August 2020 – Newsletter – About Entities, Deductions, and Pricing

Introduction:

An old proverb once stated, “May you live in interesting times.”

An old proverb once stated, “May you live in interesting times.” But interesting is not how I would classify the current situation, and problems facing our country. Still, I hope that you are making the best out of these troubling times, that you and your family are happy and healthy and you’re doing your absolute best to enjoy the summer…just think in 3-4 short months, this will all be gone!

You may have heard this before, but difficult times are often the best incubators for action. It’s natural to feel overwhelmed, unfocused, and not as motivated as you normally might be when things are difficult, but this is the perfect time to act. Planning and preparation are fine, but unless you put your ideas and plans into motion, then, you’ve accomplished very little, if nothing. The best laid plans amount to exactly zilch if you don’t put them in play.

If your competition is lying low, act. Reach out to your clients or customers, past and present, just to say hello-act. Keep your social media up to date…post a photo, an event, celebrate a business win-but, act. Yes, Business Owners need to dream and have vision, but they need to translate that vision into actions that get them from where they are to where they want to be.

Take some time to think about expanding your service or product offering, consider how best to position your product or service to best highlight and strengthen your brand. Accounting is a necessary tool and requirement for your business, but Marketing, successful marketing, is (much) about perception and positive perception drives value. If you cannot create value, you won’t need an Accountant!

As your business evolves, you’ll go through many, many changes. You’ll think, plan and implement only to find out that your product or service is not as well received as you anticipated. There will be “misfires,” “rabbit holes,” and “dead ends.” If you’ve given these plans enough time, then act by changing course. Cut your losses, change the way you’re promoting your product or service, try and target different customers if you think their needs (and problems) better align with the solutions your product(s) or services, offer. Most importantly, know when it’s time to stop thinking and act.

Ok, let’s refocus to all things Accounting. Three topics are presented in this short Newsletter – Entities, Deductions and Pricing. I hope to pick two or three short topics in these newsletters (going forward) to give my Client’s a better understanding how these topics impact them and their business with recommendations and suggestions to assist them in solving a potential problem. No jargon or technical details here. Just some short situations that summarize the importance of the topic making it as interesting as I can without curing you of your insomnia.

If you end up reading these short posts and come away feeling you got something out of it, then I’ve done my job! Share it, pass it along. My focus is to make you, more successful. I believe in sharing information – Accountants that don’t share information give the profession a bad name (IMO) and they piss me off.

Entities:

Explained: LLC’s, Partnerships, S-Corporations and Sole Proprietors 

This is where a lot of Business Owner’s need help and have questions. Let me briefly recap a few things before going further. Single Member LLC’s (SMLLC’s) are entities that are created at the State level. For Federal Tax purposes, SMLLC’s are the same as Sole Proprietors. A Sole Proprietor Business Owner is “inseparable” from his/her business. In other words, the Proprietor and Business are one and the same and the IRS refers to Sole Proprietorships as “disregarded entities.” Multiple Member LLC’s (Partners) are taxed as Partnerships and S-Corp’s are different (their Owner’s are Shareholders).

You can create an SMLLC at the State level but petition (through an election – Form 2553) the IRS to tax the LLC as an S-Corp for federal tax purposes. Why is this beneficial? S-Corporation Shareholders enjoy certain tax advantages if the S-Corp generates enough net income to take advantage of these benefits, but there’s a catch. The IRS imposes certain requirements on S-Corp Owner/Shareholders that must be met. Here’s one – the reasonable salary requirement. These Shareholders actually wear two “hats,” Shareholders are Owners, but they’re also employees, and they’re required to take a “reasonable salary.”

I’ll go into some detail here. There are two distinct (tax) advantages for electing S-Corporation status – 1. Avoiding Self-employment taxes, and 2. That S-Corporation Owners (Shareholders) can deduct their (reasonable) salaries against the earnings of the S-Corp.

Self-employment taxes are very detrimental. Few Owners make quarterly tax payments throughout the tax year to help defray the amount of tax owed when the Owner files their taxes in the year following the tax period. So, they’re stuck with a tax payment that includes a (Self-employment tax) of 15.3% on the net income (earnings) of the business. S-Corporation Owners (Shareholders) are required to take a reasonable salary with federal tax withholding as well as for Medicare and Social Security tax (same as Self-employment tax). These Shareholders “pay as they go,” throughout the year, so they don’t get stuck with a large tax when they file.

Secondly, Shareholder salaries are deductible against the net income (earnings) of the S-Corporation, reducing taxable income that is assessed on the Shareholders personal (1040) tax return. Payments made by an LLC, Partnership or Sole-Proprietorship to a Member, Owner, or Partner is NOT deductible against net income (earnings). This is probably the most glaring distinction between S-Corporations (including C-Corporations otherwise referred to as large Corporations) and other entities.

In addition, you can incorporate at the State level (as a Domestic Corporation) but State’s usually impose their own requirements as well. S-Corporations (or small corporations) are unique in that they are a “hybrid” between what the IRS refers to as disregarded entities and Corporations. They are also considered a separate entity, distinct from their Owner/Shareholder(s).

Sole Proprietors show their business expenses on a Schedule C as part of their 1040 tax filing. S-Corp’s are required to file a separate 1120S Tax Return. Owners/Shareholders declare their share of the income/losses of the S-Corp on their 1040 personal return by way of a K-1. The K-1 is the link between the S-Corporation return (an informational return) and the Shareholder’s personal return. Sole Proprietorships, LLC’s, Partnerships and S-Corporations are not taxed directly on their net earnings – these entities are referred to as “pass-through entities.” Gains, losses, income and expenses are detailed on the Owner’s personal tax return. For Partnerships (Partners) and S-Corporations (Shareholders), gains, losses, income and expenses are detailed on their respective K-1’s.

Deductions:

Vehicle Expenses

This is an area that gets a lot of attention and for good reason. Depending on the type of business that you run, vehicle expenses and depreciation can account for a significant taxable benefit for business. There are a lot of variations to answer the question – should I use a Standard Mileage Rate, Actual Expenses, what if the vehicle is owned by the Owner, Partner or Shareholder, what if the vehicle is owned by the business?

Let’s keep it simple. Sole Proprietors, a Member in an LLC or Shareholders (S-Corp’s) can deduct vehicle expenses based on a Standard Mileage Rate (a yearly rate published by the IRS) or based on Actual Expenses, for vehicles owned by the Sole Proprietor, Member or Shareholder. Sole Proprietors deduct these expenses on their Schedule C which is part of their 1040 personal return.

For an S-Corp, vehicle expenses are documented on the S-Corp’s 1120S return. The Standard Mileage Rate or Actual Expenses (both) require well-documented mileage logs. Commuting mileage, between your home and place of business does not count as business mileage. Mileage between your place of business and a customer site counts.

To get vehicle expenses on the books of an S-Corp, Shareholders must be reimbursed, by way of a documented expense reimbursement form. The S-Corp reimburses the Shareholder for Mileage or Actual Expenses for a Shareholder owned vehicle based on the percentage of business use. Reimbursements between an LLC, Sole Proprietor (and their Owner(s) or between an S-Corp and it’s Shareholder(s) require what are referred to as Accountable Plans to ensure these reimbursements are not classified as income to the Sole Proprietor, Member or Shareholder. Vehicle expenses for vehicle’s registered in the LLC or S-Corp’s name are paid directly by the LLC or S-Corp for Actual Expenses, only, Standard Mileage deduction for company owned vehicles is not permitted.

Is it (more) beneficial to register a vehicle as an asset of an LLC or S-Corporation as opposed to keeping it in the Member or Shareholder’s name? Like most answers (when it comes to tax) it depends.

From a tax strategy standpoint, oftentimes, putting the vehicle in the company’s name is not advantageous. Putting a vehicle on the company’s balance sheet allows the company to depreciate it, (with options to accelerate depreciation) and that’s great until you sell a fully depreciated asset. Now, you’re forced to recapture all that depreciation as ordinary income on the sale. Often too, transferring the title to your company will require you to pay sales tax (again) on the transfer. Also, if the vehicle’s usage drops less than 50% for business, then a portion of the depreciation taken (in prior years) must be reclassified as ordinary income.

Putting the only vehicle, you own on the company’s books may not make a lot of sense if a lot of personal use is involved. It’s a complicated topic and every situation is different. So, it must be looked at carefully to determine what’s best for every individual taxpayer based on how the Owner, Partner or Shareholder intends to use the vehicle in their respective business.

Mobile Phone Expenses 

Another topic that definitely deserves more attention. I’ll spare you the excruciating legal-ease language regarding IRS guidance. My first thought(s)…if it’s both necessary and reasonable to have you or your employees be accessible during the workday with Clients, Customers, Vendors or other business-related needs and the benefit outweighs the expense, consider putting the phone in the Company’s name. This carries more credibility in terms of validating business usage and will save you time. The alternative would be pouring over prior year phone bills trying to determine which calls were personal and which were business-related, if you used a personal phone and were under examination by your friendly IRS Representative, if they believed your expenses were excessive.

Let’s get to the good stuff…Employees that use Employer-provided cell phones, in general will not be subject to tax for the use of the phone for personal reasons, subject to a de minimis fringe benefit excludable from the employee’s gross income. If an employer requires an employee to use their personal cell to maintain contact with clients/customers outside normal work hours, IRS guidance allows the employer to reimburse the employee for the monthly cost of the basic coverage plan as long as the employee substantiates this on a reimbursement form.

This reimbursement will not be considered income to the employee as long as the pattern of reimbursement does not deviate significantly from month to month and the coverage plan is reasonable to meet the needs of the employer’s business.

Pricing and Profitability:

Importance of Accurately Pricing Your Product or Service 

I just wanted to touch on this a little. Not compliance, this has to do with a subset of Accounting called Managerial Accounting. Sometimes all that’s required is a change in perspective. I’ve talked to many business owners and profitability is (often) a topic. I could easily write a book on this, but there are two main points I wanted to share. And, sometimes, maximizing profitability may not be a primary goal, depending on what an Owner, Partner or Shareholder is trying to achieve.

Profitability for any service or product you offer is a function of two broad things: 1. the activities in your business that drive costs that allow you to deliver a product or service and 2. The flexibility you have to price your product or service in a competitive market. There are other factors, but I’m keeping this brief. Concentrating on #1 here.

Have you ever considered how much (and what) activities are required to deliver (1) unit of service or product to your customer? You may think you don’t have a complicated operation, but if you were to consider all the activities from start to finish to complete (and deliver) every service or product, you may be surprised just how much activity is required. You pay your employees to perform these activities, so that generates cost. That’s easy, you say, but have you thought about all the Indirect activities that are involved? Direct activities are those that directly involve the service or product, but indirect activities are those that are NOT linked to any particular product or service.

Think of it this way. What costs do I have that would vary with sales volume? If I increase sales, what costs are likely to increase (variable costs)? This helps to focus attention to include all those activities and costs toward understanding your cost structure and to develop an accurate unit cost. Why is this helpful? Consider a company whose unit costs (for a product or service, it doesn’t matter) are in reality, higher than the company believes. What happens? The company underbids the job and the job is (in reality) unprofitable.

Alternatively, what if the company has unit costs that are in reality, lower than the company believes. Just the opposite occurs. The company will likely overbid the job and run the risk of losing the business, all other factors being equal. Some companies enjoy little competition, so they have a lot of flexibility in how they can price their products or services. But these advantages often don’t last…word gets out and competition creeps in and forces these owners to rethink their pricing.

Referrals:

Also, I have a referral program but it’s not cast in stone, and will be subject to change. My thought process is that if you are a current Bookkeeping Client and you refer a potential (Bookkeeping) Client, I will discount your Bookkeeping fees by 20% for two Months. If that potential Client turns into a real Client, I will discount your fees 15% for six Months. Tax Clients that refer potential Tax Clients and Tax Clients that refer non-Tax Clients (and vice-versa), I will offer discounts based how involved (complex) the engagement with the new Client becomes.

Like I said, it’s not firm, but I wanted to get this out. If you know of someone looking to make a change, or starting a business, or just in need of some advice, send them my way.

Closing:

I hope you found this beneficial. I want to keep these short – to 3-4 pages or less, because no one has time to read anything longer than a few pages these days. If it helped you in any way, let me know. If you thought it was too wordy or my approach needs work, I’d like to hear that as well.

Comments? Disagreements? Please leave in the Comment Section below this article or write to me at mike@easllc.co. You can also Contact Us Here.

Alternatively, you can Book a Call Here.

Ok, folks that’s it. Until next Month, enjoy your Summer.

Best Regards, Mike