In the past several years, business owners have grown accustomed to adapting to many changes in tax rules. Some new rules have been temporary in response to COVID-19; some have been permanent. All have required businesses to comply with new tax rules. As we head into a new year, it’s helpful to recognize that some things haven’t changed, yet they continue to be problematic.
The following tax issues continually trigger IRS scrutiny and often result in litigation; taxpayers may not always win. Review your actions with respect to these tax issues and follow the better course of action.
Is a worker an employee or independent contractor for federal tax purposes? (Some states have an ABC test that differ from the IRS approach.) Worker classification matters because employee status triggers payroll taxes and, where applicable, an obligation for employee benefits; independent contractor status do not. The IRS looks at 3 basic areas to determine whether there is sufficient control over a worker so that he or she is an employee.
Best course of action: Carefully decide on the correct worker classification before engaging anyone. At a minimum, be consistent with workers doing the same or similar work and be sure to issue Form 1099-NEC for those you treat as independent contractors. Keep in mind that having an independent contractor agreement, while indicative of how the parties view the work arrangement, is not binding on the IRS (it’s not a party to the agreement) and won’t control the outcome of a worker classification challenge.
To paraphrase a proverb (“for want of a nail, a shoe was lost…”), for want of good records, legitimate deductions may be lost. Businesses are required to keep books and records. And the tax law is very specific about recordkeeping for certain write-offs, such as business travel, meals, and business use of a personal vehicle. There continues to be much ligation about deductions for which records are shoddy or nonexistent. Yes, there’s a Cohan rule, which allows the Tax Court to determine the amount of a deduction as long as there’s credible evidence for it; the Tax Court won’t accept “guesstimates.”
Best course of action: Incorporate recordkeeping into your business operations. Use apps to simplify recordkeeping on the fly. Be sure they tie into your accounting solution (e.g., QuickBooks, FreshBooks).
Business or not?
Businesses can deduct ordinary and necessary business expenses, subject to various limits and restrictions. However, this rule only applies if you’re actually in business. Two key areas of contention are:
- Start-ups: Until a nascent business has reached the stage of a functioning operation, no write-offs can be taken. There’s just no business to claim deductions. Once the business opens its doors, it may be able to deduct certain start-up costs and, of course, all other allowable deductions going forward.
- Hobby activities: Unless an activity is pursued with a reasonable expectation of making a profit, it’s treated as a hobby. As such, all income must be reported, but no deductions are allowed (at least until 2026 when miscellaneous itemized deductions subject to a 2% of adjusted gross income floor can again be claimed).
Best course of action: Keep these rules in mind to be able to take deductions. When in doubt, consult with a CPA or other tax adviser.
Errors in handling retirement and employee benefit plans
There may be simple, or not so simple, mistakes made in administering a qualified retirement plan as well as employee benefit plans. Mistakes may include failing to timely deposit employee contributions to 401(k) plans, untimely employer contributions, discriminating against rank-and-file employees in terms of contributions and benefits under the plan, and failing to file annual information returns with the Department of Labor. There is an IRS program enabling corrections with little or no penalties, but it means time and effort—and some cost if penalties apply.
Best course of action: Consider using an outside benefits company to administer your plans. Some payroll companies offer this option as well. The added administrative costs of using an outside firm may be less than costs resulting from errors when you try to do things on your own.
At the start of a new year, it’s helpful to remember that some things never change. Don’t overlook some basics or you may lose out on deductions or be penalized.