1099 More Ways to Have Tax Troubles

While most of my conversations about taxes at this point have to do with getting information about the return itself, an article in the Wall Street Journal reminded me of a change to returns this year that has big implications.  As indicated in this blog before, the IRS is falling ever deeper in love with third party reporting, and they are getting more serious about making sure it gets done.  The Service did back off on some of the more heinous aspects of making business owners reconcile the reporting they are getting from credit card companies (otherwise known as form 1099K).  Still, the reporting will be used to audit small businesses that accept payments via credit and debit cards.  What also hasn’t gone away is that if you pay for services with a credit card, and then have to issue a 1099, you need to subtract out what you put on the credit card.  Your vendor is already getting that income reported from the merchant bank that processed the transaction. Giving the IRS opportunity to double count income isn’t the best way to build business relationships.

This brings me to the matter of the 1099 Miscellaneous.

 

If you file taxes using a Schedule C, Schedule E, Form 1065 or Form 1120S there’s a question you have to answer for the first time this year asking if you did business with anyone who should have received a form 1099.  That would be anyone who you paid $600 or more to provide a service and they’re not incorporated.  Answer this question incorrectly, and if you get audited, you will face penalties, even though the form 1099 that you send has nothing to do with your gross income.  So your tax liability could be correct to the penny and you could still be in trouble with the IRS.  (Just when you thought you understood how bad this tax season was going to be!)  And the bad news doesn’t stop there.  Let me quote from the article.

In 2010 Congress stiffened the penalties on taxpayers who neglect to provide 1099 forms. The higher penalties took effect in 2011, and now the penalty for nonfiling is $100 per violation—$200, in most cases, because two forms are due, one to the IRS and one to the provider. The penalty for "intentional failure to file" is $250.

It’s a hassle to file these forms, as I know from personal experience filling them out.  However, this is a way for the government to raise more revenue without raising taxes.  That’s another way of saying it is a sure recipe for increased government action. 

A Case of Mistaken Identity

At last week’s Pittsburgh Business Times Biz-Mix event an unsuspecting entrepreneur was trapped into listening to my advice on why she should structure her new business as a pass-through entity.  I’m sure it was just what she wanted to talk about over cocktails at the Savoy.  In addition to vowing to be a more effective networker, this experience also made me think differently about tax reform.  If it's supposed to help small business, that would mean everyone is clear on what tax policies really benefit small companies and that's not the case. 

Even the IRS is getting that more clarity is needed in terms of defining what a business taxpayer looks like.  Tax Vox did a piece on the IRS overhaul of their small business count.  Using criteria that say a small business has combined income or deductions of at least $10,000 but no more than $10 million and operates in a businesslike manner, the number of small businesses in the US is now pegged at 20 million.  (Prior to the study it was 35 million).  This isn’t a story about the recession closing down businesses, it’s just cutting out businesses that are so small that they’re not really supporting anyone and also taking out businesses with small numbers of employees but lots of income.  Both those types of businesses don’t really care about things like health care tax credits or bonus depreciation.

One other item that came out of the research is only 27% of small businesses pay any wages at all.  This does bring up a recession related story.  According to a new Kaufman Foundation  study the truism about small business being the main job creator in the U.S. is true -- and that's not necessarily good news. When you net out businesses that don’t employ workers beyond the boss, the US has a decline in new business creation. According to the report new businesses in the US have historically contributed 3 million new jobs a year to the economy.  Starting in 2009, that number has fallen to 2.7 million per year.  Worse yet, the average start up staff in the 1990s was 7.5 people.  Today that same number is 4.9 jobs.  So fewer start ups and fewer jobs per business.  

My takeaway from all this is that tax reform for small business could really make a difference in helping the economy improve.  The key is paying attention to what helps businesses that grow into job creators and can scale to the point they make a difference.  This isn’t an impossible task given the available data, but it does require paying attention to more than just good sound bites. 

State of Mind

Coming back from vacation to dismal jobs news inspired me to attempt putting together some economic analysis of my own.  I started with an article from Barron’s that ranked states from a financial health perspective.  I overlaid that with a presentation done by a member of my LinkedIn alumni group  that ranks various aspects of state tax policy in terms of friendliness to taxpayers.  I had this theory that fiscal health and physical health were similar in the “no pain no gain” area.  You eat nothing but doughnuts and watch TV then you look and feel like Homer Simpson.  You eat vegetables and chop your own salads, and then you still have plenty of energy to count your money.  Or something like that…  Anyway – it wasn’t true.

California scored on two of Aaron Skloff’s worst states for “….tax” lists, and they also got the worst spot on Barron’s shakiest credit list.  However, New Hampshire tilted toward the tax friendly side of the ledger, and it sits right next to tax-unfriendly New York on Barron’s shakiest list.  Actually as an accountant I should be the first to know that you need to look at both sides of the entry.  It’s not just how much you collect in taxes – it’s also how much you spend. 

Barron’s also brought in unemployment as a factor to consider – needless to say unemployment lowers tax receipts regardless of the rate.  However, taxing tough didn’t pay or hurt in terms of jobs.  The states with no income tax had an average unemployment rate of 8.1%.  The top 5 states in terms of income tax rates had an average unemployment rate of 8.2%.  One area with a little correlation was sales tax (a recent favorite topic of mine).   The states with no sales tax had an average unemployment rate of 7.5%, and the states with the 5 highest sales tax rates had average unemployment of 8.9%. 

Clearly I should stick with accounting, and not move into economics.  The experts in that field added two more points in the Barron’s article that are worth noting.  First is that federal budget cuts will have disproportionate impact in states with many federal contracts (AAA rated Virginia gets almost 30% of state GDP from Uncle Sam and Maryland isn’t far behind).  

Last and most importantly, there is no number that indicates the willingness to introduce structural change into state spending.   That is the essential ingredient in fiscal stability, and probably the most relevant component of how one would rate a muni bond.  Sigh.

Sales Tax Not Included

Don’t know if you live in a place with a back to school sales tax holiday, but if you do, enjoy it while it lasts, which is not likely to be long.  The state scramble to raise more funds is nowhere near slowing down.   A new study done by Aberdeen Research confirms what I’m seeing anecdotally – that states are more aggressively auditing companies to make sure they’re getting every penny of sales and use tax.  Last year 43% of their respondents reported increased audit activity, this year it was 63%.  While much of the discussion about taxation revolves around income taxes, the real money for states is in sales tax.  According to Aberdeen almost a third of state revenues are connected to sales and use tax.

Despite the strong interest on the part of the government, businesses tend not to be really focused on this topic. The net result of that is they are more vulnerable to missing changes in requirements.   A Thompson Reuters Study shows that for the first half of 2011 alone there were 16 county tax changes and 90 city changes.  The prognosis is that it’s only going to get worse.

Not every business is avoiding this topic.  The Don Quixote of sales tax growth is definitely Amazon.com.  The company has started a ballot initiative in California to avoid having to collect sales tax on items it sells in the state.  The state is fighting back proposing legislation that would make any referendum useless. Regardless of who wins, the issue for businesses once all the dust settles is then figuring out how to comply.  This is particularly difficult when you get to the issue of out of state sales and online sales. 

Despite Amazon’s aggressive stance, generally states are working diligently to expand the definition of nexus.  That means the rules that determine if your business activities in a state are subject to tax are heading in the direction of making it more likely that you will face some sort of tax.  The Aberdeen study and (I think) common sense suggest that this is an area where you should identify outside resources that can help your business understand specific risks.  Depending on the type of company you are involved with, it may pay to bulk up internally as well.  If most businesses are not watching out for this topic, you can bet it will be a competitive advantage to be proactive. 

What is Appropriate Compensation?

Although the future of the tax code is all the talk these days, an article that appears in this month’s The Tax Adviser turned my attention to a different topic.  It’s a discussion of a recent Tax Court ruling about what constitutes reasonable compensation for employees of a closely held corporation.  I may not know what marginal tax rate will be associated with said compensation, but at least this a topic accountants can discuss with clients today without waiting for an act of Congress before expressing an opinion.

According to the article there are five factors that have emerged from Tax Court rulings that form the basis of current thinking about what the IRS will look at in assessing whether compensation is “in the money” or not.  The five factors are:

-       What the employee actually does in the company

-      A comparison with similar positions at similar firms

-      The character and condition of the company

-      Potential conflicts of interest, and

-      Internal consistency of compensation. 

Looking at the first two seems the most objective and therefore what I think most accountants would gravitate toward in terms of emphasis.  (It may be a misplaced stereotype, but I do think accountants tend to be objective.)  In this case though (Multi-Pak Corp., T.C. Memo. 2010-139) the case turned on the interpretation of the potential conflict of interest. 



The test used to assess if there is a conflict of interest is, would a “hypothetical independent investor” think the compensation was reasonable.  The alternative would be our friend H.I. Investor thinking that management is siphoning money out of the company disguised as salary. In this particular case in one year the compensation met the criteria, but in the year the salary payments would have resulted in an almost 16 percent negative return on equity, the court said it agreed with the IRS that the company’s amount of deductible compensation to the CEO had to be reduced. 

Now if we can just here from H.I. on the topic of S-Corporation owners taking too little compensation….