In the past decade there have been two major rewrites of the nation's income tax laws, the Economic Recovery Tax Act of 1981 and the Tax Reform Act of 1986.
In addition, Congress, the federal tax court and the Internal Revenue Service itself have amended, revised, updated, clarified, added to and/or subtracted from the tax codes hundreds of times.
Taxpayers and politicians argue whether the result really has been a reform of the nation's tax law, but just about everyone agrees that there certainly has not been any simplification.
As a result, there are dozens of little-known and often overlooked rules that can help taxpayers, especially owners of small businesses, minimize their tax bills, says Norman A. Barker, director of tax for the Orange County office of Ernst & Young in Newport Beach.
Barker, 42, earned a bachelor's degree in psychology at USC and then entered the university's law school, where he earned a law degree.
So, with that education, how did he become a certified public accountant specializing in tax issues?
Well, Barker's grandfather was a lawyer, but his father is a CPA. He decided to follow in both their footsteps.
A Southern California native, he had taken a few accounting courses at USC as an undergraduate and, in the summer of 1970, between his first and second years in law school, applied for a position in the tax department of the Los Angeles office of Ernst & Whinney, the accounting firm. It became Ernst & Young last year in a merger with the Arthur Young & Co., another major accounting firm.
Barker worked full time while completing his law degree and then was shipped off to the University of Miami in Ohio for an intensive 10-week CPA course--his only accounting classes since his undergraduate years in the late 1960s.
"Then I came back, rented a cabin in the mountains and studied 25 hours a day for the CPA exam, which I took and passed on the first try in 1973," he said.
After stints at Ernst & Whinney offices in Los Angeles and Cleveland and at the firm's New York headquarters, Barker transferred to the Orange County office in 1980.
With the April 16 deadline for filing 1989 tax returns drawing near, Barker recently shared some of his thoughts on small-business tax matters with Times staff writer John O'Dell.
Q. The corporate tax guys at Beckman Instruments probably won't get much out of this, but they can afford to hire all the help they need. Share with us some 1989 tax-filing tips for small-business owners--the ones who should hire tax advisers but often can't afford to.
A. The most fundamental thing a small business can do is decide what form it will take. The rules taxing partnerships are radically different from the rules for corporations or sole proprietorships or any of the other forms a business can take. One of the most popular vehicles for small business is the S corporation. You have to elect to be an S corporation within the first 75 days of the beginning of your corporate year. It is a form that is very good for a lot of tax reasons. It also is a form that can be used to reduce FICA (Social Security) taxes for the self-employed.
Q. And as high as Social Security taxes are for the self-employed, that could be a big benefit. How does it work?
A. If you are working for your own S corporation, even if you are the owner and only employee, then you can limit the amount of salary you take out of the corporation and the self-employment (FICA) tax only applies to what you take out in salary.
Q. An example, please?
A. Let's say your business earns $200,000 for the year, although you can use any numbers you want. You could pay yourself a salary of $40,000, assuming that would be reasonable in relation to the services you perform for the business. Your self-employment tax would be on the $40,000 salary instead of on the $48,000 maximum taxable amount for FICA in 1989. That maximum jumps to $51,300 this year. The key here is that the salary has to be a reasonable amount for the services rendered. You couldn't pay yourself $10 and get away with it. In any event, with the S corporation as your employer, the total FICA tax can be less than paying the full self-employment rate of 13.02% for 1989 and 15.3% for 1990.
Q. What about other taxes?
A. Well, the federal corporate tax rate is 34%. That's much higher than the personal rate. But except in unusual circumstances, there is no federal corporate tax on an S corporation The state tax is 2.5%, but that is pretty low. Also, the S corporation avoids some penalties that other types of corporations can face. There is no penalty for accumulated earnings or for excessive compensation, for instance.
Q. I have a feeling a lot of people who own their own businesses would argue vehemently that there is no such thing as excessive compensation.
A. One way a corporation's shareholder-employees used to drain the corporation of all of its income so it didn't have to pay any tax was to pay out all the corporate income as salaries to themselves. Sometimes, the amount of salary was more than the value of the services they provided. That still happens sometimes. But if the IRS determines that the salary paid is greater than the value of the service provided, it disallows the deduction for the excess amount. But that provision does not apply to an S corporation So the owner or owners can draw down the entire income as salary.
Q. What, if anything, does the federal tax system do to encourage small-business formation?
A. Sadly, if you follow the letter and spirit of the law, most of the expenses incurred in starting your business cannot be deducted right away. They must be capitalized. If you hire an attorney to file your incorporation papers and do other pre-formation legal work, for instance, you cannot deduct on your first-year tax return what you paid the attorney. You must capitalize the amount and deduct it over a 60-month period. So you ultimately get the deduction, but it is stretched over five years. If the law were more friendly, you would get the deduction up front, when it would probably help the most.
Q. What is the rationale?
A. The theory is that the money you paid to get organized is not a cost that relates just to the income you earn in the first year but to income you'll earn in perpetuity. So the government makes you stretch out the deduction over 60 months. The same thing is true with start-up expenses. You hire employees, paint the shelves . . . and do things like that before you open your doors, and those costs have to be capitalized and amortized over five years.
Q. There are some tax benefits for hiring the hard-core unemployed, aren't there?
A. It is called the targeted jobs credit and it's a tax credit for businesses that hire people in one or more of nine different target groups, typically persons who are economically disadvantaged. They include economically disadvantaged Vietnam-era veterans and economically disadvantaged young people. Once you, as a business owner, get a certification from the state Employment Development Department that a person you have hired qualifies in one of these categories, you get a federal tax credit, computed at 40% of up to $6,000 of the person's first-year wages.
Q. Does this have to be a full-time employee?
A. No. And the tax credit can be pretty significant. It runs as high as $2,400 for an employee who makes $6,000 or more. And it adds up when you think of all the hotels, fast food places and other businesses that hire people who fit these targeted jobs categories. The credit was scheduled to expire on Dec. 31, but Congress extended it until Sept. 30, the end of the federal fiscal year.
Q. Why only nine months?
A. It is one of several things that were extended through September, which is the end of the government's budget year and the time when Congress typically acts on new tax laws. I believe it may be extended again in whatever tax measures Congress passes in September.
Q. How does the law treat business equipment--cash registers, machinery and the like?
A. Equipment is depreciated from the time it is placed in service. Before the Economic Recovery Tax Act of 1981, in Reagan's first year as President, you could write off most equipment over five years. But now the depreciation rules have some 130 different classifications. Before I can tell you how long you must depreciate a certain piece of equipment, I have to look up what classification it belongs in. The tax code is a full employment act for bean counters.
Q. What about simpler things, like use of your personal car for business when the employer doesn't provide one, or when you are using your own car in a sole proprietorship.
A. You can get a benefit, but the record-keeping is a quagmire. There are two ways to deduct car expenses. You can take the standard mileage deduction for business use, which changes every year. Or you can keep track of actual expenses--gas, oil, repairs, maintenance, car washes and insurance--and you can depreciate the car's value and then compare those costs to the standard business use deduction and take whichever one is higher. And you can switch back and forth, using the standard deduction one year and the itemized the next. But you have to keep accurate records of your business mileage.
Q. How about home offices? Hasn't the IRS recently lightened up a bit on home office restrictions?
A. Home offices have to be used regularly and exclusively for business--period. And you have to have a reason to have one. You can't just decide to set one up because you like to bring work home at night. There has been one change in the law, however. You used to have to meet clients in your home office and conduct the bulk of your business there for it to be deductible. Now the tax court has held that the home office only has to be the focal point of your business. A salesman who meets his customers at their place of business and who doesn't have a permanent office at company headquarters--for example, a regional representative for a company located in the East--can legitimately have a home office if that's where all the record-keeping, billing and dealing with the main office takes place.
Q. What's the tax treatment for business use of personal computers and other office equipment?
A. That's what is termed 'listed property,' and it is treated differently from business equipment. A computer, for example, can be used for personal and business reasons. So you start with the regular depreciation rules and then, for listed property, the deduction has been cut down. You can deduct the business cost but over a longer period of time, often as much as 12 years. And you have to keep very detailed records to prove what part of the use was business and what was personal. Remember, unless the IRS is charging fraud, the burden of proof in any dispute with the IRS is on you. And with things like cars and computers, the best way to prove business use is to keep an accurate log.
Q. What are some other things for the small-business person to know about?
A. Well, federal law gives a real benefit to the business owner who suffers a net operating loss for the year. You basically get a 19-year period to use the loss to offset profits. You can use it for the current year, carry it back three years and, if there is still any loss to account for, then you can carry it forward for up to 15 years. It was designed to help businesses with really cyclical income.
Q. How does the state treat operating losses?
A. California didn't allow any carry-back or carry-forward of losses until 1987. You didn't have to pay taxes in the year you took the loss, but that was it. In 1987, the state introduced a limited loss carry-forward for certain kinds of losses. But you still can't go back to prior years and use this year's loss to offset previously paid taxes. The way the law is worded, businesses with operating losses can carry 50% of those losses forward to offset profits for up to 15 years, or until they are absorbed.
Q. In your experience, what kinds of things on tax returns--short of outright fraud--typically raise red flags at the IRS?
A. For individuals, the first is a return on which income doesn't match the income reported to the IRS on 1099 forms. The 1099 is the statement of interest earnings, investment income, proceeds from real estate sales and other income that you get from banks, brokerages, escrow companies and clients for whom you've done work. They have to send a copy of that statement to the IRS, and if you report $100 in interest income on an account at your bank and the bank's 1099 says you earned $120, you will almost automatically get a letter about it from the IRS and the state because of their computerized programs for matching 1099s with individual returns.
Q. That kind of thing doesn't result in an audit, does it? Don't you just get a letter asking you to either explain the discrepancy or, if you agree with the IRS, to send a check for the back tax and late penalties?
A. Yes. But if you do it enough, or if a single mismatch is big enough--like you report $10 in interest and the bank says it was $10,000--that could get you audited. The IRS is also going to take notice of tax returns that are not self-explanatory. By that, I mean returns that lack the statements and schedules that support the numbers. Agents also will red-flag a return that shows a substantial business loss, one that wipes out the tax liability, or a file that has several years of consecutive business losses.
Q. They also watch charitable contribution claims pretty closely, don't they?
A. If you report contributions that are significant. There is a new form that you must file if you make a non-cash donation worth $500 or more. You have to itemize the property and give it a value. And if your donated property is worth $5,000 or more you have to have it appraised by a professional appraiser. What gets some people is that if the recipient of a donated property sells it within two years, the charity must notify the IRS of the sales price. So if you donated a sailboat to UCI and valued it at $6,000 on your tax return and then UCI turns around and sells it for a quick $1,000, the IRS is going to want an explanation of the discrepancy. To keep your deduction, you're going to have to show that UCI sold it at an artificially low price and that your $6,000 value was the real value. Of course, sophisticated organizations that get a lot of donated property typically will not sell it until after two years has passed so they avoid reporting the sale to the IRS.
Q. With cash donations, if you don't have a receipt from the organization, is your canceled check enough proof for the IRS?
A. It is not a receipt, but it is typically accepted by the IRS as proof of payment.
Q. Are there benchmarks that the IRS uses in deciding whether your deductions, exemption claims, business losses or whatever are out of the ordinary?
A. The answer is absolutely yes. But what they are is a closely guarded secret. And they change every year. There are a lot of parameters in the IRS computer, and your name will get on a list if you go beyond them. But whether or not that triggers an audit depends on how high on the list your name goes.
Q. Finally, how long do you need to keep personal or business tax records?
A. The federal income tax statute of limitations is three years, but I recommend you keep them forever. The statute in California is four years and, in our business, we typically keep state and federal records for seven years because there is a provision in federal law that says if you forgot to include an item that is 25% or more of your gross income, then the statute is extended to six years. And, of course, there is no statute of limitations at all in cases of fraud or if you simply didn't file. They can go back as far as they like.