Keep Your Small Business Advantage! While your know-how is certain to make an important difference in your business’ success, you’re no doubt well aware that producing a winning combination for a smooth-running operation depends on many other factors as well. High on the list of considerations for your business should be creating the ability to meet criteria imposed by Uncle Sam and the Internal Revenue Service. To help you avoid headaches that can go with trying to meet tax law requirements, this brochure highlights pitfalls to be aware of and provides some tips on how to overcome them. “Material Participation” In Your Business “Material participation” has become a major issue for business people since Congress passed rules regarding “passive activities” in the late ‘80s. To show material participation, you as the owner must demonstrate that your activity in your business is continuous and substantial. The IRS has established several “tests” for measuring material participation. An owner who can’t pass any one of the tests will most likely be considered just a passive investor in a company. Since deductible losses from passive activities can be limited to the amount of income from such activities, showing material participation in your business becomes doubly important. If you work full-time in your business, you will have no trouble showing you materially participate. However, if you’re an employee at another job and operate your business on a part-time basis, you need to make sure you pass one of the material participation tests. One way you can do this is to show that you spend 500 or more hours during the year running your business. You can establish material participation in other ways too – e.g., based on your past years’ involvement or how your work time compares with others working in the business (including employees). Your Profit Motive The IRS sometimes questions profit motive of a business owner if an activity consistently shows tax losses. This is common with activities that lend themselves to personal enjoyment or hobby such as horse/dog breeding, arts and crafts, etc. You should be prepared to show that you entered your business with the intent to make a profit and that you are taking measures to realize that intent. How do you show profit motive? At least in part by establishing that you have expertise in your field and you are using businesslike practices in carrying on operations. Your Recordkeeping Routine: The recordkeeping system: Give priority to establishing good recordkeeping practices for your business. Recordkeeping goes much farther than actual check writing, depositing income, keeping receipts, etc. Also involved are the choices you must make about accounting methods, dealing with inventory (if any) and other assets, complying with regulatory and tax requirements, and technology. You will probably find taking care of all these details time-consuming and frustrating to say the least; many of the choices you have to make may require help from a financial or accounting professional. When keeping your business records, though, try to follow a few basic “rules”: Don’t commingle business and personal bank transaction: From the very outset have a separate bank account for your business in which you deposit only business gross receipts and from which you write checks or make electronic payments for business expenses. Keep backup for your bank deposits and expenses: Keep bank statements and supporting documents so you can trace your bank deposits, including those that aren’t income (e.g., loan documents for loan proceeds deposited, insurance reimbursement, etc.) If possible, pay all expenses by check (paper or electronic) or a business credit card. The payments should be supported with sales slips, invoices and any other available documents of explanation. The income and expenses should be recorded in an orderly manner (either by hand or in a software program on a computer) so that the backup can be readily available if and when needed. Sometimes you can log your expenses in a timely manner so you don’t have to keep receipts. Before you adopt a logging system though, it’s best to check with your tax advisor because the rules for logs are quite strict. Be sure to keep all reports filed with government agencies: This includes personal income tax returns, sales tax returns, payroll returns, W-2s and 1099s filed for employees and other hired labor, etc. Length of Time to Keep Records: From a federal tax standpoint (some states may be different), you should retain books and records of your business for three years after the due date of your income tax return. There are some sections of the tax law where the statute of limitations is longer than three years, however. Because of these, it’s wise to keep records at least six years. When it comes to the records that support cost basis of property, equipment or any item that you are depreciating, keep records for at least three years beyond the life shown on the depreciation schedule in your tax return.