certain petroleum derivatives. The main thrust of CERCLA is to impose liability on private owners of property to clean up hazardous wastes they have created. CERCLA also applies to owners of inherited property if it was already contaminated when it was acquired.

In short, even though you were not responsible for creating a contamination problem, if you acquire real estate that is already contaminated -- and it later becomes apparent there has been a spill or dumping that requires an environmental cleanup -- you are liable for the costs of the cleanup if you are the current owner. That may be bad news, but the worse news is that you can't simply walk away from the property and let the government take it in lieu of paying the clean-up costs. You are on the hook, potentially for all you are worth.

As the owner, you are the responsible party and may be held liable -- at a cost that can exceed the value of the property. You may even become liable if you buy a business that has formerly owned contaminated property and then you sell it later. If the government institutes environmental proceedings against the current property owner, that owner could then sue all the prior legal owners in the chain of title of the property, including you, for indemnity or reimbursement.

Of course, you may be able to sue the prior owner or anyone in the chain of prior owners for indemnification if they are still in existence and can be found. However, since that is a pretty slim thread upon which to hang your financial survival, you need to take precautions up front, before acquiring any real property, to protect yourself from possible environmental liability for cleanup under CERCLA.

The following are some things you can and should do to reduce your risk in any real estate or existing business acquisition:

  • Conduct careful research. Research the current condition and past uses of any real estate involved in a transaction. If you buy an existing corporation or limited liability company (LLC), find out what properties it owned in the past and whether any such properties were contaminated by hazardous substances.
  • Beware of particular property uses. Be particularly wary of any sites that have been used as gas stations, landfill areas, locations of dry cleaners, chemical or other industrial production processes, or for battery production, recycling, or metal plating. These may have left contaminants. Be extremely cautious if the site contains underground storage tanks.
  • Do an environmental "audit." An audit performed by you or the seller should determine the environmental condition of the property you are buying. As a minimum precaution, an audit is a first-phase risk appraisal by an environmental consulting firm. At a far greater cost, but offering much more protection from liability, is a second-phase environmental audit, which typically includes soil and water tests. Doing an audit may not protect you from all environmental liability exposure, but if a contamination problem that predates your acquisition of the property is later discovered, and you have hired qualified environmental consultants to do an environmental audit before you bought the property, you are more likely to be considered an "innocent" purchaser of the property, and avoid any cleanup liability.
  • Get a written warranty from the seller. In a business or real estate purchase agreement, require written representations about the site from the seller and include provisions under which he or she will indemnify you if there is a problem. Be mindful of the seller's financial viability, in case you are forced to seek indemnity. A promise isn't worth the paper it is written on if the seller does not have the wherewithal to make good on it. Your business purchase agreement should contain detailed representations and warranties of the seller stating that:
    • The seller has not violated any environmental law or regulation; and
    • The seller will reimburse you for any cost or liability you incur for environmental damage occurring before the acquisition.

Even though there is an innocent purchaser defense under the Superfund law, you must be able to demonstrate that you made appropriate inquiry before acquiring the property to determine any pre-existing contamination problem. There is little guidance in the law at this point as to what constitutes an appropriate inquiry, so you should not necessarily expect to escape liability under that rule.

The best defense is to avoid purchasing property that is contaminated. Even if these steps fail to discover a lurking environmental problem, at least you will have a much stronger argument to make under the innocent purchaser defense if you have done a due-diligence survey and had an environmental audit performed by a reputable consulting firm.

RCRA Requirements

RCRA contains a comprehensive set of rules for managing hazardous wastes, including petroleum-based substances, and regulating those who generate hazardous wastes, transport them, and store, treat, or dispose of them. Penalties for violations include fines of up to $25,000 a day, plus imprisonment.

One important focus of RCRA is on underground storage tanks (USTs), many of which are known to be leaking gasoline or other contaminants into the surrounding soil and ground water. Under RCRA, much of the regulation of USTs is left to state governments. Thus, under federal regulations, the owner of a UST must notify the state of the tank's existence, including tanks that were taken out of service after January 1, 1974.[3]

New USTs must satisfy federal performance standards, which generally require that they be constructed of fiberglass-reinforced plastic or steel that is cathodically protected from corrosion and must include release detection systems.[4] Furthermore, all existing USTs had to be upgraded to federal standards by December 22, 1998, a mandate which resulted in some major expenditures for many small businesses, such as gasoline service stations.[5] Not surprisingly, there are many thousands of service stations around the U.S. that were abandoned in the late 1990's, due to that mandate in many cases.

Tax Incentives for Environmental Cleanup

In 1997, after becoming aware that the IRS was forcing companies that expended large sums for environmental cleanup to capitalize such expenses, and disallowing their attempts to deduct such outlays, Congress enacted a law that permitted deduction of "qualified environmental remediation expenditures" for cleaning up certain contaminated sites.[6]

Unfortunately, the new law only allows such deductions for cleanup of sites in certain targeted areas with a high poverty rate. This provision was due to expire on December 31, 2000, but fortunately Congress has extended this provision several times, retroactively, and in 2008 extended it again to December 31, 2009. In late 2010, Congress again extended the deduction for remediation expenditures, through December 31, 2011, but it has not (as of early 2013) been extended again.

7.2 Community Right-To-Know Notification

Under the provisions of the Emergency Planning and Community Right To Know Act (EPCRA), you must report any hazardous materials your business uses or stores to state and local emergency planning agencies and your local fire department. This is a very broad requirement, one that may even apply to unlikely culprits, such as office employers who store quantities of toner for copying machines on their business premises. The law also requires that you have an emergency plan in the event of a release of any hazardous substance.

If subject to EPCRA, you must also file regular release reports with the federal Environmental Protection Agency (EPA) or state environmental agencies, even if the report is for a substance you have a permit to release. Reports are required for owners and operators of facilities that have 10 or more full-time employees, for certain specified Standard Industrial Classification Codes (as in effect on January 1, 1987, or corresponding NAICS codes as in effect on January 1, 2007).[7] Government agencies use this data to keep track of the amount of annual emissions.

7.3 Water Pollution Laws

The Clean Water Act limits the pollutants that can be released in the nation's water supplies. Related provisions protect wetlands from being developed, since wetlands are not only havens for wildlife but also natural systems that purify water that passes through them.

Clean Water Act

Under the Clean Water Act, the EPA and individual states are the watchdogs of water pollution standards.[8] The law also allows private citizens to sue to enforce the act. Penalties for violations can be as high as $50,000 a day, and even negligent but unintentional violations can result in imprisonment. For certain existing facilities, this law provides for a system of EPA permits for discharging certain amounts of water pollutants.

Wetlands Development

Portions of the Clean Water Act require that all proposed development activities that involve the dredging or filling of wetlands obtain permits from the U.S. Army Corps of Engineers.[9] Before you acquire real property that you plan to develop in any way, you need to do a careful survey to determine if the property lies within an area that is considered a wetland. Otherwise, you may end up with a piece of property that is forever undevelopable and unsaleable. Wetlands include much more than swamps and marshes. Many dry-looking parcels may also fall within the regulatory definition. Furthermore, many states have adopted wetlands restrictions which may require you to obtain state development permits.

7.4 Air Pollution Laws

The environmental laws that impact the largest number of small businesses are the air pollution laws. They have tended to affect large companies the most by imposing emission restrictions on large factories and requiring catalytic converters and other pollution control devices be installed on new automobiles sold in the U.S. More recent amendments have extended air pollution controls and regulation to small businesses such as dry cleaning establishments and auto body paint shops to reduce the amount of pollutants they emit into the atmosphere.

Clean Air Act

The Clean Air Act of 1970 was substantially revised and strengthened by the Clean Air Act of 1990 amendments.[10] The new requirements have been phased in over a number of years. Under the provisions of the 1990 act, businesses are affected by controls on three types of air pollution.

  • Primary urban pollution. The EPA already has set standards for six primary pollutants discharged in large quantities by a variety of sources: ground level ozone (smog), carbon monoxide, particulate matter, nitrogen dioxide, sulfur dioxide, and lead. These pollutants are not thought to be carcinogenic, but do pose other serious health risks. Control measures for ground level ozone have been particularly significant for many small businesses, as the 1990 amendments have gone into effect.
  • Toxic air pollutants. These include chemicals that are known or suspected to cause cancer, birth defects, or gene mutations. The amended act requires the EPA to set toxic air pollution standards for specific industry activities. A number of these standards are applicable to small businesses.
  • Ozone depleters. The third type of air pollutant regulated by the Clean Air Act includes the emissions of substances that deplete the upper (stratospheric) ozone layer, which exposes life on earth to harmful ultraviolet radiation. Facilities that repair and maintain air conditioning equipment are a major source for these emissions, and are thus subject to some of the most extensive regulations.

Under the 1990 amendments to the Clean Air Act, much of the responsibility for administering the act is vested in state governments. Each state program must include three components:

  • Appointment of a state small business ombudsman;
  • Establishment of a comprehensive small business assistance program, helping small businesses deal with specific technical, administrative, and compliance problems; and
  • Appointment of a seven-member state compliance advisory panel.

The types of businesses likely to be affected by one or more of the air pollution control programs under the 1990 Clean Air Act include:

  • Agricultural chemical applicators
  • Asphalt manufacturers
  • Asphalt applicators
  • Auto body shops
  • Bakeries
  • Distilleries
  • Dry cleaners
  • Foundries
  • Furniture manufacturers
  • Furniture repairs
  • Gasoline service stations
  • General contractors
  • Hospitals laboratories
  • Lawn mower repair shops
  • Lumber mills
  • Metal finishers
  • Newspapers
  • Pest control operators
  • Photo finishing laboratories
  • Printing shops
  • Refrigerator/air conditioning service and repair
  • Tar paving applicators
  • Textile mills
  • Wood finishers

For help and additional information on the Clean Air Act requirements that may apply to your business, contact the state environmental agency in [STATE NAME] or your local EPA office. You may also obtain assistance from the EPA Small Business Ombudsman:

Asbestos and Small Business Ombudsman
U.S. Environmental Protection Agency
1200 Pennsylvania Avenue, N.W.
Washington, DC 20460
(202) 564-6568 (From Washington, D.C.)
(800) 368-5888 (National Hotline)

7.5 Toxic Substances Control Act

If your business engages in the manufacturing, processing, or distribution of chemical substances, you may be required under the federal Toxic Substances Control Act (TOSCA) to report certain information to the EPA regarding the chemical substances and mixtures you use.[11]

TOSCA requires manufacturers to give a 90-day notification before producing a new chemical substance and, in some cases, for older chemicals. The EPA may require safety testing before approval of such a chemical. TOSCA also has extensive record keeping rules regarding use and disposal of toxic chemicals.

Penalties for failing to make the required reports to the EPA include civil and criminal penalties of $25,000 and up, plus up to a year's imprisonment for each violation.[12] Each day the violation continues is considered a separate violation for purposes of the fines levied under TOSCA.

7.6 Environmental Impact Statements

The National Environmental Policy Act of 1969 (NEPA) requires an environmental impact statement (EIS) to be prepared with respect to major federal actions that significantly affect the quality of the human environment.[13] While this would not, at first impression, seem to directly affect you, as a small business owner, the EIS requirement also applies in any situation where a federal agency approves some action by other persons, such as a private company.

In addition, many states have adopted similar EIS requirements; for instance, when a local planning board approves a real estate development, an EIS may be required under state law, if not federal.

7.7 Miscellaneous Environmental Regulations

In addition to the main environmental laws described above, a number of other specialized environmental laws and regulations may apply to your business, including regulation of the use of pesticides and asbestos, and noise control restrictions.

Pesticide Regulations

The Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA), which amends FEPCA (the Federal Environmental Pesticides Control Act of 1972), regulates both the manufacture and distribution of pesticides.[14]

Users must take exams for certification as applicators of pesticides, and all pesticides used in the U.S. must be registered (licensed) by the EPA. Registration is designed to assure that pesticides will be properly labeled and that if used in accordance with specifications, will not cause unreasonable harm to the environment.

Asbestos Regulations

Lung disease, cancer, and other health risks attributed to asbestos exposure created a number of state and federal laws to deal with this problem. In addition, large numbers of damage suits for alleged harm to individuals who were exposed to asbestos in the workplace and elsewhere have resulted in enormous judgments against many companies. Occupational Safety and Health Administration (OSHA) regulations have been issued to limit asbestos exposure in the workplace and to set construction standards regarding use of asbestos.[15]

Noise Control

Both OSHA and the EPA have issued regulations on noise emission standards, ranging from aircraft noise to protections of workers from hearing impairment in the workplace.

7.8 EPA Self-Evaluation Policy

In 1996, the EPA adopted a revolutionary "self-evaluation policy" for environmental monitoring and regulation. The policy encourages industry to self-police itself. Companies that do so can reduce civil penalties for violations and can usually eliminate criminal penalties entirely. Essentially, the new policy allows you to audit your own facility.

If you find environmental law violations in your business operations, you must report them in ten days and then act to correct them. In the past, strict liability standards applied, and violations of EPA standards were punished without regard to knowledge or intention of the violator. While strict liability is still generally the rule, the new policy allows for a major reduction of penalties for those violators who detect their own violations and immediately come forward to report them. Previously, the harsh civil and criminal penalties gave violators an incentive to conceal their pollution violations rather than come forward and take cleanup actions.

For more information on these environmental laws and others that might affect your business, talk to your legal counsel. You may also obtain information from the Environmental Protection Agency by contacting:

Environmental Protection Agency
EPA Headquarters
Ariel Rios Building
1200 Pennsylvania Avenue, N.W.
Washington, DC 20460
(202) 260-2090
(202) 272-0167 (EPA Directory Assistance)
(800) 368-5888 (Small Business Ombudsman Hotline)


EPA Website
www.epa.gov

Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code, C.F.R. to the Code of Federal Regulations, U.S.C. to the United States Code.)

1. 42 U.S.C. §§ 9601, et seq.
2. 42 U.S.C. §§ 6901, et seq.
3. 40 C.F.R. § 280.22(a), (b), and (e).
4. 40 C.F.R. § 280.20.
5. 40 C.F.R. § 280.21.
6. I.R.C. § 198, applicable to expenditures made on or before December 31, 2011.
7. 42 U.S.C. §§ 11001, et seq. and 42 U.S.C. § 11023(b)(1)(A); 40 C.F.R. § 372.22(a).
8. 33 U.S.C. §§ 1251-1376.
9. 33 U.S.C. § 1344(a) and Executive Order 11990.
10. 42 U.S.C. §§ 7401-7627.
11. 15 U.S.C. §§ 2601-2629.
12. 15 U.S.C. § 2615.
13. 42 U.S.C. §§ 4321-4347.
14. 7 U.S.C. §§ 136, et seq.
15. 29 C.F.R. § 1926.1101.


Chapter 8

Technology and Your Business

"Every business that wants to survive is going to be a digital business."
-- Robert Shapiro, Undersecretary of Commerce

"The Internet is not just a technology. It's a new way of doing business."
-- Larry Ellison, CEO of Oracle Corporation

"The future is already here. It's just unevenly distributed."
-- Cyberpunk author William Gibson

8.1 Technology -- A Revolution in Progress

Until just a few years ago, many small businesses could still choose to opt out of the technology revolution. Many small firms made only token changes, such as getting a computer to do bookkeeping or word processing. With the lightning-fast rate of change occurring in computer and telecommunications technologies, those days are over.

The Internet is now the nervous system of the economy, and the driving force behind most of the change. Advances in computer chip technology are reducing the cost of computing by 30% per year, doubling the amount of computer power a dollar buys every 18 months. Bandwidth in telecommunications is doubling every 12 months, rapidly reducing costs of voice and data transfer. The business model for whole industries has changed radically and almost overnight, as commerce migrates to the Internet.

Online sales of software, computers, books, automobiles, music CDs, and other products are cutting into sales through traditional retail outlets. With the proliferation of inexpensive Internet access and low entry costs for setting up websites, every conceivable type of business or profession has begun selling and communicating with customers via the Internet, although some small business websites are little more than billboards, and others seem more like road kill, on the "information superhighway." In addition, the Internet has created whole new businesses and ways of reaching customers that never existed before, such as search engines, BLOGs, social networks, Internet portals, Internet access providers, and online auctions -- not to mention annoyances like SPAM or spyware, and serious threats to your business like computer viruses, worms, and Trojan horses, data theft, "phishing" and countless Internet scams -- most of them brought to us by the good people in places like Nigeria or Ukrania (the Ukraine).

All this change offers you, as a small business person, a tremendous range of opportunities, including low-cost ways to sell your products to customers in every corner of the planet. It is also a threat to the survival and profitability of your business if you don't take advantage of the new technology and use it wisely and effectively. Rest assured that your competitors (the ones who survive), will find ways to take full advantage of the technology. The way you approach your business, and even your daily routine, is likely to change drastically, in unforeseen ways, in the next few years.

No matter what type of business you are going into, you must spend the time and energy to discover where the information and technological revolution will take your business, and stay at least somewhat abreast of the new tools at your disposal to make your business run more efficiently.

The rest of this chapter will familiarize you with a few of the technology trends and tools you may need in order to cope with the new challenges in the digital age, as well as make you aware of some of the various taxes and business regulations that deal with the new technologies.

8.2 Using Universal Product Codes (UPC), RFID, and QR Codes or Windows Tags

Two important technologies that have grown in importance in all areas of commerce in recent years are bar codes or Universal Product Codes and radio frequency identification, or RFID systems, which are used in ways somewhat similar to bar codes to tag products. In addition, the recent proliferation of smart phones with cameras has led to other, similar developments, Quick Response (QR) Codes and Microsoft Tags, which are basically improved types of bar codes. Each of these technologies is discussed in this section, below.

Bar Codes (UPC)

Bar codes are now found on most products, from TV dinners to the Wall Street Journal. If you develop a product to sell in retail channels, you need to know about this Universal Product Code (UPC) system, and take steps early to make sure that your product's packaging will include an appropriate UPC bar code on the label.

UPC is a system that allows retailers and wholesalers to uniquely identify the millions of different products, from thousands of different suppliers or manufacturers, that are sold, delivered, and warehoused through the wholesale and retail distribution system. UPC provides a highly accurate and economical means of tracking inventories and the flow of goods, and of automating the cash register checkout process at the point of sale.

UPC codes were initially developed for the grocery industry to speed up and capture sales data at supermarket checkout counters when laser scanners were introduced. The UPC system has been a great success in helping distributors track their inventories and sales, quantify "shrinkage," and greatly speed up the movement of customers through the checkout line. The UPC system has now been adopted by department stores, specialty stores of all types, shippers like Federal Express, and commercial and industrial companies.

Every UPC bar code has three parts:

  • A six-digit I.D. number for your company;
  • A unique five-digit product number for each product (including each different product size) offered by your company; and
  • A single twelfth digit that is a check number, to help confirm that the other digits are correct.

Thus, if you sell four different products, each of which comes in "regular" and "economy" size, you will need to assign eight unique five-digit codes for each of the eight different packages. But each bar code will have the same six-digit identification code for your company.

The UPC system is not run by the government, but is instead maintained by GS1 US (formerly known as the Uniform Code Council, Inc.) a private organization and information center for all manufacturers, retailers and distributors who wish to participate in the UPC system. GS1 US, which develops standard product and shipping container codes, is the sole organization that issues UPC codes and maintains the information base on all of them.

If you develop a product for retail and want to imprint it with a UPC, you will need to sign up to join GS1 US and obtain a UPC identification number for your business. Since it will take a bit of time to join, obtain a number, and learn how to apply the UPC bar codes to your product, you should begin the process well before you plan to ship your product.

GS1 US can also provide information on how to create and use UPCs for your various products. While a UPC is not yet an absolute necessity, it is becoming more and more difficult all the time for a small company to get its products on the shelves of large distributors or retailers without a UPC. Most large companies do not want to be bothered with non-UPC labeled products, since all of their systems for managing and accounting for products are now mostly based on the UPC via laser scanning technology.

For information on Universal Product Codes, how to sign up with GS1 US, and how to get your UPC number for your business, contact:

GS1 US
7887 Washington Village Drive, Suite 300
Dayton, OH 45459
(937) 435-3870

You can apply for membership and assignment of a UPC for your company at:

Uniform Code Council website (name recently changed to GS1 US)

www.gs1us.org

Quick Response (QR) Codes and Microsoft Tags

A QR (quick response) Code is simply a two-dimensional barcode which generally looks like a square puzzle with many pieces missing. A QR Code is readable by your (smart) cell phone that has a camera, and an "app" for scanning such codes. Once a QR Code is scanned by launching the app on your phone and using the phone's camera to scan it, the code will then take you to a certain web site on the Internet. Microsoft Tags are similar, usually colored square patterns, which can also lead a prospective customer directly to your web site for product or services information or for ordering.

Putting a QR Code on a product is an excellent way to improve your marketing of that product to tech-savvy consumers, who, upon seeing your product in a store, can simply point their smart phone camera at the QR Code on the item, start the app, and quickly be transported to your web site for detailed information about the product (assuming their phone has an Internet connection at the moment).

To create a QR Code, you will need a QR Code generator, and there are several free ones online, such as:

GoQR QR Code Generator (Free)
http://goqr.me/
Microsoft Tags are also easy to create, and are free. You have probably noticed these colorful squares in magazine and newspaper ads or even on commercial vehicles. While these patterned squares may contain various colors, they will also work if black and white. Like QR codes, people with smart phones can download a free Tag app from Microsoft onto their phone and simply use it to scan a Microsoft Tag, which will take them directly to your web address.

To create a Microsoft Tag, go to this Internet address:

Microsoft Tag page
http://tag.microsoft.com/home.aspx
Select the "MY TAGS" menu and the "Tag Manager" item on that menu. (You will need a Windows Live ID to sign in.) Once you are signed in, click on "Create a Tag" and then enter a title for your tag and the URL you wish for customers to be sent to when they scan your tag into their mobile device. Next, SAVE it, and download the tag, in the form of a .PDF file. Microsoft lets you create either a Microsoft Tag (in color, or in black and white, if you prefer) or a QR Code.

Once you have downloaded the .PDF file tag, open it and use a screen capture program (Windows 7, Windows 8, or Vista users can use the Windows Snipping Tool) to copy the tag image into an easily usable graphics file that you can save on your computer, such as a .JPG or .GIF file.

Once you have saved your Microsoft Tag file as a graphics image and have tested it with your smart phone or other mobile device to make sure it works, you can then put the image on everything from t-shirts to business cards to your business letterhead, or on product packaging or commercial vehicles, thus making it possible for potential customers with mobile devices and the Tag app to instantly go to a desired web page you have set up. (Preferably, the target web page should be sized and formatted to be easily read on a small smart phone screen.)

RFID Systems

RFID is a technology similar in theory to bar code identification, but is a newer and more versatile application. An RFID chip or tag is attached to an item and used to transmit signals, transmitting in radio frequency (RF). An RFID system consists of several parts: an antenna and a transceiver, which read the radio frequency and transfer the information to a processing device, plus a transponder, or tag. The latter is an integrated circuit or chip that contains the RF circuitry and information to be transmitted. Most RFID tags do not actually transmit, and thus don't need a battery or other power source -- it is a very inexpensive tag that is passive, until its circuits are activated by a radio frequency signal broadcast from nearby, that "pings" the RFID chip and gets a signal back.

RFID systems are being used just about everywhere, from clothing tags to guided missiles to pet tags to food -- anywhere that a unique identification system is needed. RFID tags can carry information as simple as a pet owner's name and address or the price of a store item to as complex as instructions on how to assemble a complex piece of machinery on an assembly line.

One of the main advantages of RFID over bar code technology is that RFID eliminates the need for line-of-sight reading that bar coding requires. In addition, RFID scanning can be done at greater distances than bar code scanning, since the RFID chip can transmit signals at ranges of more than 90 feet. Unlike bar codes, which are passive markings, RFID tags are active, in that they broadcast a signal that can be received and deciphered, and can carry much more complex information than bar codes.

Use of RFID in commerce, manufacturing, government, and even military applications is exploding, made possible by the ever-falling prices of powerful integrated circuits. If you hadn't heard of RFID before, this will not be the last time you will hear of it, as the RFID chips are becoming ubiquitous, despite the growing societal concerns about their infringement on rights of privacy. Some cities, like Albuquerque, New Mexico, already require such chips to be implanted in dogs, in order to obtain a pet license -- and humans may be next....

8.3 ISO-9000 Quality Standards and Certification

As a small business person, you may have already heard of ISO-9000, but may be wondering what it means and whether it is something you should find out about. The following brief discussion answers some frequently asked questions about ISO-9000 (which was updated in 2000 by the new ISO-9000:2000 and ISO-9001 standards). While ISO-9000 deals in part with technology matters, its primary focus is on quality standards. If you intend to sell goods or services in the global economy, via the Internet or otherwise, ISO-9000 certification will become increasingly important for your business.

What Is ISO-9000 (or ISO-9001), and What Does it Mean?

ISO-9000 is simply one of a set of international standards, administered by the International Standards Organization (ISO) in Switzerland, for both quality management and quality assurance. These standards have been adopted by over 90 countries worldwide. The ISO-9000 standards apply to all types of organizations, large and small, and in many industries. They cover both products and services. The ISO-9000 series of standards is comprised of several specific requirements that are intended to ensure a quality process in providing services or products to an organization's customers.

You can think of ISO-9000 as an international stamp of quality, that helps businesses define and document their own quality procedures for production and/or services. These standards can be used in any type of business and are accepted around the world as proof that a business can provide assured quality.

ISO-9000 sets forth the requirements your quality system must meet, but it does not dictate how they should be met in your organization, leaving a great deal of scope and flexibility for implementation in different business sectors and business cultures, as well as in different national cultures.

The ISO-9000 standards require:

  • Standard language for documenting quality processes;
  • A system to manage evidence that these practices are being instituted throughout an organization; and
  • Third-party auditing to review, certify, and maintain certification of organizations.

The ISO-9000 series classifies products into several generic product categories: hardware, software, processed materials, and services.

Why Is ISO-9000 Certification Important to a Business?

ISO-9000 certification is already a requirement in many international markets. Although ISO-9000 is not necessarily required (yet) for entrance into foreign markets, for many companies it is essential for maintaining and improving competitiveness. Ignoring ISO-9000 may cost you business opportunities, especially if you are seeking markets in Europe, and ISO-9000 is likely to become more and more important as time passes.

ISO-9000 registration and certification will allow your business, whether large or small, to be recognized around the world for quality. Achieving ISO-9000 conformity can result in increased sales and reduced costs in the long run. One of the main reasons for attaining ISO-9000 registration is to satisfy demands customers have for quality. To maintain quality and satisfied customers, ISO-9000 requires repeated, periodic on-site audits in the future.

Where Did ISO-9000 Come From?

ISO-9000 started in Europe in 1987 and was later revised in 1994, and again in 2000 (ISO-9000:2000 and ISO-9001). ISO-9000 is also the basis for the Big Three auto companies' QS-9000, which is now the auto industry's required quality standard.

What Must a Company Do to Comply with ISO-9000?

To comply with the ISO-9000 quality standards, a business must have a comprehensive, documented policy and procedures for all its operations, work instructions for each job, and written or computerized records that prove that the company is following its policies and procedures as written.

Documentation is an essential part of ISO-9000 conformance. In fact, the standards have been paraphrased as: "Say what you do. Do what you say. Write it down."

What Is the Goal?

The key to obtaining ISO-9000 registration is to first successfully complete a third-party audit. This requires you to hire a qualified, outside registrar agency to conduct an on-site audit of your business operations. The audit will make sure that all operations of your facility conform to the standards of ISO-9000. If the audit is successful, ISO-9000 certification is immediately granted. Even if it is not, the problem areas highlighted by the audit can be very useful to you in improving your business operations.

PLANNING POINT:
The IRS has ruled favorably for taxpayers that most costs of ISO-9000 certification are currently deductible as "ordinary and necessary" expenses, and do not have to be capitalized. Although ISO-9000 certification is voluntary, the IRS took note of the fact that it is increasingly a contractual requirement for doing business with many organizations worldwide, and is also an alternative to product certification in some foreign markets, particularly the European Union.[1]

Where Can I Get More Information on ISO-9000?

ISO has published a handbook, ISO 9001 for Small Businesses. Aimed at managers, it explains the quality system standards in plain language, with the intention of putting improvements in performance, quality, customer satisfaction and market access within reach of any manufacturing or service organization regardless of size, through implementation of an ISO-9000 quality system.

You can also visit the following website to find out more about ISO-9000 and how it may impact your small business:

ISO 9000 Website
www.iso.org/iso/home.htm

8.4 Is Electronic Data Interchange (EDI) in Your Future?

Electronic Data Interchange ("EDI") is a hurdle your small business is likely to face if you deal with large customers. Pioneered by companies like Wal-Mart, EDI is now filtering down the economic food chain to many smaller companies, and is both a problem and an opportunity for your small business.

Briefly described, EDI is computer-to-computer exchange of business information between trading partners, such as inventory data between retailers or wholesalers and their suppliers. It allows firms who do business on an ongoing basis with each other to eliminate the costly and time-wasting processes of generating and mailing paper documents that must then be re-keyed into the recipient's computer system.

Transferring such information, which is often time-sensitive, electronically by modem not only avoids mail delays and costs, but also tends to sharply reduce errors from retyping the information into computers on the receiving end.

What allows EDI data swapping to work effectively is a number of "transaction sets" (designated X12) created by the American National Standards Institute (ANSI), for common business documents like purchase orders and invoices. Using the X12 transaction sets, and in most cases relying on third-party value added networks (VANs), it is now possible for otherwise incompatible computer systems to communicate seamlessly.

The down side in this otherwise cheery picture is that many big vendors are requiring even the smallest suppliers to set up EDI links if they want to do business with those large firms. In addition, more government agencies that contract with small businesses require bidders to have EDI capability to be considered for government contracts, except for the very smallest dollar amounts. If you aren't up to speed on EDI, you may be out of contention for government contracts now or in the future, as well as being unable to deal with many commercial firms that require EDI.

To gear up your operation for EDI, you need to sign up with a VAN that can act as the intermediary between you, the supplier, and your large customer. Relatively affordable EDI software packages are also available now that can make the transition to this way of doing business relatively pain­less.

PLANNING POINT:
Do your homework and gear up for EDI now. Otherwise, you may be caught later in a tight situation when a major customer announces suddenly that it will henceforth require EDI links with all its suppliers. Many Small Business Administration offices offer seminars on how to set up your firm on EDI. For assistance or to find out where you can attend a seminar on EDI, contact your local SBA office, SCORE chapter, or the nearest Small Business Development Center. For contact information for a SBA office in [STATE NAME], see [LINK DELETED] of the [STATE NAME] state chapter.

Links to various resources on EDI include the following:

SBA Answer Desk
(800) 827-5722

SBA Online
www.sbaonline.sba.gov

Association of SBDCs
www.asbdc-us.org

SCORE Online
www.score.org

Fortunately, for small businesses, the rise of business-to-business Internet sites may eventually spell the end of EDI, or at least greatly limit its growth. Because EDI is a restrictive format that runs only on proprietary networks, it is likely that many firms, even those that pioneered EDI, like auto manufacturers, will soon migrate their purchasing functions to the Web, since suppliers tend to find using "B2B" web sites, in the open environment of the Internet, less difficult than an EDI system. Although most firms with EDI systems in place are not abandoning them, but are continuing them for now, alongside their use of the Internet, it seems likely that many will eventually migrate everything to the Internet.

8.5 Internet Taxation and Regulation

Thanks to the explosive growth of the Internet since it sprang into existence in the 1990's, it has become an ever more enticing target for taxing by governments. So far, most governments in developed countries have tended to exercise restraint in imposing new taxes on the Internet, in order to give it time to grow, although that respite may not last much longer.

Since the Internet is a global medium, doing business on it makes it necessary for you to be aware of the tax and regulatory aspects of federal law, state laws and regulations throughout the entire United States, as well as some international taxes and laws that affect Internet commerce, and which may impact your company. All of those areas of the law are discussed briefly below in this section.

Federal Anti-SPAM Laws

Congress has taken action in recent years to attempt to stem the tide of unwanted, unsolicited junk e-mail ("SPAM") and "porn mail" on the Internet,[2] by enacting the "CAN-SPAM" Act of 2003, which went into effect on January 1, 2004. This law imposes stiff penalties of up to $250 per violation (limited to $2 million total) on SPAMmers who engage in any of the following prohibited practices:

  • Sending "porn mail" -- commercial e-mail with sexual content, such as messages promoting pornographic web sites or sale of pornography;
  • E-mail with deceptive "headers" or subject lines, which disguise the nature of the commercial message within;
  • Sending e-mail with false return addresses ("spoofing") or false IP (Internet Protocol) addresses;
  • E-mail solicitations sent to "harvested" addresses (gathered automatically from Internet web sites by special robot software) or to "dictionary lists" of e-mail addresses created by mechanically generating large numbers of target addresses, such as: abc1@xyz.com, abc2@xyz.com, abc3@xyz.com, etc.;
  • Continuing to send e-mail solicitations to recipients who have requested that the sender (or all senders) cease sending messages to that recipient, more than ten business days after such a request; or
  • Sending fraudulent e-mail, such as chain letters, or other fraudulent schemes such as the infamous Nigerian Scam, which has bilked gullible recipients out of billions of dollars (making that particular scheme the second largest source of foreign exchange for the nation of Nigeria, second only to oil exports).

Other anti-SPAM penalties include statutory damages that Internet service providers ("ISPs") may seek from SPAMmers who use their facilities or servers to send SPAM that violates the anti-SPAM rules, in the amount of $25 per message, or $100 per e-mail that uses a fake or "spoofed" return address or false header. There is a $1 million limit on damages that any ISP may collect in an action against a violator. [3]

Congress also directed the Federal Trade Commission (FTC) to create, by July 1, 2004, a "Do-Not-E-Mail" registry, where anyone who wished not to receive commercial e-mail solicitations could list their e-mail address. [4] Mass e-mailers were supposed, in theory, to refrain from sending e-mail addresses listed on the Do-Not-E-Mail registry, which would be similar to the Do-Not-Call Registry that has been established to prevent unwanted telephone solicitations.

However, recognizing that SPAMmers would probably use such a registry as just another list of names to send SPAM to, the FTC advised Congress on June 15, 2004 that the Do-Not-E-Mail Registry would fail to reduce SPAM, since there is currently no way to enforce the registry effectively.

Accordingly, the Do-Not-E-Mail Registry will apparently not be implemented by the FTC until technological improvements and international cooperation make it possible to effectively enforce the anti-SPAM laws.

As anyone who has an e-mail account knows, the anti-SPAM laws have so far had little, if any, effect on the growing volume of SPAM and "porn mail" we receive daily, since most of the SPAMmers are either outside the United States or are using servers in foreign countries, where U.S. laws cannot reach. One expert recently estimated that, since the anti-SPAM laws have made it riskier to send SPAM from within the U.S., some 70% of the SPAM we receive is now sourced from ISPs in China, a nation which has shown little interest in cracking down on SPAMmers.

While the anti-SPAM laws have not been able to reduce the amount of unwanted e-mail clogging your in-box, the laws do have significant teeth, as noted above, for anyone based in the United States who sends out SPAM e-mails. Thus, if you are using e-mail as an advertising or marketing tool, you need to know what is, and is not, permissible. Points to remember include the following:

WHAT IS O.K.

  • It is generally permissible to send e-mail solicitations to anyone who has affirmatively consented to receive such messages from you.
  • Anti-SPAM rules do not apply to e-mails you send to a customer in the process of facilitating or completing a transaction or responding to questions or service requests from a customer.
  • Nor do the anti-SPAM rules apply when you send information to a customer with whom you have an ongoing relationship, such as subscribers to a publication or service you offer, or to notify a customer of product updates or upgrades to which they may be entitled.
  • You do not have to first check the "Do-Not-E-Mail Registry" before sending out solicitations, since, as noted above, the FTC has decided not to create such a registry.

WHAT IS NOT O.K. (WITHOUT AFFIRMATIVE CONSENT OF THE RECIPIENT)

  • Don't send advertising e-mail with false or misleading headers, subject lines (a tactic commonly used to trick recipients into opening a junk mail message, such as "You have won the Powerball Lottery!").
  • Don't use false or inaccurate routing information: "From" and "To" routing information must be accurate and must identify the sender.
  • Don't promote fraudulent schemes, such as chain letters, pyramid schemes, or variations on the "Nigerian Scam" described above.
  • Don't send e-mail solicitations to "harvested" addresses (gathered automatically from Internet web sites by robot software) or to "dictionary lists" of e-mail addresses that are created by mechanically generating large numbers of target addresses, such as: abc1@xyz.com, abc2@xyz.com, abc3@xyz.com, etc.
  • Don't send advertising solicitations to anyone who has asked you not to e-mail them.
  • Don't send advertising solicitations unless you:
    • Clearly identify the message as advertising, and advise the user how to opt out of receiving further solicitations, using an e-mail or other Internet-based mechanism by which the recipient can opt out. As the sender, you must process the request within ten business days of receipt, and cannot provide the recipient's e-mail address to another party;
    • Include a valid e-mail return address;
    • Identify your company; and
    • Include your physical postal address.
  • Don't send solicitations with sexual content unless the recipient has affirmatively consented to receive such messages from you, or unless the header or subject line provides a warning that the e-mail contains sexually explicit material or is promoting such material.
CAUTION:
It is still legal for you to send unsolicited commercial e-mail, or SPAM, but only if you heed all of the foregoing rules. Failure to do so may subject you to criminal penalties and fines, as well as statutory damages from private lawsuits that can be brought against you by ISPs.
IMPORTANT NOTE:
While unsolicited, non-compliant SPAM is illegal in the U.S., don't think you can simply send SPAM solicitations to e-mail addresses in Europe, instead of to U.S. recipients. The 2002 EU Directive on Privacy and Telecommunications gives everyone in EU countries the right to seek damages against the originators of unwanted e-mail, fax, or text messages.

Restrictions on Collection of Information from Children on the Internet

Another federal law, the Children's Online Privacy Protection Act of 1998 ("COPPA"), designed to protect children who use the Internet, makes it unlawful for an operator of a website or an online service directed to children to collect personal information from children, such as first and last name, street or e-mail address, telephone number, social security number, or other specified information concerning the child or the child's parents. Under this law, "children" are defined as anyone under the age of 13.[5]

COPPA is sometimes confused with COPA, the Child Online Protection Act, which was designed to restrict access by minors to pornography or other online material that might be harmful to them. COPA was held by the federal courts to be unconstitutional, as an infringement on the right of free speech.[6] COPPA, however, remains in force and limits the ability of web sites to offer services to those aged twelve and under without explicit parental consent.

Moratorium on State Taxation of the Internet

The Federal Omnibus Funding Bill signed by President Clinton on October 21, 1998, included the Internet Tax Freedom Act, a federal law that provided a three-year moratorium on state taxation of electronic commerce. The moratorium generally prohibited taxes on Internet access, unless the tax (such as a sales tax) was imposed and enforced prior to October 1, 1998. The moratorium also prohibited multiple or discriminatory taxes on electronic commerce during the moratorium period, which expired October 21, 2001 [7], but was extended to October 31, 2003. Although the tax moratorium expired on November 1, 2003, the Congress finally acted in late 2004 and renewed it (retroactively) for the period from November 1, 2003 until November 1, 2007.[8],

Two days before the law expired again, on October 30, 2007, Congress extended the moratorium for another 7 years, to November 1, 2014. The latest extension also expands the definition of Internet access to include a home page, electronic mail and instant messaging (including voice- and video-capable electronic mail and instant messaging), video clips, and personal electronic storage capacity, which are provided independently or not packaged with Internet access. Also, the grandfather provisions are amended to prohibit any state from reimposing Internet access taxes if a grandfathered state had subsequently repealed the taxes more than two years ago or if a state agency had issued a rule that it would no longer apply the tax to Internet access charges.

Some states, which already were subjecting Internet services to sales tax, have continued to do so. For example, Ohio announced it would continue to tax Internet access fees paid by businesses, and North Dakota, South Dakota, Texas, and Wisconsin have also continued to apply sales taxes to Internet access charges.

The other, less publicized part of the Internet Tax Freedom Act is the part that creates an Electronic Commerce Advisory Commission to do a study and make recommendations to Congress as to how the states and the federal government should go about taxing the Internet. Thus, the moratorium on Internet taxes under this Act should be viewed as more of a stay of execution, not a pardon, from Internet taxation. The initial report of the Commission made a number of recommendations, including one that the moratorium should be extended until 2006 (it has actually been extended until November 1, 2014, as noted above). The report also concluded that before states could be allowed to impose sales taxes on Internet services, they should first radically simplify the current hodge-podge of complex and confusing state and local sales tax rates and rules. That attempt, the Streamlined Sales Tax Project, is already well under way.

UPDATE NOTE:
In addition, as this edition "goes to press" in May, 2013 the U.S. Senate seems likely to pass a "Mainstreet Fairness Act" that would allow states to force online sellers in other states to collect sales tax or use tax from customers in the state imposing the sales tax. Passage of this bill by the House seems less likely, however.

International VAT Taxes on Internet Transactions

Effective since July 1, 2003, the European Union (EU) governments have required suppliers outside the EU who sell digitally transmitted services and products to consumers in the EU to begin collecting European value-added taxes (VAT) on such transactions. Thus, the VAT tax now applies to transactions such as sales of downloadable software via the Internet.

The standard VAT tax rates vary from country to country in European countries. The rates range from a minimum of 15% in Cyprus and Luxembourg to 27% in Hungary. These are the rates in effect in early 2013:

  • Hungary -- 27%
  • Sweden and Denmark -- 25%
  • Romania, Finland -- 24%
  • Ireland, Greece, Portugal, and Poland -- 23%
  • Latvia, Spain, Italy, Belgium, Czech Republic, Netherlands, and Lithuania -- 21%
  • U.K., Estonia, Austria, Bulgaria, Slovakia, and Slovenia -- 20%
  • France -- 19.6% (increasing to 20% on January 1, 2014)
  • Germany -- 19%
  • Malta and Cyprus -- 18%
  • Luxembourg -- 15%
UPDATE NOTE:
Under the 2010 "bail-out" of Greece by a group of Euro zone nations and the International Monetary Fund, the VAT tax rate in Greece was increased from 21% to 23% on July 1, 2010. More recently, Hungary increased its rate from 25% to 27%, Ireland from 21% to 23%, Italy from 20% to 21%, Finland from 23% to 24%, Spain from 18% to 21%, the Czech Republic from 20% to 21%, the Netherlands from 19% to 21%, and Cyprus from 15% to 18%. France's VAT rate will increase from 19.6% to 20% on January 1, 2014. Latvia, the rare exception, has decreased its VAT rate from 22% to 21%.

These EU rules that went into effect in 2003 impose significant administrative responsibilities on all U.S. sellers of digitally-transmitted services and products to individual EU consumers. The new rules do not apply to sales of printed materials, such as books, newspapers and periodicals, and do not apply to business-to-business sales into the EU, since the VAT is paid on such imports by the importing company under self-assessment arrangements.

Note that Canada and several non-EU European countries (Switzerland, Norway, and Iceland) all have VAT taxes as well, but none of those countries are members of the EU and they do not impose administrative and tax collection responsibilities on U.S. sellers of digitally-transmitted products and services to consumers in those countries. For an up-to-date list of VAT tax rates in Europe and other nations, see this EU web site: http://ec.europa.eu/taxation_customs/taxation/vat/how_vat_works/rates/index_en.htm

IMPORTANT NOTE:
How, you may well ask, do these European VAT taxes have anything to do with my U.S. business?

Generally, they do not. However, if your business is selling software or electronic publications on the Internet, for example, you may be required to collect and pay Euro Zone VAT taxes on sales made to residents of most European countries. If you make sales of digitally transmitted software or publications into Europe, you will need to consult your accountants regarding your VAT tax responsibilities and factor the collection and payment of these very hefty taxes into your business planning.

8.6 Telecommuting and Other Important Technologies and Trends To Watch

New trends and technologies may affect your business in many different ways. They could even create a new customer base. One of the most predictable trends, already well under way, is the continued growth of telecommuting. You may be one of those who work from home, communicating with your clients or employer by personal computer, modem, or fax. This has become increasingly common, as telecommuting can save both time and money wasted on commuting long distances, as well as reducing the amount of office space and overhead costs for employers.

Telecommuters are not only a source of labor, but can also be a source of customers. Major opportunities are available to businesses that find creative ways to serve these at-home workers, including businesses as mundane as pizza delivery. A whole new at-home business market is being created -- and waiting to be served.

State Tax Problems for Telecommuters

As with any other booming new economic trend, state governments are always looking for ways to increase tax revenues, or to capture lost revenues where employees live in another state and telecommute most or all of the time, rather than coming in to an office in the taxing state. Of course, the state where a worker lives will tax him or her on some or all of their compensation, but in many cases employees will live in and telecommute from a state with no state income tax or with low income tax rates, while employed in a high-tax state, hoping to avoid being taxed in the high-tax state, such as New York or California.

Traditionally, in such a case, the employee who only comes in and works part of the time in the state where the employer's office is located has been taxed in that state only on a certain percentage of his or her wages. This allocation is usually done based on the number of days of physical presence in each state where services are being rendered.

This kind of allocation is still generally in effect, but several states, including New York, Pennsylvania, New Jersey, Delaware, and Nebraska, fearing a loss of tax revenues from telecommuters who live in nearby states, have adopted a more aggressive approach. Those states (and Oregon may soon adopt a similar position) now take the position, generally, that ALL wage income earned by telecommuters who are employed in their state is taxable, if the worker telecommutes for convenience, rather than out of necessity.

Determining when an employee telecommutes for reasons of "convenience" or not is still somewhat of a gray area, except in the state of New York, which has set forth some very specific guidelines. To avoid being taxed on all of his or her salary or wages when telecommuting to a job in New York, the employee must meet either of two tests:

  • He or she meets a single criterion (a "primary factor") -- maintaining a home office that contains or is near "special facilities" that are not or cannot be made available at or near the New York employer's place of business. A memo published by the New York Department of Taxation and Finance[9] gives as an example a test track to test new cars, located in a neighboring state, near the home of an employee who does work there, rather than at the New York City office of the employer. But, the memo goes on to note, if the employee's duties require use of specialized scientific equipment set up at the employee's home (or nearby), but which could physically be set up at the employer's office in New York, then the home office would not meet the "primary factor" test.
  • Otherwise, if the "primary factor" test cannot be met, the employee must meet a combination of any 4 of 6 "secondary factors" plus any 3 out of 10 "other factors." The 6 "secondary factors" are as follows:
    • Home office is a condition of employment.
    • Employer has a valid purpose for the location of the employee's home office.
    • Employee performs some or all of the core duties of the job at the home office.
    • Employee meets with customers, clients, or patients on a regular basis at the home office.
    • Employer does not provide employee with regular office or work space accommodations at any regular place of business.
    • Employer pays for substantially all of the employee's home office expenses or pays a fair rental and for all of the equipment and supplies used at the employee's home office.

    The 10 "other factors" are as follows:

    • Employee has separate phone line and listing for the home office.
    • Employee's home address and phone number are on letterhead or business cards.
    • Home office is used exclusively for the employer's business.
    • If employee does selling of products, a supply of products or samples are kept at home.
    • Employee stores business records at his or her home office.
    • A sign designates the home office as an office of the employer.
    • The home office is identified as the business office in any advertising.
    • A business insurance policy or a rider to the homeowner insurance provides business insurance coverage for the home office.
    • A home office deduction is (properly) claimed by the employee on his or her federal income tax return.
    • The employee is not one of the officers of the company.

If an employee meets the above requirements, then New York will treat any time worked at the home office, when performing regular duties of the job, as days worked outside New York, and will only tax the employee based on the days when he or she is physically present and working in New York.

While the states other than New York that have adopted the "convenience test" in order to tax telecommuters have not spelled out their definitions of "convenience" in such detail, the various factors noted above should be taken into account if you or your employees are seeking to telecommute into one of the states that is aggressively taxing telecommuters. With most state governments currently facing large tax revenue shortfalls, it is also very likely that an increasing number of states will soon follow the lead of New York state and the other states noted above, in seeking to extract more income taxes from telecommuting employees who reside outside the state.

Trends to Watch

To stay competitive in your chosen business, also watch for these trends and new technologies:

  • Cloud Computing. One of the fastest growing technology trends at present is the rapid migration of software and data storage to "the cloud." That is, more and more software, instead of being shipped on disk or downloaded by the company or individual who has purchased it, is now placed on a server of the company that publishes it, where users can utilize it online, rather than having the program reside on their computer's hard disk. This has a number of advantages, chief among them the fact that when the software publisher upgrades or updates its software on its servers, or fixes a bug, the upgrade or bug fix is instantly and automatically available to the users, who no longer have to download a new version or "patch" onto their system. Similarly, software firms such as game developers of multiplayer interactive games can now simply rent all the computing space they need on "the cloud," rather than having to invest in their own bank of servers and pay an I.T. staff to keep their servers running.
  • Faster Internet Access. If you are in an area where access to cable modems is available and you spend considerable time using the Internet in your business, consider taking advantage of this way to access the Net. While cable modem access will cost a few dollars a month more than going through traditional Internet service providers by telephone modem, the many hours of time cable modems will save you each month make this technology a true bargain. Other technologies such as wireless or DSL telephone service may equal or surpass the speed and power of cable modem access, and you may want to compare those options. If your business is large enough, and fast Internet access is essential, you may choose to spend the money for a "T-1" or "T-3" line, which provide even faster access but are far more expensive than cable or DSL.
  • Internet Telephony. More companies are developing methods and offering services to use the Internet for voice communication, known as Voice Over Internet Protocol (VOIP). Although Internet phone services may not yet offer "pin-drop" sound quality, they are improving, and the price is right -- either free or a tiny fraction of what local or long distance telephone companies charge, and some cell phone providers are now making it possible to use VOIP systems like Skype on cell phones.
  • Electronic Imaging of Documents. As computing power grows and data storage costs drop, document imaging and manipulation, searching, and automated cataloging of documents is becoming feasible for more small businesses, taking the place of rooms or warehouses full of paper documents and improving access to them.
  • Postage over the Internet. Services now allow you to download postage electronically for a very modest monthly fee plus the cost of the stamps.
  • Electronic Authentication of Documents and Digital Signatures. You can now send "signed" documents by e-mail. In the year 2000, President Clinton signed into law federal legislation that makes electronic signatures legally enforceable. This law provides that no contract, signature or record will be denied legally binding status just because it is in electronic form. But it also provides that most electronic contracts and documents will be legally enforceable only if they are in a form capable of being retained and accurately reproduced for later reference.
  • Extensible Markup Language (XML). Most documents on World Wide Web sites are currently written in hypertext markup language (HTML). In the next few years, the much more powerful and flexible XML will be a huge boon to electronic commerce, since it does everything HTML does, plus much more, such as identifying each piece of data (such as name, address, price, and the like), permitting information to be easily and widely shared across all computing platforms. If you have a company website written in HTML now, you will probably be rewriting it in XML in the near future.

Endnotes

(C.F.R. references are to the Code of Federal Regulations; U.S.C. references are to the United States Code.)

1. Rev. Rul. 2000-4, 2001 C.B. 331.
2. 15 U.S.C. § 7701.
3. 15 U.S.C. § 7706.
4. 15 U.S.C. § 7708.
5. 15 U.S.C. §§ 6501, et seq. and 16 § C.F.R. 312.
6. A.C.L.U., et al v. Mukasey, U.S. Ct. of App. (3rd Cir., 2008); U.S. Supreme Court refused to hear government's appeal of decision, on January 21, 2009.
7. Pub. Law 105-277, Div. C., Title XI, Sections 1100-1104, October 21,1998, 112 Stat. 2681 (uncodified).
8. 47 U.S.C. § 151 (footnote re amendment to Internet Tax Freedom Act, Pub. Law 110-108, §§ 2-6, Oct. 31,2007, 121 Stat. 1024-1026).
9. N.Y. State Department of Taxation and Finance, Memo TSB-M-06(5), May 15, 2006.


Chapter 9

Miscellaneous Business Problems and Pointers


"If automobiles were like computer software, their wheels
would fall off several times a day."

-- Bob Metcalfe, Infoworld columnist

"All that happens [in a tax audit] is, you take your financial records to the
IRS office and they put you in a tank filled with giant, stinging leeches.
Many taxpayers are pleasantly surprised to find that they die within hours."

-- Dave Barry

"Paying creditors only encourages them."
-- Richard Brinsley Sheridan, in School for Scandal


This chapter contains information you can use on a variety of topics of interest to many small businesses, ranging from basic information on protecting your assets from creditors when you go into business (under the new bankruptcy law), to registering patents, trademarks and copyrights, to deciding whether to invest or participate in a multilevel marketing program. Also covered are protection of trade secrets, exports and customs rebates, consumer credit laws, mail order and telemarketing regulations, and investment reporting requirements in the U.S. if yours is a foreign-owned business.

9.1 Protecting Your Assets from Creditors

Starting a new business is a risky proposition, but careful planning can help protect you and your assets should your business experience financial trouble in the future.

Incorporation or Use of an LLC or LLP

One of the basic and most common ways to protect your assets is by incorporating or setting up another limited liability entity, such as a limited liability company (LLC) or limited liability partnership (LLP) at the outset. That will generally limit your liability to creditors to the amount you invest in the business.

However when relying on a corporation to protect you from personal liability, remember the following points:

  • Be cautious about committing too much of your personal wealth into the business. For example, instead of putting a building or piece of land you own into your corporation, consider keeping the property in your own name and leasing it to the corporation (you may also save on income and property taxes).
  • Even if you incorporate, any leases or bank loans you have personally guaranteed on behalf of the corporation could still wipe out your personal assets if the business folds and you have to make good on the guarantees.
  • If the corporation does not observe requisite legal formalities or is too "thinly capitalized," creditors may be able to "pierce the corporate veil" and proceed directly against you and the other shareholders.
  • As an officer or director of the corporation, you may be sued and be personally liable for certain actions or inactions on your part, although you are not generally liable for the debts of the corporation.

See Chapter 2, Section 2.4 for more details on incorporation in general and for state-specific information on incorporating in [STATE NAME].

An alternative to incorporating, now available in all 50 states and the District of Columbia, is to organize your business as a limited liability company. An LLC is a business entity similar to a partnership, but it provides its owners limited liability, generally to the same extent as a corporation. A single-owner LLC can also be established, which will provide you liability protection, but whose existence is usually disregarded, like a sole proprietorship, for federal tax purposes, and for state tax purposes in most states. See Chapter 2, Section 2.6 for more general information on LLC's, and for state-specific information [LINK DELETED] on LLC's in [STATE NAME].

Similarly, all 50 states and the District of Columbia now provide for limited liability partnerships (LLP's). However, LLP's are generally used only by professional service firms, such as doctors, dentists, lawyers, accountants and architects, and some states, such as New York and California, only allow LLP's to be set up by certain licensed professionals. LLP laws initially enacted in the 1990s generally did not provide full liability protection. Instead, they usually protected a partner only from liability for negligence or misconduct committed by another partner, such as professional malpractice. However, in recent years, most states have adopted revised LLP laws that provide roughly the same degree of liability protection as a corporation or LLC.

See Chapter 2, Section 2.3, for more general information on LLP's as well as for state-specific information [LINK DELETED] on LLP's in [STATE NAME].

Using a corporation or other limited liability entity will generally shield you, personally, from claims that are made against the business. However, even a corporation or LLC will not protect you from lawsuits or other creditors' claims against you as an individual, if you individually have to file for bankruptcy. The rest of this section discusses some of the ways to protect your personal assets from such direct claims.

Using Qualified Retirement Plans for Asset Protection

It often makes sense to have an incorporated business set up a tax-qualified pension or profit-sharing plan and to have it contribute as much as possible to the plan on your behalf. Not only does this provide substantial tax savings and deferral, but federal law (ERISA -- the Employee Retirement Income Security Act of 1974 -- and the Internal Revenue Code) and the law in most states will generally protect your account under such a plan from your creditors or the corporation's creditors, except for these three main exceptions:

  • Retirement plan assets are considered marital assets that are subject to division in a divorce and attachment for child support, and both ERISA and the Internal Revenue Code allow plan assets to be reached by a qualified domestic relations order from a court, in divorce or child support cases;[1]
  • Not surprisingly, the Internal Revenue Service can grab your retirement plan assets for taxes you owe;[2] and
  • Certain criminal or civil judgments, consent decrees, and settlement agreements can offset retirement benefits when the plan participants committed fiduciary violations or other crimes against the plan.[3]

Besides the three above exceptions, there are two other situations where it is possible that plan assets will not be bulletproof. One is where a fine has been imposed in a federal criminal action -- the IRS has taken the position lately that the federal government may take the pension assets of the person who has been fined. In addition, both state and federal courts have generally held that the protection of qualified retirement plan assets in bankruptcy cases is not available if the only participants in a plan (corporate or Keogh plan) are the business owner and the spouse of the owner. There needs to be at least one common-law employee participant in the plan, in order for the ERISA and Internal Revenue Code protective provisions to apply, according to various court decisions.

Until recently, it was also unclear whether assets placed in an Individual Retirement Account (IRA) could be reached by creditors in bankruptcy, as the federal Courts of Appeal had split on this issue. However, in April, 2005, the U.S. Supreme Court ruled, in the Rousey v. Jacoway case, that IRAs are similar in nature to pension plans and should also be shielded from claims of creditors under the bankruptcy code. This was a very important court ruling, since it made it safe to roll over pension or profit sharing plan monies to a "rollover IRA," thus doing so will no longer necessarily cause you to give up protection of your retirement nest-egg from potential claims of creditors.

IMPORTANT NOTE:
The revised federal bankruptcy act that went into effect in late 2005 has added to and clarified the asset protection treatment of various types of tax-qualified retirement plans, including IRAs.

These changed bankruptcy rules can be summarized briefly as follows:

  • The federal bankruptcy law now completely protects assets of a qualified pension or profit sharing plan (corporate or Keogh). Previously, case law in the state and federal courts had not generally provided this protection where the only participants in a corporate or Keogh plan were the business owner and the spouse of the owner.
  • SEP (Simplified Employee Pension plans -- IRAs that are established by employers for employees) and SIMPLE plans are also fully protected in federal bankruptcies, but where such plans are subject to ERISA (which, like the federal bankruptcy law, does not protect such plans from attachment, garnishment, or state law insolvency actions), any state law protections may be pre-empted by ERISA and thus may not offer any actual protection.
  • Rollover IRAs, where assets are rolled over from qualified corporate or Keogh plans or from SEPs or SIMPLE plans, also are completely protected in federal bankruptcy cases. Rollovers from SEP or SIMPLE plans, or from traditional or Roth IRAs may only be protected to the extent of $1 million, however.
  • Traditional and Roth IRAs funded by the employee are now protected, but only to the extent of $1 million, but are also generally protected from state law attachment or garnishment proceedings, under state laws in many states.
CAUTION:
The new federal bankruptcy law deals with bankruptcy proceedings, but does not offer any protection to retirement plan assets under state law attachment, garnishment, or insolvency proceedings.

Here the law gets quite complex, as it is a combination of ERISA anti-alienation protections, state laws, and state and federal case law. However, as a general rule, assets of qualified pension or profit sharing plans are protected under ERISA, with the exceptions noted above for divorce proceedings, fines, taxes owed the IRS, etc. The main concern is where a plan has only the owner and spouse as participants, in which case there may be little or no protection against garnishment or similar state proceedings that seek to seize or attach assets in such plans outside of bankruptcy, unless the law of a particular state offers such protection.

In addition, SEP, SIMPLE, and traditional or Roth IRA plans are not protected against garnishment or other alienations under ERISA, though many states' laws protect assets in traditional IRAs, and some protect Roth-IRA assets as well. However, any state laws that appear to protect SEP or SIMPLE plans may be pre-empted and thus ineffective, since ERISA treats such plans as pension plans and pre-empts any state laws that might affect or regulate them. Thus, SEP or SIMPLE plans are likely to fall between the cracks, and not be protected under either ERISA or state law, with regard to attachment, garnishment, or state insolvency proceedings.

Note that while most states provide protections for IRA assets, many such states impose various conditions for such exemptions, or else limit the amount that can be exempted from claims of creditors to some specified dollar limit. Some states limit such protection to deductible contributions that were made to a retirement plan or exclude Roth IRA's from protection.

An analysis of the specifics of state bankruptcy laws and their interaction with the federal Bankruptcy Act is beyond the scope of this publication.

In short, while retirement plan assets are not always protected from certain types of claims of creditors, if you can build up a significant retirement fund in your corporation's pension or profit sharing plan, you have at least some degree of assurance that financial or legal problems will not touch that nest egg. However, because the laws regarding protection of retirement plan assets from bankruptcy or claims of creditors are so complex, you should consult a [STATE NAME] lawyer for advice before you assume that any type of pension or profit sharing plan, 401K plan, or IRA assets will be safe from creditors in bankruptcy or against non-bankruptcy claims by creditors in [STATE NAME].

Consult a Bankruptcy Lawyer -- Up Front

If you are going into a particularly risky kind of business, consider spending a few hundred dollars up front consulting a bankruptcy lawyer who can outline for you what types of assets you will be able retain if the worst case scenario unfolds and you do have to file for bankruptcy. Most state laws and the federal Bankruptcy Act provide that varying amounts of assets, such as a certain amount of equity in your home, a car of a certain value, life insurance or annuity policies, tools of your trade, and sometimes a number of other specified assets, may be retained by you if you go through bankruptcy. You will want to know up front what the [STATE NAME] laws are on such matters so you can structure your affairs to take full advantage of any bankruptcy "loopholes."

Another asset protection strategy that often works, if planned for at an early date, before you have incurred liabilities, is to put a large part of your personal assets in your spouse's name, as a gift, assuming you are willing to give ownership and control of your assets to your spouse. A good bankruptcy attorney can also counsel you on whether such a spousal transfer will be effective against creditors. Note that if you wait until you have incurred a liability, or in some cases should have known that you have done something that might give rise to such a liability, the courts may set aside a transfer of assets to a spouse as a fraud against your creditors. Proper timing and getting good legal advice at an early date on this tricky issue are both critical, if you wish to use this strategy. (Being sure that you can trust your spouse is even more important. Otherwise, you may end up dealing with divorce attorneys, rather than bankruptcy attorneys.)

Self-Settled Trusts

It is an old and hoary tenet of Anglo-Saxon jurisprudence that you cannot protect assets from your creditors by setting up a trust and putting your assets in it, where you are the both the settlor (creator) and beneficiary of the trust (a "self-settled trust"). However, in recent years, several states have enacted new trust laws that allow you to create an irrevocable, self-settled trust, whose assets will not be reachable by creditors, provided you put the assets in trust well before the debts are incurred, generally. In addition, at least one of the trustees must be in the state where the trust is created. Some of these trusts are briefly mentioned below.

Delaware Trusts

A development that may offer significant protection from creditors, either in the event of a business bankruptcy or lawsuits against you personally, is a Delaware law enacted in 1997, entitled the "Qualified Dispositions in Trust Act."[4] Delaware also enacted certain improved and clarified limited partnership and LLC provisions, and has since adopted a provision for creation of what are called Delaware Statutory Trusts, which are trusts that, like corporations or LLC's, are designed to carry on business operations, while providing liability protection to the beneficiaries of the trust.[5]

The effect of these Delaware laws, which are quite complex, is to create somewhat of a domestic haven from creditors, providing that you take advantage of its trust, limited partnership or LLC provisions well before your creditor troubles first arise, and that the transfers are not considered "fraudulent transfers" or attempts to avoid existing spousal or child support obligations.

The Delaware law specifies how long after a transfer is made that a creditor can set aside the transfer. A disposition is not to be treated as fraudulent unless it is shown that the trustee or adviser acted in bad faith. A creditor can set aside a transfer that occurred after a debt or claim arose, if an action is brought within four years of the date of the transfer to the trust, or later, if an action is brought within one year after the transfer could reasonably have been discovered. However, if the disposition in trust occurs before the claim or debt arose, the creditor must sue within four years after the transfer in order to have it set aside as fraudulent.

Amendments to the Delaware trust laws in 2003 have further increased the protection of "qualified dispositions in trust":

  • Where more than one transfer is made to a trust, the more recent transfer will not invalidate an earlier transfer that was a qualified disposition, even if the later transfer of assets did not qualify (such as where the later transfer was made after the creditor's claim arose);
  • Where more than one transfer is made to a qualifying trust, any distribution to a beneficiary is deemed to first come from the latest such transfer (which obviously can be significant if the latest transfer is determined not to be a qualifying disposition); and
  • If a trustee is sued in a court other than a Delaware court and that court declines to apply the Delaware trust law with regard to the spendthrift provisions, or with regard to the validity, construction, or administration of the trust, then the trustee immediately ceases to be the trustee of the trust at that point. (Many such trust instruments will now provide that, in such an instance, the successor trustee is some foreign person or entity, over which a court in, say, Iowa, might have no jurisdiction or ability to compel the trustee to distribute trust assets to the creditor.).[6]

The Delaware laws even allow a Delaware limited partnership or LLC to "transfer" the limited partnership or the charter of an LLC to some other jurisdiction, such as a foreign country whose law provides for limited partnerships or LLC's, as the case may be. One can even choose to either cancel the Delaware charter, or keep it in existence, once the entity is "transferred" to a foreign jurisdiction. This new provision can, in some cases, be useful if you are seeking to take advantage of the asset protection laws of some foreign haven, such as the Bahamas, Cayman Islands, Cook Islands, Turks and Caicos Islands, Switzerland, or Barbados.

While these trust, partnership, and LLC provisions have been adopted by Delaware, they can be of use to you even if you do business and live in another state, provided that you set up a Delaware trust or other legal entity under the 1997 Delaware law. Because these asset protection laws are quite complex and untested, you will need to consult an experienced attorney for guidance if you wish to use Delaware as a "haven" for protecting yourself from creditors.

Alaska Trusts

Alaska has also enacted laws somewhat similar to the Delaware provisions, which may also offer possible tax benefits, in addition to asset protection. Currently, use of the new Alaska Trust provisions is one of the hottest trends in estate planning, where a family limited partnership is set up, with the limited partnership units transferred to the Alaska Trust, so that the family members who are the general partners maintain control of the assets in the trust, and the bank or other trustee has very little to do, other than hold the partnership units.

The Alaska law has a number of requirements that a trust must meet to be recognized as a self-settled Alaska asset protection trust:

  • Some or all of the trust's assets must be deposited in the state of Alaska through a bank account, certificate of deposit, brokerage account, or similar account;
  • One of the trustees must be a "qualified person" under Alaska law, defined as an Alaska resident individual or a bank or trust company with trust powers and that has its principal place of business in Alaska;
  • The duties of the Alaska trustee ("qualified person") must include both the obligation to maintain records for the trust and to prepare or arrange for the preparation of the trust's income tax returns (though neither of these obligations need be exclusively left up to the Alaska trustee); and
  • The administration of the trust must occur in the state of Alaska, including the physical maintenance of the trust's records there.
CAUTION:
Setting up such an Alaska (or Delaware) spendthrift trust, if you live in California or New York or another state, may not necessarily work, if a court in such state decides their own law should be applied, rather than, e.g., Alaska law for an Alaska Trust, or Delaware law for a Delaware Trust, and thus you might fall under usual state law fraudulent transfer rules.

(By the way, a fraudulent transfer is not necessarily a crime: fraudulent transfer has traditionally been a civil law concept, used for setting aside transfers, such as transfers of assets to a spendthrift trust, that would otherwise unfairly put assets out of the reach of creditors. However, in recent years, a number of state and federal laws have made fraudulent transfers a misdemeanor crime, and in some cases, a felony.)

Some Other States Also Allow Self-Settled Trusts

In addition to Delaware and Alaska, the states of Nevada, New Hampshire, Utah, Rhode Island, Oklahoma, South Dakota, Tennessee, Wyoming, and Missouri have also recently enacted new trust legislation that permits similar asset protection by creation of self-settled trusts. Colorado has had such a law since 1861, though rarely used. The Nevada law has become one of the most popular, since it does not grant ex-spouses any special rights to get at your assets for alimony, property settlements, or even child support.

Foreign "Asset Protection" Trusts

The main idea in using foreign-based trusts, in places like Barbados or the Cook Islands, is to put your assets beyond the reach of U.S. creditors. A country is usually selected that does not have legal reciprocity with the U.S. and thus will not enforce a judgment rendered by an American court that seeks to force the trustee in such a country to disgorge assets from the foreign trust. As a rule, the country chosen, if it is a former British colony, should be one which has repealed the Statute of Elizabeth, enacted in England in 1571, which makes almost any transfer of assets out of the reach of creditors a "fraudulent transfer," even if the transfer was made long before the debt to a new creditor arose.

Some foreign trusts will contain "fleeing clauses," which can be invoked by the foreign trustee or some other named person, in the event the laws change unfavorably in the trust's jurisdiction, or if the U.S. settlor of the trust comes under duress to "break" the trust. In any such case, the trustee or other designated person is empowered by the "fleeing clause" or "Cuba clause" to take steps to protect the trust assets by creating a new trust in a different country and moving the assets into that new trust.

Most offshore trusts will provide that the trustee is ordinarily supposed to follow the directions of some person who is not a trustee, a person who will also usually be given the power to remove or replace a trustee without cause. However, a "duress clause" in the trust instrument will typically authorize the trustee to ignore any such advice, order, or instruction where it is given under duress by the person granted such powers.

CAUTION:
The foreign asset protection trust strategy may all work perfectly, if the foreign nation's courts refuse to execute a judgment of an American court, but one must be aware that an American judge may decide that the foreign trust is a sham or that there has been a fraudulent transfer of assets to the trust. If so, the judge may simply put you under duress, such as by putting you in jail for contempt of court unless or until you somehow convince your foreign trustee to disgorge assets on your behalf in order to satisfy a judgment against you by your creditors.

Although, as noted above, there is always the possibility of a U.S. court putting you under duress to unwind a foreign trust, the real benefit of a well-structured foreign trust setup may be as a strong deterrent to creditors. If you have erected what appears to be a very solid legal fortress, creditors or potential litigants are much more likely to agree to a settlement with you for considerably less than what you may owe them, rather than undertake the considerable litigation risks and costs of trying to "break" your foreign trust.

IMPORTANT NOTE:
Foreign trusts are not for everyone. While they may work well to protect your assets from creditors, and may even have tax advantages, you will need to hire some top-tier legal and accounting talent to have a hope of succeeding. In addition, there are a host of IRS reporting requirements for U.S. citizens or residents who set up foreign trusts and you may even have to litigate with the IRS to obtain any hoped-for tax benefits. In short, unless you can afford large up-front and ongoing legal and accounting costs, a foreign asset protection trust may only make sense for you if you have a very large pile of assets that you are worried about protecting.

Family Limited Partnerships (FLP's) or Family LLC's

For relatively wealthy individuals, establishing a family limited partnership (FLP) or family limited liability company (FLLC) can have major tax and estate planning advantages, as well as offering considerable protection from lawsuit liability. However, this is a highly technical and somewhat risky estate tax planning strategy, constantly under attack by the IRS, and is thus only a realistic approach for very wealthy individuals who are will to fight it out in court with the IRS, if necessary.

Protecting Shareholder Identity and Privacy -- Nevada Corporations

Unless you live in a cave in Afghanistan, you have probably heard that there are some wonderful tax and other advantages of setting up a Nevada corporation. However, setting up a Nevada corporation to save taxes is somewhat like chasing a mirage. If your business is based in another state, or is doing business in another state, you will have to file tax returns in each state where it does business (in states that impose taxes on corporations' income), and allocate and apportion some part of the corporation's taxable income to each state where the corporation does business. None of the corporation's business would be allocable or apportionable to Nevada, unless you actually carry on business in Nevada. Thus, any supposed tax benefits would be illusory -- unless you are planning to commit tax fraud, which we don't recommend.

Most of the supposed tax benefits of using a Nevada corporation, as promoted in radio and television ads, are completely illusory. However, for businesses that incorporate in Nevada and that operate legitimately, there is one important non-tax advantage of Nevada incorporation -- Nevada's corporation laws do provide considerably more protection of shareholder identity and privacy than most other states.

9.2 Protecting Trade Names, Trademarks, and Intellectual Property

Both U.S. and international laws give wide-ranging protection to certain intangible assets you may have developed, including trade names, trademarks, copyrights, patents, and trade secrets. Each of these is discussed below in this section.

Protection of Trade Names or Trademarks

If you intend to use some type of distinctive trade name for your business or trademark for your product or in advertising your services, consider taking steps to protect the use of the name or mark by registering it under state or federal law, or both.

When considering your trade name or trademark, you may need to per­form a search to determine whether someone else has already registered the same or a very similar name or symbol. Searches can be conducted at different levels of thoroughness. A small business development center (SBDC) or an inexpensive trademark search company (several can be found on the Internet) may be able to conduct a basic search for you. However, this level of search does not guarantee you have adequately investigated whether any other company may have established rights to a trademark. If you are launching a nationwide product or service, you will want a more detailed search, which will be more expensive. Since not every trade name can be registered, you will need to consult a trademark attorney if you are interested in protecting a particular name used by your business.

You do not want to open yourself up to a lawsuit for infringement.

Federal registration of a trade name or trademark confers a number of significant benefits, including:

  • Nationwide notice to others of your exclusive right to use the name or mark;
  • An unquestionable right to use the name or mark, with certain exceptions;
  • Recovery of profits and damages if you can prove in court that someone violated your rights under the Trademark Act of 1946;[7]
  • The right to sue in federal court for trademark infringement, regardless of the amount at stake and whether or not there is diversity of citizenship -- that is, regardless of whether you and the defendant operate in the same or different states; and
  • The right to have customs officials halt importation of counterfeit goods illegally using your trademark (such as fake "Levi" ® bluejeans).

Federal registration is permitted only if you will use the trade name or trademark in more than one state. Also, when registering a trademark, you must submit a verified statement within 6 months after registration, specifying that you have used the mark in commerce.[8] If you have completed registration of a trademark, you should use the "®" symbol wherever the trademark appears.

(If registration is still pending, use TM instead.)

For more information on trademarks, consult the Nolo Press book, Trademark -- Legal Care for Your Business & Product Name, 8th Ed. (2007), by Stephen Elias. For possible [STATE NAME] requirements regarding registration of trade names, see [LINK DELETED] of the [STATE NAME] chapter.

Copyright Protection

Under our legal system, protection is also afforded for intellectual property, such as copyrights, for literary material and similar creative works, including computer software.

While you cannot copyright an idea as such, you can use the copyright law to protect the original expression of an idea, such as a written document, or a computer software program. To do so, you have to be sure to place a proper copyright notice on the item you wish to protect when you publish it. The proper form of copyright notice ("the legend," as copyright lawyers refer to it) should appear as follows:

Copyright 2013 John Doe
All Rights Reserved


or:

© 2013 John Doe
All Rights Reserved


Under U.S. law, you can use the "©" symbol OR the word "copyright" (or "Copr.") and receive full copyright protection. However, you will have trouble enforcing the copyright in some foreign countries if you leave out the "c" in a circle. Also, note that many South American countries require that you add the statement "All Rights Reserved" in order to make the copyright legend valid. Thus, if you have a copyrightable work that has potential value outside of the U.S., be sure to add the "All Rights Reserved" phrase to protect your rights overseas. For a work like this book and the related Small Business Advisor software, which is of little use or value to anyone outside the boundaries of the U.S., the "All Rights Reserved" statement probably is not necessary, although it doesn't hurt to add it.

In addition to using the legend correctly (being sure to include the year of publication--not the year of creation -- and the name of the copyright holder), it is important to file a copyright registration form on Form TX, with:

Library of Congress
Copyright Office
101 Independence Avenue, S.E.
Washington, D.C. 20559-6000
(202) 707-3000
(877) 476-0778 (Toll-free)

A $65 filing fee is generally required, effective since August 1, 2009, which should accompany the filled-out registration form. If you are registering a book or other written publication, you must also enclose two copies of it with Form TX, which will become your small contribution to the vast Library of Congress collection.

The Copyright Office has a reduced filing fee of $35 for electronic filings of copyright registrations.

If you are filing a copyright for a computer program you have written, the Copyright Office requires you to file a copy of either the object code (which you should do if your source code contains trade secrets you don't want to divulge to the world) or of the source code. If you don't want to disclose all of the source code for a large program, you need only file the first 25 pages and the last 25 pages of the source code (and, if you are a crafty and secretive sort, you can add a lot of meaningless and useless code to the beginning and end of your program, so that you still don't give away any secrets). Note that if you choose to file your object code listing (which will look like gibberish to the folks at the Copyright Office) instead of source code, they will accept your registration subject to what is referred to as the "rule of doubt." The meaning of this scary characterization is that they can't really examine your code to determine if it is copyrightable, so you must also submit a written statement or cover letter with your application, stating that the material submitted is a work of copyrightable authorship. Also, in such a case, it is a good idea to arrange it so that on the first page of the object code listing you submit, your copyright notice prints out in a form such that the good people at the Copyright Office can read it.

A work that is created (fixed in tangible form for the first time) on or after January 1, 1978, is automatically protected from the moment of its creation and is ordinarily given a term enduring for the author's life plus an additional 70 years after the author's death. In the case of "a joint work prepared by two or more authors who did not work for hire," the term lasts for 70 years after the last surviving author's death. For works made for hire, and for anonymous and pseudonymous works (unless the author's identity is revealed in Copyright Office records), the duration of copyright will be 95 years from publication or 120 years from creation, whichever is shorter.[9]

Note that you don't need to have previously registered your copyright in material you create, to sue someone who infringes upon (steals or plagiarizes) your work. However, to sue them, you will have to do an after-the-fact registration, and you may have problems proving that you actually were the creator of the material at the earlier date. Also, if you have registered your work when it was first published, before the infringement occurs, you may be able to win statutory damages from the offender. Otherwise, you can only sue for actual, common law, damages, which may be nominal in many cases. In short, don't "economize" by trying to save a $65 registration fee -- it could cost you a great deal later if you fail to register your copyright promptly after publication.

For helpful (unofficial) information on copyrights, visit "The Copyright Site" on the Internet, at:

The Copyright Website
www.benedict.com

Or, visit the official Copyright Office website for forms and information, at:

U.S. Copyright Office website
www.copyright.gov

Patent Protection

Protecting patent rights is a bit more complicated. As is the case with copyrights, you cannot patent an idea, no matter how good or original it may be. In order to protect a patentable device, process, or design, you will need to actually invent and construct one widget or whatever the item is -- conceptualizing an interstellar warp drive for spaceships, or putting drawings or descriptions of such an engine down on paper generally won't do; you'll have to actually build one. In short, patents are granted to doers, not dreamers.

The type of things you can patent vary widely, including gadgets, chemical processes, drugs, some computer programs (very rarely), or even genetically engineered bacteria, according to recent rulings.

There are three different types of patents issued by the U.S. Patent and Trademark Office:

  • Utility Patents. These may be granted to anyone who invents or discovers any new and useful process, machine, article of manufacture, or composition of matter, or any new and useful improvement of any of the foregoing. Utility patents are granted for a term of 20 years beginning with the date of grant, subject to payment of filing fees and/or maintenance fees (which are set annually) at certain intervals, to maintain the patent.
  • Design Patents. These patents are granted to a person who invents a new, original, and ornamental design for an article of manufacture, and are valid for 14 years from the date granted. No maintenance fees are required.
  • Plant Patents. Patents can be granted to anyone who invents or discovers and asexually reproduces any distinct and new variety of plant. Plant patents are granted for a term of 20 years, beginning with the date of grant.

Once you have invented something worth protecting with a patent, you will then need to hire a patent attorney, and have the attorney file an application for a patent at the U.S. Patent and Trademark Office. Since the Patent and Trademark Office takes a rather adversarial position to applications, forcing you to prove to them that you have a way of doing something that qualifies for the 14- or 20-year monopoly of patent protection, you can expect to wait a year or two and spend a lot of money on legal fees to get your better mousetrap or left-handed screwdriver patented; and that is if no one challenges your patent or claims that it infringes on theirs.

For more information on patents, including fees, which change frequently, see:

U.S. Patent and Trademark Office web site
www.uspto.gov


BOTTOM LINE:
With regard to a patent, unlike filing a copyright, you will need an attorney -- a patent attorney.

Trade Secret Protection

Unlike patents, copyrights, and trademarks, the government does not provide any registration process for trade secrets. However, there is a well-developed body of state and federal law that enables businesses to seek legal damages from competitors or other persons who steal or otherwise misappropriate their trade secrets. Under federal law, the Economic Espionage Act (18 U.S.C. §§ 1831–1839) imposes criminal penalties for theft of trade secrets. However, if your business has trade secrets, you are more likely to be concerned with enforcing your rights under the civil law than seeking criminal prosecution of anyone who may steal your trade secrets. There is a long tradition of protecting such secrets as a property right in the state and federal civil law courts, under the court-created common law.

By its nature, a "trade secret" is some form of secret information that is important to your business and that it is important for you to keep secret. Thus, you would not seek to protect a trade secret by patenting or copyrighting it, since it would then be public information, and might lose much or all of its value. The classic example of a trade secret is the formula for Coca-Cola,® which the Coca-Cola company developed over a century ago and has closely guarded ever since. The people at Coke were farsighted enough to realize that if they had patented the formula, someday the patent would have expired and competitors would have been free to use their formula from then on. Unlike patents or copyrights, there is no "expiration date" on trade secrets, so long as you are able to maintain their secrecy and so long as they continue to have economic value.

What is a trade secret? A trade secret can be any of many things, ranging from the Coca-Cola® formula to the recipe for Kentucky Fried Chicken, to software source code to customer lists, or strategic business plans, technical specifications, or even information about your profit margins on products, as a few examples.

A "trade secret" means information, including a formula, pattern, design, compilation, device, program, method, process, recipe, or technique, that has independent economic value (actual or potential) because it is not known to the public or to other persons who could derive economic value from its use or disclosure. To be considered a secret, the holder of the trade secret must make reasonable efforts, under the circumstances, to maintain its secrecy.

In general, the main approaches used by most businesses to protect their trade secrets will include the following:

  • Limiting access to the trade secrets, such as to a few high-level officers of a corporation;
  • Marking or stamping documents that are to be protected as "confidential"; and
  • Obtaining, from employees or others to whom you provide access to trade secret information, signed employment agreements, confidentiality agreements, or nondisclosure agreements regarding the secret information.
Some things that the courts have found to be reasonable steps to protect trade secrets include the following:
  • Disclosing secrets solely to top-level employees;
  • Limiting the information made available to contractors and subcontractors;
  • Keeping logs identifying trade secrets;
  • Marking documents as confidential or trade secret information or otherwise communicating to employees and others (in a well-documented fashion) that certain information is a trade secret and must not be revealed;
  • Limiting the availability of trade secrets within a computer system;
  • Obtaining signed nondisclosure agreements from anyone who is given access to trade secrets;
  • Taking various security measures to protect secrets, such as locking documents in safes, requiring personnel to wear security badges in sensitive areas of a facility, and use of security personnel and systems, such as burglar alarms;
Things you should NOT do -- actions or omissions which have persuaded courts that secrecy efforts were inadequate:
  • Failure to obtain signed nondisclosure agreements;
  • Displaying trade secret information at trade shows;
  • Allowing trade secret documents to be placed in street curb dumpsters without first shredding the documents;
  • Publishing trade secret information in various ways, such as in trade journals or on the Internet; and
  • Failing to designate information as being trade secrets when filing documents with government agencies.
BOTTOM LINE:
While even the best efforts to avoid disclosure of your important trade secrets may fail, such as when a former employee violates a nondisclosure agreement with you that he or she has signed, it is still important to be able to show (in court) that you have taken all reasonable steps to protect such secrets, in order for you to recover legal damages against someone who has illegally obtained your trade secrets.


9.3 Mail Order Sales and Telemarketing Regulations

If the business conducted by your firm involves selling goods by mail order, you need to become familiar with the Mail or Telephone Order Merchandise Trade Regulation Rule (also often referred to as "Rule 435"), a regulation issued by the Federal Trade Commission (FTC).[10] It is generally understood that the Rule 435 requirements apply to sales made over the Internet, as well as to telephone or mail order sales. Proposed amendments (December, 2011) to the FTC regulations will, when adopted, make it clear that Rule 435 is fully applicable to Internet sales.

Failure to comply with the requirements of Rule 435 can result in the imposition of serious fines on your business by the FTC.

This federal regulation requires any business soliciting mail order or telephone sales (as well as making Internet sales) to be prepared to ship the merchandise within 30 days after an order is received, unless it has clearly stated in its solicitation that orders will not be shipped for a longer period. Otherwise, the solicitation will be considered as an unfair and deceptive trade practice. In addition, if you receive an order and for some reason you cannot ship it within 30 days, or the period stated in your solicitation, you must:

  • Immediately notify the customer and offer to the customer the choice of either canceling the order and receiving a refund or consenting to the delay in shipment;
  • Indicate when you will be able to ship or that you do not know when you will be able to ship the order; and
  • Provide other required information to the customer, which will vary in content depending upon when you expect to be able to ship.

The coverage of Rule 435 extends to all orders you receive, including those received by modem, fax, or telephone, or via the Internet, in addition to those received by mail. Rule 435 is fairly complex, but you need to understand and be familiar with it if you sell goods by any of these means. For a free guide on this FTC rule, contact the FTC and request A Business Guide to the FTC's Mail or Telephone Order Merchandise Rule, which was produced by the FTC in cooperation with the Direct Marketing Association.

There are a few exemptions from Rule 435. The main ones are for:

  • Subscriptions, such as for magazines, if the initial shipment is made in compliance with the Rule;
  • Orders of seeds and growing plants; and
  • Orders made on a collect-on-delivery (C.O.D.) basis.

In addition, if you sell goods on a "bill me" basis, where you ship the goods and send an invoice payable on receipt, you are not subject to Rule 435 since it is not a prepaid or credit sale. Of course, if you are unreasonably slow in shipping the merchandise or do not ship it in the time you promised, you could still be in violation of the FTC Act’s general prohibition against unfair or deceptive trade practices.

For more information on Rule 435, contact:

Federal Trade Commission
(202) 326-2222


FTC Website
www.ftc.gov

State Sales and Use Taxes

If you sell across state lines to customers in states where you have no offices, employees, or other presence, the sale is usually not subject to sales tax in either state, since it is an interstate sale; however, technically, such sales are subject to use tax in the customer's state. A use tax is sort of a shadow of the sales tax and, in most states, applies where the sales tax does not.

The U.S. Supreme Court and other courts generally have not supported attempts of the various states to force out-of-state retailers to collect use tax on mail order or other sales made to residents of the taxing state, so that most mail order firms tend to treat such interstate sales as being tax-free, or tell customers it is up to them to report the purchase and pay the use tax, which they rarely do.

In the last few years, many states have enacted new and broader sales and use tax laws. Many of these laws require out-of-state retailers who advertise in the local media or send substantial amounts of direct mail into the state to register as retailers subject to sales or use tax in the state and to treat such direct sales as taxable.

The U.S. Supreme Court ruled that at least some of these aggressive new sales tax laws are unconstitutional in the 1992 case of Quill Corporation v. North Dakota. Under that decision, most of the broad new mail order sales and use tax laws -- which had been adopted in 34 states -- were made invalid. The court, however, also indicated in its decision that Congress could, if it chose to do so, constitutionally enact legislation that would permit the states to require use tax collection on mail order and similar sales by out-of-state retailers.

That has not happened yet, but if your business is heavily involved in mail order, you should watch for developments that might affect state use taxes. In particular, you should be aware of the "Streamlined Sales Tax Project" (SSTP), on which state governments began working in 2000. While nominally intended to simplify and provide some uniformity in the crazy-quilt patchwork of sales and use taxes in the 45 states that impose such taxes, the real intention of the SSTP seems to be (taking a hint from the Supreme Court opinion in the Quill decision) to adopt a national system of somewhat simplified sales and use taxes that will give Congress an excuse to enact legislation that allows states to force out-of-state sellers to collect and pay over use taxes -- in states where they have sales, but no other activities that would subject them to sales tax under present laws.

One of the other major changes the SSTP made, in states where it has been adopted, is to change the location where a sale is deemed to be made, for purposes of determining which state or district's sales tax rate applies. In the past, that has generally been based on where the seller was located, rather than the destination of the product (where the buyer is located). Adoption of the Streamlined Sales Tax Agreement by the states would change this, so that the destination (where the buyer is located) will determine which tax rate applies.

UPDATE NOTE:
The SSTP Governing Board voted in December, 2007 to allow states to become full members while retaining origin (rather than destination) sourcing of sales, since many states were unwilling to change to destination sourcing and two associate member states, Ohio and Utah, were unable to enact destination sourcing legislation and thus were set to exit SSUTA membership, unless this requirement were relaxed. (However, interstate sales must still be sourced on a destination basis under the modified SSUTA rules.)

If you make interstate sales by mail order or on the Internet, on which you are presently not required to collect sales or use tax from your customers, keep an eye out for adoption of the SSTP nationally and, even more importantly, the enactment of any federal sales tax legislation that allows states to require you to collect or pay tax on such interstate sales. Note that federal legislation has been introduced in Congress in 2007 (House bill H.R. 3396), which, if enacted, would give SSTP member states authority to force out-of-state sellers to collect sales and use taxes on interstate sales to residents in such states. So far, no such federal legislation has been enacted.

For more information on the Streamlined Sales Tax Project, see the following website: www.streamlinedsalestax.org

Telemarketing Rules

A set of Federal Trade Commission (FTC) regulations under the Telemarketing and Consumer Fraud and Abuse Prevention Act impose stringent restrictions on telemarketing companies and how and when they can telephone potential customers.[11] These rules are primarily designed to reign in fraudulent phone scamsters.

These standards require, among other things, that anyone who makes telemarketing calls to consumers must:

  • Inform the consumer that the call is a sales call;
  • Inform the consumer if the seller has a "no refunds" sales policy;
  • Describe the nature of the goods or services that are being sold;
  • Tell the consumer, if a prize is involved, what the odds are of winning and that they don't have to buy something in order to win;
  • Make such calls only between the hours of 8:00 AM and 9:00 PM; and
  • Make no further calls to a consumer who has asked not to be called again.

The FTC rules also impose extensive record keeping of contacts made, items sold, and other details of any telemarketing program that is covered. In general, these rules do not apply to calls initiated by the consumer, such as calls in response to publicity or advertising of the seller.

Penalties for violating these standards include fines of up to $10,000 per violation and reimbursement of consumers for any losses they have incurred.

In 2003, Congress added to these telemarketing restrictions by ratifying the creation by the FTC of a National Do-Not-Call Registry and implementing regulations on March 31, 2003.[12] The Do-Not-Call-Registry is a place where consumers can list their phone numbers if they wish not to be disturbed by telemarketing phone calls. Telemarketers are supposed to check the Registry before making any telemarketing calls, and can incur penalties for making such calls to anyone who has opted not to receive such calls by listing their number in the Registry. This requirement does not apply, unfortunately, to political parties or charitable organizations that "dial for dollars."

Some states, including Alaska, Arizona, Delaware, Indiana, Massachusetts, New Mexico, Vermont, West Virginia, and Wyoming, have their own restrictive laws regulating telemarketing or requiring telemarketing firms to register and/or post bonds.

In addition to the foregoing restrictions on telemarketing, federal law also prohibits certain types of automated electronic marketing tactics, such as those discussed below in Section 9.8.

9.4 Consumer Credit Laws Affecting Your Business

The definition of consumer credit does not refer to the practice of allowing a client or customer to buy something and pay you at the end of the month, which is largely unregulated by the government. Instead, the definition of "consumer credit" applies when a business extends credit over a period of time and charges interest during that period during which the amount financed is being paid off by the consumer.

Many of the largest and most successful companies in America have got­ten where they are, in part, by providing consumer credit to persons who buy their products. Classic examples include such giant companies as Sears and General Motors, although countless smaller companies have also found that financing their customers' purchases can be a major boon to sales and that the interest earned on such credit can also become an important profit center in its own right. In fact, it was reported a few years back that the Ford Motor Company was earning more than 100% of its profits from its credit operations, while sustaining losses on its auto business.

The three main areas of the law regulating the extension of consumer credit, which affects nearly all businesses that grant such credit, are the federal Equal Credit Opportunity Act, the federal Truth-in-Lending Act, and state laws that prohibit usury.

Equal Credit Opportunity Act

If your business is engaged in providing consumer credit, it will most likely be subject to the provisions of the federal Equal Credit Opportunity Act (ECOA).[13] In general, the ECOA prohibits discrimination in credit transactions on the basis of race, color, religion, national origin, sex, age, or marital status.

The basic principle of this law is that each person applying for credit must be considered as an individual. Strict limits govern what you may ask about marital status and about the spouse of the applicant. You may ask about marital status, but only to determine what rights and remedies you might have as a creditor -- such as in a community property state -- but not to discriminate in a determination of an applicant's creditworthiness.

The ECOA also forbids discrimination in providing credit because some or all of the applicant's income derives from public assistance programs, or because a person exercised a right, in good faith, under the Consumer Credit Protection Act (which regulates credit reporting agencies).

Truth-in-Lending Act

If your business activities involve lending money or selling to consumers on credit terms, you may have to comply with the federal Truth-in-Lending Act and state laws such as those that prohibit the charging of usurious interest rates on loans or other credit transactions.[14] Regulations under the Truth-in-Lending Simplification and Reform Act provide that a business is subject to the truth-in-lending rules if it extended consumer credit at least 25 times (5 times for loans secured by dwellings) in either the previous year or the current calendar year.[15] However, financing provided to businesses and large credit transactions, where the amount financed is more than $25,000, are exempt from the Truth-in-Lending requirements, except for consumer loans secured by real estate or by a mobile home that will be the principal dwelling of the consumer.[16]

The rules regarding the Truth-in-Lending Act are far too complex to cover satisfactorily here. But keep in mind that if you plan to extend credit to consumers -- other than sending out bills requesting payment in full, without interest charged, after you have provided goods or services -- you need to consult an attorney experienced in this area. Fortunately, legislative amendments in recent years have simplified the truth-in-lending regulations somewhat.

Cash Discount Act

The Cash Discount Act permits sellers to offer a discount of any amount to customers who pay in cash or by check without running afoul of the truth-in-lending rules. The discount, in this case, has to be clearly disclosed and made available to all customers.[17] In the past, if you offered more than a 5% cash discount, you were considered to be imposing a finance charge on credit customers and had to give them all the required truth-in-lending disclosures.

State Usury Laws

Every state has its own unique set of usury laws, which regulate the maxi­mum interest rate that a lender may charge. Penalties for violation of these laws range from loss of all interest under a usurious contract (not just the excessive portion) to severe criminal penalties. Usury laws tend to be very complex and technical, and a whole body of law has grown up that deals solely with the issue of which state's usury laws apply to a given transaction. This area of jurisprudence, called "conflict of laws," is exceedingly arcane, especially as it relates to which usury laws are to apply, and thus is well beyond the scope of this book (and well beyond the understanding and mental capacities of your humble author).

If you extend credit and charge interest to customers, you need to consult a business lawyer to determine what interest you may charge on various categories of loans and whether you are in compliance with any state usury laws that apply to your business in your state or in whichever state's laws may govern a particular credit transaction.

9.5 Multilevel Marketing Programs -- Look Before You Leap

Unless you have been living in a monastery most of your life (and perhaps even if you have), you have probably been offered an "opportunity" at least once to become a distributor in some type of multilevel, direct sales marketing program. Multilevel marketing programs (MLM) have been around for a long time, and many of them are well established. If you are a hard-working, disciplined, sales-oriented person, you may be able to make money with a good multilevel marketing company with a good product. However, countless multilevel programs are more in the nature of pyramid schemes or chain letters, in which you may make money not by selling products but by enrolling others in the program.

Every multilevel program publicizes its "stars," who earn fabulous incomes, own large yachts, and live like royalty. Obviously, these people are the exception, not the rule. Even the National Multilevel Marketing Institute, which is the national trade association for the industry, concedes that the dropout rate in MLM programs is about 40 percent, and many marketing experts suggest that number is low, since most people wind up spending more than they are taking in, and eventually decide to stop throwing good money after bad.

Almost every multilevel program involves some kind of initial investment to become a participant, usually, but not always, for an initial supply of the product in question. The initial start up kit investment can range from about $35 to several thousand dollars. Obviously, you will have a lot less at stake with a $35 investment than with a much larger outlay.

Before you sign up to become a distributor for any type of multilevel marketing program, first consider the following criteria:

  • Is a large initial investment required? If so, will you lose that investment if you fail to make a success of the program? Or do you have a written promise that the company will return most or all of the money you invest in products that you are unable to sell (as the law requires in some states)?
  • Is the amount you will have to invest to get started more than you can afford to lose?
  • Have you done a realistic analysis of the market you'll be aiming at? Is there a real need for the product, and if there is, is that market already well-served and saturated?
  • Do the promoters of the program rely heavily on emotional appeals to sign up new distributors? And do the people who are trying to recruit you make wild claims that the market for their product is unlimited and that no one drops out of the program?
  • Are the products or services sold with exaggerated claims ("It cures cancer," etc.)? Would you and your family want and use the products yourself?
  • Is it a legitimate program, selling legitimate, quality products? Or is it an illegal pyramid scheme, in which most of the money is made by enlisting new members, not by moving products or services?
  • Does the company offer you commissions or bonuses just for enlisting new recruits, without your having to sell products or train or supervise the recruits?
  • Does the company claim it has been approved by the Federal Trade Commission or by other federal or state government agencies? If so, beware, and hold onto your wallet, as the government is not in the business of "approving" any such firms.
  • Finally, have you checked with the Better Business Bureau to find out what they have heard about the company or program?

Realistically, most people never get beyond the point of working 8 to 12 hours a week on a multilevel marketing program as a sideline to their primary job or profession. With a good product and a good program, you may earn a decent supplemental income for your part-time efforts. Just be sure you don't get into the wrong program.

9.6 Reporting Foreign Investments in U.S. Businesses

Under the Foreign Direct Investment and International Financial Data Improvements Act of 1990, foreign individuals owning or acquiring a 10% or more voting interest in U.S. businesses, including interests in U.S. real estate, must report certain information, including annual financial and operating data, to the U.S. Department of Commerce, Bureau of Economic Analysis (BEA) on Form BE-15A or Form BE-15b. Failure to file can result in civil penalties of up to $10,000 and imprisonment for up to one year.[18]

A U.S. business enterprise (including a real estate holding) with foreign ownership may file for a reporting exemption if it does not meet or exceed a $40 million threshold. If it has at least $40 million of total assets, or $40 million of gross sales or gross operating revenues, or has a net income (or loss) of $40 million or more, it will not be exempt from reporting.

For more information on this law, write to or call:

Bureau of Economic Analysis
U.S. Department of Commerce

1441 L Street, NW
Washington, DC 20005
(202) 606-5566 (For assistance with Form BE-15 series)
(202) 606-9900 (General inquiries)


BEA Website
www.bea.gov/

In addition, U.S. businesses with any foreign activities or connections need to be aware of the types of income that are subject to withholding when paid to foreign recipients. These include rent, royalties, interest, dividends, license fees and U.S. source income that is not "effectively connected" with a U.S. trade or business. If making such payments, a U.S. person should either obtain representations from sellers that they are not subject to withholding or determine the proper withholding before any payments are made. Payments may need to be reported on Forms 1042, 1042-S or 1042-T.

Also, note these other tax reporting requirements that may apply to an entity with foreign owners:

  • A U.S. partnership's tax reporting requirements are increased when it has any foreign partners. This would also be the case for an LLC that is treated as a partnership for federal income tax purposes. For example, the partnership or LLC may be required to file Form 8805, Foreign Partner's Information Statement of Section 1446 Withholding Tax.
  • A U.S. corporation with foreign shareholders may be subject to other reporting requirements in addition to withholding and reporting to the BEA. For example, a corporation that becomes at least 25 percent foreign-owned may be required to file IRS Form 5472, Information Return of a 25 percent Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.

9.7 Exporting Your Product or Service

Why Export?

Many large and small American businesses have an unfortunate myopic tendency to look at the United States as their only market and to ignore the vast potential markets for their products or services that lie outside the borders of this country.

Various attempts by the U.S. government to give tax incentives to U.S. firms that export have all been shot down by the World Trade Organization as illegal export subsidies under world trade agreements. These include the Domestic International Sales Corporations, Foreign Trade Corporations, and the most recent tax break (in 2002), the Extraterritorial Trade Income exclusion for exporters. All of these tax incentives have now been repealed by Congress, wholly or in large part, in response to rulings by the World Trade Organization.

However, even without any of the above tax incentives to export, exporting is still a profitable avenue to pursue for many types of businesses, and it gets easier by the day, as the U.S. continues to run up huge trade deficits that have weakened the value of the U.S. dollar, in comparison to foreign currencies, making U.S. exporters better able to compete on prices in foreign markets.

UPDATE NOTE:
While a weak dollar may have made exporting easier for U.S. businesses, customs regulations have recently made things much more complex and confusing, at least for small businesses that only make occasional shipments to foreign customers.

Before 2010, if you wanted to ship an item to a customer in another country, you simply went to the post office and filled out a small customs slip that was partly attached to the package and paid the post office to ship it. Now, however, the customs form for even a small item like a computer disk is now a multi-page monstrosity that requires you to contact the USCIS to determine what codes you must enter for your particular type of business or product and is nightmarishly complex.

All this additional red tape almost seems designed to DISCOURAGE small U.S. businesses from exporting. It certainly did that for the author of this publication, who decided to simply stop shipping software or e-books on disk to anyone outside the U.S., rather than deal with the paperwork headaches for the occasional order from abroad. (Thanks for your help, Uncle Sam!)

The U.S. Congress recently enacted a new tax incentive program to encourage U.S. production of goods and certain services, beginning in 2005, as a replacement for previously disallowed export incentives. It consists of a 9% deduction from the net income earned from "qualified production activities" in the U.S., such as manufacturing, growing or mining. The deduction was 6% in 2007 through 2009 and was 3% in 2005 and 2006, until the higher deduction levels phased in.

While this new tax incentive makes no distinction between goods produced for export and goods produced for sale domestically, members of the World Trade Organization are already challenging the new law, since it favors the production of goods in the U.S., rather than abroad. If recent history is any guide, the WTO will find some reason to force the U.S. to repeal this tax incentive, too, in a few years -- as an "illegal export subsidy." For more on the new domestic production activities deduction, see Section 13.6.

While the World Trade Organization will not allow the U.S. government to subsidize or give tax incentives to exporters, as all European countries do by refunding their hefty (up to 25%, in Sweden, Germany, and Denmark) Value Added Taxes (VATs) on exported goods, the U.S. government, primarily through the Department of Commerce, does provide a wide range of information and technical assistance to companies that wish to export.

Rebates of Customs Duties for Exporters

Companies that make export sales may in some cases be entitled to rebates of 99% of customs duties ("duty drawback") paid on items which were originally imported into the U.S., even if they were imported by someone else. You can qualify for the rebate, if you bought such items and re-exported them, or, in some cases, incorporated such items into the products you exported. Most small exporters are not even aware of this "gift" that they may be entitled to. Contact your nearest United States Customs and Border Protection (formerly U.S. Customs Service) office or a customs broker for assistance in filing a claim for a rebate of such duties. Many customs brokers will handle the red tape in filing for such duty drawbacks for you, for a relatively modest percentage of the amount of the rebate obtained.

Government Assistance to Exporters

For general information on exporting, contact the following federal government agencies and ask for a desk officer who specializes in your particular industry or service business:

Trade Information Center
(800) USA-TRADE

Office of Service Industries
(202) 482-3575

Now that NAFTA, the North American Free Trade Agreement, is in effect between the U.S., Canada, and Mexico, many foreign trade experts expect that U.S. trade with Mexico will soon surpass that with Japan, making Canada and Mexico the largest customers for U.S. exports. To take advantage of NAFTA, you should be aware that reduced NAFTA tariff rates only apply to North American products, and at present, not all goods being exported from the U.S. to Mexico are duty free (although all Mexican tariffs on U.S. goods were scheduled to be eliminated by 2009).

If you want to know whether your products qualify as duty-free exports under NAFTA, obtain the HS number (the Harmonized Commodity Description and Coding System number) that applies to your products. To find the applicable code, contact:

U.S. Census Bureau Foreign Trade Division
(301) 763-1201

For information on exporting to Mexico under NAFTA, or to obtain a faxed list of over 50 free documents, many having to do with marketing and preparing products for export to Mexico, contact:

U.S. Department of Commerce
(202) 482-4464 (automated phone system)

For help regarding product-content rules of origin requirements and assistance completing the necessary NAFTA certificates of origin, contact:

Department of Commerce Office of Mexico
(202) 482-0300

Finally, the four major international CPA firms produce country guides with information on taxes and doing business in specific foreign countries. These can be extremely helpful to read up on, before you consider doing business in any particular foreign country. Many major public libraries in larger cities carry the guides published by KPMG, Ernst & Young, PricewaterhouseCoopers, or Deloitte & Touche.

9.8 Electronic Marketing Restrictions

A federal law, the Telephone Consumer Protection Act,[19] makes a number of telephone marketing tactics illegal, including:

  • Automated dialing of cell phones, pagers or similar communications devices, or any service for which the called party is charged for the call;
  • Using a prerecorded or artificial voice to call any residential telephone line, without the prior express consent of the called party; or
  • Using a computer, telephone fax machine or other device to send an unsolicited advertisement to a telephone fax machine.

Another federal law, the Children's Online Privacy Protection Act of 1998, designed to protect children who use the Internet, makes it unlawful for an operator of a website or an online service directed to children to collect personal information from children, such as first and last name, street or e-mail address, telephone number, social security number, or other specified information concerning the child or the child's parents. Under this law, "children" are defined as anyone under the age of 13.[20]

Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code, C.F.R. to the Code of Federal Regulations.)

1. I.R.C. § 414(p) and ERISA § 206(d).
2. Treas. Regs. § 1.401(a)-13(b)(2).
3. I.R.C. § 401(a)(13)(C) and ERISA § 206(d)(4).
4. 12 Del. Code Ann., §§ 3570, et seq.
5. 12 Del. Code Ann., §§ 3801, et seq.
6. 12 Del. Code Ann., § 3572(f) and (g).
7. 15 U.S.C. §§ 1051-1128.
8. 15 U.S.C. § 1051(d).
9. 17 U.S.C. § 302.
10. 15 U.S.C. § 57a and 5 U.S.C. § 552; 16 C.F.R. §§ 435.1 and 435.2.
11. 15 U.S.C. §§ 6101-6108; 16 C.F.R. § 310.
12. Pub. Law 108-82, § 1, Sept. 29, 2003, 117 Stat. 1006, ratifying 16 C.F.R. § 310.4(b)(1)(iii).
13. 15 U.S.C. § 1691.
14. 15 U.S.C. §§ 1601, et seq.
15. 12 C.F.R. § 226.2(a)(17)(v).
16. 15 U.S.C. § 1603.
17. 12 C.F.R. § 226.4(c)(8).
18. 15 C.F.R. § 806.6.
19. 47 U.S.C. § 227.
20. 15 U.S.C. §§ 6501, et seq.

Part III.     Money and Tax Matters

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Chapter 10

Financing Your Business

"A banker is a person who will only lend
you an umbrella if the sun is shining."

-- Alan Abelson

"If you see a banker jump out a window, jump after him.
There is sure to be profit in it."

-- Voltaire

"The LOVE of money is not the root of all evil.
The LACK of money is the root of all evil."

-- The Reverend Ike

"A dollar borrowed is a dollar earned."
-- Doc Snopes' Second Law of Business Survival

If you start a business with ample financial resources and knowledge, you are more likely to succeed. This chapter discusses some of the basic methods for obtaining small business financing. The remainder of Part III, Money and Tax Matters, discusses accounting and taxes and how to keep more of what you earn.

10.1 Venture Capital (Equity) Financing

Outside financing is to entrepreneurs what steroids are to body builders and football linemen -- in either case, you can't get nearly as big nearly as fast on your own -- and there can be some nasty side effects.

If you need to raise funds from other parties to start your business, the types of capital that you will be attempting to raise will fall into two categories -- Equity capital (such as common stock or preferred stock in a corporation, or an interest in a partnership); or Debt capital, which includes all types of loans, whether secured or unsecured, from the bank or from your mother. Most new businesses find it hard to raise equity capital, except those that are so promising that they are able to find venture capital investors to provide such financing.

Types of Equity Financing

If you are raising equity capital, it will typically be stock in a corporation -- or in some cases may be an ownership interest in a partnership or LLC. Stock in a corporation is usually "common stock" -- the basic form of ownership in a corporation.

"Common stock" is the ownership interest in a corporation that offers the most opportunity for growth -- and the greatest risk. It is "junior" to all other claims on a corporation's assets, such as those from creditors and "preferred stock" holders. In short, when a corporation is liquidated and its assets are distributed to all the stakeholders, the creditors get their debts repaid first, if there are enough assets. Only if anything is left over do preferred stockholders (if any) get an amount, up to the "par value" or liquidation value of their preferred stock; and if there are still any assets remaining, those go to the common stockholders.

Corporations may also be financed in part, by "preferred stock" -- a form of financing often used by venture capital investors who do not wish to invest in a company's common stock.

"Preferred stock" is a special kind of stock that a company may issue, in addition to its common stock. Preferred stock can have a great variety of forms, and may even be convertible into common stock, at the holder's option. However, its usual key features are that it pays a fixed dividend to shareholders, somewhat like a bond or other debt security, and that the preferred shareholders get first call on the company's earnings for this dividend, before any dividends can be paid out to the common stockholders. Thus, if the preferred stock dividend takes all of the year's net income of the corporation, there may be no income that can be paid out as dividends on the common stock. Preferred stock is much like a junior form of debt, except that there is usually no obligation to pay off the preferred stock, unlike a debt instrument, which usually has a set due date for repayment. As such, preferred stock, like common stock, is (usually) "permanent" capital.

However, when a corporation is liquidated, as noted above, the preferred stock is "senior" to the common stock, but the amount received by the holders is limited to the amount of the "par value" of the preferred stock, generally. Assuming, for example, that an issue of preferred stock has a par value of $100,000, and that is what it was issued for. Then, if the corporation is liquidated, and has only $120,000 remaining after paying off all its debts, the preferred stockholders would get their $100,000 first, and the common stockholders, who may have invested a million dollars in their stock, would get only what was left.

Or, on the other hand, if the net assets had grown to $10 million, the preferred stock owners would still only get their $100,000 back, while the common stockholders would get the rest, or $9.9 million, for example. With risk goes reward, and vice versa, and common stock is the riskiest (and potentially most rewarding) form of investment in a business.

Raising Venture Capital

Venture capital firms are investment firms that specialize in making equity capital available for businesses that have a very high potential for growth. They usually are interested in a small business only if it has demonstrated market acceptance for its products or service by generating substantial sales over a significant period of time and if the business's management has demonstrated its competence in managing other people's money (since you will be managing theirs). They are generally only interested where such a firm has explosive growth potential, as well.

Venture capitalists expect to make 10 or 15 times their original investment in 5 years or so, which can make up for the investments they make that turn out to be losers. Since most small businesses do not possess this kind of potential, the typical mom-and-pop store, no matter how well-run and profitable it might be, is not a realistic candidate for venture capital investment.

Venture capitalists are usually looking for a well-balanced management team with technical, marketing and financial expertise, poised for rapid growth and expansion. Thus, if you are a typical small business person, you will be wasting your time and theirs if you approach venture capital investors for financing to get your business started. (Besides, most "vulture capitalists," as they are often called, will demand your firstborn child and a 40% return on their investment, just for starters.)

IMPORTANT NOTE:
Venture capital accounts for only a tiny fraction of small business financing. Don't totally rule it out as a possibility, but be aware that getting venture capital financing is definitely a long, long shot, for most start ups.

Most institutions that you should approach for financing, such as banks, will only consider making loans to a fledgling business (and not equity investments), thus the rest of this chapter is a discussion primarily of sources of debt capital.

10.2 Small Business Administration Loans

If you need to borrow money for your business and cannot obtain regular bank financing, consider getting a loan through the U.S. Small Business Administration (SBA). Generally, the SBA does not make loans itself, but -- to encourage private lenders to make more money available to small business -- the SBA guarantees certain loans banks or other private lenders make to smaller enterprises. Your business must apply to a lender for the financing, not to the SBA.

The SBA estimates that some 99% of all businesses in the U.S. are small enough to qualify for SBA financing.

The SBA is not allowed to guarantee such loans unless the borrower would otherwise be unable to obtain private-sector financing on reasonable terms. The SBA does not compete with banks or other lenders; instead, it works with private lenders to assure availability of capital to small firms.

The SBA also does not make grants to small businesses, contrary to what you may have heard on late-night TV. See the following web link for what the SBA has to say about government grants:

www.sba.gov/content/facts-about-government-grants

For your business to qualify for SBA financial assistance, it must come within the current definition of a small business. In general, the types of small businesses eligible for SBA financing are:

  • Manufacturers with a maximum of 500, 750, or 1,000 employees, generally (1,500 for petroleum refineries, aircraft, and ammunition, other than small arms, manufacturing), depending upon the industry in which the applicant is engaged;
  • Retailers with less than $7 million in annual sales or higher amounts for some types of retail -- up to $35.5 million for home centers and family clothing stores, for example;
  • Wholesalers with 100 or fewer employees;
  • General construction firms, whose annual sales average less than $33.5 million; lower limits apply to various specialty trade construction firms, such as land subdivision or electrical contractors; and
  • Other specified types of businesses engaged in activities such as services, agriculture and transportation, with various size limits for each.

Small business size limits are set by the SBA from time to time, based on a company's North American Industry Classification System (NAICS) industry code, and based on either annual receipts or number of employees, generally. The most recent table for such size limits (effective January 7, 2013) is provided online at the SBA website, at:

Small Business Size Tables -- For SBA Loan Eligibility
www.sba.gov/sites/default/files/files/Size_Standards_Table.pdf

Certain types of businesses are not eligible for SBA loans, including:

  • Nonprofit enterprises, generally;
  • Businesses seeking to obtain loans to pay off creditors that would otherwise sustain losses;
  • Firms primarily engaged in speculation or investments, such as the purchase of securities or investments in rental real estate; and
  • Businesses that are able to obtain financing on reasonable terms from other sources.

Private lenders that are eligible to make SBA-guaranteed loans or participate in SBA financing packages include banks, savings and loans, and certain other lenders. The SBA has several types of loan programs for small businesses, the largest of which is the 7(a) Loan Program.

7(a) Loan Program and Other Guaranteed Loans

Most SBA financing actually consists of loans by banks or other lenders that are guaranteed by the SBA. This enables the small business to obtain such loans at reasonable interest rates because the bank's risk is largely eliminated. The 7(a) Loan Program and other SBA-guaranteed variable rate loans are tied to a base rate that is either:

  • the bank prime rate, as published in The Wall Street Journal, or other national financial daily; or
  • 3 points above the London Interbank Offered Rate (LIBOR); or
  • the optional PEG rate, published quarterly by the SBA in the Federal Register.

The interest rate that lenders may charge is 2.25% above the base rate for loans of less than seven years, or 2.75% above the base rate for loans of seven or more years. Rates can be 1% higher for loans of $25,001 to $50,000 and 2% higher for loans of $25,000 or less.[1] Interest rates on direct SBA loans or fixed-rate guaranteed rates are set by the SBA, and are published periodically in the Federal Register.[2] Otherwise, the SBA does not generally set interest rates, except for the maximum rates lenders may charge.

The SBA charges lenders a one-time guaranty fee on the portion of a loan that is guaranteed. This ranges from 2% on a loan guaranty of $150,000 or less to 3% on a loan guaranty of over $150,000 but not more than $700,000, and 3.5% on a loan guaranty amount that exceeds $700,000. Only a 0.25% fee is charged on a short-term loan with a maturity of 12 months or less.[3] An additional fee of 0.25% is imposed on the part of a loan guaranty in excess of $1 million. Lenders are allowed to charge part of this fee to the borrower. The SBA also charges lenders an annual loan servicing fee of 0.55% of the outstanding balance of the guaranteed part of the loan each year.[4] Lenders are not allowed to pass this fee along to borrowers.

SBA's 7(a) Loan Program has a maximum loan amount of $5 million dollars.[5] The SBA's maximum exposure is generally $3.75 million (75% of the loan). Thus, if a business receives an SBA guaranteed loan for $1 million, the maximum guaranty to the lender will be $750,000 or 75 percent. The SBA will guarantee up to 85% of loans of $150,000 and less, or 75% of loans above $150,000. [6] Export Working Capital Loan Program loans can have a guaranty of up to 90%, on loans of up to $1 million in size.

The SBA has adopted alternatives to the 7(a) Loan Program, which generally involve much less paperwork, although interest rates tend to be considerably higher than on 7(a) loans. These include:

  • SBA Express loans that require no paperwork from SBA and for which the turnaround time to the lending institution is alleged to be 24 hours. Keep in mind, however, that usually the guaranty on these loans is only 50 percent so the lender has less of an incentive to use this form.
  • Patriot Express loans for veterans, active duty military or reservists, or their spouses.
  • Small/Rural Lender Advantage Loans of up to $350,000, on the same terms as 7(a) loans.

SBA loan terms and fees are summarized in a table on the SBA web site, at www.sba.gov/sites/default/files/files/SBA%20Loan%20Programs%20Chart%20Nov%202011.pdf

Under the 7(a) loan program, the bank or other private lender deals with the SBA, and you deal with the bank, not the SBA. When you apply for the loan or any other SBA financing, you will need to:

  • Define the amount you need to borrow and the purposes for which the funds will be used;
  • Describe the collateral you will offer as security;
  • Determine, through your bank, that a conventional loan is not available;
  • Prepare current financial statements, preferably with your accountant's assistance. These would include, at a minimum, a relatively current balance sheet and an income statement for the previous full year and for the current year up to the date of the balance sheet; and
  • Prepare personal financial statements of the owners, partners, or stockholders owning more than 20% of the stock of the company (who will all be required to sign on as loan guarantors);

Direct Loans and MicroLoans

If you are unable to obtain sufficient conventional financing or SBA­-guaranteed loan funds, it may be possible, in very rare instances, to obtain a direct loan from the SBA. These direct loans are usually offered on a participation basis with a bank or other lender, where the bank oversees the loan payments and loan servicing on behalf of itself and the SBA. In recent years, the SBA has largely ceased making direct loans because of a lack of available funding and reluctance on the part of SBA administrators to engage in direct lending.[7]

In 1992, however, the SBA began, as part of its direct loan program, to make "microloans" at slightly below-market interest rates to veterans, business owners with disabilities, and persons desiring to start companies in economically depressed areas. These loans are of very small amounts, not to exceed $50,000,[8] and the actual average size of such loans is about $13,000. They are intended to help very small businesses, particularly those run by minorities, women, and low-income people, who generally have a difficult time raising capital. As such, microloans are designed to empower people, such as single mothers, disabled individuals, and public housing tenants, to become self-employed and self-supporting.

The SBA's microloans are modeled after microloan programs that have been operated for a number of years by nonprofit agencies in the United States and in a number of Third World countries, generally with great success. The SBA microloan program is generally run in cooperation with local nonprofit organizations, to which the SBA provides the funding to make such loans. To find an SBA microlender, contact an SBA district office or contact the SBA national office at:

SBA Answer Desk
(800) 827-5722

SBA Online
www.sbaonline.sba.gov

Should You Pursue an SBA Loan?

Some small businesses will find that SBA loans are available when they are not able to obtain conventional financing from private sources, often because they are young businesses without a significant track record of financial performance or because they lack sufficient collateral to obtain financing that is not guaranteed by the government. Thus, in many cases, and SBA loan may be the only available source of financing at a reasonable interest rate. This is particularly true in the current weak economic environment, where banks are being urged to make more loans, but in fact are under unprecedented pressure from bank regulators to refrain from making any but the safest of loans.

The downside of applying for an SBA loan, compared to conventional loans, is primarily the much greater amount of paperwork that is involved and the resulting extended time frame before a loan can be made. This can be particularly problematic if access to credit is urgently required. In addition, loan guaranty fees charged by the SBA can be substantial on large loans.

Be aware that if you are applying for an SBA-guaranteed loan, the paperwork required will include at least the last three business tax returns plus at least three tax returns for each principal who owns at 20% or more of the business. In addition, the SBA requires collateral to fully secure a loan, to the extent it is available. This will usually include putting up your home as collateral and the business may be required to give a lien on its assets and to obtain life insurance on the sole owner of a business.

Other SBA Programs

The SBA frequently adds to and modifies its programs. Some other SBA programs include:

  • Export working capital program, which offers 90% guarantees for short-term loans (12 months, with two options to renew, for a total of 36 months) to finance exports, including financing of labor and materials for manufacturing goods for export, purchasing goods or services for export, or financing accounts receivable from export sales;
  • Seasonal lines of credit;
  • Economic opportunity loans for entrepreneurs who are physically disabled or members of a minority group;
  • Short-term contract loan guarantees;
  • Energy loans to small firms to install, sell, service, develop, or manufacture solar energy or energy-saving devices; and
  • Disaster recovery loans to firms harmed by natural disasters.
Since the nature, scope, and availability of funds under these and other SBA programs are constantly changing, consult your bank or local SBA office for current availability of programs.

10.3 Other Federal Loan Programs

The federal government has a number of other loan programs which your business may qualify for, some of which are described below.

U.S. Department of Commerce Loans

The Economic Development Administration (EDA) of the U.S. Department of Commerce makes direct loans and offers loan guarantees to businesses in areas with low family incomes or areas suffering from high unemployment. The purpose of these loans is to promote creation or retention of jobs for the residents living in these areas.

To qualify for this financing, your business must be located in an EDA redevelopment area and demonstrate that the venture will directly benefit local residents without creating local over-capacity for the industry in question.

U.S. Department of Agriculture Rural Development Loans

The Rural Business-Cooperative Service (RBS), formerly part of the Farmers Home Administration, can be thought of as an SBA for rural areas. It offers insured and guaranteed loans to develop business and industry in non-urban areas with populations of under 50,000. RBS loan guarantees are for up to 80% of the total amount of the loan and are made for up to 30 years for financing real estate acquisition, 15 years for machinery and equipment, and 7 years for working capital. RBS loan guarantees are generally not available for agricultural production.

Applicants for RBS loans or guarantees must not only have adequate collateral and good business histories, they must also demonstrate that the project will have a favorable economic impact and will create new jobs in the area -- not merely shifting business activity and jobs from one area to another. Preference is given to:

  • Businesses that are expanding rather than transferring into an area; and
  • Projects in open country areas or towns with populations of under 25,000.

For more information about these loan programs, contact the Rural Economic Cooperative Development office at the U.S. Department of Agriculture:

Rural Economic Cooperative Development
(202) 720-4581
(800) 670-6553 (Toll-free)


Rural Business-Cooperative Service Website
www.rurdev.usda.gov/LP_BusinessPrograms.html

Other major federal loan programs are provided through the Federal Land Bank Association, Production Credit Association, and the Federal Intermediate Credit Bank. These organizations offer loans to businesses that provide services to farmers. These loans can be for purchasing land and equipment and for obtaining start up working capital.

10.4 Small Business Investment Companies

In addition to direct loans and guarantees from government agencies, don't overlook possible loans or equity financing from Small Business Investment Companies (SBICs) and Specialized Enterprise Small Business Investment Companies (SSBICs). Both are licensed and regulated by the SBA to provide equity capital, long-term loans, and management assistance to small businesses.

SBIC and SSBIC loans are usually subordinated to loans from other creditors and are typically made for five- to seven-year terms. Both types of investment companies are privately owned and thus tend to favor loans to established companies with significant net worth rather than new business start ups.

IMPORTANT NOTE:
If you receive funding from an SBIC, you will likely have to give up a large part of the equity in your business, as with any other investor. An SBIC is not permitted to control a company (50% or greater ownership) it lends to, but typically an SBIC lender will insist on debt that is convertible into common stock, plus warrants and stock options, which may give it up to 49% ownership in your company. An SBIC will also want seats on your board of directors, may impose controls and restrictions on the way your business operates, and may insist upon salary limits for the principal owners.

SSBICs are similar to SBICs, except that SSBICs serve only those small firms that are owned by members of economically or socially disadvantaged minority groups.

10.5 Business Development Corporations

Business development corporations are local development companies (LDCs) and certified development companies (CDCs) organized by local residents to promote economic development in their particular communities. These entities do not make working capital loans or loans to purchase free-standing equipment. Instead, LDCs or CDCs will arrange for SBA-guaranteed bank loans and sale of long-term SBA-guaranteed bonds for up to 90% financing for land acquisition, building construction, or renovation and purchase of fixed assets, such as machinery and equipment, all under the SBA Section 504 loan program.

10.6 Contact Information -- Financing

For information and help on locating financing for your small business, contact the nearest U.S. Small Business Administration office in [STATE NAME], or contact the [NAME OF APPRORIATE STATE ECONOMIC DEVELOPMENT AGENCY DELETED HERE]. For further details and information about state lending programs, contact [STATE AGENCY NAME DELETED]. See the link to the website of this agency, listed in [LINK TO STATE LAW CHAPTER DELETED].

The address of the SBA Office in [STATE NAME] is:

U.S. Small Business Administration
[ADDRESS AND PHONE NUMBER OF SBA OFFICE IN YOUR SPECIFIC STATE DELETED HERE]


Endnotes

(C.F.R. references are to the Code of Federal Regulations. Note also that the loan limits, fees, and other items in the SBA regulations frequently do not reflect the actual current terms set by the SBA and noted above in this chapter.)

1. 13 C.F.R. § 120.214(d) and (e); and 13 C.F.R. § 120.215.
2. 13 C.F.R. § 120.213.
3. 13 C.F.R. § 120.220(a).
4. 13 C.F.R. § 120.220(f).
5. 13 C.F.R. § 120.151.
6. 13 C.F.R. § 120.210.
7. 13 C.F.R. § 120.211.
8. 13 C.F.R. § 120.701(f).

Chapter 11

Accounting Basics

"An engineer will tell you that 2+2 exactly equals 4.
A lawyer will prove in court, beyond reasonable doubt, that 2+2=5.
An accountant, on the other hand, will ask, 'How much do you want it to be?'"

-- Anonymous

"In business, only the paranoid survive."
-- Andrew Grove, former CEO of Intel Corporation

"Never trust a bookkeeper who comes to work in a Rolls-Royce."
-- Doc Snopes' First Law of Business Survival

"A man who will steal for me will steal from me."
-- Theodore Roosevelt

There is no doubt that you can succeed in a business venture without needing to be a CPA or a financial wizard, but a basic understanding of accounting methods and a good accounting program will help. If you have time to do so, consider enrolling in a couple of introductory accounting courses at a nearby university or community college. Doing so will aid you immeasurably in understanding how an accounting system for your business works, or should work.

This chapter briefly covers accounting methods and reports, cash flow management, internal financial controls, and tax accounting methods. For examples of financial statements, and a line-by-line, plain-English description of what each line in the examples means, see our extensive business plan outline, which we have posted on the Internet for readers of this book series to view and/or download for your use. The business plan outline URL on the Internet is the following Web page:

Ronin Software Website -- Business Plan Outline
www.roninsoft.com/sbz/bizplan.htm

11.1 Establishing Your Accounting System

Maintaining good accounting records is a must for any small or large business. Without accurate and up-to-date records, you will be flying blind, operating your business without vitally important information. However, meaningful financial statements can only be prepared if the underlying records of transactions are accurate and current.

It may help to think of your accounting system as like an airplane's instrument system. If you are not getting current and correct feedback from either system, you may not have enough time to react to prevent a potential crash.

Single-Entry Method

While most schools and colleges teach only the double-entry method of bookkeeping, which provides a series of checks and balances in recording income and expenditures, some small business owners use a single-entry method of accounting.

If you are not knowledgeable about double-entry bookkeeping and handle most of the funds directly yourself, you may find that a single-entry system is acceptable for your needs and much simpler to use. The single-entry method is only slightly more involved than keeping a checkbook record of cash income and disbursements and usually consists of three basic records:

  • A daily cash receipts summary. This summary may come from a cash register tape or sales slips. It will not only give you a total of your daily cash receipts, but it should break down your sales by product, by salesperson, or by store, depending on how much detail you need.
  • A monthly cash receipts summary. This is simply a monthly summary of the daily cash receipts.
  • A monthly cash disbursements report. This is a report on expenses and other payments, such as debt repayments, purchases of capital assets, or distributions of profits.

A number of simplified write-it-once (single-entry) bookkeeping systems for all different kinds of businesses are available at office supply stores.

Double-Entry Method

While a single-entry system is easy to use, it is not a complete accounting system because it focuses mainly on profit and loss and does not provide a balance sheet. For all but the very smallest of businesses, a single-entry accounting system is likely to be inadequate. Even if your business is very small, but expects to grow, it is usually advisable to start out with a full set of books, using the double-entry method.

In double-entry accounting, there is a debit and a credit entry for every transaction, and the amount of the debit or debits should always equal the amount of the credit or credits for each entry. Doubtless, you have heard the accounting terms "debit" and "credit" but may not know what they mean. Fortunately, this is not rocket science. Simply put, a debit entry is a bookkeeping entry that increases the amount of an asset account or an expense account or else decreases a liability or equity (net worth) account. A credit entry is just the opposite -- one that decreases an asset account or expense account or increases a liability or equity account.

EXAMPLE:
If you pay an expense for pest control of $100, your bookkeeping entry in a double-entry accounting system would be a debit to pest control expense for $100, and an offsetting credit to cash (or your bank account, if writing a check) for $100. That is, the entry increases an expense item, and decreases your cash (or bank) account balance.

A set of double-entry books keeps track of all of the following types of accounts:

  • income and expense accounts
  • cash accounts (cash receipts and disbursements and cash balances);
  • asset accounts other than cash (accrued income, furniture, equipment, inventory, accounts receivable, real estate owned, accumulated depreciation on depreciable assets -- carried as a credit balance or offset against the cost of the asset, and prepaid or capitalized expenses);
  • liability accounts (accrued expenses, accounts payable, loans, tax liabilities, and unearned income);
  • equity accounts (common stock, preferred stock issued, treasury stock, paid-in capital, and retained earnings accounts for a corporation, or owners' equity accounts for unincorporated businesses); and
  • the general ledger (where summary entries are made, such as for total income and expenses for a period, and net income or loss that is credited or charged to retained earnings, plus occasional adjusting entries such as for accrual of expenses or accrual of income or amortization or depreciation of assets).

You can avoid many future problems if you get a CPA to help you set up the accounting system for your business. He or she will tailor a chart of accounts to your specific needs and help you to build in internal controls to record all transactions and to reduce the possibilities of employee theft or embezzlement that might go undetected with a poorly designed system.

Many accounting software packages are available to help with your accounting needs. For a very small business, adequate software packages are available for about $100. Most of the better and more user-friendly accounting software programs tend to insulate you from the need to understand the niceties of double-entry accounting. However, it will still be helpful if you have at least some grasp of how double-entry accounting works, so you can better understand what is going on "under the hood."

Survey of Small Business Accounting Practices

A survey of 300 small business owners by New England Business Services, Inc., published a few years ago in the Journal of Accountancy, illustrated several important points about small business accounting practices:

  • Roughly one of five of the small businesses in the survey identified accounting or bookkeeping as their weakest business skill, a far higher percentage than any of the other critical areas, such as marketing, organization, planning, operations, managing employees, customer relations, or collecting money.
  • Over 21% of the companies said they spent a lot of time on accounting and bookkeeping; only sales was listed as the item on which more time was spent by a larger number of respondents (23%).
  • A large majority (79%) of the small businesses said that they used accounting software, rather than manual systems, and over 50% used various Quicken products, such as Quickbooks Pro, Quickbooks, or Quicken.

Accounting Firm Services

If you are going to use an outside CPA firm to prepare financial statements, you will have to decide on which level of service you will need. CPA's provide any of four different levels of service -- audits, reviews, compilations, and assembly statements. These are listed below, in descending order, starting with the most comprehensive (and expensive) level of service -- audits.

  • Audits. An audit is invariably the most involved and most expensive level of service in connection with financial statements. An accounting firm that audits your financial statements must not only verify that your financial statements are presented fairly and in accordance with Generally Accepted Accounting Principles (GAAP), but the auditing firm also checks and verifies some or all of the accounts to satisfy itself that they are real. To verify accounts, an accounting firm can request confirmations of bank accounts or receivable and payable account balances from banks, customers, and vendors to uncover possible errors or fraud in record keeping.

    The certified public accounting (CPA) firm must also analyze your system of internal financial controls, to satisfy itself that your controls are satisfactory to capture all of your firm's financial activities, so that all transactions get recorded. The auditors will select a random sample of transactions and follow each such transaction through your files and accounting records to see that every step of the transaction was proper and was properly recorded and traceable, comparing cash disbursement records to bank statements, and doing similar analyses of other transactions.

    A common misconception regarding audits is that an audit involves checking and verifying a company's every transaction. However, that is rarely the case, except for a very small or simple business operation with just a very few transactions. In the normal audit situation, the CPA randomly selects enough transactions, as a percentage of the total, to give a statistically valid high level of assurance that no material (significant) erroneous or fraudulent transactions are being overlooked. In addition to random sampling, any unusual or large transactions will generally be carefully scrutinized, as well. While audits are not primarily intended to detect fraud, one of their side benefits is that fraud by employees is sometimes detected by the outside auditors.

    Only a small percentage of small businesses (usually the larger ones) need or can afford to have a CPA firm do audited financial statements, since audit fees are quite expensive and an audit will also require a major time commitment from the audited company's employees.

  • Reviews. A review involves some limited analysis or testing of the financial records, but the certified public accountant expresses only a very limited opinion as to the accuracy of the information in the financial statements. A review is somewhat less expensive than an audit, but more expensive than a compilation. Most small businesses hire a CPA firm to do review statements only if their bankers or other lenders or financial backers insist on a review rather than a compilation.
  • Compilations. In preparing compilation statements, the accountant takes the financial data you provide and presents it in a manner that con­forms with GAAP. A compilation is the least expensive level of service in cases where you will be presenting your company's financial statements to outside persons or entities, because the CPA has no obligation to do any investigation unless he or she notices something that looks suspicious or misleading.

    In compilation financial statements, the accountant expresses no opinion as to the accuracy of the information presented. This is important to remember because you are ultimately responsible (and legally liable) for ensuring your financial statements are prepared accurately if you will be showing them to lenders or investors in your company. For most small businesses, compilation statements are quite adequate to fill the need for financial statements that can be provided to persons outside the company.

  • Assembly Statements. This is a relatively new level of service, also sometimes called "management use only" or "plain paper" financial statements, introduced in the accounting profession after the year 2000 by SSARS 8. While each of the other levels of service includes a report signed by the accountant, describing the level of service provided, this level of service permits the accountant to submit financial statements without an attached report, if third parties (lenders, investors, etc.) are not reasonably expected to use the financial statements. Assembly statements are basically statements that your accountant prepares for your use only, within your company, and thus do not involve any auditing or other verification of the accounting data you submit to the accountant.

    The accountant who performs assembly services merely takes your information and puts it in a useful financial statement format for you, and gives you the statements. SSARS 8 requires the accountant who provides this level of service to obtain a signed engagement letter from you, the client, specifying the nature and limitations of the services to be performed, noting that the financial statements may make material departures from GAAP, and must include your acknowledgement and agreement that the financial statements are not to be used by or presented to third parties outside your firm.

PLANNING POINT:
Because audits and reviews are relatively expensive, you may, like many small businesses that need to have financial statements done by a CPA firm, elect to only have compilation statements done. However, you may not always have a choice in the matter, as some lenders or bonding companies will insist that you have a certified audit, or at least have review statements, particularly as your business grows larger.

11.2 Depreciating Assets

Tax Depreciation Methods

Depreciation, in accounting terminology, is a method of recognizing an expense you have incurred for a business asset over a period of more than one year, rather than treating the cost as an expense at the time it is purchased. Depreciation applies to tangible assets that have a "useful life" of more than one year and which are not held for resale as inventory. (Some assets, like land, have an indefinite useful life, and are neither expensed nor depreciated. For those assets, you only get to deduct the cost against the selling price when the assets are sold.)

Most tax-deductible expenses you incur in your business, such as travel expenses, minor supply items such as computer supplies or paper clips, and most wages you pay are "expensed" immediately, in the year the expense is incurred. Other "capital" expenditures, ranging from computers to production equipment to trucks to office buildings, must be set up on your books as assets and expensed gradually, each year, over their useful life or, for tax purposes, over a "recovery period" that is allowed under the tax law.

Note that the useful life and the depreciation method (straight-line or one of various "accelerated" depreciation methods) used for financial statement purposes may differ from the recovery period and tax depreciation method that you must use for income tax purposes. This means that you will generally need to keep two sets of depreciation records for each depreciable asset -- one for "book" purposes and one for tax purposes. In many instances, you will need to keep a third set of depreciation records for Alternative Minimum Tax purposes, and in many states, most of which depart from federal tax depreciation rules to some extent, you may need to keep a fourth set of depreciation records for state income tax or franchise tax depreciation purposes, where the allowable recovery periods or depreciation methods under state tax law differ from what is allowable for federal tax purposes. It can get almost absurdly complex if you have to keep a fifth set of books for state alternative minimum tax purposes in some states, or even a sixth set of books if your business is in some type of regulated industry that mandates certain methods of accounting or depreciation for federal or state regulatory (non-tax) purposes.

Thus, recordkeeping for depreciable assets can become quite onerous, time-consuming, and expensive, even for a relatively small business. Your CPA or bookkeeping service can help you set up a system of recordkeeping for such fixed assets, which may include the use of certain commercial software packages designed specifically for fixed asset accounting.

When you later sell an asset that you have been depreciating, its cost is reduced by the depreciation deductions you have claimed (or the amount allowable, if you or your accountant failed to take at least the minimum depreciation the law allows), thus increasing your gain or reducing your loss when you sell the asset. This "allowed or allowable" rule is a nasty trap for the unsophisticated business owner who fails to take depreciation that he or she is entitled to deduct.

TAX TIP:
If you are ever caught in the foregoing tax trap, there is now a way out. For example, assume you bought a building for $600,000 seven years ago, and failed to tell your tax preparer about it, so you have failed to claim 7 years of depreciation on your tax returns. You could amend your tax returns for the last 3 years, but it is too late to amend the returns for the first 4 years. What to do?

The solution is to file a Form 3115 to "change your accounting method" for depreciation, since your former accounting method (not taking any depreciation) was erroneous. By doing so, you won't even need to amend the last 3 years' tax returns -- you will be able to deduct the entire 7 years of depreciation to date this year.[1]

The modified accelerated cost recovery system (MACRS) tax depreciation system went into effect in 1986. MACRS is the part of the tax law that tells you how quickly you may depreciate (write off) the cost of various types of property you acquire for use in your business. The MACRS system does not provide depreciation tables you can use to compute deductions, unlike the previous ACRS system. Instead, you (or more likely your accountant) must compute the annual depreciation deduction, using the proper number of years and the correct depreciation method for each item of property.

Different types of property must be depreciated over different numbers of years. The number of years over which an item is to be depreciated is called its "recovery period," since that is the number of years it will take you to "recover" the cost of the item by fully depreciating its cost for tax purposes. It is important to know the length of the recovery period when preparing your taxes and figuring your company's assets. Assets other than real estate are mostly assigned to the various 3-, 5-, 7-, 10-, 15-, or 20-year recovery periods based on the industry in which the assets are used, while real estate (other than land, which is not depreciable, generally) has a 39-year recovery period, or 27.5 years for residential real estate, such as apartments.

However, as discussed in more detail in Chapter 13, Section 13.6, certain "qualified leasehold improvement property" or "qualified restaurant property" placed in service after October 22, 2004 and before January 1, 2014 qualify for a 15-year, straight-line depreciation write-off, and "qualified leasehold improvement property" placed in service in 2008 through 2011 qualified for a 50% (or 100% in late 2010 and all of 2011) bonus depreciation write-off in those years. Also, under recent stimulus legislation, certain real estate improvements to restaurant property or to retail property can also be depreciated over a 15-year period if placed in service before January 1, 2014 or can be deducted as bonus depreciation.[2]

In addition, under 2010 legislation, up to $250,000 of the three above types of such qualified real property could be expensed under Section 179 if placed in service in 2010 or 2011, and the American Tax Relief Act of 2012 extended the $250,000 expensing deduction through 2012 and 2013.

IMPORTANT NOTE:
Unfortunately, none of the special write-offs for the three above types of qualified real property will be in effect for such property placed in service on or after January 1, 2014.

The IRS MACRS cost recovery guidelines and classifications by industry are too voluminous and technical to reproduce here. The IRS MACRS tables for cost recovery periods can be found in Rev. Proc. 87-56,[3] but be forewarned that these detailed tables go on for quite a few pages and are not easily comprehended by civilians. Talk to your accountant about how your company's assets are to be depreciated for tax purposes. Good tax planning results can often be achieved by choosing to either take more or fewer depreciation deductions in a given year, whichever provides the better overall tax result.

PLANNING POINT:
When buying a building, which must be depreciated over a recovery period of 39 years (or 27.5 years for residential rental property, such as apartments), it can be advantageous to break out the cost of certain personal property items separately in the agreement of purchase, such as carpets and movable partitions, which you can generally depreciate over a much shorter recovery period (such as 5 years, generally, under MACRS). It is NOT permissible to break out separate structural components and attempt to write them off over a period less than 39 years (or 27.5 years, for residential rental property).

If constructing or buying an expensive building, it is often advisable and profitable to employ a consulting firm that specializes is doing cost segregation engineering studies to allocate significant dollar amounts to other than 39 (or 27.5) year cost recovery categories. Such studies will usually cost about $6,000 to $8,000, but can be well worth it on a building that costs more than about $400,000, unless you plan to resell the building in the relatively near future (in which case the tax deferral benefits would be recaptured). Another possible benefit of such studies is that they may also help you save on property taxes in many states.

One engineering firm with a good reputation among tax professionals, whose studies are routinely accepted by the I.R.S., and which will do such studies in any part of the United States is Bedford Cost Segregation, LLC. See their website, at www.bedfordteam.com/ for examples of cost segregation studies for various types of structures and to use their Online Estimator to see how much taxes you may save (defer).

CAUTION:
Before spending serious money on a cost segregation study, however, your accountant or tax attorney should first take a hard look at the Tax Court decision in the recent (2012) case of Amerisouth XXXII, Ltd., T.C. Memo 2012-67, which disallowed all but a few cost segregated items in a large apartment complex, where a study had identified over 1,000 such items for more rapid depreciation.

Items disallowed by the Tax Court and treated as structural components (which had to be depreciated over 27 1/2 years) included earthwork and site preparation costs; water distribution systems; sanitary sewer system; gas line; special HVAC system; special plumbing; finish carpentry; special electrical work; millwork; interior windows and mirrors; and special painting.

Expensing

One tax rule you will want to be aware of -- and likely take advantage of -- is the rule allowing you to "expense" rather than depreciate a certain amount of tangible personal property bought for your business. By treating these purchases as an "expense" you are able to write off the entire cost, or at least a large portion of the cost, in one taxable year, rather than spreading the deductible amount over a number of years. Thus, you more quickly gain the tax benefit of the deduction.

Until 2003, only a fairly limited first-year write-off of the cost of depreciable tangible personal property was allowed, in addition to the regular MACRS depreciation on the remaining cost. The additional first year write-off under Internal Revenue Code Section 179 was limited to $25,000, with that amount phasing out if more than $200,000 of qualifying property were placed in service that year, and thus was completely phased out if $225,000 or more of such property were placed in service for the taxable year. Thus, the Section 179 first-year expensing deduction was usually only available to relatively small businesses, or those with relatively small capital expenditures for machinery and equipment -- of $225,000 or less in a given tax year. (This will be the case again in 2013, if the "Bush tax cuts" are allowed to expire on December 31, 2013.)

However, beginning with the Jobs and Growth Act of 2003, Congress has repeatedly tinkered with increases in the allowable expensing deduction, greatly increasing the maximum possible expensing deduction, with increased phase-out levels as well.

UPDATE NOTE:
Under the Small Business Jobs and Credit Act of 2010, Section 179 expensing was generally increased from $250,000 to $500,000 in 2010 and was also extended through 2011. Phase-out of expensing during 2010 and 2011 began at $2 million of such property placed in service (instead of $800,000 in 2010 and $200,000 in 2011, as was previously scheduled). In addition, up to $250,000 of qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property could be expensed under Section 179 under this amendment. Beginning with acquisitions in 2012, all such non-residential real estate assets were to revert to the old depreciation rule -- straight-line depreciation over 39 years. However, Congress has extended 15-year depreciation for such real estate items through the end of 2013, instead of 39-year depreciation, as well as extending the $250,000 expensing deduction for such "qualified" real estate through 2012 and to the end of 2013.

Beginning in 2012, the expensing deduction was to have reverted back to $25,000 and the phase-out level to $200,000 again (neither of which amounts is indexed for inflation).[4] However, the Section 179 deduction did not revert to those levels in 2012, since Congress acted in December, 2010 to extend the Bush tax cuts and to reinstate the 2007 limits under Section 179 ($139,000 inflation-indexed deduction, with phase-out beginning at $560,000) for the year 2012. The pre-Bush era $25,000 deduction limit and $200,000 phase-out level were then to have returned in 2013, but Congress has extended the 2012 amounts for another year, until the end of 2013.

IMPORTANT NOTE:
As under pre-2003 law, such expensing of assets under Internal Revenue Code Section 179 cannot reduce a business entity's trade or business income to below zero, or in the case of a sole proprietor or an individual to whom Section 179 deductions are passed through from a pass-through entity such as a partnership, LLC, or S corporation, cannot reduce the individual's earned income from active trades or businesses below zero. Both the dollar limits and the net income limitation apply at both the entity level and the owner level.
PLANNING POINT:
In determining whether an individual taxpayer can claim the Section 179 deduction from a business on his or her tax return, the taxpayer can apply the deduction against ALL earned income, including W-2 salary or wages, not just the income or loss from the business. In fact, even the W-2 salary of the business owner's spouse counts as earned (trade or business) income and, if a joint tax return is filed, can also be used to increase the allowable Section 179 expense!
PLANNING POINT:
Because 100% bonus depreciation was permitted for qualifying assets placed in service after September 8, 2010 and before January 1, 2012, it may in many cases be better to have elected 100% bonus depreciation instead of Section 179 expensing for assets acquired during that period, since there is no dollar limit or phase-out level that applies to bonus depreciation. In addition, bonus depreciation may be taken even if it creates a net taxable loss for the taxpayer, which may be advantageous if the loss can be carried back to prior years to claim a tax refund. However, remember that bonus depreciation only can be taken on new property, generally, while Section 179 expensing can be claimed on both new and used property.

If, when filing your 2010 and 2011 tax returns for your business, you claimed Section 179 expensing on some new assets placed in service in late 2010 or in 2011, consult your tax advisor about possibly amending your return and claiming bonus depreciation instead, if there is a tax benefit to you for doing so, as you may be able to create a tax loss that can be carried back to 2009 or earlier years for a refund of taxes paid in those years.

It is almost always advisable to claim the maximum Section 179 deduction that can be taken, even if it is not all currently deductible, since any unused Section 179 deduction (due to insufficient earned income) can always be carried forward indefinitely and can be deducted against active trade or business income in subsequent years. About the only case in which you would not want to claim the full Section 179 deduction on newly acquired assets would be in a year when you happen to be in a very low tax bracket and where you would prefer to save some tax write-offs for the following year.

Note, however, that the IRS has pointed out in detail in Notice 2013-59,[5] that Section 179 deductions for personal property which are disallowed in the years 2010-2013, due to the taxable income limitation, can generally be carried over and deducted in subsequent years, subject to the limitations that apply in those years on Section 179 deductions. However, any such disallowed Section 179 deductions from the expensing of "qualified real estate" during those years (2010-2013) cannot be carried over to years after 2013.

Section 179 expensing is very flexible, so you could, if you chose to, claim just enough of the allowable deduction in any given tax year to get your taxable income down to a certain given level, but not down into the next lower bracket, such as the 15% tax bracket. You can even make the election to expense items under Section 179 several years after the fact, on a timely amended tax return or, during the tax years 2003-2010, you can revoke a Section 179 expensing election without obtaining IRS approval.

PLANNING POINT:
If your goal is to get the maximum current year tax deductions, remember, when choosing the assets on which you will take the Section 179 deduction, to select the assets with the longest MACRS recovery period, such as 10-year MACRS property, if possible, rather than 5-year property, since the latter property can be written off faster as annual depreciation expense when it is not expensed immediately under Section 179.

The Section 179 expensing election only applies to tangible personal property that is used in a trade or business and that is depreciable property. Thus, items such as machinery, equipment, office furniture, computers and similar tangible items are "qualifying property" for purposes of the Section 179 expensing deduction. Real estate and intangible personal property, such as computer software, generally do not qualify. However, during the 2003-2013 period, when the annual expensing amount is temporarily increased from $25,000 to as much as $125,000 (with indexing adjustments) or $250,000 in 2008 through 2009, $500,000 in 2010 through 2013, off-the-shelf computer software also qualifies for the Section 179 deduction.[6]

Expensing of Repairs on Real Estate -- New (2013) "Safe Harbor" Regulations

For many years, a contentious issue between taxpayers and the IRS has been whether amounts paid to restore or improve property, especially real property, are deductible immediately as repair and maintenance expenses, or, as the IRS often asserts if large expenditures are made, are "capitalized costs" that must be depreciated over 39 years for commercial property or 27.5 years for residential rental property. This battle has continued to rage in the courts, based on the facts and circumstances of each case. Naturally, taxpayers always argue that the expenditures are for necessary repairs or maintenance, and should be allowed as expenses, while the IRS takes the position that they are optional capital improvements, made to increase the value of the property.

UPDATE NOTE:
However, in 2013, the IRS finally issued new regulations on this issue, which provide an important new "safe harbor" for small businesses, allowing for expensing of repairs in many cases, with no questions asked, if certain numerical tests are met.[6A]

Under the safe harbor in the new regulations, a "qualifying taxpayer" must have average annual gross receipts for the last 3 years of $10 million or less. If your business has been in business for less than 3 years, then the $10 million test is based on the average annual gross receipts for the number of years you have been in business. If one of those years is a short taxable year, the gross receipts for that short period must be annualized.

To benefit from the safe harbor, a qualifying small business may expense repair or similar expenditures only on an "eligible building," which is one with an unadjusted basis (cost, ignoring any depreciation taken on it) of $1 million or less, and the repair expenses incurred for that building may not exceed the lesser of $10,000 or 2% of the unadjusted basis of the eligible building. In other words, a major re-modeling project is very unlikely to qualify.

If the costs you incur exceed the 2% or $10,000 limit (whichever is less), you do not qualify for the safe harbor, but you may still be able to expense your repair costs in some cases if you can qualify under the old "facts and circumstances" rules that have been so frequently litigated over the years.

If you qualify for the safe harbor, you must attach an election statement to your company's tax return (for 2012 or later years), titled "Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers," and list on the statement, with a description, each building for which the election is being made, plus listing the taxpayer's name, address and taxpayer identification number. The safe harbor election, once made, is irrevocable, and cannot be made as a change in accounting method or on an amended tax return, except with the consent of the IRS.

Bonus (First-Year) Depreciation

In order to jump-start the economy after the 9/11 terror attacks, Congress also enacted, in 2002, a temporary 30% first year "bonus depreciation" deduction, with no dollar limits. For purposes of this deduction, "qualifying property" is basically the same as qualifying Section 179 property, except that the first use of the property must begin with the taxpayer to qualify -- i.e., used property does not qualify for the bonus depreciation deduction. [7] In the Jobs and Growth Act of 2003, this bonus depreciation deduction was increased from 30% to 50% of qualifying assets placed in service after May 5, 2003.

The 30% or 50% bonus depreciation deduction (and any Section 179 expensing) reduces the cost of the asset, and the regular MACRS depreciation for that year and each subsequent year is computed on that reduced cost, or "tax basis" of the assets. The bonus depreciation deduction applied only to assets placed in service before January 1, 2005.

However, the Economic Stimulus Act of 2008 restored 50% bonus depreciation, for assets placed in service in 2008 (only), generally. The 2008 bonus depreciation rules also extended the definition of "qualified property" that qualifies for bonus depreciation to include "qualified leasehold improvement property," although such leasehold improvements would generally not qualify for Section 179 expensing.[8] The American Recovery and Reinvestment Act of 2009 extended 50% bonus depreciation through the end of 2009 and the Small Business Jobs and Credit Act of 2010 extended it again through the end of 2011. Subsequently, 50% bonus depreciation was extended again through the end of 2013, by the American Taxpayer Relief Act of 2012.

EXAMPLE:
Your company acquires items of new machinery that qualify for both Section 179 expensing and 50% bonus depreciation in early 2010, at a cost of $600,000. First, you could expense $250,000 of the cost under Section 179. Then, on the balance of $350,000, you could take 50% bonus depreciation of $175,000, further reducing the depreciable tax basis of the assets to $175,000. You would then compute regular MACRS depreciation for the first year, which might be, for instance, 20% of the remaining tax basis if the machinery is 5-year MACRS property, or $35,000 of regular depreciation.

Thus, all told, you would have deducted $460,000 of the cost in the 2010 tax year. In contrast, if you elected neither the Section 179 expensing deduction nor bonus depreciation, the first-year deduction for 5-year MACRS property would only be $120,000 (20% of $600,000).

Better yet, when Congress extended the Bush tax cuts in December, 2010, it also enacted a 100% bonus depreciation provision for assets placed in service between September 8, 2010 and December 31, 2011, and increased Section 179 expensing to $500,000 (with phase-out beginning at $2,000,000) for 2010 and 2011, and Congress extended those limits further through 2012 and 2013 in subsequent legislation. Thus, in the foregoing example, if the assets were acquired in 2011 or in 2010 after September 8, 2010, instead of earlier in 2010, you could use 100% bonus depreciation to write off the entire $600,000 cost.

But the above example will not be relevant in the future, of course, unless Congress again extends the increased Section 179 write-off, which drops from $500,000 after 2013 to only $25,000 (with no inflation indexing). Also, the 100% bonus depreciation deduction expired at the end of 2011 and 50% bonus depreciation expires after 2013.

Assuming neither provision is renewed or revived by Congress after 2013, your purchase of $600,000 of qualifying 5-year MACRS assets in 2014 will generate zero Section 179 expensing (the $25,000 limit on such deduction would be completely phased out since you placed over $225,000 of Section 179 property in service) and bonus depreciation would no longer apply. Thus your deduction in 2014 would be limited to the MACRS 5-year property depreciation deduction of 20% of cost, or $120,000.

Comparing that deduction to a $460,000 deduction for the same asset if placed in service in 2008 or 2009, or even larger deductions in late 2010 or 2011, perhaps $600,000, it is likely that the various economic stimulus acts passed in 2008-2010 have done a good bit to stimulate and revive the weak economy -- although temporarily reducing the government's tax revenues and adding to the massive deficits.

IMPORTANT NOTE:
Nearly all state governments, to prevent a serious loss of tax revenue, have "decoupled" their taxable income calculations from federal taxable income since the 2001 federal tax legislation, by prohibiting businesses from claiming the new federal bonus depreciation deductions or the expanded federal Section 179 expensing deduction.
UPDATE NOTE:
As noted above, in 2008 and 2009 federal tax legislation, Congress restored 50% bonus depreciation for qualifying depreciable assets purchased and placed in service during calendar years 2008 and 2009, and has since extended 50% bonus depreciation as an option for taxpayers, through December 31, 2013. In addition, that legislation also provided that the maximum allowable amount of depreciation that can be taken on a passenger car in the first year, which was otherwise limited to $2,960 for 2008, was increased by $8,000 for cars acquired in 2008 and placed in service before 2009, if bonus depreciation was elected. Thus, for a new "luxury automobile" acquired in 2008, a taxpayer was able to write off as much as $10,960 of the cost in the first year.[9]

This additional $8,000 write-off for automobiles was subsequently extended several more times after 2008. (Note: Congress has again extended 50% bonus depreciation and the $8,000 additional write-off for automobiles, through the end of 2013, with a maximum first-year auto depreciation deduction of $11,060 in 2010 and 2011, and $11,160 in 2012 and 2013.)

Non-Tax Depreciation

The foregoing discussion of tax depreciation methods will not necessarily apply to the "book" depreciation that you will show on your financial statements, although, for the sake of simplicity, some small businesses elect to use the same depreciation methods for financial statements and internal accounting records as they use for tax reporting purposes.

Often, "book" depreciation will be taken on a slower basis, over a longer period of years and perhaps on a "straight-line" basis, rather than using an accelerated method, such as 150% declining balance, that may be allowed for tax purposes. Using book depreciation methods or periods different from those used on your tax returns may make your financial statements look better by showing less depreciation expense each year, thus improving your net profit number. But keep in mind that doing so will require some rather complex calculations of "deferred taxes" on your financial statements, which will tend to increase your accounting fees if you hire a CPA firm to prepare financial statements for your business.

11.3 Selecting Tax Accounting Methods

Choosing tax accounting methods for your business may seem like a dull, uninteresting chore. However, the whole point of choosing the best tax accounting method for your situation is to maximize and accelerate your cash flow, a goal which should be close to the heart of every business owner. In effect, the name of the game in choosing a favorable (and permissible) tax accounting method is to defer income to some time in the future, or else to accelerate tax deductions, taking them now, rather than later. By doing either, you will reduce your tax liability this year, and defer it to next year, or to an even later date in some instances.

Generally, you should rely on your tax accountant's advice when choosing which tax accounting methods to adopt in your business. However, this section will give you an overview of the two tax accounting methods most commonly used, the cash method and the accrual method, so that you can have some intelligent input into the process when you and your accountants sit down to discuss what tax accounting method or methods your business will use. But be forewarned that the rules for determining who can use which method of accounting have become extremely complex, with exception piled upon exception to every rule, so your eyes may glaze over as you read this section, despite our best efforts to make this highly technical tax subject (somewhat) comprehensible to civilians....

Cash Method

The cash receipts and disbursements method of accounting, called the cash method, is the simplest accounting method in use. Under this method, you include income only as it is actually or constructively received. Likewise, you generally only become entitled to deductions when you actually pay expenses -- except for certain special items like depreciation or amortization of certain kinds of expenditures -- rather than when you receive bills for the expenses.

EXAMPLE:
You receive an order from a customer in November, 2013, but they don't pay you until January, 2014. Income from that sale would not have to be reported until your 2014 tax return is filed, if you are using the cash method -- but would be treated as earned in 2013 if you are on the accrual method of accounting.

With the cash method, you usually do not have to report your year-end accounts receivable in income for the year and cannot deduct your year-end accounts payable. This will normally allow you to defer some taxable income each year if your year-end receivables are larger than accounts payable and other accrued but unpaid expenses. Obviously, this gives you some flexibility, too, if you want to pay off a number of payables just before year-end to reduce your taxable income for the current year.

The cash method is mostly used by most individual taxpayers and by businesses in the real estate, financial, and service fields, where inventories of goods are not material factors in producing income. Large businesses with significant inventories, such as manufacturers and wholesale or retail firms, are usually required to use an accrual method of tax accounting.[10] In some cases, however, it is possible even for those businesses to use a hybrid accounting method -- accounting for income and the cost of goods sold on an accrual method -- while using the cash method to report selling expenses and administrative expenses or income from sources other than sales of goods (such as investment income or income from services rendered).

Sole proprietorships, S corporations, and partnerships with no C corporation partners (unless they are considered tax shelters) may use the cash method if that is a permissible accounting method for their particular type of business. The Tax Reform Act of 1986 disallowed use of the cash method for C corporations and for partnerships that have C corporations as partners. One exception was made for small C corporations with average annual gross receipts of five million dollars or less during the three preceding years.[11] Another exception is made for larger firms in the farming business and for certain employee-owned qualified personal service corporations in fields such as law, medicine, accounting, architecture, or consulting.

Firms that are forbidden from using the cash method must adopt the more complex accrual method of accounting, unless new IRS rulings -- which apply to some companies with $10 million or less of average annual gross receipts -- are applicable; in which case some such companies with between $5 million and $10 million in annual gross receipts may be allowed to use the cash method, as discussed below.

In recent years the IRS has greatly liberalized the use of the cash method for small businesses. In the year 2000, the IRS announced, in Rev. Proc. 2000-22, that any small business with average annual gross receipts of $1 million or less for the three preceding tax years could opt out of the requirement to account for inventories.[12] In short, such small businesses can now elect to use the cash method, rather than having to use the accrual method and inventory accounting, provided they obtained IRS approval, which has generally been granted.

The election of the cash method under Rev. Proc. 2000-22 was initially only allowable if a business met a conformity requirement -- meaning that for the current and three preceding years ending after December 16, 2000, the business had to have kept its books (including issuance of financial statements) using only the cash method. However, Rev. Proc. 2000-22 was modified by the IRS in 2001 (by Rev. Proc. 2001-10) to eliminate this conformity requirement. Rev. Proc. 2001-10 also clarified the earlier pronouncement, making it clear that while small taxpayers with $1 million or less in average gross income may use the cash method for receivables, they must treat goods bought for inventory like purchases of supplies that aren't incidental and that must not be expensed until consumed (or sold, in the case of inventoried goods held for sale).

Then, in 2002, the IRS issued another major pronouncement on tax accounting, Rev. Proc. 2002-28, which ruled that certain "eligible trades or businesses" with average annual gross receipts of between $1 million and $10 million would no longer be required to use the accrual method and account for inventory. [13] The latter ruling is intended to apply to firms that have some inventoriable items, but where sales of such inventory items are not the taxpayer's principal business activity. For those "eligible trades or businesses" that have some inventoriable items (other than supplies they use or consume themselves), no deduction is allowed for purchasing such items until they are resold to a customer or, if later, when the taxpayer pays for the goods.

Many small businesses that meet the $1 million to $10 million gross receipts test still do not qualify as "eligible trades or businesses" that can use the cash method. To be eligible, a taxpayer's principal business activity (from which it derives the largest percentage of its gross receipts) had to be in a North American Industry Classification System (NAICS) code OTHER than:

  • mining (NAICS codes 211 and 212);
  • manufacturing (codes 31 to 33);
  • wholesale trade (code 42);
  • retail trade (codes 44 and 45); and
  • information industries, such as publishing (codes 5111 and 5122).

If a taxpayer's principal business activity is the provision of services, it is eligible to use cash method accounting for all of its trades or businesses, even if some of them (or even its principal business activity) is described in an ineligible NAICS code.

A taxpayer will also be an "eligible trade or business" (able to use the cash method) if its principal business activity is the fabrication or modification of tangible personal property upon demand, in accordance with customers' designs or specifications.

Even where a taxpayer's overall business does not qualify, any separate and distinct business it operates can qualify for use of the cash method. For example, if a business grosses $5 million a year and is primarily engaged in operating retail stores, it would not be "eligible" under Rev. Proc. 2002-28. However, if it also operates a travel agency, and keeps a separate and distinct set of books for that business, the travel agency could qualify to report its income and expenses using the cash method of accounting.

CAUTION:
Don't make the mistake of thinking that being exempt from the required use of the accrual method will allow you to deduct your purchases of inventory before the purchased items are sold. Even the smallest businesses, which have been exempted from the inventory accounting (accrual) method generally, must still account for inventory purchases by adding them to inventory and only recognizing such costs as cost of goods sold when the items are sold. Being able to use the cash method, when you have inventories, mainly means being able to use the cash method for your receivables and payables, rather than accruing such items. This will still provide some tax deferral benefits, if your receivables are greater than your payables, or if you pay off your payables (other than amounts owed for inventory purchases) before year-end.

Accrual Method

Most large corporations and businesses with significant inventories are required to report income on the accrual method of accounting for tax, except as noted above. This method requires you to report income when income is earned rather than when you receive it. Similarly, expenses can be deducted when they are incurred rather than when they are actually paid.

EXAMPLE:
You use an accounting service of your CPA in November 2013, receive the bill in December 2013, but don't pay it until January 2014. The expense is still deductible in the 2013 tax year, if you are on the accrual method of accounting (but wouldn't be deductible until 2014 if using the cash method).

However, if you sign a contract with your accountant in 2013 to prepare your tax return in 2014, "economic performance" does not occur until 2014, and you may be unable to accrue the deduction in 2013 for tax purposes, unless you meet several other requirements, such as recurring expenses or performance that occurs within a reasonable time after the end of the tax year.[14]

Even though the accrual method may not be required for your business, you may prefer to use it if most or all of your income is from cash or credit card sales and you pay a large part of your expenses on a delayed (credit) basis. In this case, you would have few receivables at year end but might have substantial accrued payables you could deduct in the current year without having to actually make payment before year end. This would often be the case in a retail business, where most of your customers pay you immediately, in cash or by credit card.

Accrual of bonuses to employees, in an incorporated business, is a good example of a deduction that can be accelerated by a business using the accrual method.

EXAMPLE:
XYZ Company declares employee year-end bonuses in December, but does not pay them until January. It may deduct the bonus expense in December.
But expenses owed to you or to a related owner of the business can't be deducted until actually paid.[15]

Special Accounting Methods for Long-Term Contracts

If your business is engaged in heavy construction work on a long-term contract basis, it may be difficult to tell in advance whether a particular contract will result in a profit or loss since many unforeseen difficulties may arise. The tax regulations recognize this problem and allow long-term contractors to use special methods of accounting, which may delay the time when profit or loss is recognized on a long-term contract. They are:

  • The percentage of completion method, where at the end of each tax period, a determination is made of the probable total profit or loss on each contract, and a portion of such net income or loss is reported, based on whatever percentage of the work on the contract is estimated to have been completed; and
  • The completed contract method, under which no income or expenses related to a contract are reported for tax purposes until the year the contract is completed.[16]

Needless to say, taxpayers like the completed contract method, which provides the longest deferral of income on a profitable long-term contract. In the past, it was sometimes possible to defer reporting profits on such a contract for several years, if the contract took that long to complete.

However, the Tax Reform Act of 1986 and subsequent legislation has eliminated the use of the completed contract method of accounting for most large companies, except for some home construction and other residential building contractors. Fortunately, small businesses, whose average annual gross receipts for the three preceding years do not exceed ten million dollars, are still allowed to use completed contract accounting for tax purposes, at least for contracts that are estimated to take no more than two years to complete.[17] However, even those completed contract method deferrals that survive these restrictions are mostly considered tax preference items under the alternative minimum tax rules, except for certain small home construction contracts for four units or less.[18]

Installment Sales

If your business makes casual or occasional sales of personal property -- other than merchandise held for sale -- or makes sales of real estate it owns, the profit on any such sale can, in general, be reported on the installment basis as and when payments are received, rather than in the year of sale.[19] The installment method of reporting, however, is not available for "dealers," such as retailers, in personal or real property, except for certain dealers in real property. The latter exception is an election that sellers of residential lots or time-shares may make to use the installment method. The catch is that a dealer making this election must agree to pay interest on any tax that is deferred by using installment reporting.[20])

In the case of non-dealer sales of property for more than $150,000, if the total face amount of all installment notes exceeds five million dollars for the year, at the end of the year, the seller must pay interest on the deferred tax liability.[21] Sales of personal-use property or of farm property, for any amount, are exempt from the interest-on-deferred-tax provisions.[22]

Inventory Valuation Methods

If you maintain substantial inventories, how you account for your inventory can have an impact on your taxes, profitability, and net worth. The two main methods of valuing inventory are: FIFO -- first in, first out -- and LIFO -- last in, first out.[23]

FIFO method. Under the FIFO method, the cost of ending inventory is calculated under the assumption that the first items of inventory bought were the first ones to be sold, so that only the most recently purchased items are assumed to be left in inventory at the end of each year. This usually means the highest-cost items, in times of inflation. For example, if a company turns all its inventory over every three months, FIFO assumes, in effect, that the inventory remaining on hand at December 31 was all bought in the last three months of the year, rather than at some earlier date when prices may have been lower.

Most companies use the FIFO method because:

  • FIFO is much simpler to use in terms of maintaining accounting records;
  • When prices of goods are generally rising, FIFO has the effect of making a company's net income appear to be greater than if the more conservative LIFO method were used -- but it also tends to inflate the amount of a company's taxable income; and
  • Their accountants never mention to them that there is an alternative method (LIFO) of inventory accounting that can be used (since most accountants would rather not grapple with the awful complexities and difficulties of doing LIFO accounting).

LIFO method. In contrast to FIFO, the LIFO method assumes that the items in your ending inventory are the first or oldest ones that were acquired. Thus, under LIFO, ending inventory values for many of the items of inventory will be based on what that item cost in the very first year in which the business began using the LIFO method. The difference in inventory valuation can be dramatic if, for example, a business using LIFO for ten years was paying $10 ten years earlier for the widgets it keeps in inventory versus a current price of $75 per widget. Under LIFO, the widgets would still be carried on the accounting records at a cost of $10 apiece versus $75 under FIFO.

Accordingly, the difference in inventory cost, or $65 per widget in the above example -- called the LIFO reserve -- would be the amount of taxable income per widget that the company has deferred over the ten years. Thus, for a company with large amounts of capital invested in inventories, it is easy to see how LIFO can result in a huge tax saving (deferral).

At present, using the LIFO method is extremely complex, and the tax savings may in some cases be offset by increased accounting fees incurred and the additional management time and energy spent in attempting to comply with the LIFO tax regulations. The tax requirements for using LIFO, however, are somewhat relaxed for small businesses with less than five million dollars a year in sales.[24]

Choosing LIFO or FIFO. Any firm with inventories may elect to use either FIFO or LIFO. If a firm is already using FIFO, it may be able to change over to LIFO if a number of technical requirements set by the IRS are met. Or, a company using LIFO may also change over to FIFO. Note, however, that if a firm uses LIFO and changes to FIFO for some reason, it will usually have to pay a large amount of tax when it recaptures the LIFO reserve described above, at the time of the accounting method changeover. Any such changes in inventory accounting methods should not be attempted without the assistance of a competent tax adviser, as the IRS technical requirements are quite detailed and complex.

UPDATE NOTE:
The LIFO accounting method may soon become a thing of the past. While LIFO accounting for inventories is permitted under Generally Accepted Accounting Principles ("GAAP") in the United States, it is not allowed under international financial accounting standards, and it appears that in the very near future, U.S. accounting methods (GAAP) will be replaced by the international (IFRS) standards, so that companies will no longer be able to use LIFO for financial accounting purposes. Since the tax law only allows companies to use the LIFO method for tax purposes if they also use it for financial statement purposes, the upshot of the coming change is that once companies are forced to comply with international accounting standards and quit using LIFO, they will no longer qualify to use LIFO for income tax purposes unless the tax law is changed to continue to allow LIFO for tax purposes.

Uniform capitalization rules. Regardless of whether a company uses LIFO or FIFO for inventory accounting, it generally must allocate a wide range of its indirect costs to inventory, rather than simply deducting them as expenses, under the IRS's uniform capitalization rules. The practical effect of this is that those indirect costs that have been absorbed into the cost of inventory on hand at the end of the tax year do not get deducted currently for tax purposes. Manufacturing and processing operations of any size are subject to these complex capitalization rules. However, the uniform capitalization rules do not apply to a wholesale or retail business in any year when the company's annual gross receipts for the preceding three years have averaged ten million dollars or less.[25]

11.4 Cash-Flow Management

Cash flow is the lifeblood of any business organization, yet small business operators are often so concerned with other matters, they don't pay attention to managing their cash resources properly. Good cash management can make a significant contribution to the competitiveness and profitability of your business.

Poor cash management is one of the main causes of business failures, particularly among smaller firms, since a cash shortage due to poor planning can set off a chain reaction of disastrous consequences, even in a profitable business.

Cash-flow management has two aspects:

  • Projecting future cash flow; and
  • Controlling and maximizing the cash available from operations at all time.

Projecting Cash Flow

Perhaps the most important part of cash-flow management is accurately projecting your business' near- and long-term cash needs and making your business decisions reflect those needs. Often, to project what your sales will be in coming months, you will need to rely on what has happened in the past -- what percentage will be credit sales and when your receivables are likely to be collected.

Similarly, you have to estimate what you will pay out in payroll, rent, taxes, debt servicing, inventory purchases, and existing payables, plus extraordinary outlays you can anticipate.

The purpose of making these detailed projections of expected cash inflows and outflows is to point out any future cash shortages or deficits, so you can take steps in advance to prevent such occurrences. For example, if your projections indicated you were going to experience a severe cash crunch in about three months, you might take any of a number of steps to avert it, such as:

  • Seeking to raise new capital;
  • Borrowing money;
  • Liquidating some of your inventory by cutting prices; or
  • Cutting back on planned expenditures.

If you are handy with spreadsheet software, you may be able to prepare such cash flow projections yourself. Otherwise, you may want to enlist the help of your accountant, or ask your accountant to recommend a specialized software package for doing cash flow projections.

Controlling and Maximizing Cash Flow

If you are able to increase available cash by speeding up collections, delaying payments, or other means, you can use the extra cash to reduce your borrowing, thus saving interest expenses -- or you can invest the surplus cash to earn interest. Either way, improving your cash flow should increase your net earnings and should also help you avert cash shortages.

Here are some basic ways to improve your business' cash flow:

  • Bill your customers promptly. The later they receive the bill, the later you will usually collect for a particular sale.
  • If you know that certain large customers must receive bills by certain days of the month so you can get paid in that month, try to bill them before those deadlines.
  • Deposit your cash receipts daily if possible.
  • Keep close tabs on credit customers. Send them past due notices as soon as payments become overdue.
  • If you can do so without hurting business, add late charges to overdue accounts.
  • Never pay bills until just before they become due, unless you will receive a worthwhile discount for quick payment.
  • Try to keep inventories as lean as possible. Even if you occasionally lose a small sale because you are temporarily out of an item, you should be far ahead of the game by substantially reducing the amount of cash you have tied up in inventory.
  • Look for items in your inventory that are moving slowly or not at all. Consider slashing the price on those articles to convert them to cash and also to reduce the cost of storing them or having them take up valuable shelf space.
  • Consider leasing equipment items instead of buying because this will usually require a smaller cash outlay.
  • Do not pay more on your estimated income taxes than you have to. You may qualify -- without incurring interest charges or late payment penalties -- under one or more exceptions that will allow you to delay paying much of your tax for the year until the tax return is due.
  • If your business has a net operating loss for tax purposes that can be carried back to prior years, a procedure exists for filing a claim for a quick refund of the prior years' taxes. File it as early as you can because the IRS no longer pays interest on these refunds.
  • Instead of keeping all your business cash in a simple bank account, consider putting a significant portion of your cash in a fund that pays interest and allows you to write checks against the account. Since you continue to earn interest on funds on deposit until the checks clear, you might even consider using a bank in a distant part of the country so that it will take longer for your checks to clear after you make payments to local firms.

11.5 Don't be a Victim of Accounting Fraud

If your business is large enough that you have turned over much of the everyday accounting and bookkeeping functions to a bookkeeper or accountant who works for you, you are in a potentially vulnerable position. Billions of dollars are lost every year to embezzlement by people thought to be trustworthy and honest. More money (by far) is stolen each year with the stroke of a pen, or by a keystroke on a computer, than by all the armed robbers in America. Accounting fraud isn't violent, isn't obvious, and sometimes isn't ever detected, which is why it is such a serious and costly problem.

Internal Accounting Controls

Poor internal accounting controls and record keeping procedures are a weakness for many small business owners. Lax procedures are frequently to blame when a secretary or bookkeeper departs for the south of France with thousands of dollars of stolen or embezzled funds belonging to his or her employer. If you can, consult a good accountant to set up and review your internal financial controls; however, do your own review of your internal controls using the checklist at the end of this chapter first [LINK TO WORKSHEET DELETED], to look for obvious flaws in your system of internal controls.

Watch for These Red Flags

Embezzlers can be anyone. Sometimes they are close friends, relatives, or even a spouse or ex-spouse of one of the principals in the business. They are people whom you would never dream would steal from you, which is why they are able to steal. Embezzlers often resort to crafty and involved schemes to loot the company they work for, setting up phony bank accounts or creating "dummy" companies, complete with mailing addresses and official-looking letterheads and invoices.

As a result, your company may wind up paying out large sums based on invoices from suppliers who don't exist and who don't actually provide anything to the company. Or, in some cases, the embezzlers simply forge checks, often drawn on secret accounts they have set up in your company's name, into which they divert payments received by the business. If you are counting on the bank to catch forged signatures, don't hold your breath. The sad fact is that many banks today make little or no effort to examine signatures on checks to determine whether they are real or forged.

Look for these "red flags" that may indicate your accountant or bookkeeper could be embezzling from you:

  • The embezzler usually seems exceptionally devoted to his or her job, never wanting to take a vacation for more than a long weekend. This is a major tip-off, as the dishonest bookkeeper will be very afraid that if he or she isn't around all the time to open all the mail from the bank and otherwise keep a lid on things, you or someone else will discover the pattern of fraud.
  • An accountant or bookkeeper who is stealing funds from you will also tend to come in early and work late much of the time. Because maintaining the fraud and creating all the phony paperwork to continue the cover-up often takes a great deal of time and effort, it is not surprising that they will have to come to work before you do and be the last one out at night, as they have a lot of extra work to do.
  • While many embezzlers are simply greedy and dishonest, or have a grudge against the company, many are people who would otherwise never think of stealing from you, but who get into a deep financial hole, either from gambling or another expensive addiction (such as narcotics), or who have a financial emergency. They use their position of trust to secretly "borrow" money from the company -- which they often fully intend to pay back. Make sure that you or another employee regularly do the bank reconciliations, particularly if your chief financial person makes frequent trips to gambling casinos, plays the lottery heavily, or is constantly gambling on risky stock or commodity market investments. In the real world, hardly anyone wins regularly at gambling. Also be very careful of a bookkeeper or accountant who has a substance abuse problem, as they may have a very expensive legal or illegal drug habit they they can't sustain on the salary you pay them.
  • Pay attention to whether your accountant or financial person appears to be living beyond his or her means. If they frequently buy expensive cars, boats, or the like, or move into an expensive house, and you can't understand how they can do so based on their level of income, it may well be because that income is being "supplemented" by your company, unbeknownst to you.

If your in-house accountant who keeps your books exhibits some or all of the characteristics listed above, it doesn't mean you should fire them, only that you should maintain adequate controls to make it difficult or nearly impossible for them to carry on a fraud without detection. Many accountants are simply very hard-working, devoted employees, who naturally tend to work long hours and rarely take vacations, which does not mean they are embezzlers. But your occasional cross-checking of their work, or insisting that they take their accrued vacations, is the ounce of prevention that may just save you a fortune. Just as long as they aren't going on an extended vacation to Brazil....

A recent (2012) study by the Association of Certified Fraud Examiners, the Report to the Nations on Occupational Fraud and Abuse, found that small businesses or organizations with fewer than 100 employees are much more likely than larger organizations to neglect instituting basic fraud controls in their operations. The survey found that:

  • Only 56% of organizations with under 100 employees that were surveyed underwent external audits of their financial statements, compared with 91% of larger businesses
  • Just 18.5% of employees received fraud training at small organizations, compared with almost 60% in organizations with 100 or more employees.
  • Management certification of the financial statement occurred at 43% of small organizations, compared with 81% of larger ones.
  • Only 50% of the small organizations had formal codes of conduct, compared with 90% of businesses with 100 or more employees.[26]

A small business owner can become obsessed with matters of financing and accounting in the first few years of business. You may even end up concentrating more on your business' finances than on the product or service you are selling. Try to avoid falling into that trap -- concentrate more on making money, not counting it. With the help of some competent professionals and good common sense, you can overcome the daunting tasks of financial management and fraud protection and can focus on why you went into business in the first place.

Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code.)

1. Rev. Proc. 2002-9, 2002-1 C.B. 327; Rev. Proc. 2007-16, 2007-4 I.R.B. 358.
2. I.R.C. §§ 168, 168(e)(6) and 168(e)(7), 168(e)(3)(E)(iv) and (v).
3. Rev. Proc. 87-56, 1987-2 C.B. 674, as modified by Rev. Proc. 88-22, 1988-1 C.B. 785.
4. I.R.C. § 179(b)(1) and (2).
5. Notice 2013-59, 2013-40 I.R.B. ___ (page number to be determined when Internal Revenue Bulletin 2013-40 is published, on September 30, 2013).
6. I.R.C. § 179(d)(1)(A)(ii) and Rev. Proc. 2011-52, 2011-45 I.R.B. 701.
6A. Treas. Regs. § 1.263(a)-3(h).
7. I.R.C. § 168(k).
8. I.R.C. §§ 168(k) and 168(k)(2)(A)(i)(IV).
9. I.R.C. § 168(k)(2)(F)(i) and Rev. Proc. 2009-24, 2009-17 I.R.B. 885; Rev. Proc. 2011-21, 2011-12 I.R.B. 560.
10. Treas. Regs. § 1.446-1(c)(2)(i).
11. I.R.C. § 448.
12. Rev. Proc. 2000-22, 2000-1 C.B. 1008, as modified by Rev. Proc. 2001-10, 2001-1 C.B. 272.
13. Rev. Proc. 2002-28, 2002-18 I.R.B. 815.
14. I.R.C. § 461(h).
15. I.R.C. § 267(a)(2).
16. Treas. Regs. § 1.460-3(b).
17. I.R.C. § 460.
18. I.R.C. § 56(a)(3).
19. I.R.C. § 453(b).
20. I.R.C. §§ 453(l)(2)(B) and 453(l)(3).
21. I.R.C. § 453A(b).
22. I.R.C. § 453A(b)(3).
23. I.R.C. § 472.
24. I.R.C. § 474.
25. I.R.C. § 263A(b)(2)(B).
26. Text of the full report is available at the website of the Association of Certified Fraud Examiners, at: www.acfe.com/.

Chapter 12

Employee Fringe Benefits and Stock Options


"A leader is powerful to the degree he empowers other people."
-- I Ching

"I work for cash. You want loyalty, hire a cocker spaniel."
-- Wall Street bond trader, in Liar's Poker, by Michael Lewis

"If you think health care is expensive now, wait until
you see what it costs when it's free."

-- P.J. O'Rourke


12. 1 Introduction

The federal tax laws contain a host of tax-favored employee fringe bene­fits -- you can deduct them, and the employee can receive them tax-free. This represents a major tax savings to both you and your employees.

If your business is a C corporation, you as an employee of the corporation receive the same favorable treatment as other employees for health insurance, medical reimbursement, disability insurance, and group-term life insurance. If your business is not incorporated, or is an S corporation and you own 2% or more of its stock, payments for your employees' fringe benefits are generally deductible, but payments for your benefits are treated differently, as though you were a partner in a partnership.[1]

PLANNING POINT:
This is not as bad as it once was, with regard to health insurance, since a self-employed person (a sole proprietor, partner in a partnership, or member of an LLC) can now deduct 100% of health insurance costs, even if not itemizing his or her deductions, on Form 1040. In fact, the IRS now even allows an S corporation shareholder/employee to claim the "self-employed health insurance" deduction in most cases. However, the downside for a self-employed person is that the health insurance deduction is still allowed only for income tax purposes -- it does not reduce your self-employment income or the self-employment tax on the earnings from your business. (But note that for the taxable year beginning in 2010 only, the self-employed health insurance was allowed as a deduction for self-employment tax purposes.[2])

As a side note, self-employed individuals may now deduct Medicare Part B premiums as self-employed health insurance, for income tax purposes. Although the IRS has never issued any formal announcements as to whether Part B premiums could be treated as self-employed health insurance, tax form instructions in for years prior to 2010 have indicated that Medicare premiums could NOT be claimed as such, although it has long been accepted that individuals who itemized deductions could treat Medicare premiums as medical insurance for purposes of the itemized medical expense deduction (allowed only to the extent medical expenses exceed 7.5% of adjusted gross income, and thus rarely deductible).

However, the IRS has apparently had a change of heart, and the 2010 and 2011 Form 1040 instructions indicated that, for individuals claiming a self-employed health insurance deduction, Medicare Part B premiums can be deducted (in addition, presumably, to any private Medicare supplement or MediGap insurance premiums). Presumably, Medicare Part D drug insurance premiums would also be deductible, although deductibility of Part D insurance was not specified.

PLANNING POINT:
Self-employed taxpayers who have not deducted Medicare premiums as self-employed health insurance in 2009 and other open years (not closed by the statute of limitations) may want to file amended returns for those years, claiming a tax refund, since deductibility of Medicare premiums was not changed by any act of Congress, but merely by a change in the interpretation of the law by the IRS. Whether the IRS will allow such refund claims for prior years is not certain, but filing such a claim is likely to be worth a try.

Many companies have seen the benefits that come from having employees feel a sense of ownership in the company and participate in the growth in value of the company over time. Classic examples of this strategy are companies that have grown to be giants, such as Sears, Wal-Mart, and Microsoft, all of which adopted policies designed to provide ownership interests to employees at an early stage in their growth of those companies. To help achieve a sense of ownership by employees, companies are increasingly providing stock option plans to enable employees to purchase or receive stock in the company at favorable prices, thus giving them a stake in the success or failure of the business.

This chapter provides an overview of many of these benefits and how you can implement them, plus suggestions on how to assure the greatest tax savings.

12.2 Fringe Benefits

Despite rising costs of medical insurance, many small businesses are still striving to offer this benefit to employees, as well as other benefits such as life insurance and dependent care benefits. These and other types of fringe benefits are discussed in this section. Retirement benefits for you and your employees are discussed in the next section, Section 12.3, and stock options which are relevant only to incorporated businesses are discussed in Section 12.4.

Medical Insurance and Long-Term Care Plans

If you provide pre-paid medical insurance for your employees, you are permitted to deduct from the company's taxable income the premiums you pay to the insurer. In addition, your employee does not have to include either the cost of the premiums or the benefits provided by the insurer in his or her taxable income, as a general rule.[3] This tax benefit has recently been extended to include insurance for long-term care plans (to provide for nursing home costs, for example).[4]

Self-Insured Medical Reimbursement Plans

A corporation can set up a plan where the corporation directly reimburses employees for medical expenses or even for expenses such as dental care, orthodontic work, and prescription eyeglasses or contact lenses.[5] If the plan satisfies tax law requirements prohibiting discrimination in favor of highly paid employees, the reimbursements paid can be deducted by the corporation and are not taxable to the recipients. However, under the 2010 Patient Protection and Affordable Care Act ("Obamacare"), reimbursement for non-prescription drugs (other than insulin) no longer qualify after December 31, 2010.[6]

These plans are often set up in addition to medical insurance plans, either to cover deductibles that the insurance does not pay or to cover particular types of medical or dental costs that the insurance plan does not cover. However, the costs of cosmetic surgery are not deductible as medical expenses, and cannot be covered in a medical reimbursement plan. Also, such plans cannot reimburse employees for the cost of medical insurance, only for actual medical expenses they incur.

PLANNING POINT:
While self-insured medical reimbursement plans can be attractive to provide benefits for yourself -- tax-free -- if you own a small incorporated business (that is not an S corporation), one drawback is that you have to provide the same medical benefits to any employees of the business, and may not discriminate in favor of owners or key employees, as a general rule.

But note that while medical REIMBURSEMENT plans can't discriminate among classes of employees, medical INSURANCE plans can, and that includes long-term care insurance, which now qualifies as health insurance, generally.

CAUTION:
The Patient Protection and Affordable Care Act ("ObamaCare") law has greatly complicated the use of medical reimbursement plans. For example, the new law added Section 2713 to the Public Health Service Act, requiring health plans, including medical reimbursement plans (referred to as Health Reimbursement Arrangements, or HRA's) to provide certain preventive care coverage without any cost-sharing -- i.e., at no cost to the employee -- such as colonoscopies. In addition, an HRA must meet a number of highly technical requirements in order to be integrated with a group health plan, and cannot generally impose dollar limits or be integrated with individual market coverage or individual health policies. [7]

If you wish to establish or continue a medical reimbursement plan, you will need to consult an attorney who is knowledgeable with regard to the rapidly changing ObamaCare requirements for health plans, since ObamaCare's complex new rules have largely eliminated the ability of employers to offer such self-insured plans, except for large companies that have the legal expertise and financial resources to successfully implement and administer such plans in accordance with all of the new technical requirements for HRA's.

Health Savings Accounts (HSAs) and Medical Savings Accounts (MSAs)

Prior to 2004, taxpayers were allowed to establish Archer Medical Savings Accounts (MSA's).[8] However, that program has been phased out, and no new MSA's can be created any longer. Existing Archer MSA's may continue to operate.

Beginning in 2004, taxpayers have been allowed to establish HSA's, which are similar in many ways to an MSA. An HSA is a tax-exempt account, also somewhat similar to an IRA, except that distributions from an HSA to pay qualified medical expenses are not taxable to the recipient. As with an IRA (or MSA), funds held in the HSA can be invested and the investment earnings are not taxed currently.

HSAs can be set up by or for any "eligible individual," and unlike MSAs, HSA contributions can be offered by a "cafeteria plan." An "eligible individual" for HSA purposes is someone who, with respect to any month:

  • Is covered under a high deductible health plan as of the first day of the month, and
  • While covered by a high deductible health plan is not covered under any non-high-deductible health plan that provides coverage for any benefit covered under the high deductible health plan.[9]
  • Is not covered by Medicare, has not reached age 65, and may not be claimed as a dependent on another person's tax return. [10]

Certain types of insurance coverage are disregarded in determining whether an individual is covered by another plan. These include workers' compensation, tort liabilities, insurance for specific diseases or illnesses (such as cancer insurance), and insurance that pays a fixed amount per day or other time period of hospitalization.

For self-only coverage, a high deductible plan is one that has an annual deductible of at least $1,250 in 2013 (or in 2014) and the total annual out-of-pocket expenses required to be paid by the covered individual may not exceed $6,250 in 2013 (or $6,350 in 2014). These amounts are doubled for family coverage and are indexed annually for inflation.

Contributions to an HSA are tax-deductible by the covered individual or by his or her employer, if the employer makes contributions. For calendar years prior to 2007, the maximum contributions for eligible individuals with self-only coverage under a high deductible health plan was computed under a complex formula. However, for years after 2006, the maximum allowable deduction is simply the statutory amount, which is $3,250 in 2013 ($3,300 in 2014) for an individual with self-coverage only or $6,450 in 2013 ($6,550 in 2014) for family coverage.[11]

In addition to the maximum contribution amount computed as described in the preceding paragraph, catch-up contributions may be made by or on behalf of individuals age 55 or older and younger than 65. The catch-up contribution amount was $700 per year in 2006, $800 in 2007, and increased to $900 in 2008 and $1,000 in 2009 and thereafter.

Under 2006 tax legislation, effective beginning with the 2007 tax year, the initial contribution for a new HSA started mid-year is now the full-year limitation, rather than a fraction of the full-year amount.

IMPORTANT NOTE:
It is not necessary to have any amount of earned income in order to make a tax-deductible contribution to an HSA, unlike for an IRA or an MSA. Thus, if you retire before age 65, and no longer have any earned income, you can still make HSA contributions, as long as you are an "eligible individual," up till age 65.

In addition to paying out-of-pocket medical expenses you incur, the HSA can pay or reimburse you, tax-free, for items such as over-the-counter medicine or drugs, antacids, cold and allergy medicines, and pain relievers, even though those items are not ordinarily deductible as medical expenses for income tax purposes. However, under the Patient Protection and Affordable Care Act ("Obamacare"), payments for such non-prescription medicines (other than insulin) are no longer qualified medical expenses, after December 31, 2010.

Note that while you may no longer make contributions to an HSA after age 65, the HSA can continue to exist after that date, as long as there is money in the account, and can continue to be used to pay for out-of-pocket medical expenses, as well as certain types of insurance, such as Medicare Part A or B coverage or long-term care insurance. Premiums for Medigap policies will not qualify as medical expenses that can be paid by the HSA, however.

Distributions can be made from an HSA at any time you wish, to pay for qualified medical expenses, and are not taxable. Any other distributions you receive are taxable, and are also subject to a 10% penalty tax (20% after December 31, 2010, under Sections 9004(a) and (c) of Pub. L. 111-148, the Patient Protection and Affordable Care Act) if you receive taxable distributions from the HSA before you attain age 65. Similar rules apply to distributions from MSAs.

PLANNING POINT:
You should strongly consider setting up an HSA if you are under age 65 and have a high deductible health insurance plan, as it provides considerable tax benefits for medical expenses that you would be unable to deduct from your taxable income, giving you an HSA deduction each year instead -- and you get this deduction even if you don't incur any medical expenses! And if your medical expenses are zero or less than you contribute each year, the excess money accumulates in the HSA, so that after you reach the age of eligibility for Medicare (65 at present), it can be withdrawn to pay medical expenses or Medicare Part A or B premiums (non-taxable) or for any other purpose (in which case distributions are merely taxable, like IRA distributions, but are not subject to penalty).


PLANNING POINT:
HSAs also make good economic sense for an employer, if you obtain high deductible medical insurance for your employees and contribute up to the amount of the statutory limit to an HSA for each employee. They will still have full coverage of their medical expenses, but often this will cost you less than a full-coverage, no-deductible health insurance policy for your employees. And since they will have an incentive to reduce their usage of the coverage (because they can keep any unspent HSA contributions), they will be less likely to overuse the coverage. Employees who get no-deductible insurance or HMO coverage may tend to over-utilize such "free" health care coverage, which often causes the insurer or HMO to raise prices for the employer. Instead, your employees will pay for their routine medical expenses out of the HSA, and any unspent amounts will be theirs, eventually. They will rarely use the high deductible insurance, except in catastrophic situations or for hospitalization.

An HSA can be a win-win situation for both you and your employees. However, it appears that high-deductible plans may be banned for most employers in a few years, as the Patient Protection and Affordable Care Act is implemented, eventually requiring insurers to only offer "one size fits all" health care plans to employers.

Personal Medical Insurance

If you are an owner or part-owner of an unincorporated business, you can deduct any medical insurance premiums that you pay for employees, but as an owner you can only deduct your own medical insurance premiums against your income tax; no deduction is allowed against your self-employment income, for purposes of computing your self-employment tax.

If your spouse works for you, however, you can put your spouse on the payroll and provide a medical expense reimbursement plan or medical insurance for your spouse and his or her family -- which includes you -- and then deduct the payments or premiums in full (for both income tax and self-employment tax purposes) since your spouse is an employee.[12] The IRS has long recognized and allowed such arrangements, but issued guidance in 1999 warning that such a deduction will only be allowed where the employee-spouse is an actual employee (and not a co-owner) of the business. In addition, the IRS pronouncement notes that the employee-spouse must comply with any eligibility requirements you impose on other employees, such as having to be an employee for six months or a year before they can be covered under the health plan.[13]

Note that the same tax benefits can be achieved if you are a partner in a partnership, and your spouse is hired as an employee of the partnership and is provided medical insurance coverage that includes family coverage for your spouse, you, and your children. Similar treatment is available for a limited liability company (LLC), if the LLC has elected to be treated as a partnership for tax purposes. However, this back door tactic for obtaining tax-deductible medical coverage for yourself will not work in an S corporation setting, if you are more than a 2% shareholder and employee of the S corporation, since the spouse of a more than 2% owner of an S corporation is treated the same as the shareholder-employee for certain employee fringe benefits, such as medical plans or health insurance.[14]

UPDATE NOTE:
Tax advisers (and small businesses) should take note of a recent (2006) Tax Court case, Peter F. and Maureen L. Speltz v. Commissioner, TC Summary Opinion 2006-25, dealing with medical reimbursement plans for an employee-spouse. In this case, the IRS sought to disallow an arrangement where a wife, Maureen Speltz, a licensed day care provider, hired her husband for various duties as a part-time employee of the day care business, providing him with medical reimbursement plan benefits. She paid him no salary, but a medical reimbursement plan was established (unwritten, but communicated to employees in a written announcement), which provided he could receive up to $6,500 a year in medical expense reimbursements in lieu of cash salary or wages. The Tax Court fully upheld the taxpayer's deductions, since the husband was found to be a bona fide employee and the amount he was reimbursed was less, for the hours he had worked, than his wife would have had to pay an unrelated employee, so that his compensation was not unreasonable.

Just recently, the IRS changed its position on the treatment of health insurance costs where an S Corporation pays medical insurance (or reimburses the cost of such insurance) to a 2% or greater shareholder, or his or her spouse lineal ancestor or descendant. Such payments are deductible to the corporation, but only if the amount of such payments is included on a W-2 of the 2% shareholder (or relative) as taxable income. The amount taxable to the shareholder/employee is not subject to federal or state payroll taxes (FICA or unemployment taxes) if the insurance is provided as part of a "plan" for the S corporation employees and their dependents.

A 2% S corporation shareholder may now claim an offsetting deduction as "self-employed health insurance" on his or her individual tax return, due to a change in the IRS position announced in IRS Notice 2008-1.[15] This deduction is now allowed even though the shareholder/employee is not actually "self-employed" and the self-employed health insurance deduction is allowed on the shareholder's individual income tax return whether the S corporation pays the premiums directly, or if there is a reimbursement plan under which the shareholder pays the premiums and is reimbursed by the S corporation. This deduction will also be allowed where an S corporation shareholder is reimbursed for Medicare Part B premiums he or she pays, according to an e-mail response from the IRS received in 2011 by Spidell Publishing, a major California tax publisher.

IMPORTANT NOTE:
No deduction is allowed if the shareholder simply pays the insurance premiums and is not reimbursed under a "plan" of the S corporation. In that case, the shareholder can only claim the health insurance as an itemized medical expense deduction, if at all, and only to the extent his or her total medical expenses exceed 7.5% of Adjusted Gross Income on Form 1040 (10% after December 31, 2012, under the Patient Protection and Affordable Care Act for taxpayers under the age of 65, or after December 31, 2016 for individuals who are 65 or older) Thus, if the shareholder pays the premium, the S corporation should reimburse the employee (pursuant to a plan set forth in board of directors' minutes) and should report the reimbursement as income to the shareholder on a Form W-2.

The same is true for a partnership, where the partner pays the premium. The partnership should reimburse the partner and report the reimbursement as income to him or her on Schedule K-1 (rather than on a W-2).

Disability Insurance

If a corporation pays disability insurance premiums, the premiums are deductible by the corporation and are not considered taxable income to the employee -- except in the case of certain shareholders of an S corporation.[16]

If an employee becomes disabled and receives disability benefits under a policy for which the employer has paid the premiums, the disability benefits will then be included in the employee's income for tax purposes. On the other hand, if an individual, such as a sole proprietor or partner, has paid his or her own premiums for disability insurance, any disability benefits received are tax-free, since the payments were non-deductible.[17]

Group-Term Life Insurance

Your corporation may set up a group-term life insurance plan and deduct the insurance premiums it pays on behalf of employees. As long as the life insurance coverage on an employee does not exceed $50,000 under the plan during the taxable year, the employee does not have to report the premiums you pay for that coverage as taxable income on his or her personal income tax return.[18] Even if an employee's coverage exceeds $50,000, the amount of additional premiums the employee must include in taxable income is based on IRS tables, and is sometimes considerably less than the premium actually paid and deducted.

The exclusion of the cost of up to $50,000 of coverage does not apply to key employees, if the plan is discriminatory. (A group-term life insurance plan is not discriminatory if it covers 70% or more of the employees and at least 85% of the participants are not key employees.) "Key employees" are defined as those who either are:

  • 5 percent shareholders; or
  • 1 percent shareholders with over $165,000 of compensation in 2012 and 2013 or officers with over $130,000 of compensation (adjusted for inflation each year, but only in $5,000 increments).[19]

No more than 50 employees are treated as officers (or, if less, the greater of 3 employees or 10% of all employees), for purposes of the key employee definition. In making these calculations, certain new or part-time employees are not counted -- those who have less than 6 months of service, or work less than 6 months a year or who normally work less than 17 1/2 hours a week. In addition, employees under the age of 21 are not counted.

Section 132 Excludable Fringe Benefits

The following fringe benefits are excludable both from income and employment taxes (FUTA and FICA) for you, as employer, and for the employee who receives such benefits, under Section 132 of the Internal Revenue Code:

  • No-additional-cost services provided to an employee. These services consist of benefits such as free airline, rail, or bus transportation provided by companies in those industries; rooms for hotel employees; or free phone service for telephone company employees.
  • Employee discounts. Service companies can provide their services to employees at up to a 20% discount. For companies selling goods, the discount may not exceed the employer's gross profit percentage multiplied by the usual selling price of the item to customers.
  • Working condition benefits. These fringe benefits are tax-free, up to the amounts that would have been deductible if paid by the employee. Benefits include such items as a company car or plane used for business purposes; subscriptions to trade or professional publications; on-the-job training; business travel; and others.
  • Qualified transportation benefits. These fringe benefits include employer­-provided transit passes and commuter transportation worth up to $230 a month and parking provided to employees worth up to $230 a month in 2011. For 2012, the exclusion for parking increased to $240 a month, but the exclusion for transit passes and commuter transportation was scheduled to revert back to $125 a month. However, in 2013, Congress retroactively restored parity between these two exclusion, $240 per month for each for 2012, and extended parity through the end of 2013 at the inflation-indexed amount determined by the IRS ($245).[20] For 2014, the exclusion for parking increases to $250 and the exclusion for transit passes and commuter transportation drops back to $130.

    A $20 per month allowance for bicycle expenses was allowed in both 2011 and 2012.

    Parking benefits are only available for employees, and not to self-employed individuals or 2% shareholder-employees of an S corporation.
  • Minor ("De Minimis"") fringe benefits. These benefits are items that are considered to be too minimal to justify the administrative costs of accounting for them, such as using the company's copier machine or having a secretary type a personal letter.
  • Qualified Retirement Planning Services. An employer may provide retirement planning advice and information for employees on a non-taxable basis, if the employer maintains a qualified retirement plan. The advice and information the employer or hired counselors may give is not limited to information regarding the qualified retirement plan, however, and may, for example, include advice and information regarding retirement income planning for the employee and spouse and how the employer's retirement plan fits into that planning. The tax exclusion does not apply to related services, such as tax preparation, brokerage services, or accounting or legal services, and highly compensated employees (as defined by the IRS) do not qualify for this tax break unless the retirement planning services are available on substantially the same terms to rank-and-file employees who are normally provided information and education regarding the employer's qualified retirement plan.
  • On-premises athletic facilities. Providing and operating facilities such as gyms, pools, tennis courts, or golf courses on the business premises, substantially all of the use of which is by employees, their spouses, and dependent children, is a nontaxable fringe benefit.[21]

Meals or Lodging on Premises

If meals are provided on-premises to employees, for your convenience as the employer, the value of these meals is usually not taxable to the employee for income tax purposes. (However, you or your corporation can only deduct 50% of the cost of furnishing on-premise meals.) On-premises lodging is also not taxable to the employee and is fully deductible by the employer. This favorable treatment of lodging only applies if the employee is required to accept such lodging as a condition of employment.[22]

Educational Assistance Plans

You may pay educational expenses on behalf of an employee free of employment taxes or income tax to the employee if the purpose of the education:

  • Is to maintain or improve skills required by the job, or
  • Meets requirements set by you or applicable laws to retain employment or rate of compensation.

You may also set up tax-qualified educational assistance plans to provide other -- not necessarily job-related -- educational benefits for employees, in amounts up to $5,250 a year per employee.[23] To qualify, the plan must be in writing, disclosed to employees, and no more than 5% of benefits paid under the plan can go to 5% owners of the firm or their spouses or dependents. The Economic Growth and Tax Relief Reconciliation Act of 2001 repealed the former provision of the tax law that had denied the exclusion to payments for graduate level courses, such as for law school or medical school, so under Code Section 127 it is now possible to provide tax-free benefits to employees for attending such graduate level schools. (However, under the "sunset" provisions of that 2001 tax law, the former restriction against benefits paid for graduate level courses were to be reinstated in 2011, although Congress has now postponed that "sunset" date to January 1, 2013. Section 127 was then made permanent in 2013 by the American Taxpayer Relief Act of 2012, enacted in January, 2013.)

Dependent Care Plans

Dependent care plans are one of the most popular and rapidly growing types of employee fringe benefit plans in recent years, providing up to $5,000 a year of dependent care benefits for children or elderly dependents per employee. Not more than 25% of benefits provided, however, can be on behalf of 5% owners of the employer company, and other technical nondiscrimination rules also apply. An "employee" includes a sole proprietor or other self-employed person, who is treated as an employee of the sole proprietorship or partnership for purposes of interpreting the provisions of this law.[24]

Flexible Spending Plans (Section 125 Plans)

Another non-retirement fringe benefit plan, the Section 125 flexible spending plan or flex plan, has become a popular type of tax-favored employee benefit. The three flex plans described below are all designed to permit employees to choose how much to spend on a tax-free basis for various employee benefits, such as health care or dependent care. Flex plans are for employees only and cannot cover sole proprietors, partners in a partnership, or 2%+ shareholders in an S corporation. Under flex plans, the golden rule is "use it or lose it." Until recently, any amount in an employee's account that was not used by the employee during the year was forfeited, and reverted back to the business at the end of the year.

However, this rule was modified somewhat on May 17, 2005, when the IRS and Treasury Department announced that new rules would allow plans to provide up to a 2½ month "grace period" during which claims incurred during the new plan year could be reimbursed with money left over from the previous plan year. [25] Although the general "use-it-or-lose-it" rule remains in effect and the new rule was "optional", this change did give cafeteria plan participants a chance to utilize unused amounts from the previous year, for up to an additional 2½ months, effectively creating a 14½ month plan year. In other words, if you were a participant in a calendar year flexible spending plan which had been amended to allow the maximum 2½ month grace period, you actually could us your plan allocation for the preceding plan year by March 15th of the following calendar year.

UPDATE NOTE:
The "grace period" rule no longer is allowed for unused allocations under a flexible spending plan for qualified health care expenses. However, pursuant to IRS Notice 2013-71 and newly proposed IRS regulations issued in October, 2013, a participant will instead be allowed to carry over up to $500 of unused allocations to the next plan year, if a plan is amended to allow the carryover. Note, however, that if a plan provides for the maximum ($2,500) spending on health care expenses, and you use only, for example, $1,200 of it by the end of the year, you can only carry over $500 of the remaining $1,300 to the next year, and will forfeit the other $800.

Premium-Conversion Accounts. Premium-conversion accounts are the simplest kind of flex account. They are primarily set up to allow employees to pay for their share of health, disability, or group-term life insurance premiums with untaxed dollars by deducting specified amounts out of their regular paychecks to pay for the coverage. The amounts the employees agree to have withheld from their salaries or wages to pay the insurance premiums are excluded from their taxable income and deductible by the corporation or unincorporated employer. Such plans, in effect, convert part of wages directly into insurance payments, without having the government first remove a slice for taxes. Premium-conversion accounts are practical for even the smallest companies with only one or two employees.

Flexible Reimbursement Accounts. Flexible reimbursement accounts allow an employee to contribute a specified amount into an account each year and draw on the account to pay for health care expenses not covered by the company. Health care expenses could include medical insurance deductibles, vision care, dental coverage, and dependent care expenses for as much as $5,000 per year.

Here is how these accounts work: Before the start of each year, the employee must estimate his or her medical and dependent care costs for the coming year that the employee wants paid out of the accounts. The amount designated by an employee is withheld from his or her paycheck during the year (tax-free). As expenses are incurred during the year for health and dependent care, the employee submits requests for reimbursement out of the account to the plan administrator, up to the specified maximum. Employers may choose to supplement or match amounts employees choose to have withheld from their pay, as an additional tax-free benefit to the employee.

Flexible reimbursement accounts may stand alone, or may be combined with premium-conversion accounts. They are feasible for fairly small employers as well, although the administrative costs usually tend to be greater than for premium-conversion accounts.

Cafeteria Plans. Cafeteria plans are more complex and are rarely adopted by companies with fewer than 50 employees. Under a cafeteria plan, a company gives employees a menu of benefit choices, provides a fixed number of tax-free dollars per employee each year, and allows each of the employees to select or buy the particular benefits desired, such as:

  • 401K contributions
  • Health insurance
  • Life insurance
  • Disability insurance
  • Vision or dental care, or both
  • Vacation time
  • Contributions to an HSA

If the selected benefits cost more than the dollar amount you provided, the employee may fund the balance with salary reduction amounts through premium-conversion or reimbursement accounts, or both, untaxed.

The options offered under a cafeteria plan may not include contributions to any type of deferred compensation plans except to an HSA (Health Savings Account).

In all of these flexible spending plans, any amount in an employee's account that is not used by the employee during the year is forfeited, and reverts back to you, the employer, at the end of the year (unless, as noted above, your plan provides a 2 1/2 month "grace period" after the end of the plan year, in which benefits may be used). Flex plans are required to meet nondiscrimination tests to ensure that highly compensated employees do not receive a disproportionate share of the benefits provided.[26]

UPDATE NOTE:
Under the new health care reform law ("Obamacare"), any cafeteria plan that allows contributions to a health care flexible spending arrangement must limit such salary reduction contributions to $2,500 a year, beginning in 2013. Additional employer contributions are not so limited. This limitation remains at $2,500 in 2014.

For more information on flex plans, contact:

Employers Council on Flexible Compensation
1444 I Street NW, Suite 700
Washington, DC 20005-2210
(202) 659-4300

Web Site: www.ecfc.org

12.3 Retirement Plans

There are four main types of tax-favored retirement plans:

  • Qualified retirement plans, a broad category that includes corporate pension plans, profit-sharing plans, and stock bonus plans (like a profit-sharing plan, but where funds are invested in company stock), as well as Keogh pension and profit-sharing plans of unincorporated businesses, and 401K plans;
  • Simplified employee pension (SEP) plans for any type of business, incorporated or not;
  • Savings incentive match plans for employees (SIMPLE), which can be set up by small employers; and
  • Individual retirement accounts (IRAs), which may be set up by any individual who has earned income, including an employee.

The primary tax advantages of all types of tax-qualified retirement plans are:

  • Amounts contributed, up to certain limits, are deductible from the income of the corporation or individual taxpayer.[27] This deduction can be as much as 25% of the individual's compensation for the year (not counting the plan contribution) or $52,000 (indexed) in 2014, whichever is less, for a "defined contribution plan" (such as a profit sharing plan).

    Where you, the owner of the company, take much more compensation from the business than any of your rank-and-file employees, it is usually advantageous to contribute a low percentage, considerably less than the 25% limit, since your annual contribution would hit the $52,000 limit if you earned over $210,000. Thus, you would be making unnecessarily large contributions on behalf of your employees.

    However, if you earn, for example, $1,040,000 a year as your compensation from the business, don't think you can set the contribution rate as 5% for all participants and still get your maximum ($52,000) contribution for yourself. Only the first $260,000 (in 2014) [28] of any participant's compensation can be counted when applying the defined contribution plan's contribution percentage, so the maximum plan contribution to your account at a 5% rate would only be 5% of $260,000, or $13,000, in this example, not $52,000, even if your compensation were $1,040,000 or any other amount greater than $260,000. The $260,000 compensation limit for 2014 ($255,000 for 2013) is adjusted each year for inflation.

    Even larger contributions can be made by what are called "defined benefit plans." In 2013 an actuarially determined contribution to a defined benefit plan can be made that is sufficient to fund an annual retirement benefit of $210,000 in 2014 ($205,000 in 2013). The amount of such allowable deductible contribution that can be made to fund the retirement benefit will depend on various factors such as:

    • The participant's age;
    • The participant's compensation level;
    • Projections of the rate at which the plan's investments will grow in the future;
    • Estimates of how much will be forfeited by employees who quit or are fired before their benefits vest, which will reduce the amounts the employer needs to contribute for the continuing employees;
    • How long the retired participant will live to collect the pension benefits after retiring; and
    • Various other actuarial factors.

    In some cases, the maximum deductible contribution for a highly paid individual in a defined benefit plan can be roughly 50% more than the maximum benefit amount, or around $300,000 at present, depending upon how aggressive your enrolled actuary is willing to be. (An enrolled actuary, a professional whose services you will require if you have a defined benefit plan, must certify to the IRS the amount that may or must be contributed to the plan.)

  • Contributed funds can gain in value in pension or profit-sharing plans on a tax-free basis.[29] The qualified retirement trust that is set up to hold the retirement funds is exempt from state and federal income taxes on its income or capital gains from investments in stocks, bonds, savings accounts, mutual funds, real estate, and other passive investments.
  • When trust funds are paid out to you at retirement, you may be in a lower tax bracket than when you made the contributions to the plan. Thus, not only do you get to defer payment of any tax on amounts contributed to the plan until you retire, but the tax you finally pay at retirement is apt to be at a lower rate than you would have paid when you were working.

Qualified Retirement Plans

Qualified retirement plans (pension, profit-sharing or stock bonus plans) can be expensive and complex beasts to maintain. If you are setting up a qualified corporate plan or Keogh retirement plan, for either your corporation or your unincorporated business, consider obtaining a model plan from a bank, insurance company, stockbrokerage firm, or mutual fund. These "canned" plans usually have variable terms that can be tailored somewhat to suit your needs, unless you want to do something out of the ordinary, such as allow participants to do things like borrow money from the plan.

For an unincorporated business, these pre-approved plans will usually be suitable for you unless you have a significant number of employees to cover under the plan.

The great advantages of getting a model SEP or Keogh plan from a financial institution are cost and simplicity. Most institutions will charge you only $10-$25 to adopt their plan, and some are even free of setup charges. By contrast, hiring a lawyer or benefit consultant to draw up a customized SEP or Keogh plan for you could easily cost you several thousand dollars in fees.

You can obtain prototype or model plans from banks if you allow them to act as trustee -- or from insurance companies if you buy their insurance or managed fund accounts through the plan.

However, certain special types of qualified plans, such as "ESOPs" (employee stock ownership plans), in which most or all of the plan assets will consist of stock of the employer corporation, require highly technical legal and accounting expertise, so you will not be able to use any kind of "off-the-shelf" canned plans if you wish to establish an ESOP. This type of plan is given a whole range of extremely generous tax benefits by the tax laws to encourage employers to establish them for employees, but the legal and administrative costs for ESOPs are very great, which generally makes them uneconomical for any corporation with less than several hundred employees.

If you do need something unusual that requires a customized retirement plan for your corporation, you will probably find it more cost effective to have a benefit consulting firm rather than a lawyer draw up the plan for you. This way, your attorney is only involved in reviewing the plan and obtaining approval of the plan from the IRS. Typically, benefit consultants or pension consultants will charge only a fraction of what a law firm would charge to draw up the plan, and the larger benefit consulting firms are generally quite competent. Most of their fees come from helping you administer the plan under ERISA after it is set up -- a service you will need anyway. (See Chapter 6, Section 6.4, for information on ERISA compliance requirements.)

One reason you may want to set up a qualified plan, such as a corporate defined contribution plan (a profit sharing plan, for example), despite the greater administrative and setup costs than for SIMPLE or SEP/IRA plans (discussed below), is delayed vesting. In a corporate defined contribution plan, the plan may have a "vesting schedule" that determines how much of the money in the account of a particular employee is his or hers to keep if he or she leaves your employment. That is, depending on how many years the employee has worked for you, he or she may forfeit some percentage of the amount in his or her account in the event of a separation from service.

The forfeited amounts are generally re-allocated to the other participants (you, as owner, probably being the prime recipient), in proportion to their compensation on which plan contributions are based. Thus, when employees leave your company without working long enough for their accounts to vest fully, the forfeitures can reduce your cost of making contributions to the plan, while the remaining plan participants may still have significant additions to their accounts, due to the forfeitures by the departed employees.

Under the Pension Protection Act of 2006, all defined contribution plans must now have the same minimum vesting schedule, under which benefits (accounts) become nonforfeitable. It requires all defined contribution plans that do not provide immediate vesting of plan contributions to vest such contributions at no less than either 100% ("cliff vesting") vesting after 3 years of service, or no less rapidly than according to the following minimum vesting schedule:

  • 20% vesting after 2 years of service
  • 40% vesting after 3 years of service
  • 60% vesting after 4 years of service
  • 80% vesting after 5 years of service
  • Full (100%) vesting after 6 years of service
Having delayed vesting provisions in a defined contribution plan tends to encourage employees to stick with your company, at least until they are fully vested. It penalizes the employees who leave early and rewards those (who share in the forfeitures) who stay with you -- the "golden handcuffs" concept.
EXAMPLE:
Employee Bill Jones works for XYZ Corporation and participates in the XYZ Corporation's qualified profit sharing plan, which provides vesting according to the above table. After 4 years of service with XYZ, Jones has a profit sharing account that has grown to $25,000, but he quits to take a better job elsewhere. Since he is only 60% vested after 4 years, he can only receive a profit sharing payout of 60% of the $25,000 account, or $15,000, when he quits. The other $10,000 that had built up in his account from company contributions and investment growth will be forfeited and re-allocated to the accounts of the other employees who remain as participants in the plan.

Similar vesting rules apply for defined benefit plans, except that such plans may only choose between "cliff vesting" after 5 years (rather than 3) or 20% vesting each year, beginning after 3 years of service (rather than after 2 years, as in the above table for defined contribution plans). In a defined benefit pension plan, any forfeitures are used to reduce the required employer contributions, rather than increasing benefits of remaining participants (which are defined and fixed by the plan document).

Tax Credit for Setup and Administrative Costs of Plan

To encourage the establishment of qualified retirement plans for employees, by reducing the setup costs, tax legislation in 2001 created a new tax incentive for small employers, a tax credit for such employers. The credit is available to any company that has no more than 100 employees who earned at least $5,000 each in the preceding year.

This tax credit is designed to encourage such small firms to set up qualified retirement plans for their employees. It also applies to the setup costs of a SIMPLE or SEP plan. The tax credit is equal to 50% of a new plan's "qualified start up costs" or $500, if less, for the year the plan becomes effective and in each of the next two tax years.[30] Qualifying for this tax credit is subject to the following requirements and rules:

  • The plan must have at least one participant who is not a "highly-compensated employee" -- that is, some employee other than certain highly paid employees or employees who are owners of a significant interest in the business;
  • The amount claimed as a tax credit cannot also be claimed as a deduction; and
  • Qualified start up costs include expenses such as legal and consulting fees, payroll system changes, and administrative costs of the plan, plus any costs of retirement-education of employees with respect to the plan.

Thus, in the year you establish a new qualified plan for your employees, if the start up costs are $1,700, your business could claim a $500 tax credit and a $1,200 deduction, which should ordinarily reduce your taxes considerably more than if you simply claimed a deduction of $1,700. In addition, for your next two tax years, you could claim the $500 tax credit again each year (or 50% of the plan's annual administrative costs, if 50% of such costs is less than $500).

Section 401K Plans

The 401K plan (named after Section 401(k) of the Internal Revenue Code, which authorizes such "cash and deferred" plans) is a popular, but different, form of qualified retirement plan. This type of plan generally permits employees to elect to have a percentage of their salary -- with various limitations -- deducted from their paychecks, free of income tax, and deposited on their behalf in a profit-sharing-type plan. In many cases, as an additional incentive to employees to make such tax-favored savings, an employer may provide some degree of matching contribution to the plan on behalf of the employee.

EXAMPLE:
A typical example of a 401K matching plan would be one where you, as employer, contribute $0.50 (50 cents) for every dollar the employee elects to have withheld from his or her pay. Your tax-deductible contribution is placed in the 401K plan and is tax-free to the employee. For 2012, the maximum elective deferral amount per employee was $17,000 and that limit increased to $17,500 in 2013 and 2014.

Simplified Employee Pension (SEP) Plans

Simplified employee pension (SEP) plans can be set up by corporations, partnerships, or sole proprietorships. SEPs offer most of the attractive features of typical Keogh and corporate plans with virtually no administrative costs. This is in contrast to a Keogh or corporate plan that may cost several thousand dollars a year to maintain for only five or ten employees.

A SEP plan is basically a glorified individual retirement account (IRA), but it is one where as an employer, you contribute to each employee's IRA account an amount up to 25% of the employee's compensation -- with a maximum of $51,000 in 2013, $52,000 in 2014 (the limit is indexed for inflation, if any, each year).

The amount contributed is not taxed to the employee and can be invested in any type of IRA account the employee chooses. Participants can still contribute up to $5,000 a year in 2012 ($5,500 in 2013 or later) to their SEP/IRA or to another IRA plan. However, SEP participants with taxable income in excess of $60,000 (single) or $96,000 (married filing jointly) in 2014 will have their IRA deductions reduced or eliminated.

The main drawback of an SEP is that employer contributions "vest" immediately. Thus, an employee covered by an SEP will not forfeit any portion of his or her account under an SEP upon leaving your employment. Even so, a SEP strongly merits consideration as an alternative to Keogh or corporate retirement plans, due to its relative simplicity.

SIMPLE Retirement Plans

The Small Business Job Protection Act of 1996 created another type of retirement plan, called SIMPLE (Savings Incentive Match PLan for Employees.[31] These plans can be set up as either SIMPLE IRAs or SIMPLE 401K plans, and are available for small employers who had 100 or fewer employees who earned at least $5,000 in compensation for the preceding year. Under a SIMPLE plan, an eligible employee can elect to contribute a percentage of his or her compensation to the plan, up to a dollar limit of $10,000 in 2005 and later, indexed for inflation in $500 increments after 2005. In 2009, the limit had increased to $11,500 and remained at that level for 2010, 2011, and 2012 (plus an additional $2,500 in 2006-2014 for an employee who is age 50 or older). The $11,500 limit was increased for inflation to $12,000 in 2013 and 2014. The additional $2,500 amount for older employees remained unchanged for 2013 and 2014.[32]

The IRS has released a model SIMPLE plan that an employer may use in combination with SIMPLE IRAs to create a SIMPLE retirement plan. It can be adopted by using IRS Form 5305-SIMPLE, which also contains a model notification to eligible employees (which an employer may also use, to meet SIMPLE plan notice requirements), plus a model salary reduction agreement.

You do not file the form with the IRS, but keep it on file as the sponsoring employer. A plan is considered to be established when the form is completed and signed by the employer and the designated bank or other financial institution which will hold the IRA assets. If your plan is to allow employees to choose the financial institutions for their SIMPLE IRAs, you will not be able to use the IRS Form 5305-SIMPLE, but will need to instead use Form 5304-SIMPLE, in which you do not designate a financial institution, or else have your lawyer or benefits consultant draw up your own plan for you, which is also permitted. To use the IRS standard form, Form 5305-SIMPLE, all assets under the plan must be held by a single financial institution that you (the business owner) designate.

Individual Retirement Accounts

IRAs are of limited interest to most business owners, since the maximum annual contribution to an IRA is only $5,000 each year, per person, from 2008 to 2012 or $6,000 for individuals who are age 50 or older. These amounts are increased to $5,500 and $6,500 for 2013 and 2014.

The higher contribution limits for an individual who is 50 or older by the end of the tax year, of $500 in 2005, or $1,000 in 2006 or later years, are "catch-up" contributions for such older individuals.

Your spouse can also contribute. Even these small deductions may not be available if you or your spouse participate in a Keogh or corporate retirement plan and your modified adjusted gross income is more than $96,000 -- $60,000 if you are a single person (2014 limits). For 2013, the limits were $95,000 for couples and $59,000 for unmarried single persons. Above those income levels, your allowable deductions quickly phase out, eventually to zero.

Contributions to an IRA may still be made if your income exceeds the above levels and you are a participant in an employer's retirement plan, but will not be deductible.

UPDATE NOTE:
Under the Pension Protection Act of 2006, the above income limits on deductible IRA contributions, as well as the income limits for Roth-IRAs (discussed below) are indexed for inflation, in $1,000 increments, after 2008.[33]

Roth-IRA's

Congress created a "Super IRA," called a Roth IRA, beginning in 1998. Nondeductible contributions of up to the same amounts shown above for regular IRAs may be made to a Roth IRA, and if not paid out for five years (and if other distribution requirements are met), all withdrawals from the Roth IRA can eventually be made free of federal income tax. Unlike with traditional IRAs, contributions may be made to Roth IRAs even after an individual reaches age 70 1/2, and unlike other tax-qualified retirement plans, a Roth IRA is not subject to mandatory distribution rules at age 70 1/2 or any other age.

The IRA deduction limitations (shown in the table above) where income in 2014 exceeds $60,000 (or $96,000 if married, filing jointly) and where the taxpayer is covered by an employer's qualified retirement plan, do not apply to a Roth IRA, since Roth IRA contributions are not deductible in any case. However, whether or not a person is covered by an employer retirement plan, certain high-income individuals are not allowed to make Roth IRA contributions: The amount that can be contributed to a Roth IRA phases out in 2014 between $181,000 and $191,000 of adjusted gross income (AGI) for married couples filing jointly, or between $114,000 and $129,000 of AGI for single filers (including heads of households). As noted above, these income limits are indexed for inflation, thanks to provisions of the Pension Protection Act of 2006.

Contributions to a Roth IRA were limited to $4,000 in 2007 ($5,000 if you were 50 years old before the end of the year), increasing to $5,000 in 2008 through 2012 ($6,000 if 50 years old or older). These limits are increased to $5,500 and $6,500 in 2013 and 2014. Contributions may not exceed the total amount of your earned income (wages, salary, bonuses, plus any net self-employment income), if less than the foregoing amounts. In addition, any contributions made to a traditional IRA for the taxable year, whether or not they are deductible, will reduce the amount you can contribute to a Roth IRA.

IMPORTANT NOTE:
For calendar years 2010 and later, there is no income limitation on who may convert a regular IRA to a Roth IRA. In previous years, high income taxpayers were not allowed to do such a conversion.

While the amount you took out of your regular IRA to transfer to the Roth IRA in 2010 was taxable, you were allowed to report half of that income in 2011 and the other half in 2012. However, depending on your circumstances and what your personal tax bracket was expected to be in 2011 and 2012, you had the option of choosing to report all of the income from the conversion on your 2010 tax return. The election to defer reporting of the income was only permitted in 2010.

Under current law, in 2011 or later, any Roth conversion amount is taxable entirely in the same year as the conversion. Since tax rates are likely go higher in the coming years, you may want to consider converting some portion of your existing regular IRA (or IRA's) to a Roth IRA while rates are still relatively low. However, don't do a large, taxable Roth conversion unless you trust the government not to eventually renege on its promise that Roth distributions would not be taxable. Remember that Social Security benefits were never going to be taxable either, but we know how that turned out....

Roth conversions are complex matters and may or may not make sense in your particular case, so it is strongly recommended that you consult your tax or financial advisor about whether to take advantage of this opportunity.

Roth-IRA Back Door Contributions

Because there is no longer an income limitation on who may do Roth conversions, a new loophole has opened up that can allow high-income taxpayers, who are ineligible for making regular Roth contributions, to make what are called "back-door Roth contributions." This is fairly complex, but the basic approach is to make an annual non-deductible contribution to a traditional IRA (non-deductible because you are in a high income bracket). Because you will then have a "tax basis" in your regular IRA equal to the contribution (for example, a $6,500 contribution in 2013 if you are over age 50), you can soon thereafter convert the traditional IRA to a Roth tax-free (unless the IRA has appreciated in value before you do the conversion, in which case only the appreciation amount, if any, would be taxable).

However, "don't try this at home" without the assistance of a competent tax professional, as there are a number of possible pitfalls to be avoided. For example, if you have an existing IRA, in which you have no tax basis from any prior non-deductible contributions, and you make a $6,500 non-deductible contribution to it, increasing its value to $65,000, the "back-door" strategy will not work, if you try to convert $6,500 of the IRA to a Roth. That is because a pro rata portion of any distribution from an IRA is deemed to come from the taxable portion of the IRA (90% of the $65,000 in the IRA), and only 10%, or $650, of the amount converted would be deemed to come from your "tax basis." In that case, of the $6,500 converted to a Roth, 90%, or $5,850, would be a taxable distribution.

In some cases, even that problem can be avoided, if you are able to do a rollover of all of the taxable part of the IRA ($58,500) to a qualified retirement plan, such as a 401K plan. The pro rata rule would not apply in that case (it would apply if rolling over to another IRA, so don't try that), so that only the $6,500 non-deductible portion of the IRA would remain, which could then be converted to a Roth.

12.4 Stock Option Plans

Companies have devised, or Congress has provided for, a number of different stock option plans with various tax advantages, all of which are designed to encourage employees to acquire a proprietary stake in the companies they work for. Major types of such plans include:

  • Non-Qualified stock options. In this type of plan, a corporation grants certain employees the right, or option, to acquire stock of the company at a reduced price during a period of several years. Receipt of such an option itself is usually not a taxable event, but when the option is eventually exercised, the employee then pays tax on the increased value of the stock (the excess over the option price paid). This is usually taxed as ordinary compensation, unless the stock is restricted or forfeitable, in which case taxability will be delayed until the restriction or risk of forfeiture lapses, unless the employee elects to pay the tax up front at the time the option is exercised, by making what is known as a Section 83(b) election.
  • Incentive stock options (lSOs). ISOs are options granted under a plan that meets IRS requirements, where the term of the option is limited and the option price is not less than the value of the stock on the day the option is granted. That is, with an ISO, there is no bargain element built into the option. If the stock is worth $20 a share the day the option is granted to the employee, the option must be at an exercise price of no less than $20. Thus, the employee will not stand to profit from exercising the option unless the value of the stock subsequently rises above $20 a share -- which is a good incentive for the employee to help make the company as profitable as possible.

    If the amount of options that may be exercisable, in the aggregate, exceeds $100,000 in any calendar year, all such options in excess of $100,000 will not qualify as ISO's. Only the first $100,000 (based on earliest dates granted) will continue to qualify.

    The employee must not dispose of the stock within 2 years after the option is granted, or within 1 year after the stock is acquired by exercise of the option. If these and other requirements are met, the employee does not recognize taxable income when he or she exercises an ISO and may qualify for subsequent capital gains treatment if the stock purchased is later sold at a gain. Otherwise, any disqualifying (early) disposition of the stock will result in recognition of ordinary income, if the employee has any gain.[34]

    Prior to the enactment of the American Jobs Creation Act of 2004, the IRS was proposing that any remuneration under ISO plans, where a disqualifying disposition of stock resulted in ordinary income, was to be considered wages, and thus subject to income tax withholding and FUTA and FICA taxes. However, the 2004 legislation put an end to any such withholding requirement or FUTA or FICA taxes on such income, effective after October 22, 2004.

  • Employee stock purchase plans. Under a Section 423 tax-qualified employee stock purchase plan, a corporation may allow employees to purchase its stock, directly from the company, for up to a 15% discount from the fair market value of the stock. The employee is not taxed when exercising the right to purchase stock under such a plan, except to the extent the option was granted at a price below fair market value, and may receive capital gain treatment when the stock is eventually sold at a gain. The IRS was proposing to impose FICA and FUTA taxes on the taxable portion of the gain on exercise of such option by employees, but tax legislation in 2004 has prohibited such taxation, or the treatment of such gain as wages subject to income tax withholding, effective after October 22, 2004.[35]

    While a Section 423 plan can be an excellent incentive plan for employers, it is usually only suitable for larger companies, especially those with publicly-traded stock. Due to the administrative complexities and the need to comply with numerous state and federal securities law requirements, as well as the need for sophisticated legal and tax counsel in connection with such a plan, a Section 423 stock purchase plan will usually be too expensive to be practical for a small, non-public corporation.

12.5 Non-Qualified Deferred Compensation Plans

We should point out in beginning this section, if you are an attorney, accountant, tax advisor or compensation consultant, that almost everything you thought you knew about the tax treatment of non-qualified deferred compensation for executives became obsolete on January 1, 2005, when new Internal Revenue Code Section 409A became effective. This new law makes planning for any kind of deferred compensation, other than for qualified plans, extremely complex and more difficult from now on, with severe tax penalties if any mistakes are made in dotting "i's" or crossing "t's." Now that the new law has been fleshed out by the issuance of IRS final regulations under Section 409A, this section briefly summarizes some of the key provisions of the new deferred compensation rules.

New Deferred Compensation Requirements

The new tax rules for non-qualified deferred compensation plans apply to any such plans where compensation is deferred after December 31, 2004, or to changes in existing deferred compensation plans established before 2005. The types of plans to which these rules apply are all types of plans that defer compensation, other than qualified plans such as qualified pension, profit sharing, or stock bonus plans, IRA-type plans or certain tax-qualified plans of nonprofit organizations. Vacation leave, sick leave, compensatory time, disability pay or death benefit plans are not considered deferred compensation plans under Section 409A.

Deferred compensation is compensation an employee (usually an executive) earns, but which is not to be paid until some later date. Where all tax requirements are met, the amount earned is not taxable when earned, but taxability is deferred to some future date, such as when it is actually paid to the employee or when certain triggering events occur, such as a failure of the deferred compensation plan to meet all tax requirements at some point. Non-qualified deferred compensation plans generally fall into one of the four following categories:

  • Salary reduction plans;
  • Bonus-deferral plans;
  • "Top hat plans" (supplemental executive retirement plans or SERPs); or
  • Excess benefit plans for employees whose benefits under the employer's qualified plans have reached the limits that are allowable under a tax-qualified retirement plan.

The following requirements must all be met for any covered non-qualified deferred compensation plan, in order to obtain a tax deferral (for the employee) of the amounts in question:[36]

  • Distributions The plan may only allow distributions to be made under the following circumstances:
    • Separation from service by the employee (such as retirement);
    • Disability (as it is defined) of the employee;
    • Death;
    • Payment at a specified time (or pursuant to a fixed schedule) as specified under the plan at the date of deferral of such compensation;
    • A change in ownership or effective control of the corporate employer, under circumstances to be defined by IRS regulations; or
    • Occurrence of an unforeseeable emergency (as defined by the law and future IRS regulations).
  • Acceleration of Benefits The plan cannot allow for an acceleration of the time or schedule of any payment under the plan, except as allowed under regulations to be issued by the IRS.
  • Election by Employee to Defer Compensation Very specific and technical rules now apply as to when an employee must make an election to defer any part of his or her compensation. In general, to defer any compensation in the current year, the employee must have made an election to defer it by the end of the preceding year. Special exceptions apply for the employee's first year of eligibility in the plan (a 30-day period to defer, after becoming eligible) or where compensation is performance based.

Funding Requirements

Under the new rules, if the employer transfers funds (to fund the deferred compensation in the future) to a foreign trust or similar arrangement outside the U.S., the transfer will generally be treated as a transfer of such funds or assets to the employee at such time, and any increase in such assets in subsequent tax years will be considered additional transfers to the employee, and taxable, generally. Similar rules apply where a plan provides that certain assets will become restricted, available only for payment of plan benefits, in the event of defined changes in the financial health of the employer.

Consequences of Failure To Comply

Failure of a plan to meet the above requirements (or where a plan meets all requirements but is not operated in accordance with its terms) now has dire consequences. The amount of income to the employee is not merely taxable at the time the plan fails to meet the tax requirements with respect to that employee; instead the following penalties apply where previously deferred income becomes taxable because a plan fails to comply or because of transfers of assets to a foreign trust or similar arrangement: [37]

  • A penalty tax of an additional 20% of the amount includible in income is added to the regular tax on such income; and
  • The tax is computed as if the income were taxable in the earlier year when the compensation was deferred, and additional tax, computed as non-deductible interest (at 1% over the normal tax underpayment interest rate), is computed from that date to the present.

In short, the new deferred compensation rules have made life much more complex for companies that wish to offer non-qualified deferred compensation to their employees, and the penalties are now much more Draconian for any failure to meet all the new technical requirements for deferral of taxation.

UPDATE NOTE:
The IRS finalized its regulations under Section 409A, effective as of April 17, 2007. All nonqualified deferred compensation arrangements had to be in writing and in compliance with Section 409A no later than December 31, 2007 (later extended for another year, to December 31, 2008). Plans were not required to be amended retroactively to cover the period from the January 1, 2005 effective date of Section 409A through the end of the transition period, but they had to show operational compliance with the rules during that time. The final regs made only minor changes from the earlier Proposed Regulations, such as by allowing an employer to delay payment of deferred compensation if making payment would jeopardize the employer's ability to continue to operate as a going concern.[38]

12.6 Restricted Stock Plans

A recently very popular and largely unregulated method of compensating key employees of a corporation is by the use of "restricted stock" plans, which are increasingly taking the place of stock option plans. "Restricted stock" plans generally involve a transfer of stock outright to a key employee, but with restrictions on the stock that will not lapse for a number of years. Typically, these are restrictions that will cause the employee to forfeit the stock back to the company if he or she leaves the company for some reason or fails to meet some defined goal or benchmark. Often, other than being unable to sell or otherwise transfer the stock, the employee has all the rights of a shareholder, such as the right to receive any dividends paid on the stock, while holding the restricted stock.

If shares of restricted stock transferred to an employee are subject to certain conditions, such as a "substantial risk of forfeiture" and "lack of transferability,"[39] the transfer is not a taxable event at the time the stock is granted. At a later date, when the restrictions finally lapse, the value of the stock at the time it becomes transferable or no longer subject to a substantial risk or forfeiture is (ordinary) income to the employee and a deduction for the employer at that time. The amount included in the employee's income becomes his or her "tax basis" for the stock, for computing gain or loss when it is sold.

A number of conditions can be attached to the stock besides those that qualify as a "substantial risk of forfeiture," such as requiring the employee to sign a non-competition covenant if leaving the company or requiring that the employee provide consulting services after leaving employment.

Employers tend to prefer restricted stock grants to stock options, since the amount of stock transferred can be less than under stock option plans, reducing dilution of the company's earnings as well as reducing the charges to earnings that can occur with options. Since the employee will not have to buy the stock, the grant of restricted stock can be for fewer shares than a grant of options, but can still be of equal value in the mind of the employee. For example, if you are an employee and are given 1,000 shares of stock when it is worth $100 a share, which will be yours in 5 years if you stay with the company, you might prefer that to an option to buy 2,000 shares of the stock at $100 a share 5 years in the future, which will have no value in 5 years if the stock does not appreciate above $100 a share.

IMPORTANT NOTE:
Restricted stock plans will not work for you as an employee of a corporation in which you own a substantial amount of the company's voting stock or other classes of stock, unless you can demonstrate that you do not control the company and that the chances of the company enforcing the forfeitability provisions are substantial. Unless you can make such a showing, the I.R.S. regulations warn that no "substantial risk of forfeiture" exists, and thus the transfer of stock will be immediately taxable.[40]

However, in some cases, an employee may want to be immediately taxable on the transfer of restricted stock, despite the restrictions. Employees are allowed by the tax law to make a "Section 83(b) Election," under which they can elect to immediately include the value of the stock in income (deductible then to the employer), at the time the restricted stock is granted -- or at some later date while it is still subject to the restrictions. Income is reportable as of the date the election is made.

Making this election is somewhat risky for the employee, since if the stock has to be forfeited or declines in value and is eventually sold at a loss after the restrictions lapse, the loss will be a capital loss and the employee will have paid tax on an ordinary income amount he or she never actually received.

EXAMPLE:
If an employee makes a Section 83(b) Election on a grant of $100,000 worth of restricted stock, he or she will recognize $100,000 of taxable income at the time of the election. If the stock is later forfeited back to the employer, the employee will then have a $100,000 capital loss (his or her tax basis), which may not be deductible immediately, except against capital gains.

On the other hand, if the stock appreciates in value after the election is made, the eventual lapse of restrictions is not a taxable event, since the tax was already paid at the time of the election, and the employee's holding period, for long-term capital gain purposes, will have begun on the day the Section 83(b) Election was made. Thus, any appreciation in the value of the stock when the employee sells it will usually be taxable at favorable capital gains rates.

12.7 Play or Pay -- Preparing for Obamacare

Whatever you may think of the Patient Protection and Affordable Care Act ("PPACA"), better known as "ObamaCare," it is a fact of life, and the provisions that most drastically affect employers will generally go into effect in 2014. The details of this law are still being fleshed out by the IRS and other government agencies, in the form of thousands of pages of grotesquely complex regulations. This section will give you basic guidance as to some of the decisions you will need to make if you are an "applicable large employer," which generally means you employ 50 or more full-time employees or the equivalent, as computed in a fairly complex formula, under the Internal Revenue Code[41] and IRS Regulations.[42]

If your business is treated as an "applicable large employer," it must offer full-time employees (and their dependents) the opportunity to enroll in a health insurance plan that provides the employees "minimum essential coverage" (we won't try to define that here) with "minimum value" at an affordable cost. Coverage provides "minimum value" if the health plan's share of the cost of of allowed benefits is at least 60%. A plan is "affordable" for the employee if the amount the employee is required to contribute for self-only coverage is no more than 9.5% of his or her household income, which can be tricky to compute, although there are several "safe harbor" methods of determining affordability.

Such a large employer that fails to provide the required coverage will generally be required to make large "assessable payments" (a tax or penalty), which will be collected by the IRS. Needless to say, all of the above definitions are quite technical in nature.

An "applicable large employer" is one that had, in the previous calendar year, at least 50 full-time employees or full-time equivalent (FTE) employees. To make this determination, an employer must make the following calculations:

  • 1. For each month in the prior calendar year, determine the number of full-time employees, those employed an average of at least 30 hours per week or 130 hours per month.
  • 2. Then, calculate the number of FTE employees by taking the aggregate of all hours worked by other than full-time employees for each month (counting no more than 120 hours for any one part-time employee), and divide the total hours by 120.
  • 3. Add the number of full-time employees to the number of FTE's for each month. If the average total for each month during the prior calendar year is 50 or more, then the employer is an "applicable large employer" and thus is required to either provide insurance coverage for full-time employees or face possible penalties ("assessable payments").
Note that failing to provide minimum essential coverage with minimum value does not automatically subject a large employer to the penalties. Furthermore, coverage of employees who are not full-time is not required. The penalties are triggered only if one or more full-time employees of a particular employer have been certified by a health benefit insurance exchange as having received a premium tax credit or cost-sharing reduction, which are subsidies for low income individuals. In that case, the employer will have a chance to challenge the certification, but if unsuccessful, the IRS will begin collecting a monthly penalty from the employer of 1/12th of $2,000 ($166.70) for each full-time employee in excess of 30, if the employer did not offer essential minimum coverage.[43]

For example, if a large employer has 80 full-time employees and must make assessable payments because it offers no health insurance plan, the annual amount of the payments would be 80 minus 30, or 50 employees times $2,000, or a total penalty of $100,000 per year.

If the employer does offer a plan, but it does not meet the "minimum value" or "affordable" requirement, it may be liable for penalties of $3,000 a year ($250 a month) for each employee who is certified as enrolled in an exchange plan, but only for those employees.[44] The penalty amounts will be indexed for inflation in years after 2014.

Also starting in 2014, the individual mandate provisions of ObamaCare will impose a penalty or fine on individuals, other than certain low income individuals, who do not provide proof that they have qualifying health insurance coverage. The penalty or fine (called a "tax" by the Supreme Court, in order to uphold the constitutionality of the law) will only be $95 in 2014, $325 in 2015, and rising to 2.5% of income (or a maximum of $2,085 per family) in 2016.

PLANNING POINT:
In 2013, many large employers, including some fast food chains, have already begun reducing the hours worked by many employees to less than 30 hours a week. While they will still be considered "applicable large employers" (since the larger companies will still have considerable numbers of full-time employees), the companies will not be required to provide health care coverage for the part-time workers. This is an unintended consequence of the PPACA (ObamaCare) law that will have a harsh impact on many rank-and-file workers who are being demoted from full-time to part-time status, only allowed to work fewer than 30 hours a week. While reducing many of your workers to part-time status may be one way to deal with the crushing financial impact of the new health care law, you will need to weigh that benefit against the effects on employee morale, your ability to attract good employees, and the efficiency of your business operations.
PLANNING POINT:
Many employers are also likely to drop existing health care insurance plans they currently provide for employees, if they determine that paying the $2,000 per full-time employee penalty is cheaper than providing the insurance. Thus many employees who lose their coverage will be forced to obtain coverage through a government insurance exchange if they want to retain health insurance coverage, or else pay the individual mandate penalty to the IRS if they choose not to obtain coverage, or cannot afford it. In some cases, if the numbers work out right, employers may drop existing health insurance plans, advise their employees to sign up for insurance through a government exchange, and increase employee wages enough to cover their insurance costs (or cover the cost of their individual mandate penalty if they choose not to obtain insurance). This is another approach you may want to consider, but you will need to do a careful, detailed analysis of the pros and cons of doing so.
CAUTION:
The IRS has already cautioned that some schemes to avoid ObamaCare will not work. For example, some people have suggested that a company could lease employees for 20 hours a week from a temporary employment agency and hire the same employees 20 hours a week as an employee, so that the individual would not be a full-time employee of either that employer or the temp agency. In that case, the IRS warns that the worker would almost surely be considered to be a full-time employee of the company where he or she works, and not of the temp agency.

Note that the Proposed Regulations of the IRS introduce a safe harbor that was not in the PPACA (ObamaCare) legislation. If an employer offers minimum essential coverage to all but 5% of its full-time employees (or five, if greater), the employer will be considered to have offered coverage to substantially all of its employees, and the only "assessed payments" it would owe would be $3,000 a year ($250 a month) for any of the excluded employees who obtained subsidized coverage through an insurance exchange.

Planning to either provide coverage or pay the penalties is made difficult by the uncertainties built into the law. If you provide health care coverage that does not meet the federal requirements, you will probably be subject to some $3,000 a year penalties, but only for your workers who are certified as enrolled in an exchange plan, which is an unknown number of workers, as many may choose to simply pay the individual mandate penalty, rather than enroll in an exchange plan.

On the other hand, the costs of failing to provide any health plan at all for full-time employees are more quantifiable, since it is almost certain that if you have a good many full-time employees, at least one will seek to get insurance through an insurance exchange, thus subjecting your firm to $2,000 a year penalties for all but 30 of your full-time employees.

UPDATE NOTE:
President Obama announced in July, 2013 that the Employer Shared Responsibility ("employer mandate") provisions of the Patient Protection and Affordable Care Act ("ObamaCare") will not go into effect in 2014 as the Act requires, but will be postponed until 2015, a delay which the IRS has made official in Notice 2013-45. However, it is not clear that the President or IRS has any authority to ignore an act of Congress, as the U.S. Constitution requires the President to enforce all acts of Congress, not just selected ones. This may have to be worked out in the courts, but at this time (July, 2013), it appears that "applicable large employers" will not be subject to the mandate tax/penalty in 2014 for failing to provide medical insurance to employees.

In addition, Notice 2013-45 states that employer reporting with regard to such mandated health care coverage will also be postponed for a year, since no such coverage is to be required in 2014.

12.8 Overview of Fringe Benefits

If you hope to have your business grow and prosper, you will need to attract and keep capable, ideally excellent, employees. To be competitive in attracting such employees -- as well as to be fair -- you will want to offer a reasonable package of benefits. In our society, many of the most important benefits, such as health and retirement, are expected to be provided by employers. As a result, the government has made them overwhelmingly tax-deductible to you as an employer and tax-free to your employees as recipients.

Providing a package of fringe benefits not only enables you to attract the best employees, but it also indicates your commitment to treating your employees professionally -- just as you hope they will treat you.

Endnotes

(I.R.C. references are to the U.S. Internal Revenue Code.)

1. I.R.C. § 1372.
2. I.R.C. § 162(l)(4).
3. I.R.C. §§ 105 and 106.
4. I.R.C. §§ 213(d)1(C) and 7702B.
5. I.R.C. § 105(b).
6. I.R.C. § 105.
7. IRS Notice 2013-54, 2013-40 I.R.B. ___.
8. I.R.C. § 220.
9. I.R.C. § 223(c)(1)(A).
10. I.R.S. Notice 2004-2,2004-1 C.B. 269.
11. I.R.C. §§ 223(b)(2) and 223(c)(2)(A), eff. in 2007; Rev. Proc. 2012-26, 2012-20 I.R.B. 933; Rev. Proc. 2013-25, 2013-21 I.R.B. ___.
12. Rev. Rul. 71-588, 1971-2 C.B. 91.
13. Coordinated Issue All Industries Health Insurance Deductibility for Self-Employed Individuals, UIL 162.35-02 (issued by IRS as a coordinated issue paper under its Industry Specialization Program, March 29, 1999).
14. I.R.C. §§ 318 and 1372.
15. IRS Notice 2008-1, 2008-2 I.R.B. 251.
16. I.R.C. § 106.
17. I.R.C. § 104(a)(3).
18. I.R.C. § 79(a).
19. I.R.C. §§ 79(d) and 416(i)(1); Notice 2009-94, 2009-50 I.R.B. 848.
20. I.R.C. § 132(f)(2) and 132(f)(5)(E); and Rev. Proc. 2013-15, 2013-5 I.R.B. ___, modifying and superseding Rev. Proc. 2011-52, 2011-45 I.R.B. 701.
21. I.R.C. §§ 132(a), 132(f)(2), and 132(j)(4).
22. I.R.C. § 119.
23. I.R.C. § 127.
24. I.R.C. § 129.
25. IRS Notice 2005-42, 2005-1 C.B. 1204, modified by Prop. Treas. Regs. §§ 1.125-1(o) and 1.125-5(c) and IRS Notice 2013-71, 2013-47 I.R.B. ___.
26. I.R.C. § 125.
27. I.R.C. §§ 219 and 404(a).
28. I.R.C. § 401(a)(17) and IR-2011-103, Oct. 20, 2011.
29. I.R.C. § 501(a).
30. I.R.C. § 45E.
31. I.R.C. § 408(p).
32. I.R. 2011-103, Oct. 20, 2011 and I.R. 2012-77, Oct. 18, 2012.
33. I.R.C. § 219(g)(8), eff. in 2007.
34. I.R.C. § 422.
35. I.R.C. § 423 and § 251(c) of the American Jobs Creation Act of 2004.
36. I.R.C. § 409A(a).
37. I.R.C. §§ 409A(a)(1)(B) and 409A(b)(4).
38. T.D. 9321, 72 F.R. 19234-19325, 4/17/07; Notice 2006-79, 2006-43 I.R.B. 763; Notice 2007-86, 2007-46 I.R.B. 990; and I.T. Regs. §§ 1.409A-1, et seq.
39. I.R.C. § 83(a).
40. I.T. Regs. § 1.83-3(c)(3).
41. I.R.C. §4980H.
42. Prop. Regs. §§ 54.4980H-1, et seq.
43. I.R.C. §4980H(a).
44. I.R.C. §4980H(b).


Chapter 13

Business Expense Tax Deductions and Credits


"I'm proud to be paying taxes in the United States.
The only thing is -- I could be just as proud for half the money."

-- Arthur Godfrey

"The difference between tax avoidance and tax
evasion is the thickness of a prison wall."

-- Denis Healey

"Last year I had trouble with my income tax.
I tried to take my analyst off as a business deduction.
The government said it was entertainment.
We compromised -- we made it a religious contribution."

-- Woody Allen



Operating a business costs money. As a result, reasonable business expenses can be deducted from your income before computing how much tax you owe. In addition to deducting most normal and ordinary business expenses, such as printing brochures or buying office supplies, you are also able to deduct the costs of certain other activities -- some might even say luxuries -- as business expenses. These and other deductions and credits -- some of which do not even require you to incur an expense -- can prove very helpful in reducing your taxes. Keep them in mind when developing your tax-saving strategies for your business.

13.1 Travel, Entertainment, and Meal Expenses

Expenses associated with legitimate business travel, entertainment of clients or customers, and business-related meals are tax deductible. However, you can only deduct 50% of qualifying business meals and entertainment. Some types of transportation workers, such as long-haul truck drivers, may be able to deduct 80% of meal expenses, but this exception applies only to meals consumed while away from home by such person, during or incident to the period of duty subject to the hours of service limitations of the U.S. Department of Transportation.[1] This is a very limited exception; all other business people generally can only deduct 50% of the cost of their business meals.

Consequently, the 50% (or 80%) deductibility limit considerably complicates recordkeeping for these types of expenses. For instance, if you stay in a hotel on a business trip and charge your meals to your room, you are required to separately break out your meal expenses for tax purposes because your meal expenses are only 50% deductible, while your room expenses are usually 100% deductible.

If you are an employee of your business, the 50% disallowance of meal and entertainment expenses does not apply to you individually if your company reimburses you for the expenses; it applies only at the company level.

PLANNING POINT:
If you bill your clients or customers for meals and entertainment expenses you incur on their behalf, but do not itemize those expenses on the bill, YOU lose 50% of the tax deduction, since they are considered to be your expenses in that case, while the full amount the client pays you is taxable to you. Heads the IRS wins, tails you lose.

On the other hand, if you do itemize those expenses when billing, THE CLIENT loses 50% of the tax deduction (assuming the client is a business that can claim any deduction at all for amounts you are billing them, in the first place); but you can then deduct the full amount of the expenses, and are not subject to the 50% reduction. In that case, the taxable income you must report from the client reimbursements you receive will be fully offset by your deduction for the billed expenses, a much better tax result for you.

RECOMMENDATION: When billing your client for expenses you incurred on their behalf, be sure to send the client a bill that itemizes those expenses, rather than just adding it to the bill, or showing it as a single item, like "Travel expenses incurred."

Note that a similar rule applies if you provide meals to employees (which are not "for the convenience of the employer"): If the cost of the meals is reported as W-2 taxable income to the employee, it is fully deductible by the employer.

Not All Entertainment Expenses Are Deductible

Not all expenses for entertaining clients or customers are deductible. Entertainment expenses and meals with clients or potential customers intended to create a good impression but where no business is discussed are classified as "goodwill entertainment" and are not deductible. Ever. As a general rule, to get any deduction for business meals or entertainment, your records must show that you were engaged in a substantial and bona fide business discussion during or immediately before or after the entertainment or meal.[2]

Deductions for attending foreign conventions are now completely disallowed, unless you can show that:

  • It is just as reasonable for the convention to be held abroad as it would be to hold it in North America; and
  • The meeting is directly related to your trade or business.

"North America" is defined as including the United States and its possessions and certain former possessions, such as the Republic of Palau, Republic of Marshall Islands, and Federated States of Micronesia, as well as Canada, Mexico, Honduras, Costa Rica, Panama, Bermuda, and most of the Caribbean islands, other than Cuba, the Cayman Islands, the British Virgin Islands, and Saint Lucia. (Panama became an eligible area on April 18, 2011, as noted in Rev. Rul. 2011-26, 2011-48 I.R.B. 803.)

If the above convention requirements are met, you must then meet the general requirements for traveling outside the United States. Deductions for conventions or seminars on cruise ships are limited to $2,000 and are allowable only if the vessel is registered in the United States and all ports of call are in the United States or possessions. Other travel by "luxury water transportation" is deductible only up to twice certain per diem (daily) allowable amounts that are announced by the government from time to time.[3]

Club dues are also not generally allowable deductions, whether they are for business clubs, social clubs, country clubs, health clubs, or luncheon clubs. However, dues for public service clubs, such as Rotary, Lions, or Kiwanis, can usually be deducted.

Detailed Records Required

To claim any of these kinds of deductions, you must keep daily, detailed records of such expenditures, including bills, receipts, and the following information for each expense:

  • The relationship of the expenditure to the business;
  • The time when the expense was incurred;
  • Where the money was spent, and to whom it was paid;
  • The amount of the expenditure; and
  • The identities of the persons involved, including persons entertained.[4]

The law requires that taxpayers keep "adequate records or... sufficient evidence corroborating the taxpayer's own statement."[5] Use a daily expense record book or diary and enter all expenses for travel, meals, and entertainment you think should be deductible. Include the above information for each item. Documentary evidence is not required to substantiate travel and entertainment expense items of less than $75, except for the cost of lodging while away from home.[6]

For more information on business-related expenses, contact your local IRS office and request Publication 463, Travel, Entertainment, Gift, and Car Expenses, or download it from the IRS Website.

PLANNING POINT:
Partners in a business partnership need to be aware of a recent Tax Court case,[7] which appears to have changed the tax rules for partners who individually deduct expenses they incur on behalf of the partnership.

Since, from a liability standpoint, a general partner is not distinct from a partnership, the IRS has always allowed a deduction on Schedule E, Page 2 of Form 1040 for a partner's "unreimbursed partnership expenses" in the past. However, in the Tax Court's Hines case in 2004, the summary opinion has changed the rules for taking such deductions. Under this decision, according to the Tax Court, a partner can no longer deduct unreimbursed partnership expenses unless the partnership has an agreement that meets all the following requirements. It must:
  • Require, in writing, that the partners pay expenses personally;
  • State, in writing, that no reimbursement will be made by the partnership; and
  • Be specific as to what expenses will not be reimbursed.

Accountable Expense Reimbursement Plans

If you provide expense allowances to your employees, it is critically important that your plan for doing so be an "accountable plan" under Section 62(a)(2)(A) of the Internal Revenue Code and Regs. Sec. 1.62-2. For example, if you simply give an employee a $500 a month expense allowance for travel expenses, the employee will have $6,000 of taxable income for the year, subject to income tax and FICA tax, and your business, as employer, will also owe FICA taxes on that amount of wages, if the plan is not "accountable." If, on the other hand, this arrangement is an "accountable plan," the expenses you reimburse to the employee (which may be less than $6,000 for the year, if the employee actually incurs less than that amount) will simply be an expense for your business, and will be nontaxable to the employee and thus your firm will not owe any FICA taxes on the amount paid, either.

To qualify as an accountable plan, the plan must require that:

  • The employee expenses have a business connection;
  • The employee adequately account for the expenses within a reasonable time period; and
  • The employee return excess allowances within a reasonable period of time.
Under the IRS regulations, a reasonable time period is based on the facts and circumstances, but actions that take place within the following time periods will always be considered reasonable:
  • Advances are received within 30 days of the time the expense is paid or incurred.
  • Expenses are adequately accounted for within 60 days after they were paid or incurred.
  • Any excess reimbursement is returned within 120 days after the expense was paid or incurred.
The determination of whether or not the employee expenses have a "business connection" can be complex and tricky. For examples of situations that will qualify, or will not qualify because they are an attempt to re-characterize compensation as expense reimbursements, you (or your tax adviser) should consult Rev. Rul. 2012-25, I.R.B. 2012-26.

13.2 Automobile Expenses

If you use an automobile part of the time for business purposes, you will generally be able to deduct a percentage of the costs of owning and operating the car if you can substantiate the business mileage.

The expenses of using the car for commuting to and from work or for personal travel are not deductible.[8]

For example, if you purchase a car for use in your business, and 80% of the mileage on the car can be shown to be for business trips and only 20% for commuting to work and other personal use, you should be able to deduct 80% of the gas, oil, insurance, and maintenance costs relating to the car. You can also depreciate the cost of the car, less 20% for personal use.

If business use is less than 50%, automobile depreciation is stretched out over at least six years, straight-line: 10% the first year; 20% a year thereafter, for four years; and 10% the final year. For boats or planes, it must be stretched out for longer periods.[9] There are also strict dollar limits on maximum annual depreciation deductions for so-called "luxury automobiles" costing more than about $15,000 in recent years ($15,300 in 2011. Rather than increasing the dollar threshold amount that defines a "luxury automobile" each year, the IRS has been lowering this threshold amount almost every year, from a peak amount of $15,800 in 1997.

For such "luxury" automobiles, the maximum annual depreciation deduction allowed is limited to the amounts specified by the IRS each year.[10] This amount is relatively small, and for a true luxury car, costing $80,000 or $100,000 or more, it can take quite a few years, if ever, to fully write off the vehicle's cost, under the strict luxury auto depreciation limits, as the following example indicates:

EXAMPLE:

DEPRECIATION LIMITS FOR "LUXURY" PASSENGER
AUTOMOBILES PLACED IN SERVICE IN 2013

  • 1st tax year -- $3,160 (plus up to $8,000 bonus depreciation)
  • 2nd tax year -- $5,100
  • 3rd tax year -- $3,050
  • Each succeeding year -- $1,875

The dollar amounts in the above table are the inflation-adjusted deduction limits in 2013 for a vehicle used 100% of the time for business and placed in service in 2013.[11] If used less than 100% for business, the above limits are reduced proportionately. These amounts are all unchanged from 2012. Note that in 2013, as in 2009 through 2012, if 50% or 100% bonus depreciation is elected for an automobile, the first year amount in the above table can be increased by $8,000, for a new vehicle, so that the first-year write-off could be as much as $11,160 in 2012 or 2013.[12]

CAUTION:
Because the tax law depreciation rules never before considered the possibility of 100% bonus depreciation, a strange trap could arise for a taxpayer who purchased an automobile costing over the $11,060 first-year limit and who elected 100% bonus depreciation in 2010 or 2011. The way the laws work, the remaining undepreciated basis of the auto could not be amortized during the 6-year amortization period, but the taxpayer could only begin depreciation of the remaining cost starting in the seventh year. (This is not a problem in 2012, since 100% bonus depreciation is no longer allowed in 2012, and no bonus depreciation is allowed after 2012, unless Congress changes the law again.)

Fortunately, the I.R.S. has recognized that this anomalous result is a trap for unwary taxpayers, and has issued a special "safe-harbor" Revenue Procedure that allows a taxpayer to continue depreciating the remaining basis in years 2 through 6 as if 50% bonus depreciation had been elected, rather than 100% bonus depreciation.[13] This is a reasonable, if not necessarily ideal solution to the problem, but leads to some rather complex accounting that your CPA will need to calculate for you.

While the H.I.R.E. Act of 2010 extended some rapid depreciation (Section 179 expensing) limits, it did not extend 50% bonus depreciation for 2010. However, additional 2010 tax legislation was passed by Congress, restored bonus depreciation and this $8,000 additional depreciation for autos in 2010, 2011 and 2012, greatly increasing the first year write-off in those three years.) Subsequently, the 2013 "fiscal cliff" legislation (the Taxpayer Relief Act of 2012) extended 50% bonus depreciation and the $8,000 first-year write-off for autos used 100% for business for another year, through the end of 2013.

The above limits don't apply to business vehicles such as ambulances, hearses, taxis, delivery vans, or heavy trucks, or to large trucks (including SUVs) of at least 6,000 pounds unloaded gross vehicle weight and rated at not more than 14,000 pounds gross vehicle weight.[14] However, because the exemption for large trucks and SUVs was used as a loophole by many taxpayers, utilizing the expanded $102,000 (Section 179) expensing deduction in 2004 to buy and fully write-off in one year the cost of a large, expensive SUV, Congress largely closed this loophole after October 22, 2004. It did so by limiting the first-year Section 179 expensing deduction on such large SUVs (up to a gross vehicle weight of 14,000 pounds) to $25,000.[15]

Thus, after October 22, 2004, if you purchase a large SUV of between 6,000 pounds unloaded gross vehicle weight and 14,000 pounds gross vehicle weight, you can only expense $25,000 of its cost under Section 179, plus take MACRS depreciation equal to 20% of the remaining cost. But while Congress closed the Section 179 loophole for large SUV's, it opened a new one in 2010-2012: Bonus depreciation.

EXAMPLE:
You or your business purchased a large SUV, subject to the $25,000 expensing limit, in 2009, for $75,000, and used it 100% for business. You could expense $25,000 of the cost, plus take a depreciation deduction for 20% of the remaining $50,000 of cost, or $10,000 of depreciation in 2009. Therefore, your total first-year write-off on the SUV in 2009 would be $35,000 of the total cost of $75,000. Prior to October 23, 2004, in the same circumstances, you could have expensed the entire cost of $75,000, before Congress closed the SUV loophole. If purchased in 2009 or 2010, or in 2012, you can also take 50% bonus depreciation, and thus a total write-off of $55,000 ($25,000 expensing, $25,000 bonus depreciation, and $5,000 regular first-year depreciation); or, if acquired between September 8, 2010 and December 31, 2011, you could take 100% bonus depreciation and write off the entire $75,000 cost of the SUV.

Mileage Deduction

If you drive an inexpensive economy car on business, it may be simpler and more advantageous to elect to deduct business mileage of 56.5 cents per mile in 2013 or 56 cents in 2014,[16] rather than keep records of your various kinds of automobile expenses. If you use this method, you can still deduct tolls and parking incurred on business trips, as well as taxes and interest paid with respect to owning or financing the automobile. However, you may not use the standard mileage allowance on a vehicle on which you have previously claimed any depreciation under the MACRS system or any expensing deduction under Internal Revenue Code Section 179, and the standard mileage rate cannot be used for more than four vehicles used simultaneously.

If you drive an expensive car, you will probably get much larger tax deductions by reporting your actual operating expenses, plus depreciation, than by electing the standard mileage allowance.

Be sure to keep an accurate record of your business mileage so you can substantiate that the car was used for business purposes. Form 4562 of your annual tax return requires you to answer a number of detailed questions if you claim an automobile deduction.


13.3 Start Up Expenses Must Be Capitalized, but Some Now Deductible Immediately

This may come as a surprise, but you cannot immediately deduct all your start up expenses when you start a business, if your pre-opening expenses exceed $5,000. In fact, before October 23, 2004, ALL of your pre-opening expenses had to be "capitalized" and amortized -- that is, they had to be written off (straight-line) over 60 months instead of being deducted on your first year's tax return.[17] While that rule has been liberalized somewhat (see next paragraph), you may still have to capitalize some of such expenses. For example, if you are starting a restaurant and are paying salaries to a manager and to employees being trained before the day the restaurant opens for business, you might well think those expenses are immediately deductible. Not necessarily so! All such pre-opening expenses must be capitalized, and you can't begin to expense them or amortize them until opening day, when you begin to do business, and until recently, you had to make an election on your first tax return for the business to expense or amortize the costs.

Fortunately, since enactment of 2004 tax legislation, if a business incurs any pre-opening expenses after October 22, 2004, it may now expense up to $5,000 of such start up expenses in the tax year when it begins doing business, if its total of such start up expenses do not exceed $50,000. If such expenses exceed $50,000, any amount over $50,000 reduces the $5,000 that can be expensed, so that if the total start up costs exceed $55,000, the business will not be able to expense any of such costs. However, any amount of start up expenses that cannot be expensed immediately, because of the foregoing limitations, can be amortized, straight-line, over a period of 15 years (180 months).

UPDATE NOTE:
Under the Small Business Jobs and Credit Act of 2010, the amount of start up expenses that could be immediately deducted was temporarily increased from $5,000 to $10,000 for the year 2010 (only), and the threshold amount at which phase-out of the deduction begins was increased from $50,000 to $60,000 for 2010.

Start up costs are costs that are paid or incurred before the business begins. They include amounts paid for both investigating a prospective business and getting the business off the ground. These may include, for example, costs such as the following items:

  • A study or survey of potential markets;
  • An analysis of available facilities, labor, supplies, and other business needs;
  • Salaries and wages for employees who are being taught or trained, and the instructors who teach or train them;
  • Advertisements for the opening of the business;
  • Travel and other necessary costs for securing prospective distributors, suppliers, or customers; and
  • Salaries and fees for executives and consultants, or for other professional services.

In order to EVER claim a tax deduction for business start up costs, either as immediate expensing or as 180-month amortization, it has long been necessary to make an election under Internal Revenue Code Section 195 to expense and/or amortize such costs. This could be done by attaching a simple statement to your tax return for the tax year in which the trade or business first became active, stating that you elect to deduct your start up costs under Internal Revenue Code Section 195.

However, that requirement is no longer applicable, under new IRS Regulations. In Treasury Decision 9411, the I.R.S. announced that from September 6, 2008 on, taxpayers are "deemed" to have made the election to deduct and/or amortize start up expenses, unless they clearly elect to instead capitalize all such costs.

"Start up costs" do not include items of expense such as underwriters' fees for issuing stock (which are generally non-deductible), syndication fees for selling interests in a partnership, or costs incurred in acquiring assets (though such asset acquisition costs can usually be depreciated over varying periods of time, depending on the type of assets acquired).

Organization costs of a legal entity, such as legal and accounting fees, or government fees such as for filing articles of incorporation, must also be expensed and/or capitalized and amortized over a 180-month period, under an identical set of tax rules as for start up expenses, as described above. An appropriate election statement under Internal Revenue Code Section 248 (for corporations) or Section 709 (for partnerships) formerly had to be attached to the first tax return of the entity. A limited liability company (LLC) must make the appropriate election under Internal Revenue Code Section 248 or 709, depending upon whether it chooses to be treated as a corporation or as a partnership for income tax purposes.

At this time, it is not clear how an LLC would treat organization expenses if it is a single-owner LLC, since such an LLC would not be taxable as either a corporation or as a partnership, ordinarily and since the Internal Revenue Code Section 195 definition of "start up expenditures" does not seem to include items such as organization costs that would not be immediately deductible if incurred by an existing active trade or business in the same field. However, some tax experts are of the opinion that such organization expenses of a single-owner LLC, such as attorney fees to draw up an LLC operating agreement and articles of organization, can be treated as start up expenditures under Section 195.

UPDATE NOTE:
As in the case of start up expenses, Treasury Decision 9411, effective September 6, 2008 and thereafter, has removed the requirement that a taxpayer formally elect to deduct and/or amortize organization costs, and a taxpayer is now "deemed" to have made such an election, unless the taxpayer clearly elects to capitalize such costs.

Since the expensing deduction or amortization deductions for organization costs of a corporation or partnership are the same as, but separate from the start up expense deductions or amortization, a new business may claim both, as illustrated in the following examples.

EXAMPLE:
XYZ Restaurants, Ltd. incurs $6,800 of start up expenses and $4,500 of limited partnership organization costs as it starts a new business in 2013, opening its doors on July 1, 2013. For its first tax year, ending December 31, 2013, it can deduct all $4,500 of its partnership organization costs, and $5,000 of its start up expenses. The other $1,800 of start up expenses must be amortized over 180 months, at $10 per month, so it is only able to deduct 6 months of amortization, or $60, for its 2013 tax year, in addition to the amounts expensed.


EXAMPLE:
Same facts as above, except that XYZ Restaurants, Inc. is a corporation, and it incurs start up expenses of $52,500 and corporate organization expenses of $8,600. On its 2013 tax return, it can only deduct $2,500 of its start up expenses ($5,000 minus excess of $52,500 over $50,000), and must amortize the remaining $50,000 over 180 months, or $1667 for six months in the 2013 tax year. It may also expense $5,000 of the organization expenses, but must amortize the other $3,600 of such organization expenses, at $20 per month for 180 months, or a total of $120 amortization in 2013.


13.4 Office in the Home Expenses

If you use part of your residence for business purposes, you may be able to deduct part of your office-in-the-home expenses, but the rules are rather stringent. Office-in-the-home expenses are only deductible for tax purposes if you meet a number of very technical requirements, discussed below:

Exclusive-use tests. If you use part of your residence exclusively for business purposes and on a regular basis, you may be able to claim office-in-the-home deductions if you also qualify under one of these tests:[18]

  • You use a portion of your home as your principal place of business.
  • You use your home as a place to meet clients, customers, or patients.
  • Your home office is a separate structure that is not attached to your house or living quarters.

In 1999, a tax law amendment went into effect allowing your "principal place of business" to include a home office that is used only for administrative or management activities of the business, if there is no other fixed location where you conduct such activities.[19] This largely overruled a 1993 case in which the Supreme Court had disallowed home-office deductions of a physician who had no office other than a room in his home where he kept his business records and made business-related phone calls. His actual "work" as an anesthesiologist was done at various hospitals. Now such a home-office would qualify as the "principal place of business."

Nonexclusive uses that qualify. Two special exceptions are made where part of a home is regularly, but not exclusively, used for business purposes:

  • Storage of inventory -- a wholesaler or retailer who uses part of a home to store inventory that is being held for sale, if the dwelling unit is the taxpayer's sole fixed location of the trade or business; or
  • Day care facility -- part of the home is used for day care of children, physically and mentally disabled persons, or individuals age 65 or older.

If you can show that a portion of your residence qualifies as a home office, you have cleared the first hurdle. If the business use of your home qualifies under one of the above tests, then you may be able to deduct part of the home office expenses that are allocable to the portion of your home that is used in your business, in addition to home mortgage inter­est, property taxes, and casualty losses.

For example, if 15% of your home is used exclusively and regularly as your principal place of business, you could possibly deduct up to 15% of your occupancy costs, such as gas, electricity, insurance, repairs, and similar expenses, as well as 15% of your rent, if you are a renter, or the depreciation expense on 15% of the tax basis of your house if you own your home. (The IRS and the Tax Court don't agree on the deductibility of certain other types of expenses, such as lawn care.)

Also, business expenses that are not home-related, such as business sup­plies, cost of goods sold, wages paid to business employees, and other such operating expenses, are not affected by the limitation on home office-related deductions.

But note that even if you don't meet any of the above requirements, these rules will not disallow your deductions that are otherwise allowed for tax purposes, such as interest on your home mortgage, real estate taxes, or casualty losses from damage to your residence.

Deductions Are Limited to Income. This is the second hurdle you must get over. The amount of qualifying home office expense you can deduct for the year is limited to the gross income from your home business, reduced by regular operating expenses (wages, supplies, etc.) and an allocable portion (15% in the above example) of your mortgage interest, property taxes, and any house-related casualty loss deductions. If you still have any net business income after taking those deductions, then you may deduct the allocable portion of your home office expenses, up to the amount of such net income.

PLANNING POINT:
Any portion of your home office expenses that isn't deducted due to the income limit in one year can be carried over to future years until usable, if ever. Thus, it pays to keep track of any such disallowed expenses, in case your home-based business becomes more profitable in the future, and you are then able to deduct the carried-over expenses from earlier years.

Your federal individual return, Schedule C of Form 1040, no longer asks you whether expenses for business use of a home are being deducted. Instead, you must determine a tentative profit or loss on Schedule C, without taking into account home use expenses. Home office expenses are computed separately on Form 8829. On this form, you must compute the amount of deductible expenses for business use of the home, which (if any) can then be deducted from the net Schedule C income.

CAUTION:
If you have home office expenses, it is illegal for you, when filing Schedule C, to simply bury the home office expenses in with other business expenses. You must report them separately on Form 8829.

Potential Tax Trap of Office-in-Home Expenses. The downside of taking home office deductions in the past was a potential large tax bite when you sold your home. For example, if 15% of your home had been used for business and you sold your home for a gain, you had to pay tax on 15% of the gain, even though gains on sale of a residence have generally been tax-free under certain conditions over the years. Thus, a few hundred dollars of home office deductions might later result in many thousands of dollars of tax on the "business" part of your house if you sold it for a large gain a few years later. This was a serious potential tax trap for anyone who claimed any home office deductions in the past.

However, since law changes in 1997, only the depreciation on your home taken after May 6, 1997 must be recaptured as taxable income upon sale of a residence partly used as a home office. Paying tax on a portion of the gain on sale of the house, rather than simply recapturing any depreciation previously taken, now only applies in two situations -- where the business portion of the home is a separate structure, rather than a room in your main house, or is a separate dwelling unit, such as in a duplex. Thus, for example, if you have claimed $500 of depreciation on your home after May 6, 1997, where one room was used as a home office, and you have a $100,000 gain on sale of your house, which qualifies for the $250,000 or $500,000 exclusion of gain on sale of a residence, the only taxable gain you have to report is the $500 of depreciation you had deducted in the past.

UPDATE NOTE:
Under the Housing Act of 2008, rental use of your house, followed by a period in which you use your house as your principal residence, may result in any rental period after December 31, 2008 being treated as a period of "nonqualified use" of the property. This new law is designed to limit the tax-free treatment of sales of a residence where taxpayers buy property as a rental unit, and then convert it to their principal residence for two years, in order to qualify for the $250,000 or $500,000 gain exclusion. Under the new law, any period of "nonqualified use" (after December 31, 2008) must be taken into account in computing the fraction of the gain that is excludable. Thus, if you rented out a house for two years, followed by living in it as your principal residence for three years before it is sold, 2/5, or 40% of the gain on sale would be taxable (plus any depreciation recapture).

Apparently, use of part of your principal residence as a home office will not be considered a "nonqualified use," though this is not entirely clear. However, the latest release of IRS Publication 587 (regarding home office tax treatment), discusses the tax implications of the sale of the residence, and still indicates that the only taxability of such a sale would be the depreciation recapture on the home office, except for recognition of gain on a separate dwelling unit or separate structure that was used as the home office. The IRS publication, updated 12/15/2009, makes no mention of any change in such tax treatment as a result of the Housing Act of 2008.

For more information on the deductibility of home-office expenses, obtain IRS Publication 587, Business Use of Your Home and Publication 523, Selling Your Home.

UPDATE NOTE:
Beginning with 2013 individual income tax returns (due April 15, 2014), the IRS has announced that taxpayers who have qualifying home offices may take a simplified shortcut office in the home deduction, equal to $5 per square foot of the area of the home office, up to a maximum of $1,500, in lieu of the various complex calculations of your office expenses that are normally required. According to Rev. Proc. 2013-13, if you use the simplified method, you cannot deduct depreciation on part of the cost of your home or other home office expenses such as utilities, rent, or maintenance, but you no longer need to allocate part of mortgage interest and real estate taxes on your home to the home office, which apparently means you can deduct the full amount of those expenses as itemized deductions (if you itemize on Schedule A).

The new IRS ruling does not limit your ability to deduct other business expenses that are unrelated to the home, such as supplies, employee wages, or advertising. Current restrictions on the home office deduction, such as the requirement that a home office must be used regularly and exclusively for business and the limit tied to the income derived from the particular business, still apply under the new optional method.

Deducting the Cost of Your Home Computer. If you have a computer in your home that you use for business purposes, the amount you will be able to deduct will be considerably affected by whether or not it is used in a qualifying home office. If your home office does qualify (under the "exclusive use" test), you can generally write off most or all of the cost of the computer in the year it is put in service, under the IRS Section 179 expensing rules. (However, note that if your computer is used, say, 40% of the time for playing computer games and for other personal, non-business purposes, only the 60% business portion of its cost is deductible or depreciable, even if it is not considered "listed property.")

On the other hand, if you do not have a home office that meets the "exclusive use" tests discussed above in this Section 13.4, the home computer would be considered "listed property." In that case, you would need to keep a detailed log or other substantiation of the percentage of business use. If the business use percentage is over 50%, you could either depreciate the business portion of its cost over five years, or could take the first-year (Section 179) expensing deduction. If used 50% or less for business, you could not take any Section 179 expensing deduction and would be limited to using straight-line depreciation over 5 years (actually in six taxable years) to write off the business percentage of the cost -- taking 10% of the depreciable cost in the first tax year, 20% in each of the next four years, and 10% in the sixth tax year.

The cost of computer peripheral equipment is treated the same way as the cost of the computer itself.


13.5 Business Tax Credits

Tax credits are usually much more attractive to a taxpayer than tax deductions, since a tax credit offsets tax liabilities dollar-for-dollar. If you are in a 25% income tax bracket, one dollar of tax credits is worth as much to your bottom line as four dollars of tax deductions.

Numerous tax credits are offered as incentives to businesses to invest their money in certain socially desirable ways: hiring disadvantaged or unemployed individuals, doing business in depressed areas such as inner cities, and putting money and effort into research and development activities. Some of the more important business tax credits that can reduce your federal income tax are discussed in this section.

Work Opportunity Tax Credit

For many years, the tax law has provided tax credits to employers for hiring individuals from certain targeted groups of economically disadvantaged people.[20] These credits are up to 40% of the first $6,000 in wages per employee.

The Work Opportunity Tax Credit has been authorized for a few years and expired, several times, but each time has been reinstated by Congress, retroactively. Most recently, the Work Opportunity Tax Credit expired on December 31, 2007, but then in legislation enacted on May 25, 2007, Congress extended the expiration date for the credit again, to August 31, 2011.

In 2009, the American Recovery and Reinvestment Act of 2009 added two new categories of employees who may qualify under the Work Opportunity Tax Credit provisions, if hired in 2009 or 2010 -- "disconnected youths" and unemployed veterans.

The Work Opportunity Credit has expired after December 31, 2011, except for veterans, for whom it has been extended to December 31, 2012, with various technical changes to the definition of an unemployed veteran for those veterans hired after November 21, 2011. The amount of wages on which the 40% credit is computed remains at $6,000 for "short-term unemployed veterans" but is increased to $12,000 or $14,00 for certain long-term unemployed veterans and to $24,000 for veterans with a service connected disability who were unemployed for at least 6 months in the year before they are hired.

To qualify for the credit, employers must generally file IRS Form 8850 with their state employment security agency within 28 days after hiring a qualified veteran, in order to obtain a certification that the veteran qualifies under this program. However, for any veteran hired on or after November 21, 2011 and before May 22, 2012, employers were given until June 19, 2012 to file this newly revised form.[20A]

Employers who claim this credit have to forego a tax deduction for wages, equal to the amount of the credit claimed.[21] Even so, the net effect is still a very substantial tax subsidy to employers for hiring employees from any of the targeted categories.

Empowerment Zone Credit

An employment credit has been enacted for certain businesses deriving at least 80% of their gross income from within designated urban and rural "empowerment zones" and meeting other requirements. The credit for qualified wages paid to residents of the zone is 20% of the first $15,000 of wages paid to each such employee each year, or a maximum credit of up to $3,000 per employee. Unlike the Work Opportunity Tax Credit, this credit is not limited to wages paid to the employee in the first year of employment; however, the employee must work for at least 90 days to qualify. This credit expired on January 1, 2010.[23] In early 2013, Congress has reinstituted the Empowerment Zone Credit, through the end of 2013.

Research Tax Credit

This tax credit, often referred to as the R & D tax credit, as it is intended to encourage research and development (R & D) programs by businesses, has been around for many years in many forms, and has regularly expired and been revived by Congress[24] It had only been authorized through December 31, 2005, but was extended again by Congress in late 2006, to December 31, 2007, and 2008 tax legislation further extended the credit for R & D expenditures paid or incurred before January 1, 2010. (2010 legislation then reinstated the R & D credit for the years 2010 and 2011.) While this credit expired on December 31, 2011, Congress has reinstated it, retroactively, as it has on numerous occasions in the past, and has extended it through the end of 2013.

Only a portion of research and development spending qualifies for the regular R & D credit and, before 2007, only companies that increased their outlays on qualified research expenditures could earn the research credit, generally. Thus, this tax incentive has mainly been of benefit to fast-growing companies that are regularly expanding their R & D budgets. However, as noted below, the Tax Relief and Health Care Act of 2006 added a new simplified alternative R & D credit that can be claimed even by a company that does not increase its R & D spending from year to year, or, in many cases, even if such spending decreases.

The regular R & D credit is computed at the rate of 20% of a company's incremental research expenditures for the year, determined by comparing its current year's research expenditures to a "base amount." The base amount is ordinarily determined by first calculating a fixed base percentage, which is found by taking qualifying research expenditures as a percentage of a company's gross receipts during a fixed period between December 31, 1983 and January 1, 1989. The fixed base percentage, which cannot exceed 16%, is then multiplied by the taxpayer's average annual gross receipts for the four tax years preceding the current year, to determine the base amount, which cannot be less than one-half the current year's qualifying research expenditures. In short, only one-half, at most, of the cur­rent year's research expenditures can ever qualify for the (regular) R & D credit.

Obviously, if yours is a relatively new company, it will not have a history for the 1983-1989 fixed base period. That does not mean you cannot qualify for the credit, however. Companies that were not in operation during that base period may also qualify for the research credit on a reduced basis after an initial phase-in period, under an exceptionally complex formula. If your company is incurring increasing amounts of research and development expenditures, you will need the help of your CPA or other tax adviser to determine whether, and to what extent, you may qualify for the federal R & D tax credit or, in some states, similar state tax credits.

New Simplified Alternative R & D Tax Credit

The Tax Relief and Health Care Act of 2006,[26] enacted on December 20, 2006, has created a new and simplified alternative version of the R & D tax credit, which can be computed by simply calculating the current year R & D expenses and reducing that number by 50% of the average R & D expenses for the three preceding years. If the resulting amount is greater than zero, the tax credit is equal to 12% of that amount. However, a special rule applies if the R & D expenses for the three preceding years were zero. In that case, the tax credit is simply 6% of the current year's R & D expenses.[27]

The two following examples will illustrate how the simplified, alternative R & D calculation will work, if you elect that method. The first example is where a company had R & D expenses in one or more of the three preceding taxable years.

EXAMPLE:
XYZ Company has qualifying R & D expenses of $150,000 in 2012 and average R & D expenses of $150,000 in each of the prior 3 years, or no annual increase in the current year. Under the "regular" method of computing the R & D credit, XYZ Company would generally not earn any credit. However, under the new alternative simplified method of calculating the credit, the $150,000 of current R & D expenses would be reduced by 50% of the 3-year average (.50 x $150,000), or $75,000, so the tax credit would be 12% of $75,000, or a $9,000 R & D tax credit.

In this second example, ABC Company had zero R & D expenses in each of the three preceding tax years.

EXAMPLE:
ABC Company had no R & D budget in the three preceding tax years, but spent $100,000 on R & D in 2012. Under the new simplified alternative method of computing the tax credit, the R & D credit would simply be 6% of the $100,000 of current year R & D expenditures, or $6,000.



13.6 New Business Tax Deductions

The American Jobs Creation Act of 2004 added several important new deductions for businesses, each of which went into effect on October 23, 2004, except for the newly added deduction for "Domestic Production Activities," which became effective on January 1, 2005. In addition, the Tax Extenders and AMT Relief Act of 2008 and other legislation added new, more rapid write-offs for retail store improvements leasehold improvements, and restaurant improvements, although these all expired at the end of 2011. The new deductions are summarized as follows:

  • A new $5,000 (or less) expensing deduction for new business start up expenses (temporarily increased to $10,000 for 2010 only), and a similar deduction for corporation or partnership start up expenses;
  • A drastically shortened period (15 years) for the depreciation of certain real estate leasehold improvements, instead of the normal 39-year depreciation period that formerly applied to such real estate improvements, for improvements placed in service before 2008 or, as since extended, before 2012 (and subsequent stimulus legislation now allows a 50% or 100% bonus depreciation deduction in the first year, through December 31, 2011);[30]
  • A drastically shortened period (15 years) for depreciation of certain real estate used in a restaurant business, instead of the normal 39-year depreciation period that formerly applied to such real estate improvement items, applicable to improvements made before 2010 (since extended to improvements made before January 1, 2012);[31]
  • A drastically shortened period (15 years) for depreciation of certain improvements to real estate used in a retail business, instead of the normal 39-year depreciation period that formerly applied to such real estate improvement items, applicable to improvements placed in service during the year 2009 (since extended through 2010 and 2011);[32]
  • An "artificial" deduction for a certain percentage of "Domestic Production Activities," beginning in 2005.[33] We refer to this as an "artificial" deduction, since, unlike most tax deductions, it is not based on the allowance of a deduction for some kind of expenditure. Instead, it is more like a tax rate cut, in that it is a deduction equal to a flat percentage of your net profits from manufacturing or other specified production activities that are carried on in the United States, which you are allowed to deduct from your regular taxable income and for purposes of the alternative minimum tax (AMT).

Each of these important new types of tax deductions is described more fully below.

Expensing of Business Start Up and Organization Costs. While all business start up costs and costs of organizing a corporation or a partnership formerly were required to be capitalized and amortized over 60 months, the first $5,000 of such expenditures (in each category, separately) may now be expensed in the year a business commences, if the total such expenditures for that category (start up costs, or organization costs) does not exceed $50,000. The balance of such costs (in each category) that are not expensed in the year the business commences must now be amortized (deducted) over a period 15 years (180 months). How you can obtain and must calculate these deductions were both discussed more fully, earlier in this Chapter, at Section 13.3.

Note that for the year 2010 (only), up to $10,000 of start up costs could be expensed and the phase-out point was temporarily raised from $50,000 to $60,000. (These increases applied only to start up expenses, however, and not to organization costs of corporations or partnerships.)

15-Year Recovery Period for Qualified Leasehold Improvement Property. In the past, leasehold improvements by a lessee (or by a lessor -- the landlord) that were considered to be real estate improvements, rather than personal property improvements, were required to be depreciated over a 39-year recovery period, which was usually much longer than the usual commercial lease, even though such improvements might not be very useful after the current lease expired. In 2004, Congress concluded that this was an unrealistic restriction, and changed the law to permit the depreciation of such "qualified leasehold improvements" over a 15-year period. However, you had to use straight-line depreciation only, rather than the 150% of declining balance method, which is generally allowed for 15-year recovery period property.

"Qualified leasehold improvements" only include building improvements that are placed in service more than three years after the building was first placed in service, and thus leasehold improvements are not eligible for the 15-year write-off in the case of a new, or nearly new, building. In addition, only improvements made to a nonresidential structure will qualify.

This new provision (as amended in 2006) applied to "qualified leasehold improvements" placed in service after October 22, 2004 and before January 1, 2008. However, subsequent tax legislation has extended the applicability of this deduction for four more years, for leasehold improvement property placed in service after December 31, 2007 and before January 1, 2012. In addition, the Economic Stimulus Act of 2008 allowed a 50% bonus depreciation deduction (50% of the cost) for such leasehold improvements, for the year 2008 only. Further legislation has extended 50% bonus depreciation for leasehold improvements through September 7, 2010 and enacted 100% bonus depreciation for assets placed in service between September 8, 2010 and December 31, 2011. The American Taxpayer Relief Act of 2012 extended 15-year depreciation for this type of property for two more years, 2012 and 2013.

Note that all these accelerated depreciation deductions for leasehold improvements will expire on January 1, 2014. Thus, for 2014 and later years, leasehold improvements must be depreciated over a 39-year recovery period, unless Congress changes the law again.

15-Year Recovery Period for Qualified Restaurant Property. The 2004 Congress concluded that restaurant buildings are generally more specialized structures than other commercial buildings, and because of their heavy usage and traffic, generally suffer more wear and tear than other types of buildings, and thus often require frequent improvements or refurbishing. Accordingly, as with leasehold improvements, Congress felt that the 39-year recovery period for restaurant building improvements was unrealistically long, and also has shortened the depreciation recovery period for improvements that are "qualified restaurant property," from 39 years to 15 years.

Expenses for restaurant improvements are "qualified restaurant property" only if these three requirements are met:

  • The expenditures are for improvements to an existing restaurant building (or for the cost of a building, in 2008 or later);
  • The improvements must be placed in service more than three years after the building was first placed in service (this was only required before 2008); and
  • More than 50% of the building's square footage must be devoted to preparation of, and seating for on-premises consumption of, prepared meals.

Like the deduction for qualified leasehold improvement property, the 15-year cost recovery period for qualified restaurant property only applied initially to property placed in service after October 22, 2004 and before January 1, 2008. However, subsequent tax legislation has extended the applicability of this deduction for four more years, for property placed in service after December 31, 2007 and before January 1, 2012. In addition, new legislation provides the cost of the actual building itself will qualify as "qualified restaurant property" for restaurant buildings placed in service after December 31, 2008 and before January 1, 2012. (The American Taxpayer Relief Act of 2012 extended 15-year depreciation for this type of property for two more years, 2012 and 2013.)

Note that all these accelerated depreciation deductions for restaurant real estate improvements will expire on January 1, 2014. Thus, for 2014 and later years, such improvements must be depreciated over a 39-year recovery period.

15-Year Recovery Period for Qualified Retail Improvement Property. The Tax Extenders and AMT Relief Act of 2008 added a tax relief measure for retail businesses, by allowing a 15-year straight-line depreciation deduction for improvements made to certain retail buildings during the year 2009. Tax legislation passed in 2010 extended this 15-year depreciation for qualified retail improvement property through 2010 and 2011. The American Taxpayer Relief Act of 2012 extended 15-year depreciation for this type of property for two more years, 2012 and 2013.

For expenditures to be treated as "qualified retail improvement property" and eligible for this accelerated depreciation (instead of 39-year MACRS depreciation), three requirements must be met:

  • The expenditures must be for improvements to the interior portions of a building that is nonresidential real property;
  • That portion of the building must be open to the general public and used in the retail trade or business of selling tangible personal property to the general public; and
  • The improvements must be placed in service more than three years after the date the building was first placed in service.
PLANNING POINT:
Year-end tax planning for 2010 and 2011 needed to take into account the fact that for 2010 and 2011 alone, up to $250,000 of "qualified real property" could be considered Section 179 assets and expensed. "Qualified real property" includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, as those items are defined above. Without any further action from Congress, those types of real property will revert to 39-year straight line depreciation if placed in service on or after January 1, 2014. Neither 15-year amortization nor Section 179 expensing will be allowed after December 31, 2013, under present law.

Deduction for Domestic Production Activities. This is a major new deduction, which will require some complex accounting calculations and that very detailed records be kept to compute your profits from your "domestic production activities." In simple terms, this is a special deduction, similar to a tax cut, that is designed to encourage companies to manufacture or engage in other production activities within the United States, and to discourage companies from moving their plants abroad.

It is the latest U.S. response to various actions by the World Trade Organization (WTO) in recent years, which has declared three different U.S. tax laws, which were designed to help U.S. exporters, to be in violation of international trade agreements. These were the Domestic International Sales Corporation (DISC) provisions, the Foreign Sales Corporation (FSC) provisions that replaced DISCs, and the more recent (2002) Extraterritorial Income (ETI) exclusion; all three of which were held to be illegal export subsidies by the WTO.

Since the WTO is largely controlled by European countries (the United States has only one vote), it has ruled that European value-added tax (VAT) provisions that rebate all VAT taxes on exports from European countries are NOT illegal export subsidies. This places the U.S. at a great disadvantage in international trade with Europe, where most countries have such a VAT tax, at rates as high as 25%. Thus, the new Domestic Production Activities deduction is the latest attempt to find a way to encourage U.S. production of goods, in a way that will not be considered an illegal export subsidy by the WTO, since it is similar to provisions in other countries that are considered to be valid under WTO free-trade rules. (WTO members are already seeking to have this new U.S. tax law declared to be another illegal export subsidy, although it is applied to both export profits and domestic profits from production activities.)

This tax law provision, effective as of January 1, 2005, allows a deduction equal to the lesser of:

  • The taxable income of your corporation (it cannot create a tax loss) or, in the case of an individual taxpayer your adjusted gross income, with certain modifications; or
  • 9% of your company's "qualified production activities income" for the taxable year. However, the 9% deduction is being gradually phased in, and was limited to 3% in 2005 and 2006, increased to 6% in 2007, 2008, and 2009, finally becoming 9% in 2010; or
  • 50% of the Form W-2 wages reported for the tax year -- thus, for a sole proprietorship, partnership or LLC that has no employees and pays no W-2 wages, the "Domestic Production Activities" deduction is not available.

However, a 2006 tax law amendment, effective for tax years beginning after May 17, 2006, now limits the deduction to 50% of W-2 wages "allocable to domestic production gross receipts," rather than 50% of ALL W-2 wages of the taxpayer entity, which will significantly reduce this deduction for many businesses.[34]

On the other hand, the 2006 law also simplifies and liberalizes the rules for the pass-through of W-2 wage expenses to partners in a partnership, members of an LLC, or shareholders of an S corporation, so that a previous limitation on the amount of such wages that could be allocated to an owner of a pass-through entity has been repealed.[35]

PLANNING POINT:
Because the 2006 law amendment has limited the Domestic Production Activities deduction to 50% of W-2 wages that are allocable to such production receipts, employers who plan to claim the Domestic Production Activities deduction now need to design and implement recordkeeping systems to track the portion of employees' time (and pay) that is devoted to domestic production activities. This may require setting up separate general ledger accounts to break wages down into two components -- wages that relate to domestic production gross receipts and wages that do not.

The deduction, while it may be claimed by an unincorporated individual (sole proprietor, partner, or member of an LLC), can only be claimed as a deduction in computing the person's income tax; it cannot be claimed as a deduction in computing the self-employment tax.

IMPORTANT NOTE:
Be aware that for an unincorporated business, not only is it a negative that the owners do not receive salaries, unlike in a corporation, which will tend to put a lower limit on the amount of the Domestic Production Activities deduction that can be claimed for income tax purposes (limited to 50% of W-2 wages), but also, any such deduction that can be claimed will not be allowable as a deduction in computing the owners' self-employment income, for purposes of the self-employment tax.

Also, a business that has no employee payroll will not be able to claim ANY Domestic Production Activities deductions since 50% of its W-2 wage expense will be zero.

This can be a significant factor in choosing whether or not to incorporate, if you are engaged in a business that might qualify for the Domestic Production Activities deduction, since operating as a corporation and paying compensation to the owner or owners will significantly increase the potential amount (and tax benefits) of this special tax deduction.

"Qualified production activities income" (QPAI) is the excess (if any) of the taxpayer's domestic production gross receipts over the sum of:

  • The cost of goods sold that are allocable to such receipts; plus
  • Other deductions, expenses or losses directly allocable to such receipts; and
  • A ratable proportion of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income.

QPAI is computed separately, as a net profit or loss for each type of domestic production gross receipts, and QPAI for the taxable year is the total of the various QPAI items. "Domestic production gross receipts" include gross receipts from the following types of business activities carried on in the U.S.:

  • Any lease, rental, license, sale, exchange or other disposition of "qualifying production property" which was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part in the United States, any qualified film produced by the taxpayer in the United States, or electricity, natural gas, or potable water produced by the taxpayer in the United States;
  • Construction performed in the United States; and
  • Engineering or architectural services performed in the United States for construction projects in the United States.

For taxable years beginning after 2009, oil and gas-related income (from refining, production, transportation, or distribution) no longer qualifies as QPAI.

"Domestic production gross receipts" do not include the sale of food or beverages prepared by the taxpayer at a retail establishment or the transmission of electricity, natural gas, or potable water.

Gross receipts from "Qualifying production property" can include gross receipts from sales, rental, license, or exchange of tangible personal property, computer software, or certain sound recordings.

The IRS has issued an explanatory notice, IRS Notice 2005-14, plus final Treasury Regulations issued on June 1, 2006,[36] which provide that whether a property is considered to be manufactured by the taxpayer in the United States in significant part depends on whether the activities were substantial in nature. It further provides, as a safe harbor, that if conversion costs incurred in the United States (excluding certain design, development, and packaging costs) are 20 percent or more of the total cost of the property, the activity will meet the "manufactured in significant part in the United States" requirement.

Regarding construction gross receipts, IRS Notice 2005-14 and the final regulations also say that items of tangible personal property (for example, appliances, furniture and fixtures) that are sold as part of a construction project are not considered real property, and thus do not qualify. However, the final IRS regulations say that if more than 95 percent of the total gross receipts derived by a taxpayer from a construction project are attributable to real property, then the total gross receipts derived by the taxpayer from that project will be considered to qualify as domestic-production gross receipts from construction, without any allocation for personal property.[37]

By enacting the Domestic Production Activities tax deduction, Congress has, in effect, given many U.S.-based businesses, including the owners of many unincorporated businesses, a modest tax cut for certain production activities they carry on within the United States. For a corporation or individual in a 35% tax bracket, the 9% deduction roughly equates to a 3% tax rate reduction. However, a great deal of complex accounting and recordkeeping is required in order to calculate the QPAI on which the 9% deduction is based. Nevertheless, this new provision is a significant boon to companies that manufacture, produce, grow, or extract products or provide certain services within this country.


13.7 Small Business Tax Breaks for Hard Economic Times

In response to the deep recession into which the U.S. economy began to descend in 2008, Congress has attempted to give taxpayers, including small businesses, a few tax breaks to help lessen the pain. Some of the major tax breaks for small businesses in general and others for companies that are experiencing losses or reduced income in the current tough economic environment, include the following provisions of the various economic stimulus acts that have been enacted in 2008 through 2010:

  • A major increase in first-year deductions under the Section 179 expensing rules and the new 50% (or 100%) bonus depreciation deduction, both of which have been extended several times, so that the Section 179 expensing deduction for new or used equipment has been increased to $500,000, with phase-out of the deduction beginning at the $2 million level (amount of assets placed in service) in 2010 and 2011, or a maximum deduction of $139,000 with phase-out beginning at $560,000 for 2012 acquisitions. In addition, 50% bonus depreciation for new equipment was extended from January 1 through September 8, 2010 and during the full year 2012, with 100% bonus depreciation allowed for assets placed in service between September 8, 2010 and December 31, 2011;
  • Eligible small businesses (with average gross receipts of $15 million or less for the last three years) were allowed to carry back their 2008 tax net operating losses for five years, rather than the two year carryback previously allowed, enabling small businesses that incurred tax losses in 2008 to obtain a refund of taxes paid in as many as five previous taxable years; [38] (Note: Under the Worker, Homeownership, & Business Assistance Act of 2009, net operating losses from 2009 may also be carried back for as many as 5 years, and the extended carryback is no longer limited to small businesses.)
  • Businesses that buy back their debt at a discount recognize taxable gain, but a new law[39] permits businesses to delay recognition of such gain until 2014 and spread the gain that is recognized over five years, if the business purchased specific types of its debts in 2009 or 2010;
  • The Work Opportunity Tax Credit (discussed in Section 13.5 of this chapter) was expanded to cover two new classes of eligible hires -- "disconnected youth" and unemployed veterans.[40] Companies that hired members of those groups during 2009 or 2010 are eligible to take this tax credit. "Disconnected youths" are persons of ages 16-24 who are not readily employable due to a lack of sufficient basic skills and who, in the previous six months, have not been employed or attending any type of school. Legislation enacted on December 17, 2010 added additional classes of eligible hires to include certain needy families, after the date of enactment, and extended the Work Opportunity Tax Credit sunset date to December 31, 2011. (The Work Opportunity Credit has expired after that date, except for certain unemployed veterans hired before December 31, 2012.); and
  • The research and development tax credit (R & D credit) that had expired at the end of 2009 was reinstated for the years 2010 and 2011.

Relaxed Rules for Cell Phones Issued to Employees

In addition to the above tax breaks for small businesses that have been enacted into law, the Internal Revenue Service has also eased up on the requirements for deducting the costs of an employer-provided cellular phone. Congress has long since defined cell phones as "listed property,"[41] meaning that they were subject to strict record keeping and substantiation requirements, like cars or computers used in a business. Accordingly, except to the extent the employee could document the business use of the phone, the cost of it would be taxable compensation (income) to the employee.

However, the I.R.S. has issued Notice 2009-46,[42] in which it outlined three possible methods by which an employee can establish the business use of a cell phone that is supplied by an employer, without keeping detailed logs (who, when, what business was discussed) of each use of the phone. These three methods are as follows:

  • The Minimal Personal Use Method. An employer-provided cell phone may be treated as used solely for business if the employee has his or her own personal cell phone and can produce phone records showing the personal phone was used for personal calls during work hours. The I.R.S. indicated it will also issue rules that define when personal use of a business cell phone is so minimal that it can be ignored, regardless of whether the employee personally owns a cell phone.
  • The Safe Harbor Method. An employer may simply treat a cell phone issued to an employee as used 75% of the time for business purposes, so that only 25% of its cost is taxable to the employee, with no record keeping required of the employee.
  • The Random Statistical Sampling Method. An employer may use an approved statistical sampling method, such as those used by CPA's in audits, to determine the percentage of personal use by the employee.

This 2009 policy pronouncement by the I.R.S. was designed to make compliance with the tax law requirements much simpler and more predictable for businesses and their employees to whom cell phones are provided, so that it will not be necessary for the employee to keep a log describing the business (or personal) nature of every call made or taken on the phone. At a time of widespread economic adversity, this is a welcome development for small businesses. As noted below, however, Congress and the I.R.S. have recently gone even further in relaxing the tax rules for employer-provided cell phones, apparently making the above rules irrelevant.

UPDATE NOTE:
For years beginning after December 31, 2009, cellular phones are no longer defined as "listed property" for tax purposes. Under the Small Business Jobs and Credit Act of 2010, cell phones are thus no longer subject to strict substantiation requirements in order to be depreciated and cell phones and other similar devices provided to an employee predominantly for business purposes are now excludable from the employee's gross income.[43]

While the new law removed cell phones from the "listed property" definition and the heightened substantiation rules that apply to "listed property," the regular fringe benefit rules still apply to cell phones if they are given to employees as a form of additional compensation. Any fringe benefit provided by an employer to an employee is presumed to be income to the employee unless it is specifically excluded from gross income by some section of the Internal Revenue Code, such as the provision that a "working condition fringe benefit" can be excluded from gross income.[44]

Fortunately, the I.R.S. has provided new guidance, in Notice 2011-72, as to how employer-provided cell phones will be treated for income tax purposes after December 31, 2009, including guidance as to when cell phones will qualify as "working condition fringe benefits."[45]

The Notice states that when the cell phone is provided for non-compensatory reasons, it will be excludable from income as a working condition fringe benefit and gives three examples of what would be considered non-compensatory reasons for providing cell phones to employees:

  • The employer's need to be able to contact the employee at all times for work-related emergencies;
  • The employer's requirement that the employee be available to speak with clients at times when the employee is away from the office; and
  • The employee's need to speak with clients located in other time zones at times outside of the employee's normal work day.
Another provision of the tax law allows employees to exclude "de minimis" (minimal) fringe benefits where accounting for such small benefits would be unreasonable or administratively impracticable. Notice 2011-72 also addresses the question of whether an employee's personal (non-business) use of a cell phone is a de minimis fringe benefit. It (generously) concludes that the I.R.S. will now treat the value of any personal use of a cell phone that is provided by the employer primarily for non-compensatory business purposes as also being excludable from the employee's income, as a de minimis benefit.

On the other hand, Notice 2011-72 points out that a cell phone that is provided to promote the morale or good will of employees, to attract a prospective employee, or as a means of furnishing additional compensation to an employee is not provided primarily for non-compensatory business purposes and is thus a taxable fringe benefit.

13.8 Federal Tax Changes for 2012 and 2013

TAX CHANGES OCCURRING IN 2012

Although the Bush tax cuts were generally extended through the end of 2012, a number of important tax incentives expired on January 1, 2012, and various other new tax laws went into effect. The following are some of the major 2012 tax law changes from 2011:

  • Social Security (FICA and Self-Employment Tax) Wage Base Increase. After several years of no change in the $106,800 wage base on which FICA and self-employment taxes are imposed (other than the Medicare portion, which applies to 100% of wages), the wage base was increased to $110,100 in 2012, the first change since 2009.
  • Decrease in FICA and Self-Employment Tax Rates. For 2012, the 2% reduction in the FICA payroll tax rate on employees and in the self-employment tax rate has been extended through the end of the year (after an initial 2-month extension). However, Congress has allowed this tax reduction to expire after December 31, 2012.
  • Work Opportunity Credit Has Expired, Generally. The Work Opportunity Credit for hiring various classes of individuals has expired on December 31, 2011. However, the credit has been extended and, in some cases expanded, for certain unemployed veterans, until the end of 2012.
  • AMT "Patch." The "patch" in the federal alternative minimum tax (AMT), which has temporarily increased the AMT exemption for individuals in recent years, expired on December 31, 2011, so that many more, perhaps millions more, taxpayers would have been shocked to find that they owed AMT in addition to regular income tax when they filed their 2012 income tax returns, if Congress did not act to extend the "patch." Fortunately, the "fiscal cliff" legislation, enacted in January, 2013 (the American Taxpayer Relief Act of 2012), has extended the AMT "patch" and made it permanent and will also index the AMT exemption amounts in the future.
  • 3% Government Withholding on Payments To Contractors Repealed. The 3% withholding requirement on federal, state, and local government payments to businesses contracting with such government entities was initially to go into effect in 2011, but was twice postponed, to 2012 and then to January 1, 2013, but has now been repealed entirely by legislation enacted in November of 2011.
  • Qualified Small Business Stock Provision Expired. For certain small business stock acquired after September 27, 2010 and before January 1, 2012, taxpayers may be able to exclude 100% of the capital gains when such stock if sold, if various requirements are met. For such stock acquired between February 18, 2009 and September 27, 2010, the exclusion percentage was 75%, and was 50% if acquired before February 18, 2009. Beginning January 1, 2012, the exclusion percentage was to revert back to 50% of the gain for stock acquired on or after that date, but the 100% exclusion has now been extended for qualifying stock acquired between September 27, 2010 and January 1, 2014.
  • Recovery Period for Certain Real Estate Improvements. The 15-year recovery period for depreciating certain qualified leasehold improvements, qualified restaurant property, and qualified retail improvements was to revert back to 39 years for property placed in service in 2012 or later. However, the "fiscal cliff" legislation in early 2013 has restored 15-year recovery periods for these classes of assets for two more years, 2012 and 2013.)
  • 100% Bonus Depreciation Expired. The 100% bonus depreciation allowed on various types of depreciable property in 2011 is reduced to 50% of cost for eligible property placed in service in 2012.
  • Expensing of Environmental Remediation Costs. The ability to immediately expense environmental remediation costs has expired, for such costs incurred after December 31, 2011.
  • Section 179 Expensing of Assets. The allowance for expensing up to $500,000 of certain business assets in 2011 has expired, and applies only to a maximum of $139,000 of such assets in 2012. Phase-out of the Section 179 deduction, which applied in 2011 only when more than $2,000,000 of Section 179 property was placed in service, begins at $560,000 in 2012.
  • The R & D Credit Expired. The research and development (R & D) tax credit expired on December 31, 2011, unless retroactively reinstated by Congress, as it has been many times in the past. (Congress has done so, extending the credit two more years, through December 31, 2013.)
  • Estate Tax Exclusion Increased. Under indexing provisions of the federal estate tax law, the lifetime estate tax exclusion or exemption increased from $5 million in 2011 to $5,120,000 in 2012.
  • Employer provided transit passes. The fringe benefit allowance for transit passes, which was the same as the exclusion for parking benefits, was scheduled to drop from $230 to $125 in 2012, but will instead remain the same as the parking benefit exclusion in 2012 ($240) and 2013 ($245).
  • Standard Mileage Allowance. The standard mileage allowance for business use of an automobile, in lieu of interest, taxes, and operating expenses, is 55.5 cents per mile in 2012, as it has been since July 1, 2011 (increased to 56.6 cents on January 1, 2013).

TAX CHANGES SCHEDULED TO OCCUR IN 2013

While many of the Bush era tax cuts were scheduled to expire on January 1, 2013, Congress finally enacted last-minute legislation that was signed into law (remotely, from Hawaii) by President Obama on January 2, 2013, extending many of the Bush tax cuts, except for high-income individuals, as described below. Other scheduled tax increases, such as new income and Medicare taxes under Obamacare, went into effect as scheduled on January 1, 2013.

  • Bush Tax Cuts Expired for High-Income Taxpayers. The significantly lower "Bush tax cuts" tax rate schedules that have applied for the last ten years were to expire after 2012, causing across the board tax rate increases on all taxable income in 2013, but have been made permanent, except for high income taxpayers. The maximum tax rate on income of individuals increases from 35% in 2012 to 39.6% in 2013 and itemized deductions will phase out in 2013 for single filers with over $250,000 of adjusted gross income (AGI), heads of household with AGI over $275,000, or married couples with over $300,000 of AGI. The higher regular tax rates are imposed by a new tax bracket that applies only to single individuals with taxable incomes over $400,000, heads of household with taxable incomes over $425,000, or married couples filing jointly with taxable incomes over $450,000.

    A 39.6% tax rate also applies to the taxable income of estates and trusts in excess of $11,950 in 2013.
  • Special Tax Rates on Dividends and Capital Gains. The special (reduced) 0% or 15% tax rate on "qualified dividends" and long-term capital gains was to have expired in 2013, reverting back to 20% on capital gains and a taxpayer's regular tax rate for dividends. However, the "fiscal cliff" legislation, the American Taxpayer Relief Act of 2012, extends the 0% or 15% rates for most taxpayers, except that a 20% rate now applies (in 2013) to capital gains for single taxpayers over $400,000 of taxable income, heads of household with over $425,000 of taxable income, or married couples with incomes over $450,000. In addition, as noted in the next paragraph, an additional 3.8% income tax now applies to capital gains and other net investment income of certain high-income taxpayers, beginning in 2013.
  • New Health Care Reform Tax on Investment Income. Under Obamacare, a new 3.8% income tax is imposed on the LESS