Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.
Many smaller businesses and more than a few larger ones often take shortcuts in recordkeeping. That's a big mistake. The IRS can take issue with regard to a number of items and you could lose deductions simply because of the recordkeeping. Many of the items below involve transactions between related parties, frequently a hotpoint for the IRS.
There are two ways to run afoul of the IRS here--using the wrong method and switching methods without permission. We normally think of accounting methods as cash and accrual, but the term can be much more involved. For example, accounting for a sale when a product is shipped versus booking the sale when title passes. Capitalizing certain construction costs in some cases and expensing them in another would be two different accounting methods. In some cases the proper method is mandated by law such as using the accrual method if you maintain inventories. In other cases a taxpayer chooses the method when he first uses it, e.g. booking a sale when product ships instead of when title passes. In the second situation there's no right or wrong method, but you can't switch without IRS permission.
Unless your business is very simple, you should have an accounting policy statement outlining when and how to account for an item. In some cases, particularly if an outside bookkeeper is used, mistakes are made. They may or may not be caught by your outside accountant or tax preparer, particularly if the mistakes aren't consistent. Have a policy statement and make sure it's being used.
Many small business owners do business through more than one entity. They may have two corporations--one for business in Massachusetts, one for New York. Or one for consumer sales, the other for commercial. There's nothing inherently wrong with that, but it does mean you've got to be careful if there are intercompany transactions.
And things get trickier if the entities are not all the same. For example, one is a C corporation and the other an S corporation. That's because the C corporation pays its own tax; the S corporation generally pays no tax, the income is passed through to the shareholders. But that doesn't mean there aren't issues between a partnership or LLC and an S corporation even though in both cases the income is passed through to the owners. In this case the partnership or LLC income will generally all be subject to the self-employment tax. That's not the case with the S corporation income.
A number of the pitfalls outlined below involve multiple entities.
While it can be more pronounced if there are different types of entities, even intercompany transactions challenged by the IRS that involve the same type of entity (e.g. two S corporations) can become more of a problem if the ownership between or among the entities are different. For example, you own 75% of Madison Inc.; your son owns the other 25%. You also own 25% of Chatham Inc.; your son owns 75%. Both are S corporations, but you allocate intercompany expenses in such a way that Chatham generates a disproportionate amount of the profit. Shifting income to your son saves taxes because he's in a much lower bracket. It's also a way to get assets out of your estate.
Allocating Combined Purchases
Both Madison and Chatham use major amounts of diesel fuel. In order to get quantity pricing Madison orders the fuel. It's delivered to a single tank and both companies draw from it. Madison informally charges Chatham for the amount used. The IRS could challenge the charges. You'll be on safer ground if you have a formal way of metering the fuel and keep accurate records of the usage. Madison should then charge Chatham using a formal invoice. It may seem like busy work, but it could prevent an issue if you're audited. The same approach would apply to office and shop supplies, equipment usage and rental, etc.
If the items you're purchasing under the same order aren't fungible like diesel fuel, but are unique such as small tools, various office supplies, etc. you've got to be more careful and identify the items. By the way, the same rules would apply to labor and outside services purchased jointliy.
There's a good accounting reason for doing so too. Without a proper allocation or chargeback, you won't have an idea of how profitable each operation is. Besides the obvious reasons, there could be real issues at one of the entities that could go unnoticed such as pilferage.
If you do business in more than one state, not accounting for the intercompany transaction could generate problems. And there may be issues other than income taxes involved. If the items are subject to or exempt from sales tax, excise taxes, etc. You've got to be more careful. Using items that were purchased without sales tax for taxable purposes could prove costly on audit. Talk to your tax advisor or accountant. If the objective is to save money by making a quantity purchase, talk to the vendor to see if you can get the quantity discount even if the purchase order is from two different entities.
Intercompany transactions that have no valid business reason are more likely to get closer scrutiny. Getting a quantity discount is a good business reason. The IRS and courts are suspicious of intercompany transactions that don't have a business purpose.
Loans and Expense Payments
Madison has just gotten through its busy season and is sitting on a bunch of cash; Chatham is having trouble making payroll this week. Madison pays one of Chatham's larger invoices to ease the pain. It's not uncommon but it'll cause trouble. S corporations, LLCs, or partnerships often handle this by making journal entries showing a distribution to the owners who then make a capital contribution, loan, or a payable from the recipient entity. In many cases that's unlikely to fly on audit. It becomes more of a problem if there are multiple owners involved.
If there are no other options, Madison should make a formal distribution to the owner(s), followed by a formal loan or capital contribution to Chatham.
The same rules apply for cash payments between entities. You may sometimes make a loan between entities, but you'll generally be on safer ground if the owners make a loan or capital contribution to the entity needing cash. That will also create basis in the case of S corporations, LLCs, etc. so that any losses can be used currently.
Whether the loan is from one entity to another or by an owner to the entity, you should draft a formal note with interest, a due date and a payment schedule. Short-term loan? You can skip the payment schedule but have a due date. This is a complicated issue and the law allows some small exceptions.
While we're on the subject, expense payments by owners should be done through an expense report. That is, Fred may be the sole shareholder of Madison, but if he's not reimbursed for expenses he pays, neither party may get the deduction. Fred should submit an expense report and be repaid by Madison.
Charges between entities should be determined on an arms' length basis. For example, Madison provides support services to Chatham by having a Madison mechanic maintain Chatham's equipment (Chatham has no mechanics). Again, a formal invoice is called for.
Finally, the issue of salary is sure to come up in an S corporation. You're the CEO of both Madison and Chatham. Madison has been around longer and is the larger entity. You take a salary only from Madison. Generally, you should also be taking a salary from Chatham. There's no offset here.
This attention to detail is important here. Talk to your accountant or tax advisor for the proper approach in your situation.
Rental to Self
It's common for a business owner to own a building, factory, etc. in his or her name or through an LLC and rent some or all of the property to the business. It makes sense from a legal and business standpoint, but you can't get sloppy with your accounting here either. The rental should be at a fair market rate and the other formalities discussed above followed. That means the lessee shouldn't pay the expenses of the lessor, unless it's provided for in the lease agreement. Special rules apply to self rental--where you, your LLC, etc. rent property to a related party. Charging more or less than the market rent can backfire.
This is one of those times in taxes when you've got the receipts and it's a valid expense, but you could still loose out because the transaction wasn't handled carefully. Also keep in mind that there can be accounting issues if you have to report to outsiders such as a bank lender, shareholders, etc. Discuss the issues with your accountant.
Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 07/14/15