Please note that this site is for informational purposes only, users should seek advice from competent legal or accounting professionals before making specific decisions.

Accounting Methods

Q. What is the difference between cash basis and accrual basis accounting?
A. Cash Basis accounting records transactions when cash (or other form of currency) changes hands. That is when the customer pays for the product. Accrual accounting records the transaction when the buyer and seller agree that a sale has occurred, i.e. when an order is placed or a contract is signed which is usually before the cash is actually received. For tax purposes, the cash basis results in lower taxes when a business usually gets paid after they have paid for their expenses related to the sale. When the company usually is paid up front, and then incurs expenses, the accrual basis produces a lower tax.


Q. What are the advantages of cash basis accounting over accrual based accounting?
A. Generally speaking accrual based accounting is a more accurate measure of the performance of your business, however for tax purposes, cash basis will often result in a lower net income and accordingly less taxes. Please note that the IRS requires all businesses that have inventory to use the accrual method and that you are not allowed to arbitrarily switch back and forth. Furthermore in cases were you are generally paid up front such as in the snow plowing business the accrual method would produce lower taxes. Finally contractors are generally required to use a variation of the accrual method called the completed contract method. Be sure to talk to your accountant or tax preparer to make sure that you are using the method which is best for your business.


Q. When is Last In First Out (LIFO) better than First In First Out (FIFO) for inventory costing purposes?
A. Using LIFO will show higher income for either financial statement purposes or tax purposes when the cost of your product is dropping. For example if you sell computer chips which tend to decrease in value relatively quickly, using LIFO will expense the cheaper (more recently purchased) chips first minimizing costs and maximizing profits. If on the other hand your product tends to become more expensive like say diamonds, LIFO would result in lower profits since the more expensive diamonds (purchased recently) would be expensed before the cheaper diamonds purchased earlier. In addition, there are IRS imposed restrictions on switching between methods and AICPA reporting requirements for Reviewed and Audited statements. Consult your tax advisor based on your specific facts regarding which method to use and whether you can use different methods for book and tax purposes.


Q. I have a small business and would like to know a simple accounting system to keep track of my income and expenses?
A. Generally speaking, how complex your accounting system needs to be depends on how many checks you write each month, how much you buy and sell on credit, if you are in a construction business or manufacturing and how many different types of inventory you carry. The simplest method is to keep a daily or monthly calendar and track all income, expenses, mileage, etc. right on the calendar. Then summarize the numbers by month and transfer to a sheet of columnar paper listing the months down the leftmost column and the amounts in columns marked sales, purchases, supplies, utilities, mileage, etc.

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Q. I have an opportunity to purchased a well maintained car coming off lease at year end. Should I pay cash $14k or search for a used car loan?
A. Any decision regarding paying cash versus financing boils down to what are your alternative uses for the cash. If your cash will be sitting in a savings or money market account earning 2-5% interest, then it makes no sense to finance at 8-10%. On the other hand if using this cash will require you to borrow other money for your business at 12% then finance the auto and save the cash for your other purposes.

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Q. I am just starting out, and have $12,000 budgeted for furniture and equipment. What should I do to make sure that I am getting the most for my money?
A. There are a couple of factors to consider. First does the furniture and equipment have to be new? Second what is your financing structure? The first factor is based on how your customers will react if you have used furniture rather than new. In most cases this should not be significant, but it will be a factor in high profile professions where image is important to customer satisfaction. Otherwise the simplest way to stretch your budget is to buy used equipment. Ideally find someone in a similar business to yours who is going out of business and buy up all their furniture and equipment for as little as 10% of the cost of buying new. With a little cleanup and minor repairs you should be way ahead of budget. The second factor is based on your financing structure. Another alternative to buying new is to lease or rent the furniture and equipment. The benefit to leasing or renting is that it significantly reduces your up front costs. The downside is that it will increase your expenses which will affect your ability to attract financing. Furthermore banks may loan money to purchase furniture and equipment, but not to lease it. Therefore be sure to consider how renting will affect your financing and budgeting.


Q. I want to buy a new computer, but don’t want to spend $2,000. Does anyone sell cheap computers anymore?
A. The cheapest way to buy a computer is used. Check out the classified ads in your area to find used computers for sale. However, used computers are not always the best computers. Factory refurbished or computers that are two tiers below cutting edge (cutting edge is usually over $3,500, the next tier is around $2,500 – $3,500 and the second tier is around $2,000 – $2,500) can be purchased online. For example, you can buy an Intel 300 MHz machine with a monitor and all the bells and whistles including a scanner for less than $1,000 as proven by my recent experiment. These machines still have their factory warranty and haven’t been beaten up by a previous owner.

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Q. How do I calculate the appropriate inventory level for my business?
A. The trick to carrying inventory is to not carry too much since it ties up cash, costs more to store, greater risk of loss from depreciation, obsolescence or theft, costs more to insure, etc. but still carrying enough to not lose sales due to lack of product on hand. For general office supplies like paper and paper clips the cost of record keeping usually exceeds the cost of carrying too much, so you are better off stocking a little extra of those types of inventory. For other inventory, the following basic mathematical formula can be used to calculate your appropriate inventory size.
Estimated annual sales x Cost of Goods Sold (as % of Sales)
Inventory Turnover per year

Market research or previous history should determine annual sales. The appropriate Cost of Goods Sold as a percentage of sales and Inventory Turnover ratios can be obtained from trade associations or services such as Financial Research Analysis or Robert Morris & Assoc. (see your local library). The Cost of Goods sold refers to the price, including shipping, of the product being sold to you. Inventory Turnover is the number of times that you replace your inventory in a given period. Once the average inventory level is calculated, you can fine tune the number for a given period based on seasonal fluctuations. For example if you are a toy retailer your sales in November and December will be higher than other times during the year and therefore require higher inventory levels. Furthermore, even if you have 12 inventory turns a year, you may require 4 inventory shipments during those two months, but may need to order three weeks in advance. In other words, factors such as lead time (the time between placing and receiving an order), and peak sales times can affect the required inventory levels.

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Q. Can you please give me some tips on reducing my personal debt?
A. Four quick steps to reducing personal debt.

  1. Minimize the number of credit cards in your wallet. Keeping your available credit low will keep your debt low.
  2. Transfer balances from high interest credit cards to low interest cards – even if the low interest rate is for only a few months, you can always transfer again when the rate jumps.
  3. If you own your home, use your home equity to get a line of credit to pay off your credit card debt. Home equity rates are usually much lower than credit card rates and the interest may be deductible on your tax return.
  4. When you have some extra cash (a bonus at work, gift from relative, etc.), put the money toward your highest interest rate credit card. Note that prepaying a home mortgage or student loan may not be the best idea since interest on home mortgages and student loans may help reduce your taxes and it is harder to borrow more if you have a sudden expense, while credit card’s interest is generally not deductible on your tax return and can be borrowed against very easily.

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Q. I am interested in finding out procedures for setting stock options to attract investors to my company. How do I do this?
A. Before I start to answer, let me emphasize that this response is specifically for small businesses, large business would use an investment firm to sell options or raise funding for them, small companies cannot afford investment firms. There are many ways to set up stock options which mostly depend on the type of company you have, how mature (old) the company is and what you plan on doing with the proceeds. Essentially stock options are like any other contract where in return for money or as compensation for services you are giving the right to purchase your company’s stock within a given time period for at a given price. Stock options are seldom used as a source of financing on their own, but are usually included in sales of stock or included with loans to increase the appeal to the investor/lender. If your company is young and is raising money for operating capital, especially for research and development you will need to sell stock or at a minimum offer options with any debt financing. When negotiating with your lenders, mention that you would be happy to include stock options as incentive. An alternative is to make the debt convertible into stock.

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Q. What are some steps I can take to reduce advertising costs?
A. There are many ways to cut down on advertising costs. The simplest way is to not spend advertising dollars on media that do not work for your business. [See the next question on how to find the right media for you.] Other ways include:

  1. Reduce the size of your ad. More frequent smaller ads are often more effective than larger ads.
  2. Share ads. Join with firms in your shopping area to attract shoppers (malls do it all the time) or join with companies that provide a complimentary product (i.e. Fitness Clubs and Health Food or Office Supplies and Equipment leasing or a fast food store and a automobile repair shop {think about it, go eat lunch while they change your oil})
  3. Use alternative delivery sources. Rather than paying a company to distribute a flyer in a neighborhood, consider using a High School or College Student.
  4. Take advantage of discounts. This advice goes for all expenses. In most cases, if you charged the supplier the interest rate equivalent to the discount offered, you would be breaking the usury laws.
  5. Take advantage of volume discounts or specials. You are usually better off committing to purchase more than you need at a lower rate even if you have to pay a penalty at the end of the year for unused space.
  6. Consider bartering. If you have a large mark up on your product, say 50%, then you can buy advertising for only $.67 on the dollar (not taking into account membership and transaction fees.)
  7. Use co-op advertising. Like the shared ads above, only with the manufacturer (or wholesaler) of the product you are selling.


Q. How do I know what is the right advertising media for my business?
A. The object of advertising is to find the media that will reach the most people who are likely to buy your product or service without wasting too much on people who will not buy your product or service. The two factors are how many potential customers will be exposed to your advertising and what is the ratio of potential customers to total people. Obviously the higher these two factors are for a specific media, the better that media is for advertising. You should be willing to pay more for media that hit most of your potential customers and few potential non-customers. The simplest way to determine which media your customers use is to ask them. Conduct an unscientific survey of your customers (for hundreds or thousands of dollars a market research firm will conduct a scientific survey for you). Either use the next 50 customers you talk to or select 50 customers and ask them the following questions.

  1. How did you first hear about my product or service?
  2. What magazines, newspapers, radio or television stations do you normally read, listen to or watch?
  3. How far did you travel to reach our store?
  4. Do you ever look up our listing in the yellow pages? If so, which book do you use and which listing did you find us under? (Adapt to whatever forms of advertising are currently used i.e. which commercial did you hear/see, which advertisement did you see, etc.)

The purpose of question two is to identify media that are common to most of your customers. Question three should help you identify if you should use neighborhood, local, regional or national advertising. Ideally, the most popular answers to question one should be the only advertising media used. Note that for service businesses, the most popular answer to number one may be referral from another customer, if that is the case, you should consider how to spend money to increase referrals. Furthermore, if the answers to question four are generally no, that form of media should be dropped.

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Bad Debts

Q. What are some early signs to look for to determine that an otherwise good regular customer is becoming a ‘bad debt’?
A. There are many signs to look for that foretell a customer is getting into trouble. Obviously, these sings can be misunderstood, but when several appear, it is time to reevaluate your credit policy. The most basic theme is sudden unexpected change.

  1. Starts paying invoices using different checking accounts particularly if from different banks.
  2. Stalls before releasing financial data.
  3. Permits liens to be placed on inventory or receivables.
  4. Requests that goods be sold on consignment.
  5. Customer’s facilities begin to show neglect – they are cutting back on overhead.
  6. Frequent management or purchasing agent changes.


Q. I found out through the grapevine that one of my customers is having some financial troubles, what can I do to minimize my financial risk?
A. The first step you should do is to confirm that this is true. Talk to whoever handles Accounts Receivable and the customer to identify how bad off the customer is. Realize that the customer may not be willing to reveal their situation for fear that you will cut off their credit, so look for other signs. (See above for a list of signs). Remember, even if you do correctly identify a potential bankruptcy early, cutting off credit may cause the business to fail, preventing you from collecting what is already owed and of course result in fewer future sales. Consider trying to work with the customer and they might surprise you by pulling through. Instead of limiting credit consider securing collateral or providing the product on consignment. If the customer does pull through, they will be much more loyal to you for helping them get through a tough time.

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Home Office

Q. How did the new tax laws change the deductibility of home offices?
A. Before the tax law changes, the deductibility of home offices was limited based on the Supreme Court’s Soliman decision. That ruling limited home office deductions from business that performed services or delivered goods outside of the home even though significant amounts of work were performed in the home. The new rules allow the deduction to anyone who conducts administrative or management activities at home that does not have another fixed location where substantial amounts of administrative or management activities are performed.

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Independent Contractors

Q. Can I have an employee that I also pay as an independent contractor?
A. The short answer is absolutely not. The IRS would consider this an attempt to avoid payroll taxes and fine you double what it would have cost you to pay the taxes originally. Having said that, there are two ways around the IRS’s restrictions. The first and riskier way is to make sure that the tasks assigned to the individual as an employee and as an independent contractor are unique and well defined, that the timing of these tasks are clearly separated, that other than also being paid as an employee the individual passes the independent contractor tests, and most importantly the individual agrees to the classifications in writing (you may want to include a clause which has the individual reimburse you for taxes you pay on their behalf due to a reclassification by the IRS). The second, more complicated way is to use a third party as an intermediary. Rather than hiring the person as an independent contractor directly, use an outside employment service instead. When the individual performs the independent contractor functions, you would pay the employment service instead of your employee. The employment service would then pay the individual. As long as you show a business purpose for the employment service, there should be little risk of the IRS collapsing the transactions into one.


Q. I recently started an internet based business involving “franchises” making and receiving payments from my customers. Since I am sending out a paper trail payment to these individuals, must I also send them a 1099-misc with each payment? They can earn income from me by referring other customers. If I were to hold the proceeds in my on-line bank account for them, re-entering their proceeds back into the program, would there be any 1099-misc reporting? Would they, or I have to report any tax reportable earnings as long as the proceeds stay in my on-line bank account, or in the program?
A. You are required by law to provide any individual (including incorporated attorneys) who you pay $600 or more a year as an independent contractor a Form 1099 by January 31 of the following year. Even if the individual also has payments to you so that the net payment is below the threshold, a 1099 still must be issued once the $600 gross payment is passed. Furthermore, even if the money stays in the program, you would still have to recognize as income any receipts and could deduct any payments and they would recognize the opposite.

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Rental Income

Q. I own the building in which my business is located. I heard that I should not keep the building in the businesses name. Is this true?
A. Generally speaking, this is almost always true. There are tax advantages as well as liability protection advantages to keeping assets such as real estate out of the businesses name. These advantages are greater for corporations (subchapter C or S) and limited liability companies/partnerships, but the principals can apply to partnerships and sole proprietorships as well. There are two tax advantages. The first is that you gain some control over the businesses taxable income since you can set the rent charged to best benefit yourself overall. The second tax advantage relates to the avoidance of double taxation on the appreciation in value to the real estate which would occur in C corporations. The liability protection is relatively straight forward, if the business gets sued, the plaintiff cannot touch assets that are not in the businesses name. For sole proprietors this only works if you put the property in your spouses name and your spouse has no ownership interest in your business. However, this type of ownership setup tends to be easier to pierce for legal purposes.

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Q. I am first starting out my business, how do I project the sales level for the first year?
A. There are several methods available and you should probably use a couple to help refine your predication. The method you choose will most likely depend on the types of information you have available. The simplest method is to check industry statistics (or FRA, RMA or similar sourcebook) for the average sales level for a business your size (either assets or advertising budget) in your industry. Another basic method is if you know the current market size ($X) for your product or service and the total number of providers of that product or service (Y) in the market then divide $X by Y+1 (the plus one being you). The total number of vendors can be estimated by looking in the yellow pages. The market size can be estimated by knowing how much the average consumer in your market area spends on your product (taken from industry statistics) and multiplying by the total number of consumers (from census data). More complicated methods include various levels of surveys that can be used to find more detailed information on how much consumers in your specific area would be willing to spend on your product. Developing a survey is beyond the scope of this question.


Q. Will accepting credit cards increase my sales? If so, how do I go about doing it?
A. Most businesses can expect sales to increase by around 25% from customers who buy more than they normally would and by customers only willing to put it on the charge card. However, there are two other important factors to consider when deciding whether you should accept credit cards. First, what is your gross margin and second, how much are you going to be charged for the credit card service. The charge for the service depends on your average sale and total sales for the year. The higher those two factors are, the lower the service charge. One might think that your bad debt rate should affect the decision, but this is not true. (See bad debt). Nevertheless, an added bonus of accepting charges is that your bad debt rate should drop. In order to accept charge cards, you need to contract the services of a credit card provider such as your bank or Novus. You may lease or buy a card reader which is hooked up to the phone lines. At the end of the day, you settle out the card reader. The provider then credits your bank account with the settlement amount, usually the next business day. Its that simple.


Q. I don’t think that I charge enough for my products, but don’t want to lose customers by drastically increasing prices or by repeatedly inching up prices to find the right level. Is there any simple formula for pricing?
A. Pricing a product is mostly simple math. Step one is to find out what the cost of goods sold as a percentage of sales for your (or a similar) business or industry by checking with industry trade groups or looking in the RMA Annual Statement Studies or Financial Studies or the Small Business. Step two is to find the markup factor associated with the percentage. Finally multiply your cost of making the product available for sale (purchasing material, delivery costs, direct labor, etc.) by the markup factor. Compare your current price to the calculated price. Some minor tweaking can be done based on such techniques as loss leaders or to take advantage of limited availability or to get rid of excess inventory. See the pricing page.

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Q. What are the most important factors that I should take into account when selecting a second location for my business?
A. There are many important factors that you should consider, but the most important factor is the one that you should not consider and that is the proximity to your own home. The factors that you should consider include: Rent, Zoning, Competition, Side of Street, Traffic Patterns, Vacancies, Property Taxes, Local Business Taxes, Utilities, Road Access, Public Transportation, Available Labor, Union regulations and changes in any of the above expected in the near future. Discussing each of these factors is another answer in itself. Furthermore, the weight of each factor is different based on whether you are selling general retail, specialty retail, wholesale, service or manufacturing.

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Q. Where can I go to get free or low cost business advice?
A. Several federal, state, county and even local agencies provide various forms of free pamphlets and advice in addition to low cost seminars. Specific agencies to contact about programs and services available in your area are the U.S. Small Business Administration (SBA), SCORE (a volunteer association sponsored by the SBA), U.S. Department of Housing and Urban Development, U.S. Department of Veterans Affairs, State, County & Local Industrial Development Agencies, and State Labor Department, State Urban Development Corporation to name a few. In addition many colleges, universities and banks sponsor courses in the community that range from free to extremely expensive. However, I should remind you that every business decision should be considered as a cost – benefit equation. You should therefore examine exactly what is included as far as materials, classroom time, instructor availability for follow up, etc. before wasting your valuable time or money by taking a program.


Q. What can I do to protect my business investments from the ups and downs of the stock market?
A. There are three basic methods to protect against wide swings in the stock market. Hedging, diversifying and investing in low beta stocks. Hedging, the most complicated of the three, is an investment strategy which uses options to protect against price swings. Hedging is particularly useful if your business relies heavily on commodities such as oil, gold, coffee, or even foreign currencies. Diversifying is a strategy which involves investing in a variety of investments that will respond differently to factors that affect the stock market such as interest rates or GNP. This can involve investing in different industries or investing in both stocks and bonds. The strategy of investing in low beta stocks first requires that you understand what the beta of a stock measures. Beta measures how the price of a particular stock is likely to be affected by a shift in the market as a whole. Stocks with high betas are likely to increase at a greater rate than the market and conversely drop at a greater rate than the market as well. On the other hand, stocks with low betas will not move as significantly when the stock market does.


Q. I’m looking to buy a business. What documents do I need to look at to determine the value and how do I know that these documents are accurate?
A. There are two sets of documents that should be considered reliable. Audited financial statements (signed by a reputable accounting firm) and signed tax returns. Anyone can prepare financial statements for a business with numbers that are picked out of the air, but audited financial statements can only be prepared by Certified Public Accountants. CPAs are licensed by the state and subject to certain penalties for issuing false financial statements. Financial statements come in three levels: Compiled, Reviewed and Audited. Compiled statements are little more than the CPA compiling information provided by the business. Reviewed statements involve some analytical testing of numbers. Audited statements require the CPA to make sure that the information is free of material misstatement by confirming all material balances and analytical testing for accuracy. However, due to the expense of an audit most small businesses have only Reviewed or only Compiled statements prepared, if any. A signed (and presumably filed) tax return is also relatively reliable. In addition to the fear of being audited by the IRS, the desire to minimize taxes would prevent the return from overstating income or understating expenses. Once you have passed the preliminary analysis, an attorney should perform a due diligence search to confirm unencumbered title to all assets and review all contracts, leases or other legal documents pertinent to the sale.


Q. I am concerned about fire/storm damage, what records must I absolutely keep safe?
A. Disaster recovery experts recommend that you keep the most vital financial and insurance information in a small, easy to move, fire safe container. These documents include:

  1. Copies of your four most recent tax returns and financial statements.
  2. Copies of all insurance policies (including telephone numbers).
  3. Car and equipment titles.
  4. Photos or videotape of inside and outside of business.
  5. Important phone numbers for employees, client/customers, suppliers

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Buying/Selling a business

Q. What steps should I follow when considering purchasing a business?
  1. Determine if you have what it takes to run your own business.
  2. Determine what business or industry you are interested in.
  3. Consider the advantages of buying a business (or franchise) over starting the business from scratch for the desired industry.
  4. Find businesses for sale in the desired industry.
  5. Consider why the sellers are selling – watch out for ‘bad’ reasons.
  6. Look the business over – facilities, employees, customers, intangibles, etc.
  7. Determine value of available businesses (consider seeking advice from appraiser, CPA or other business advisor).
  8. Examine legal considerations (consider seeking advice from lawyer and CPA).
  9. Negotiate business purchase for best available deal (don’t use lawyer or accountant, do it your self).
  10. Close the deal (seek support from lawyer)


Q. I am looking to sell my corporation, what are the advantages and disadvantages of a stock sale versus an assets sale?
A. The biggest advantage of a stock sale are minimal legal costs. Since all you are selling is stock, there is no need for several title changes for assets or complex sales agreements. A second advantage is that presuming the corporation has been around for more than a year (or five years if certain tax proposals are signed into law) you would benefit from lower capital gain tax rates. The biggest advantage of an asset sale is that you can pick and choose specifically which assets are sold. This can allow you to hold on to automobiles, buildings, life insurance policies, investments, cash or just about anything else you value more than the buyer does. Since you value the assets more the total value to you increases. A second advantage is that if you hold onto appreciated assets in the corporation, and you leave the corporate stock in your estate, you heirs receive a step-up in basis saving income taxes on their ultimate sale. A major disadvantage of the asset sale, is that if done improperly, you get hit with a double tax, at the corporate and at the individual level.

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Q. Should I hire you (or another accountant) to do my taxes?
A. Hiring an accountant, tax preparer or bookkeeper or buying software to prepare your tax return should be treated like any other business decision using cost-benefit analysis. How much will you have to pay vs. how much time, aggravation and money will you save. If you have a simple return and do not mind spending the time and doing the math, prepare your return by hand. As your return becomes more complicated, software or a tax service can save you time. Taxpayers with returns that include large unreimbursed employee expenses, rental property, small businesses, farms, children under 14 with over $1,400 investment income, questions about retirement contributions or questions about classifying expenses between forms should definitely hire an accountant or other professional to help with the return preparation. Expect more expensive preparers to include tax savings tips for the future as well. Remember if your accountant costs more than they save you, go somewhere else.


Q. What are some good year end tax planning strategies?
A. The simplest time honored year end tax planning strategy is called timing. The idea is estimate whether you will be in a lower tax bracket this year or next year and accelerate or postpone income into the lower tax bracket year and to accelerate or postpone deductions into the higher tax bracket year. Furthermore medical and miscellaneous itemized deductions subject to AGI limitations that would be otherwise lost should be bunched together. How to figure out which year your tax bracket will be higher and which income and expense items can be moved around and how will be subjects of future QOWs.


Q. Can you tell me about the electronic payment options available for income tax returns.
A. Last year, the IRS introduced two electronic methods for paying income taxes. They are by credit card and by direct debit from your account. The credit card method is a little unusual since the bank fee normally paid for by the ‘store’ (in this case the IRS) is paid for by the taxpayer instead. That means that when you pay a $1,000 tax bill on your credit card, a second line item will show up on your credit card statement ranging from 1.5-5% (different cards charge different rates) or $15 to $50 in this example. Please note that interest charged by the credit cards for late payments will continue to be at their rate, not at the IRS’s rate (currently 8%) so using credit cards is not recommended if you will not be able to pay the balance off. The direct debit is a second alternative which is essentially the opposite of the direct deposit of refunds. If you have a balance due, you can authorize the IRS to deduct the balance on any day you want up to April 15th (so you don’t have to pay early). Please note that unless your bank charges a fee for the direct debit, there are no transaction fees related to this method.


Q. What is the difference between a deductible and non-deductible IRA?
A. Anyone with earned income (wages, self employed business income, etc.) can make a contribution to an Individual Retirement Arrangement up to the lesser of $2,000 or total earned income. If you do not participate in a retirement plan (401K, Pension, Profit Sharing, etc.), the entire contribution is deductible. If you do participate in a plan, the portion of the contribution which is deductible depends on your total adjusted gross income. Non-deductible contributions do not affect your taxes currently. Deductible contributions reduce taxable income and therefore taxes as well. Both deductible and non-deductible contributions accumulate earnings tax free. When the assets are withdrawn from the arrangement, deductible contributions are fully taxable. When an arrangement has non-deductible contributions, a portion of the withdrawal is not taxable. That portion is based on the ratio of total arrangement assets to total non-deductible contributions multiplied so that once all assets are withdrawn the value of the non-deductible contributions will not be taxed. Note that with the passage of the Tax Relief Act of 1997 rather than making non-deductible contributions, taxpayers can make Roth IRA contributions instead. See the question regarding the difference between Traditional and Roth IRAs for more information.

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Q. When will it be better to use a Traditional IRA versus the new Roth IRAs?
A. The choice of which type of IRA is better boils down to expectations regarding current and future tax rates. If your tax rate when you withdraw funds from your IRA is lower than your current tax rate, the Traditional IRA will have a higher return on investment. Of course the opposite is true if your tax rate when you withdraw funds from your IRA is higher than your current tax rate. This holds true regardless of what the expected return on your investment is or the expected time to retirement. Since predicting future tax rates or income is difficult the best rule of thumb is to use current facts. If you are currently in the lowest tax bracket (15%) then the chances of being in a lower tax rate at retirement are low meaning a Roth IRA will maximize your return. Furthermore, these facts hold true when considering whether to roll over Traditional IRAs into Roth IRAs. If you are currently in a high tax bracket do not roll over your IRA unless you will be in an even higher tax bracket at retirement. Other factors to consider would be if you will need to make an early distribution for either the first time purchase of a home or higher-education expenses (not allowed for five years after contribution to Roth IRA) or if you wish to make contributions after age 70 ½ (not allowed in Traditional IRAs). Finally, all other things being equal the following factors could change the optimal decision.

Factor IRA Type
High miscellaneous itemized deductions Traditional IRA
High level of disposable cash Roth IRA
High medical expenses at retirement Roth IRA

Since these guidelines are general, specific circumstances may warrant different decisions. Consult your tax advisor to see which IRA account will be best for you.

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Q. I heard that there are tax advantages to putting your small business in your spouse’s name. Can you explain the benefits and the risks?
A. The benefits of putting your Schedule C business in your spouse’s name relate to the social security and Medicare taxes, also known as self-employment (SE) taxes. By placing the business in the name of the spouse that earns more money outside of the Schedule C business from wages and partnership income you might be able to decrease taxes. The way this works is that social security is only taxed on the first $72,600 (in 1999). So if you had a business and your spouse had wages or partnership income and you each earned $40,000, you would pay $5,652 SE tax and receive an income adjustment of $2,826. The income adjustment reduces your taxable income and therefore the benefit depends on your tax rate. In this example the adjustment would be worth around $791 for a net tax of $4,861. If you put the business in your spouses name, the SE tax drops to $5,113 since only $72,600 of the $80,000 would be subject to the social security portion of the SE tax. Accordingly the adjustment to income drops to $2,557, worth $716, for a net tax of $4,397 or $464 less than if the business were in your name. Note if combined income is less than the $72,600 threshold (increased each year) there is no tax advantage to this strategy. There are two major risks. The first is that you absolutely must conduct the business in your spouses name to avoid the risk of losing an audit. If you continue to do business in your own name but put your spouse’s name as owner on the return you risk some major penalties if you are audited. The second problem is that by putting all the business assets, bank accounts, automobiles, equipment, etc. in your spouse’s name you can run into some serious problems if you have a falling out with your spouse or your spouse has financial problems. One other consideration is that in many states women are considered minorities and eligible for many minority owned business government programs. Theses advantages may outweigh the tax advantages of a woman putting the business in her husbands name.

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