Mind the ($450 billion) Tax Gap

If you’ve been following the news regarding tax law for small businesses in the past year, you’ve surely heard of the $450 billion tax gap between taxes owed and taxes paid. Since the beginning of 2012, the IRS has upped its vigilance in monitoring 1099 compliance. The 1099 form is required if you’ve paid someone who is not your employee, such as an independent contractor, $600 or more throughout the year for their services (for more information about classifying employees and the 1099 see this previous post). The biggest part of the tax gap, $179 billion came from 2006, was due to businesses misreporting income and self-employment taxes, according to the Government Accountability Office. It is unclear how much of that discrepancy was unintentional or not.

With this increase in attentiveness on the part of the IRS, there has been a corresponding increase in the volume of notices and audits, a trend that will undoubtedly continue in the coming years. This is important for small businesses because incorrectly filing 1099 forms can lead to severe penalties. Knowing the rules and complying with them can save your small business huge headaches and fines when tax season comes around. If a business states on a tax return that it made payments that would require filing a 1099 form but failed to file one, they have intentionally disregarded the law. If they state they were not required to file a 1099 form but were later shown that they should have, they have also intentionally disregarded the law. These falsifications can result in fines up to $100 per return or 10 percent of the total amount that should have been reported.

With plenty of time before the 2013 tax deadline, it is important to make sure your small business is staying on top of sending out the requisite 1099 forms to those whose services you’ve utilized. Working with a qualified tax professional can ensure you are complying with the IRS regulations, and can prevent you from having to dole out unnecessary penalties.

Exempt But Not Excused: Don’t Jeopardize Your Nonprofit’s Tax Exempt Status

Although nearly all nonprofit organizations are tax exempt organizations and vice versa, these terms are not identical—nonprofit status is granted by state governments, whereas tax exempt status is granted by the federal government. The most common tax exemption is the 501(c)(3), but there are actually 26 exemptions under the federal tax code, and different activities require appropriate designations. For the purposes of this post, we’ll discuss fulfilling the requisite measures to remain tax exempt under the 501(c)(3).

The process of attaining federal tax exemption status takes several months, and should be done with the help of a tax professional. Once the status is obtained, there are steps an organization must continually take to maintain tax exempt status, and the neglect of these requirements can result in the revocation of tax exempt status.

Primarily, the organization must pursue its stated exempt purposes while avoiding certain activities that can jeopardize the 501(c)(3) status. Activities that can threaten 501(c)(3) status are:

• Private benefit/inurement: 501(c)(3)’s must contribute to public interests, not exist for the benefit of private individuals or organizations
• Lobbying: attempting to influence the opinions of public officials
• Political campaign activity: affiliation with or action against specific candidates
• Activities generating excessive unrelated business income: nonprofits may generate a profit, but that profit must be used to sustain the organization’s primary mission, and not for extraneous means
• Failure to comply with an annual reporting obligation: filing an annual return with the IRS is required, and if an organization is delinquent for three consecutive years it can no longer receive tax-deductible contributions

For more information about obtaining or retaining tax exempt status, contact your tax professional.

Correct Classification: Making Part-Time Employment Work For You

With the holidays around the corner, many small businesses are in the process of hiring seasonal help. In this economy, part-timers are an excellent choice for businesses who will benefit from their flexibility and lower cost. All year round, part-time employees or self-employed contractors are attractive in many ways compared to full-time employees, but managing these types of employees is not as simple as it may seem.

One common misconception about part-time employees is that they don’t qualify for overtime or benefits. Worker status is not determined by the length of employment or number of hours—employment taxes apply to all employees. Many states have daily overtime rules (in addition to weekly ones) even for those employees who only work one day out of seven. Generally, it is up to the employer to decide which voluntary benefits a part-time employee is eligible for, such as vacation, sick leave, health insurance and retirement, but there are legal limits. For example, the Employee Retirement Income Security Act (ERISA) states that employees who have worked 1,000 hours in the period of 12 consecutive months are eligible to take part in any company pensions or profit-sharing plans. In all cases, it is advisable to have a written policy that clearly and consistently states who is eligible for what.

Hiring part-time employees versus commissioning a contractor are two very different things. Contractors are responsible for declaring their own taxes and are not entitled to benefits, whereas with any employee, the employer is responsible for the tax payments, paperwork and filing. It may be tempting to choose a contractor over a bona fide employee, but if that person is treated like a employee, penalties will apply. If a worker does not use office space or equipment, sets his or her own hours, and works for other clients as well, he or she can safely be classified as an independent contractor.

The Department of Labor’s website provides helpful information regarding the Fair Labor Standards Act, but for additional assistance, contact your tax professional.

Avoid these 10 common payroll mistakes

Running a small business requires wearing many different hats, and sometimes processing payroll can end up on the back-burner. However, payroll mistakes can result in thousands of dollars in penalties and hours of correction time. Nearly 40% of small businesses pay an average of $845 a year in IRS penalties. Transparency regarding policies and the minimization of errors will result in strengthened trust of employees and a smoother running business.

Here is an overview of ten common payroll mistakes small businesses make:

1.    Misclassifying employees.

For independent contractors, employers are not required to pay matching FICA, Medicare, or unemployment contributions. These requirements can add up to 30% in labor costs. However, if a worker is misclassified, fines and penalties can add up.

2.    Not having a written pay policy.

Being able to point out your firm’s policy on a particular issue will sidestep disagreements about awarding bonuses, raises, promotions and paid time off.

3.    Incorrectly reporting reimbursements.

On a paycheck, reimbursements must be itemized and separated. It is also important to know what types of reimbursements are taxable and which are not.

4.    Not obtaining W-9s from independent contractors and vendors.

If W-9s are not collected on time, up to 28% backup withholding may apply, in addition to failure-to-deposit penalties.

5.    Not including taxable fringe benefits in income.

Taxable fringe benefits include spousal travel, company-provided cars (when not being driven for business purposes), and housing that is not for business use.

6.    Mishandling exemptions, contributions and taxes.

Knowing whether to make deductions before or after taxes is important to keep payroll running smoothly. This includes deductions, such as health insurance, retirement contributions, and court-ordered child support.

7.    Not allotting enough time for payroll.

If payroll is not completed on time, late deposit of withheld taxes will incur a penalty of 2%-15% plus interest.

8.    Ignorance of the law is not an excuse.

Not hanging notices concerning OSHA and minimum wage can become a liability. Also, small businesses without an HR department need to be cautious about breaching employee confidence and knowing what information can be revealed to other companies.

9.    Not maintaining impeccable records.

With limited space, some small businesses elect to throw away (or not collect at all) employee files or W-4s. Additionally, maintaining accurate Social Security numbers will avoid penalties.

10.    Not implementing pay changes in a timely manner.

If there is a time lag between awarding a pay increase and executing the changes in payroll, employees may become disgruntled and question the firm’s reliability.

Contracting out payroll is an option, but for many that isn’t a viable choice. Many small businesses have made one or more of these mistakes before, but one of the benefits of being in charge of the payroll process is the ability to amend it. Taking the time to properly set up payroll and learning and understanding tax laws will save time, money and peace of mind in the long run.

Apprehending Appraisals

Finally giving away that dusty old Picasso that’s just been lying around the house? Make sure you take the measures needed to get a charitable tax deduction.

Picassos and joking aside, if you donate an item that’s worth more than $5,000 and is “nonmarketable” (i.e., not easily bought and sold on the market, like art) to a charitable organization, you have to get a “qualified appraisal” of the item to obtain a charitable deduction for it.

So, what qualifies an appraisal? First of all, a qualified appraiser. That means a person who:

• Promotes herself as an appraiser and performs appraisals regularly.
• Is qualified to value the type of item in question.
• Plays no other role whatsoever in the donation transaction.
• Does not perform the majority of her appraisals each year for the donor or the charitable organization.

Too, paying an appraiser based on the to-be-appraised value of the item is a no-no, for obvious reasons.

The appraiser must attest to all of her qualifications on the appraisal document. She also needs to include in the document, among several other pieces of information:

• A detailed-enough description of the item that someone who didn’t know the item could be sure what was described was what was being donated.
• The terms of any agreement the donor and the organization have made with respect to the way the organization will use the item.
• Her method for determining the item’s fair market value

Finally, the appraisal itself must be performed no more than 60 days before the donation is made.

If you still have questions about the substantiation requirements for high-value, nonmarketable donations, contact your tax professional.

Getting Credit Where Credit’s Due

Do you run a nonprofit? If so, there’s a chance you’re eligible for a tax credit, but don’t even know it.

The Small Employer Health Insurance Tax Credit was made available by the Patient Protection and Affordable Care Act in order to encourage employers—including not-for-profit employers—to provide their workers with health care coverage. The Government Accountability Office reported in May, though, that while 107,300 small employers claimed the Small Employer Health Insurance Tax Credit in tax-year 2010, estimates for how many small employers were eligible ranged from 1.4 million to 4 million.

If your nonprofit is among those that didn’t take advantage of the tax credit, there are plenty of reasons you might have chosen not to: the credit wasn’t enough of an incentive, or the qualification requirements were too complex. But you also simply might have been unaware of the opportunity.

Currently, with the credit, nonprofit employers can claim up to 25 percent of the premiums they pay against payroll taxes. And in 2014, the maximum credit will increase to 35 percent for qualified organizations. To be eligible, your nonprofit must:

• Pay for at least half of the cost of its employees’ single coverage
• Employ fewer than 25 “full-time equivalent” (FTE) employees (this is where things get tricky and you might need tax-professional help)
• Pay its employees an average annual salary of less than $50,000

Match that profile? Contact your tax professional and ask for more information about the Small Employer Health Insurance Tax Credit.

Debt Forgiveness Comes With a Price Tag

With Americans deeper in debt than we’ve ever been, having a loan you can’t repay is becoming practically commonplace. In fact, loans in default are getting so common that many lenders, in an attempt to recover at least some of their money, are forgiving the debts in part. Others are forgiving whole loans.

Debt forgiveness is a break, to be sure—but it’s not a free pass. The amount of debt lenders forgive is considered income by the IRS—the agency calls it “cancellation of debt” (COD) income—and is therefore taxable. Even if you don’t report COD income to the IRS, the bank or credit-card company or what-have-you is required to.

There are a few exceptions. You don’t have to pay taxes on COD income if:

• You’re in Title 11 bankruptcy proceedings (Title 11 includes Chapter 7, Chapter 13 and the infamous Chapter 11) when the debt is forgiven.

• The debt that has been forgiven is “seller-financed debt,” meaning mortgage debt you owe to the prior owner of a property of yours.

• The forgiven debt is home mortgage debt, and the debt cancellation occurs in 2007 through 2012. This applies to debt of no more than $2 million; that was used to buy, construct or improve your primary residence; and that is secured by that residence. (The home-mortgage exception is set to expire at the end of this year.)

• You are insolvent (i.e., the amount of your debt is greater than the fair-market value of your assets) immediately before the debt is cancelled. But if the cancellation reduces the amount of your debt to less than your assets’ value, the amount by which the latter exceeds the former is taxable.

• The COD income consists wholly of unpaid interest. If unpaid interest (which, if you’d paid it, you could have deducted) comprises only a part of the forgiven debt, you don’t have to pay taxes on that part.

The above list is far from comprehensive and includes many invisible footnotes. If a debt of yours has been cancelled, congratulations—now, contact your tax professional to find out how to properly and effectively report that on your income-tax filing.

High Earners Have High Chance of Getting Audited

The more you earn, the closer your tax returns are being watched, recently released IRS data show.

The 2011 IRS Data Book, released earlier this year, reveals that while the IRS audited only 1.1 percent of all taxpayers in 2011, they audited high-net-worth individuals at a significantly higher rate. Most notably, of taxpayers who reported an income of more than $10 million, the agency audited a whopping 29.93 percent.

Among taxpayers who made between $5 million and $10 million, the IRS audited 20.75 percent. The agency audited a higher-than-average 2.66 percent of those earning between $200,000 and $500,000.

The audit rates of the wealthiest groups rose sharply from last year’s. For the over $10 million group, it increased from 18.38 percent, and for the $5 million to $10 million set, it went up from 11.55 percent.

In addition, one accountant told Bloomberg the IRS is also auditing the wealthy more quickly. Joe Perry, of Marcum LLP, told the news service the agency is in some cases contacting people within months of their return’s filing.

This faster, more intense scrutiny of high-net-worth individuals is likely a result of the IRS’ creation in 2009 of a unit dedicated to reviewing the wealthy’s tax returns. “We want to better understand the entire economic picture of the enterprise controlled by the wealthy individual and to assess the tax compliance of that overall enterprise,” IRS Commissioner Douglas Shulman said in a speech at the time of the unit’s creation.

Paying Piecemeal: Making Estimated Income-Tax Payments

The next quarterly deadline for making estimated income-tax payments is September 17. Does that apply to you? Well, you should be making a payment if:

• You’re self-employed
• Your nonwage income (i.e., income from such sources as interest, dividends, alimony, unemployment compensation or self-employment income) is increasing (or is expected to increase) this year
• Stock you own has gone up significantly in value
• You’ve gotten a substantial inheritance or other windfall with assets that produce income

If you fall into any of these categories, then you must pay estimates if you expect to owe $1,000 or more beyond any payroll withholding and either (a) your withholding or other tax credits will account for less than 90 percent of the taxes you expect to owe on your current-year tax return or (b) your withholding or  other tax credits will account for less than 100 percent of the tax return shown on your prior year’s tax return.

To make estimated payments, you use Form 1040-ES (and the California equivalent, Form 540-ES). Even though they’re described as “quarterly,” the payments are actually ingeniously scheduled at funky intervals of between two and four months. Go figure—it’s the IRS.

For more information about withholding and estimated tax payments, view IRS Publication 505 and/or contact your tax professional.

Just the Facts, Ma’am: New Data on Nonprofit CEO Pay

The issue of compensation is fraught enough in the private sector, but in the nonprofit world, where organizations are answerable to donors, grantmakers and the IRS regarding their finances, it’s even more so. The question of how much to pay executives bedevils nonprofit boards: Too much, and they’re criticized for using limited resources on administrative, rather than programming costs; too little, and they risk not being able to attract and retain competent executives. This problem is exacerbated by the dearth of data on nonprofit executive compensation.

A new analysis from the Economic Research Institute (recently summarized by researcher Linda Lampkin on the nonprofit e-magazine Blue Avocado) provides some welcome relief. Lampkin and co-researcher Christopher Chasteen used a database of Form 990 information in the Nonprofit Comparables Assessor, an ERI-developed software program, to review 100,000 nonprofit CEO salaries. They offer the following key findings:

• The median salary for nonprofits with annual revenues of $100,000 to $500,000; $500,000 to $1 million; $1 million to $5 million; $5 million to $10 million; and more than $10 million were, respectively, $42,600; $61,694; $86,277; $122,042; and $189,943.
• “The vast majority” of nonprofit CEOs earn less than $100,000.
• Only approximately 1 percent of nonprofit CEOs make a significantly greater amount than the average (i.e., two or more standard deviations above the mean).

Lampkin, who has spent her career working as an economist for nonprofits and labor unions, advises nonprofits to take advantage of cold, hard facts in making executive-compensation decisions that are “defensible” to stakeholders (e.g., grantmakers), “reflect the organization’s compensation philosophy,” and strike a balance between administrative and programming spending. The statistics she and her organization have provided should help.