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.

 

Estate planning – your homework before and after

Before – what you have to do to get the proper documents executed

Estate planning and the analysis of life insurance connect in the following way, so you want to do the analysis with your financial advisor in order to make sure that the survivors have sufficient resources to maintain the same lifestyle during their life expectancy. The reason that the analysis of life insurance should be done before deciding on what documents you need for your estate plan is that you may choose to increase your death benefit, which could change the size of your potential estate, thereby changing the estate tax planning. That is, if the investable assets are not sufficient, even after making liquid certain kinds of personal property (e.g., a second home), then there is a need for additional life insurance.

In most cases, the type of insurance to be acquired is term insurance. This is merely a death benefit used to fund the shortfall between assets required to maintain the lifestyle of the survivors and actual assets available. Whole life 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.

After you determine the assets required to support the lifestyle of the survivor, you determine to whom the assets flow. For example, you could leave everything directly to the survivor, you could separate some portion of the assets by gift now or at death to go directly to children or you could have a trust control the division of assets as needed over time. 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.

Selection of fiduciaries is next: In determining the final estate plan, many choices revolve around the fiduciary that you select for a particular role. For example, people who typically would have chosen to have all assets flow to the surviving spouse become willing to use trusts when they realize that the person whom they expect to select as trustee will make decisions that they would have made had they survived. The fiduciaries that must be put in place include the following:

a) 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.

b) 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 in Massachusetts).

c) 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.

The trustee acts as the owner of assets and manages the investments, taxes and distributions. The trustee can delegate this work, and review what people he or she hires complete for the trust and beneficiaries.

d) Medical representatives and attorneys in fact: you will also want to select people to make medical decisions and manage your finances is you are not able.

After – what you have to do after you have the proper documents executed

Make sure that you update all of your beneficiary designations:

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 should also consider compiling a reference book or adding 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:

* 1. Location of original will, trust, etc.
* 2. Location of health care proxy and durable power of attorney
* 3. List of professionals with contact information: doctor, attorney, CPA, etc.
* 4. List of fiduciaries with contact information: health care proxy, guardians, executors and trustees, attorney-in-fact for durable power of attorney, etc.
* 5. Location of insurance policies and valuables such as original titles, etc.
* 6. Location of safe deposit box for valuables and items in #5 or 7
* 7. List of all bank and investment accounts and location of any stock certificates or other documentation for investments
* 8. List of all mortgages, loans and credit card accounts
* 9. Any appraisals or other listing of items by value
* 10. All automatic debits that need to be addressed (stopped, changed)
* 11. 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 passwords!

Let us know if you have questions or comments. Thanks,

Steven

Comments on health insurance, tax changes and asset allocation (not even having all investments in cash is safe)

Investing
Starting with my reoccurring theme of asset allocation, I post below two comments on investing.

The first short comment from Morningstar reaffirms that you need to diversify by class, as well as in each class, of investment.

The second comment from Merrill Lynch provides a year to date summary of returns, showing that the people who tried to market time, by going to cash last year, missed out on substantial returns by being out of the stock markets in 2009.

Finally, as another example on diversifying, we had some clients invest in Euro bonds. They made over 20% in the last two years, which is much having gone to cash.

So, again, I urge anyone who has not reviewed their allocation to do so now …..

Tax impact of Health Care Reform
On the health care reform and its impact on your taxes, I reprint a section from the Kiplinger’s Tax Letter below.

As with many other sources, they believe a bill will pass and that it will have an impact on taxes.

The impact is likely to be predominately on people with income in excess of $250,000, but not beginning until 2011. When we know more on this, we will give you an update.

Estate Taxes
Kiplinger’s expects Congress to keep the estate tax much like it is today, rushing to avert the year of no estate tax and the year after or a $1 million credit (we now have a $3.5 million credit)…

Kiplinger’s also has comments on the “cash for clunkers” and changes likely in 401(k) plans…..

Let me know if any of this raises questions or comments please. Thanks,

Steven

From Morningstar:
Theoretical and empirical research, as well as long-term data from financial markets, confirms that risk is minimized significantly and performance can be enhanced when a portfolio holds, for long periods of time, different asset classes with dissimilar price movements. This approach, which fulfills the fundamental underlying objective of modern portfolio theory, is also in accord with the standards of modern prudent fiduciary investing.

From Merrill Lynch:
…. In the meantime the S&P 500 Index had its best quarterly return since 1998, rising almost 16%. Most US equities rose sharply in the second quarter as investors regained their appetite for risk; investors bid up stocks beginning in March after it appeared that the financial sector had stabilized and this momentum continued through the second quarter. Investors seized upon indicators such as retail sales, industrial production and ISM survey data that suggested economic growth, although weak, was showing improvement. Indeed, retail sales and durable goods orders were higher than expected and employment figures showed a moderation in worsening trends. After the strong end to the first quarter, analyst estimates for company earnings were on average revised higher as the depression scenario faded into memory. During the quarter, the riskiest assets were bid up the most, with the Russell 2000 Small Cap Index returning more than 20%.
Outside the US, the story was similar: markets improved sharply on the turn in economic data. The MSCI Emerging Markets Index had its best quarter in U.S. dollar terms since it was launched in 1988 – rising almost 35% in the second quarter…..

The Kiplinger Tax Letter (ISSN 0023-1762)
Health care reform may seem stalled for now, with both the House and Senate missing the deadline that Obama set for action on a bill…early August.
But work still goes on behind the scenes, so Democratic leaders can make a final push this fall.
Readers are asking what’s going to happen to the legislation and what it will mean for taxes.
We’ll share our answers to those questions.
What are the chances that no bill will pass?
Very unlikely, given all the political capital that the president has spent on this issue. He’s sure to insist Congress keep at it.
But if gridlock continues, Obama may have to accept a scaled down bill… a lesser expansion of the government’s role in providing coverage to the uninsured.
A smaller bill would lower the price tag, reducing the need for tax hikes. The odds of a big-ticket tax increase such as an income surtax would go way down. It wouldn’t be needed to offset higher federal spending from revamping health care.
Does a smaller bill mean no employer mandate? No, although the number of small businesses that would be covered by the mandate and the tax penalties for failing to provide coverage to employees would be smaller than originally thought. The tax would be somewhat less than the $750 per worker proposed in the Senate, and would be phased in for those businesses with payrolls that exceed $500,000. As first proposed, the tax would have covered firms with payrolls over $250,000.
Would a mandate apply beyond the private sector? Yes. The coverage rule and tax penalty are sure to cover nonprofit groups and state and local governments.
Could employers avoid the mandate by classifying workers as contractors?
Theoretically. However, it’s a risky move. Tax pros predict that a mandate would spur many firms to consider reclassifying employees to avoid covering them, forcing them to buy their own coverage. But you can expect that angry workers will squawk to the IRS, giving the agency lots of leads for employment tax exams.
Are middle incomers likely to see higher taxes to fund the overhaul?
Don’t rule it out. Lawmakers are considering, for example, a new tax on gold plated insurance plans. Those policies aren’t owned just by upper incomers. They are included in the contracts of many union members…police, firefighters, etc.
Would Congress consider making tax hikes start in 2010? Definitely not. Figure that 2011 would still be the earliest year that hikes would become effective.
Will continuing delays on health care push estate tax changes into 2010?
Not very likely. Lawmakers still intend to act before the end of the year to prevent the estate tax rate from dropping to zero in 2010. The exemption amount for 2010 will be kept at $3.5 million and the rate will stay at 45% for another year. The estate tax bill is sure to include extensions beyond 2009 of popular tax breaks, such as tax free IRA payouts to charity and the deductions for tuition and sales tax.

The “cash for clunkers” program has tax angles for people and businesses. Vouchers are tax free for individuals. Therefore, if you trade in a vehicle for a more fuel efficient one and get a $3,500 or $4,500 dealer credit on the trade-in, you owe no tax, even if the amount of the credit far exceeds the trade-in’s value. And if you purchase a qualifying hybrid or a lean diesel vehicle as a replacement, you still can claim the hybrid or diesel credit, even though the voucher isn’t taxed.
But car dealerships don’t benefit from the tax break, IRS officials say. The voucher amount is included in the gross receipts from the sale of the vehicle.

Many 401(k) plans will have a different look a couple of years from now. The economic downturn is prompting changes that firms will implement to reduce plan expenses and to prompt their employees to save more for retirement.
More employer payins will be discretionary. Although most plan sponsors that suspended matching contributions during the downturn will reinstate them, those payins won’t return before 2011, and they’ll probably be in a different form. Fewer firms will automatically match a set percentage of pay. More contributions will be tied to company performance. And many firms will stop obligating themselves to a contribution level at the start of the year but will wait until year-end to decide.
Companies will try to get more 401(k) accounts on autopilot to help workers boost savings. One idea: Having employee payins increase automatically each year until reaching a preset level…around 10% of pay…if the employee selects this option. The number of companies adopting automatic enrollment will continue to grow, though some will limit it to employees with at least two years of service. That way, firms can avoid incurring the administrative hassle and expense for short-timers.

Another subject:
Bad news from IRS for exchange-traded funds that invest in metals: Those funds do not qualify for the 15% rate on long–term capital gains. Instead, their top tax rate is 28%. It applies if the fund owned the metal for more than one year and the investor owned fund shares for over a year, IRS says privately.
The fund’s investors are deemed to own a share of the metal, such as gold, silver or platinum. The gain is treated as coming from the sale of a collectible.
The Service takes a different stance for IRAs investing in these funds. If the metal is held by an independent trustee, the Service will not treat the IRA as owning a share of the fund’s underlying metal. This favorable interpretation keeps the IRA from running afoul of the rule barring direct investments in bullion.