If you, like many business owners, are awash in a sea of papers, take a look at the tax documents you're hanging on to. You may be keeping your checks and other supporting records longer than necessary. Here are the basic rules. The Internal Revenue Service cannot assess additional taxes after these time periods:
* Under normal circumstances, three years after the tax return was filed or the due date of the return, whichever is later.
* After six years, if you failed to report part of your gross income and it is more than 25% of the amount you did report.
This means that most of you can safely set up a tax-record disposal system that automatically gets rid of mountains of paper after the three-year period. A suggestion: organize your system to meet the recordretention requirements of other federal and local laws that apply to your business. And a postscript: a fraudulent return with intent to evade the tax -- or failure to file a return -- leaves you open forever.
Taking money out of your company
In the initial stages of growing your company, survival, profits, and building corporate equity come first. Then, if you're lucky, the welcome head of success appears. And because you'd like to enjoy the business's success personally, you start looking for ways to get money out of the company without getting hit by taxes.
There is a problem, though. Taking money out of a closely held corporation can vary from the painless to the disastrous when it comes to taxes owed. So, when you are assessing your options, the following guidelines should help. They're arranged in order, starting with the most desirable for tax purposes, and ending with the least desirable. The list, of course, is only a suggestion -- nontax considerations or your own circumstances may override any of these options.
1. Payments deductible by the corporation, tax free to the shareholders, and providing a current benefit. These include fringe benefits, such as medical and legal reimbursement plans, travel and entertainment expense reimbursements, and tuition-assistance programs. Also, pension and preofit-sharing plans are included in this category, provided you can borrow from the qualified plan.
2. Payments deductible by the corporation, but taxed to the shareholder, that provide a current benefit. Examples include salaries and bonuses.
3. Payments deductible by the corporation, but not taxable to the shareholder until received. Many pension and profitsharing plans fit in here.
4. Nondeductible payments by the corporation that result in current benefits to the shareholders that do not have to be repaid and that yield tax-free money (return of capital) and capital gains (or losses). This is the world of stock redemptions: the corporation buys back some of its stock.
5. Payments that are nondeductible by the corporation, nontaxable to the shareholders, but that must be repaid. This includes loans (with interest at market rates) from the corporation to the shareholders.
6. Payments that are nondeductible by the corporation, taxable to the shareholder, but provide a current benefit. These are dividends -- and are truly a tax disaster. The corporation gets no deduction and you must pay a tax.
Refinancing your house?
Any number of company founders will tell you about refinancing their houses to keep their businesses going. If you're in the market for refinancing, you should know about a recent IRS ruling, still to be tested in the courts. The ruling has to do with the deduction of points and can best be explained with an example.
Say the balance on your existing mortgage is $50,000, and you've found a lower interest rate at another bank. You decide to borrow $100,000 with a 20-year mortgage, and invest $30,000 in your business and $20,000 in home improvements. The new lender charges you 3.6 points ($3,600), but according to the new ruling, you can no longer deduct the entire $3,600 in the year paid. The IRS now allows current deductions only for house purchases or improvements -- $720 (20% of $3,600) in the above example. That means that the remaining $2,880 must be written off over the 20-year mortgage period.
In my opinion the IRS is not right -- the new loan simply replaces the original loan, which was for the purchase, and the new points should be deductible. With several bills pending in Congress, a new law may kick over the ruling. In the meantime, you may want to take your chances and claim a current deduction for all the points. If so, there are two approaches. One is to put a disclosure statement on your Form 1040 saying, "Points for refinancing home mortgage." This should avoid any penalty for understatement of tax in the event the IRS ultimately wins support for its position. The second way is not as aggressive: don't deduct the points on your Form 1040, but file a claim for a refund immediately after Filing your tax return.
One more tip: even if the points are deductible, you lose the current deduction if the points are merely subtracted from the proceeds when the loan is closed. To save the deduction, pay the points to the lender with a check from a separate account.
Travel & entertainment expenses
Many a businessperson thinks all that's needed to substantiate entertainment expenses is a canceled check. But that's not enough, the IRS and the courts have ruled. You must keep a record of 1) amount, 2) time or date, 3) place, 4) business purpose, and 5) business relationships. And a check, the tax court held in at least one case, does not describe business relationships -- it does not show who was entertained. In the same case, checks to a travel agency and hotel were allowed to support deductions for travel expenses. That's because records of only the first four items above are required to support travel deductions, and the checks met the test.