7 things to do when starting a business to avoid nasty surprises

The only thing that hurts more than paying an income tax is not having to pay an income tax. Thomas Dewar

When you decide to start a business, taxes may be the last thing you think about. However, not realizing that you owe the self-employment tax as well as income taxes can lead to a nasty surprise when you file your taxes. This post is aimed at avoiding that costly surprise.

But, before we discuss the self-employment tax, there are other important steps to take when you become self-employed. Here are the 7 things to do after you start your own business to avoid nasty surprises:

Avoid nasty surprises – set up bookkeeping, form your entity, get licensed, buy insurance, and pay taxes

Bookkeeping – set up bookkeeping using software like QuickBooks (either online or on your laptop). You don’t want to be scrambling to find receipts at tax time or not be able to tell somebody if you are making money or not.

You can save time by downloading from your bank and credit card companies. If you set up things well, all income and every expense will be properly categorized for your profit and loss statement, or P&L. The P&L and balance sheet help you monitor your business to see how well you are doing and are essential for preparing your tax returns. The balance sheet will also come in handy if you need to apply for financing.

For all these steps, you may want to hire an accountant or speak to an attorney.

Entity – for many small businesses, being a sole proprietor is appropriate. You avoid paying corporate excise taxes and filing annual reports. However, if you have partners, you may want to form a partnership, corporation or LLC (details on choosing are beyond the scope of this post).

If your business involves risks that could lead to law suits, form a corporation or LLC to shelter your personal assets from liabilities of the business that insurance may not cover. Make sure that any actions you take for the business are in your capacity as an officer or manager – i.e., never sign personally.

Remember, you may want to consult with an attorney.

Get licenses, file annual reports and pay local taxes – certain businesses require a license to operate. Most entities are required to file annual reports. And, your city may impose taxes on the personal property in your business. Be sure to find out so you don’t owe penalties for failing to file and pay.

Buy health and other insurance – in addition to liability insurance, you will want to obtain health insurance if you are no longer working for another employer. You may get favorable treatment for this expense on your income taxes. You can also purchase insurance to cover damage to equipment, loss of data, identity theft and so on.

File payroll taxes – if you hire people to work for you and pay them over $600 per quarter in any year, you need to report the compensation. If they are independent contractors, you file a form 1099 with the IRS. If they are employees, you file a W-2 with the Social Security Administration. You also provide these forms to your people for the income tax filings.

You may need to withhold and remit FICA and Medicare taxes. Also, your employees may request that you withhold and remit federal and state income taxes (unless you live in a state that does not impose income taxes). Failure to withhold and pay to the IRS and state can lead to serious penalties.

Pay your income tax – one big shock for many who start a business is how much they owe in taxes. When you received a paycheck, you probably did not focus much on the fact that your employer withholds federal and state income taxes and FICA and Medicare taxes. And, you never had a chance to spend what was withheld.

However, when you run your own business, you have full access to the pre-tax income, so you must diligently allocate funds ahead of time so that you don’t come up short at text time. To avoid owing interest on the taxes due, you make estimated tax payments each quarter to the IRS and state.

Pay the self-employment tax – when you were an employee, your employer withheld FICA and Medicare taxes from your paychecks. The employer also contributed FICA and Medicare taxes on your behalf

When you become self-employed, you are responsible for both the employee and employer amounts. This tax is based on your net self-employment income

A lot to remember, right?

Maybe, but knowing and planning is far better than trying to scrape together money in April to cover taxes you did not expect.

Good luck with your new business!

In future posts, we will examine partnering with others, assessing your profitability, rules on deducting expenses, and entry into the real estate market.

 

Okay then, what is a financial plan?

You may hear some argue that robo-planners will not replace individual, human planners. I call them the “There’s no app for that” group.

We do believe that “There is an app for that.”
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Well, that is not what I had in mind.

But exactly what is “a financial plan”? Finding a good, workable definition is a challenge.

Wikipedia says:

Textbooks used in colleges offering financial planning-related courses also generally do not define the term “financial plan.” For example, Sid Mittra, Anandi P. Sahu, and Robert A Crane, authors of Practicing Financial Planning for Professionals[8] do not define what a financial plan is, but merely defer to the Certified Financial Planner Board of Standards’ definition of ‘financial planning’.

Can’t we define “financial plan”?

Yes. Investopedia offers this broad definition:

While there is no specific template for a financial plan, most licensed professionals will include knowledge and considerations of the client’s future life goals, future wealth transfer plans and future expense levels. Extrapolated asset values will determine whether the client has sufficient funds to meet future needs.

And Wikipedia gives more detail:

In general usage, a financial plan is a comprehensive evaluation of an individual’s current pay and future financial state by using current known variables to predict future income, asset values and withdrawal plans. This often includes a budget which organizes an individual’s finances and sometimes includes a series of steps or specific goals for spending and saving in the future.

So you need to project where your assets can take you to be sure you meet your future in good shape. Makes sense

And what is my definition?

A to do list or “action plan” that tells you what you need to change now so you optimize the use of all your resources to achieve your major, long term goals in the future.         

So what does a financial plan look like?

If you paid to have a financial plan prepared, and have a complicated situation, you may get a glossy, bound book filled with projections, charts and graphs, plus text. While much of it may be boilerplate, it will tell you where you are going from now until you die, how your money will follow if you invest according to the plan, and what you need to change on taxes, insurance, and your estate plan.

At the other extreme, you can glean the essential steps and write them all on a PostIt note, which you then place in a spot you see often enough to remind you what to do:

  • Maximize my 401(k) contributions,
  • Set up and contribute to a Roth IRA,
  • Review my investment allocation, use ETFs,
  • Steer clear of any major credit card debt,
  • Review my beneficiary designations,
  • Sign an medical directive, and
  • Save enough for a fun (not too expensive) vacation next summer!

In the end, it doesn’t matter how many pages or what the plan looks like; what matters is that you learn from reviewing your finances and change how you manage your resources so that improve your finances.

So, yes, a simple to do list could be enough, if you follow it!

If you help support others, you need life insurance and an estate plan – really

Purchasing adequate life insurance and doing your estate plan, meaning signing a will and creating a trust, are probably low on your list.

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If you help support others, I hope you will rethink your priories. I will give you two good reasons that you should:

I saw the confusion and pain a wife had to address when she lost her husband, before he bought the life insurance he had promised to obtain, and had to help her kids adjust to the massive change of lifestyle as they sold their home and downsized because they could no longer afford what their dad, the chief income earner of their family, had provided them. If they had proceeds from his life insurance, they would have only been dealing with the grief of losing him.

I saw adult children deal with the probate process so they could be appointed administrators of their mom’s estate just to be able to access bank accounts, pay funeral expenses and then sell and distribute the remainder of her assets, making their own decisions in place of knowing what she would have wanted.

If you have not obtained life insurance to replace your earning power, which helps support your family, and if you have not executed a will, along with a trust, medical directive and other documents that may be appropriate, you are not just avoiding an inconvenient imposition on your time and the payment of premiums and fees, you are failing to properly think of the consequences of not acting and the impact that could have on your loved ones.

So please think again.

Estate planning overview update – key issues to consider for your wills & more

Whether you’re updating an existing plan or starting from scratch, this overview presents the key issues to consider when designing and executing the best estate plan. The work does not stop at signing your estate plan documents; you must also complete the follow up work of beneficiary designations, memorandum to fiduciaries, etc. The goal is to avoid the pitfall of having no plan and the disaster when wills and trusts are in place but the asset ownership and beneficiary designations frustrate the plan by having assets pass to the spouse and not the trust.

If you do nothing else after reading this, write and deliver a “Memorandum to Survivors” and review asset ownership, all as described at the end of this post. A comprehensive estate plan can accomplish many goals, such as providing for survivors, ensuring your children are cared for, determining the flow of your assets upon your death, and reducing the amount of taxes your estate will pay while administering your estate. The most important goal is that you have peace of mind knowing that your estate will be administered in accordance with your wishes.

Updating an Existing Plan
If you have a plan already in place, be sure to review it every couple of years. As you grow older, your life circumstances change and these changes may affect your wishes and plans for your estate. Events such as the emancipation of your children, divorce, lapsed relationships with fiduciaries will likely affect your estate plan. Keep these matters in mind when reviewing the remainder of this post. Your change of circumstances could change your pyramid level.

Estate Planning Pyramid
Constructing a pyramid can be helpful for understanding all that goes into an estate plan, much like nutrition and investments. Each level of the pyramid addresses a new level of complexity in your family and financial situation – that is, everyone needs level one, but not all need the later, more complex levels.

Pyramid: Level One
The first level of estate planning provides the most basic protections so it is most suitable to single individuals with no children and few assets. This level of estate plan typically includes the following forms:

  • Health Care Proxy: This document allows you to appoint people to make decisions about your health care and treatment when you are not capable of doing so. You typically select the surviving spouse and then have a first and second alternate if you wish. Some states call such documents “medical directives” or “medical powers of attorney.”
  • Living Will: This makes your wishes clear as to whether or not you want to have heroic means used to prolong your life.
  • Anatomical Gift Instrument: This allows you to have a hospital use organs and other body parts for others in need of a transplant.

Pyramid: Level Two
The second level is most appropriate for individuals in committed relationships. This level includes all the forms listed in the first level, but adds a durable power of attorney. This document grants a power of attorney to the other to manage your financial affairs if you are absent or you become incapacitated.

Pyramid: Level Three
When you have children, you want to ensure that they will be both cared for and provided for in the manner you wish. To achieve this, you need a will to appoint a guardian, for the “care,” and create a trust to manage assets, for the “providing.”

  • A will is a formal document that designates your personal representative or executor, any alternates, plus a guardian and any alternates for children under age 18, then instructs your personal representative to pay off your debts, and distribute your estate per your wishes.
  • A trust is an entity that you create and can be used for many purposes. The trustee acts as the owner of what the trust holds, while the beneficiaries get all the benefits from what the trust holds. For estate planning, trusts are used to reduce estate taxes in various ways. Trust vehicles can also describe how and when assets are distributed. For example, the grantor of a trust could insist that assets not go to children until they are age thirty-five. The trust vehicle could also provide where assets flow if all family members die without issue. For example, assets could flow to a charity or educational institution.

  Providing for Survivors: You need to address how your assets and any life insurance flow after your death in order to ensure that your resources allow those who survive you to maintain the same standard of living, during their life expectancies, that you all had during your life. If your investments are not sufficient, even after making liquid certain kinds of personal property (e.g., a second home), then there is a need for life insurance.

Life Insurance: Term insurance, providing only a death benefit, funds the shortfall between assets required to maintain the lifestyle of the survivors and actual assets available. Whole life, variable or other types of insurance should only be used when permanent insurance is required, as in the case of maintaining estate liquidity throughout your lifetime.

Flow of Assets: After you determine the assets required to support the lifestyle of the survivor, you determine to whom the assets flow. For example, at Levels One and Two, you can leave everything directly to survivors, while at Levels Three to Six, you use a trust, and at Level Six you may even separate some portion of the assets by gift now.

Control Over Assets: In Levels One and Two, the survivors have complete control over the assets. At higher Levels, trust vehicles are used for the estate tax savings. However, you also gain a heightened level of attention on the assets: you have engaged a trustee to focus on providing for the surviving spouse, maintaining his or her lifestyle, while still attending to the interests of other beneficiaries, such as children. In this way, the trustee will try to preserve the trust assets in the best way possible for the longest duration. Finally, the trustee must distribute the assets per your instructions; if assets went to a survivor, they are not bound in any way to follow your wishes, so you may not achieve your estate planning goals.

Fiduciaries: In designing the estate plan, many choices revolve around the fiduciary that you select for a particular role.

  • Personal Representative or Executor: This is the person who “marshals” all assets of the estate together, pays death expenses and transfers ownership of property to the surviving spouse or trust. This is approximately a nine-month task.
  • Guardian: This is the person whom you select to love and care for your children in your absence. The spouse selects the surviving spouse and then a second or third choice beyond that. This job lasts until each child has reached majority (age eighteen).
  • Trustee: This person has potentially the longest-term job because he or she must manage the trust assets and make distributions of income and sometimes principal to the surviving spouse, children and even grandchildren. Depending on the terms of the trust, this job could last until the children are young adults.
  • Beneficiary Designations and Ownership: ownership and how life insurance proceeds and retirement plan assets flow is described below.

Pyramid: Level Four
This level of planning addresses state taxes. When the potential combined estate of a husband and wife exceeds $1 million, and they have other beneficiaries for whom they want to maximize the estate after taxes, then trusts are typically used. States such as Massachusetts impose an estate tax over $1 million. Other states have similar amounts, but many are increasing, such as New York which will match the federal credit in 2019. Therefore, additional planning is required if you reside in a state with an estate tax.

Pyramid: Level Five
The fifth level contains trusts that address federal estate taxes, as well as state. Congress has retained the unified gift and estate tax credit, now at approximately $5.34 million (inflation adjusted) with a 40% estate tax rate (up from 35% last year). In addition, the unused portion of the estate tax credit of a deceased spouse is “portable”, allowing it to pass to the estate of surviving spouse.

With the trust structure, sub-trusts can be created so that both the credit and the marital deduction are used. This structure takes advantage of the credit at the first and second deaths. In contrast, wills that pass all assets outright to the surviving spouse would only take advantage of the credit at the second death. The total tax savings for an estate of $10 million or more is excess of $1.75 million for the combined estates.

  • Life Insurance Trust: You can also make an irrevocable trust the owner of any insurance on your life to exclude all proceeds at death from both estates, avoiding estate taxes. That is, the proceeds are completely estate tax free. However, this requires an irrevocable transfer to the trust; you cannot get the insurance back out. You can use this trust to receive insurance proceeds that can pay for estate taxes, thereby preserving more of your estate after taxes without increasing the taxable estate.

Pyramid: Level Six
The final level is for complex estate planning that minimizes federal and state estate taxes through multiple generations. An example of this is a generation-skipping trust. These trusts transfer assets from the grantor’s estate to his or her grandchildren. This is what allows the grantor’s estate to avoid taxes that would apply if the assets were transferred directly to his or her children. The grantor’s children can still enjoy financial benefits of the trust by accessing any income that is generated by the trust while leaving the assets in trust for grantor’s grandchildren.

  • Other entities: Separating assets by gift now would be important if you wanted to ensure some minimum funding for children, such as guaranteeing coverage for their college expenses.
  • 529 Plans: you can use 529 plans or trusts for gifting to cover college costs of a child.

After the Plan has been Executed – Ownership and Beneficiary Designations
Once the documents and insurance are in place, make sure to review and complete the following:

Qualified Plans (IRA’s, 401k plans, etc.):

  • Primary Beneficiary – to the surviving spouse (so he or she can roll over the proceeds to an IRA and thereby defer income taxes); and
  • Secondary Beneficiary – to your children (or your own revocable, depending on whether you want the assets controlled or available to children).

Life Insurance and Annuities:

  • Primary Beneficiary – when not owned by an irrevocable trust, such as group term, to your own revocable trust (for estate tax benefits, e.g., using credit at first death); and
  • Secondary Beneficiary – to the surviving spouse (in case of trust has been terminated for some reason).

Other Assets
Consider changing ownership of any jointly held assets to ownership by one of you. Any assets held as joint tenants with rights of survivorship will go to the survivor by operation of law and never get to your revocable trust. (You want to be sure that you have sufficient assets going to the trust to realize the full tax reduction effect.)

You may even want to fund your trusts, moving investment accounts over to your own revocable trust. This has no impact on your income taxes. You can also choose to fund your revocable trust now. This will save a significant amount of time for the executor, and the attorney he or she hires, as this will need to be done after your death otherwise.

Memorandum to Survivors
Compile a reference book or add to your financial plan book photocopies of important papers, identifying where the originals are, then adding a list of important contacts, instructions to your executor and trustee and other important notes for family and friends. You would update this at least annually with new asset statements (consider this as you gather information for preparing your taxes). To be more specific, the list (and copies) should include:

  • Location of original will, trust, etc.;
  • Location of health care proxy and durable power of attorney;
  • List of professionals with contact information: doctor, attorney, CPA, etc.;
  • List of fiduciaries with contact information: health care proxy, guardians, executors and trustees, attorney-in-fact for durable power of attorney, etc.;
  • Location of insurance policies and valuables such as original titles, etc.;
  • Location of safe deposit box for valuables and items in #5 or 7;
  • List of all bank and investment accounts and location of any stock certificates or other documentation for investments;
  • List of all mortgages, loans and credit card accounts;
  • Any appraisals or other listing of items by value;
  • All automatic debits that need to be addressed (stopped, changed); and
  • List of all password protected accounts (e-mail, on line banking and credit cards, etc.) and where to locate the passwords… and the password to access the password.

Please see planning-for-the-inevitable-end-of-life-services for more ideas on such memoranda. Also, after you review this overview, let us know how we can help you get your estate plan in order.

Your family will appreciate it.

Plan now to avoid surprises from the Affordable Care Act when filing 2014 taxes

2014 was the first year Americans had access to health insurance options through the Affordable Care Act (the “ACA”). With this new access to insurance came the obligation to purchase it or face new tax consequences. If you opted not to buy health insurance in 2014, you may be faced with a penalty when you file your 2014 tax returns. Even if you did buy insurance through one of the insurance marketplaces, you may have new tax forms to complete and some surprises when it comes to your refund or tax bill.

For most taxpayers, the impact on their tax filing will be minimal, requiring those who were covered to simply check a box indicating they had insurance throughout the year. Those who received subsidies to purchase insurance and who later had increases in their 2014 salary may be required to pay back some of that subsidy. Those whose salary decreased may receive a larger than expected refund.

As these provisions are new to everyone, there may be confusion for taxpayers and tax preparers alike. Unfortunately, due to recent budget cuts, the IRS expects to be able to speak with only half of the people who call in for assistance.

While gearing up for the 2014 tax season, it’s helpful to understand some the most important provisions of the ACA:

  • 1. Exemptions: The ACA provided some exemptions that allow taxpayers to opt out of purchasing insurance without any penalties, including hardship, affordability and religion. There are different methods for applying for an exemption depending on the type of exemption you are requesting. To learn more, go to: https://www.healthcare.gov/fees-exemptions/apply-for-exemption/
  • 2. Penalties: Those who do not qualify for an exemption, were insured for only part of the year, or remain uninsured will be required to pay a penalty called “The Individual Shared Responsibility Payment.” The penalty is set to increase over the coming years, so compare not to see if it is more beneficial for you to pay the penalty or buy insurance. The Tax Policy Center has designed a calculator to help you determine your penalty is you opt to remain uninsured: http://taxpolicycenter.org/taxfacts/acacalculator.cfm.
  • 3. Reconciling: Those who purchased subsidized insurance on the exchanges received an advance on a tax credit. At the time of requesting the subsidy for insurance in 2014, the amount of the subsidy was calculated based on the taxpayer’s 2012 income. The amount of the subsidy granted will be reconciled in the taxpayer’s 2014 filing using the taxpayer’s actual 2014 income and that will affect the taxpayer’s refund or bill. Changes in an individual’s personal circumstances, such as divorce, marriage or a new child can also impact those numbers.
  • There’s still time to plan. Taxpayers facing a loss in premium subsidies because of an increase in income can reduce their income to qualify for the credits. For example, they can contribute to an IRA by April 15, 2015, for the 2014 tax year.