Bookkeeping & Accounting Issues

Bookkeeping & Accounting Issues
A business that is either just starting out or undergoing a significant growth stage must deal with four main issues in regard to recordkeeping: the use of the most appropriate "tax year;" whether to use a cash vs accrual method of accounting; maintaining a good recordkeeping/bookkeeping system; and, having a working knowledge of the major IRS reporting requirements for various payments.

The right decisions in these matters help increase the chance of business survival and of maximizing business profits.  In addition, it can make matters much easier in dealing with such groups as the IRS, your state tax authority, an insurance carrier, outside investors, and accountants.  This can save you time, aggravation, and money.

Use of the Most Appropriate Business Tax Year
A business may be required to choose between two different tax year periods: a Calendar Year or a Fiscal Year.  A calendar year is one which ends on December 31.  A normal fiscal year consists of 12 consecutive months ending in a month other than December.  The business must establish which of these two options it will use for its operational life.

Why would a fiscal year be chosen?  Many businesses use a fiscal year to match the business cycle–take advantage of the highs or lows.  Others do it for convenience of recordkeeping.  Getting information ready for doing taxes or financial reports can be time consuming, so a fiscal year that ends during a lull period gives the owners a more efficient time frame to do the recordkeeping activities.  Businesses where inventory(and inventory-taking) is a big factor frequently elect fiscal years.

Similarly, businesses where the cash flow may differ from a calendar year period may decide on a fiscal year so money will be available to pay any required income taxes.  In brief, a fiscal year may be more beneficial than a calendar year for a business where the preferred operating or income cycles end other than December 31.

From an income tax reporting standpoint, there are some business types that are either limited in the choice, or must make a special application to get permission to use a specific choice.  This is due to the so-called "default" issues related to certain types of  entities in which they are restricted in their selection.

In this regard, businesses that are either sole proprietorships, partnerships, or special subchapter S corporations must generally use a calendar year for income tax filing purposes.  Regular C-type corporations can usually elect either calendar or fiscal without any restrictions, unless they fall under the classification of a "personal service corporation." In that case, a calendar year would also become the required default choice.  A personal service corporation is one in which the principal activity consists of personal services done by owner/employees.

There are ways in which a business may still be able to qualify for a fiscal year selection instead of a required calendar year.  The IRS may grant special permission to use other than the required tax year if the business can prove it has a definite "Business purpose" for another tax period.
For instance, a business that is highly "seasonal" in nature where the main activities have monthly "peaks and valleys" that do not end on December 31 would be a good candidate.  A tax preparation business where April is the dominant month is a good example; certain farming related businesses also fall into this category.

Other determining areas might be such things as the use of a fiscal year due to employee hiring patterns, consumer buying patterns(swimming pools, boats, etc.), regulatory purposes, or model year changes, to name a few.  Reasons that CANNOT be used to get out of using a required tax year revolve around a business purpose that causes a significant shift in income or deductions such that it reduces potential tax liability.

Another way for certain business types to use a tax year different from a required tax year is to make a Section 444 Election.  This is done by filing IRS Form 8716, "Election To Have A Tax Year Other Than A Required Tax Year." This may work for partnerships, personal service corporations, and subchapter S corporations where the "business purpose" test doesn't apply.  This involves meeting various deferral period requirements and possibly making a payment if there are any calculated tax benefits from this deferral into a fiscal year.

Change In Tax Year: If you decide to try to change an existing tax year, an IRS Form 1128, "Application To Adopt, Change, Or Retain A Tax Year" must be filed.  This is due before the 15th day of the second calendar month following the close of the prior tax year.

Cash Vs Accrual Accounting Methods
Under IRS definition, an accounting method is a set of rules used to determine when and how income and expenses are reported.  Normally for IRS purposes, the accounting method–cash vs accrual–is chosen before you file the first business income tax return.  It must then be used on a consistent basis for the life of the business, unless changes in the business occur that statutorily necessitate a change in the accounting method.  If you wish to change methods for particular reasons of your own, you must get written permission from the IRS.

Normally, you calculate your income and expenses by using three major methods: 1) Cash Method; 2) Accrual Method; or, 3) Hybrid Method in which select elements of cash and accrual are combined.

Cash Method 
This is used by most sole proprietorships, and many businesses where inventory is not a major factor.  In this method, income is reported when actually(or constructively) received, and expenses are deducted when paid or legally charged(like with a credit card).

"Constructive receipt" means the money is made available to you without restriction.  It doesn't always mean you have to have it in your possession.  If it is credited to you, or given to your agent, it is still considered constructively received by you.

Expenses that you pay for are generally deducted in that particular year, unless you have substantially prepaid expenses that actually were for another year.  As an example, if you prepay a three year service contract you cannot deduct the full three years of expense in one year.  You would have to allocate the cost instead.

Note that there are restrictions on which type of business can and cannot use the cash method.  Generally, this method can be used by sole proprietors, corporations with less than $5 million dollars in gross receipts (current 2000 year rules), most general partnerships (unless a C Corporation is one of the partners), and farm businesses with less than $25 million dollars in gross receipts.

Tax planning opportunities exist with the cash method if you can time your constructive receipt of the income in such a way as to push it into another tax year.  When you bill the client, when you actually receive the money and bank it, and when the job and its guarantees reach completion can each define when you have to report the income.

As to taking expense deductions, buying and placing into use such things as business equipment and supplies can be equally timed.  Advertising, marketing, and employee bonuses can also be timed to best suit you for tax planning purposes.

Accrual Method 
Using an accrual method, income is reported in the year it is earned, not necessarily received, and expenses are deducted in the year they are incurred, not necessarily when paid.  From the gross receipts perspective, an accrual method generally means you report the income when the client is billed and/or has received your service or product.  So if you finish a job and bill the client this December 2000,  but don't get paid until January 2001, the income is reported in 2000 under the accrual method.  Note that there are certain exceptions to this if the business transactions involve "related persons, entities, and controlled groups" but this is relatively rare for the scope of this discourse.

Unlike the cash method of accounting, accrual methodology can also involve making adjustments to reported income for bad debt allowances.  If you report income when billed, but do not end up collecting all that is due you, you then may be able to write off the non-collectible portion as a business bad debt.

In regard to business expenses, you deduct or capitalize these when you become liable for them.  This liability issue involves meeting the "events and economic performance" rules.  Before taking the deduction, all necessary events that create the liability must have happened, and the economic performance of the action must have occurred.  Thus, if the expense is for materials, property, or services you incur in the production of income for your trade or business, economic performance occurs as you provide your service or product.

Tax planning avenues that may be open to accrual type operations involve the attempt to defer income into a future year, and accelerate expense deductions into the current year.  In this way, the net income from the business may be lowered for the current year at the expense of the next year.  This may be possible by arranging it so the job you are doing is not fully completed before the close of the year, in which case the receipts collected don't necessarily have to be posted as taxable income at that point.  You get the cash, but defer paying taxes on it until a later date.

Similarly on the expense side, you would attempt to accelerate expenses into the current year so the bill you receive can be written off even though you haven't paid for it yet.  This type of tax deferring can be beneficial in two ways.  First, from a "use of funds" perspective it may make sense since you will have an extra year's use of the tax money you have delayed.  Second, if your business experiences relatively large swings in taxable income from year to year, this is a way of "levelling off" the taxable income, thus possibly lowering the marginal tax bracket and actually saving taxes overall.

So if you are billed for office equipment placed into use in December 2000, but don't pay for it until January 2001, the deduction is taken in 2000 under an accrual method.

While the use of an accrual method may be elective for most, a business that maintains inventory as a significant part of the production of income(stores, manufacturers, wholesalers) must use some form of accrual based accounting for the purchases and sales of the particular products in question.  The full cash method is generally not allowed in this case.

Hybrid Method 
This combination of cash and accrual may be allowable if you can clearly show income and expenses in a consistent methodology.  If you have two distinctly different businesses, you may use a cash method for one, and an accrual method for the other.  If inventory is a significant part of your business, you could use accrual for purchases of inventory and sales of these items, but you may use cash methods for all other income and expense items.

However, there are limitations.  If you elect the cash method for income, you must generally use the cash method for expenses.  Conversely, if you elect accrual for expenses, you must use accrual for income.

Within this hybrid method there may be different elections as to how income will be reported.  As an example, a completed contracts method may be elected for income.  This may apply to a construction-type business where the projects take more than one year to complete.

Minimum Bookkeeping System Requirements
Maintaining a good, acceptable bookkeeping/recordkeeping system should not be solely to satisfy the government.  There's no question that the more successful businesses also have more efficient bookkeeping systems in place.  This is because a good bookkeeping system can give a business the timely information it needs to increase profit-making opportunities.

A good bookkeeping system can help the business answer many important questions such as:

○ How much business is being done?  
○ How much cash is on hand?
○ How much is tied up in receivables, and how old are these receivables?
○ Should credit continue to be extended?  
○ Should collection action be taken?
○ What are the expenses by categories?  
○ What are the important business ratios that should be analyzed?
○ Are sales, expenses, capital, and profits showing improvement over previous periods?  
○ Where is the break-even point?    
○ How does this business compare with others of its size and industry?
○ What is the projected income tax bill going to be, and how can this be minimized?
○ Is payroll at its optimum level, and is there enough cash coming in to meet payroll?

A good bookkeeping system allows the business owner and accountant to create and review important business ratios, profit and loss statements, balance sheets, customized management reports, reconciled bank statements, and required tax return information.

Requirements of a Good System
For most businesses, especially privately-owned ones, an adequate recordkeeping system should be relatively simple to use and understand, accurate, designed to provide timely information, consistent in its treatment of income and expenses, reliable, and exportable in its context.  The last feature refers to how easy it is for others besides the one recording the information to be able to understand, compile, and make adjustments to the information for their own purposes.  Tax accountants, bankers, outside investors, shareholders, and actual business owners fall into this group.

Single Vs Double Entry: There is sometimes a choice between these two types.  A single-entry system is the easier to keep, and also the more limiting for information, auditing, and accuracy-checking purposes.  In single entry, an income or expense item is posted once with no other account offsets.  For simple, one-person sole proprietorships where the owner also pays the bills, collects the income, does the bookkeeping, and where managerial reports are secondary, this system is easier to use and understand.  A single-entry system tends to concentrate primarily on the profit and loss statement and not the balance sheet side, so it is really only a partial system.

The double entry system involves the use of journals and ledgers to track profit and loss and balance sheet items.  Transactions are entered into a journal, then summarized in ledger accounts.  These include income and expenses, assets, liability, and capital accounts.  Unlike the single-entry, the double entry system is designed to be self-balancing.  Every entry involves both a debit and credit in which the ultimate sum of the debits equal the sum of the credits.

At given periods(usually monthly, quarterly, annually), financial statements can be prepared which usually center around the Income Statement and the Balance Sheet.  The income statement is similar to a profit and loss statement in that it reflects the income and expenses for the period.  The Balance Sheet shows the business financial position at a given point in time in regard to assets, liabilities, and capital.    While more complicated to maintain, double-entry systems allow for much more flexibility and standardization.  They help to minimize errors, and possible embezzlement problems.  Further, for businesses that may require audited, compiled, or certified financials (for investors, or lenders, etc.) double-entry systems are definitely the preferred way to go.

Features of an Adequate Bookkeeping System
Whether single entry or double entry is selected, a bookkeeping system should have as a minimum the following component parts:
1)  Income Register: This records and details money received by the business.  It's especially important from a tax audit standpoint to be able to track the nature of the business deposits and differentiate between taxable and nontaxable sources.  This income should be in balance with your bank statements, and supported by sales slips, invoices, register tapes or any documents used in the sales process which are stored separately.
2)  Disbursements Record: This classifies, categorizes, and summarizes the expenses paid out for the business.  Reimbursements and cash payments are handled the same way as checks.  These expenses are recorded according to the date, check number, amount, and expense category.  Further, all expenses should be backed up with an invoice or cash receipt which are stored separately.
3)  Petty Cash Vouchers: For minor, incidental expenses where writing a check would be a nuisance(such as for office coffee, stamps, etc.), the use of a petty cash system is recommended.  A check is written to fund the petty cash box for a designated amount.  Money is taken out to pay for these small items(usually under $5), and the receipts are recorded on petty cash vouchers.  Periodically, another check is written to replenish the petty cash fund.
4)  Travel & Entertainment Reports: For tax purposes, contemporaneous records must be kept for such expenses as food and entertaining, use of vehicle, outside travel, and other employee paid business expenses to be reimbursed.  This T & E log breaks down the expenses per employee, and per category.  In addition, back-up receipts where required for these expenses must be stored in case of audit.
5)  Equipment Register: This records all assets/equipment bought or disposed of by the business.  It shows the dates involved, purchase amounts, check number, supplier's names, and disposition details.  For calculating depreciation, and any tax consequences upon disposition, this register is highly recommended.
6)  Payroll Register: A separate, detailed record is in order for controlling various aspects of payroll.  Records verifying the accuracy of how payroll is calculated, taxes are credited and deposited, overtime is calculated, etc., are mandatory.
7)  Insurance Log: Business insurance policies are identified and detailed as to the type of coverage, premium costs, policy numbers, name of insurer, effective policy dates, and expiration dates(to avoid unwanted loss of coverage).
8)  Accounts Receivable Control Ledger: This helps you keep track of who owes the businesses, how much is owed, and for how long it has been owed.  It is essential to maximize your cash flow situation, and to minimize business bad debts.  Accounts receivable are usually tracked according to their "age" using 30 day, 60 day, 90 day, and 180 day cycles.

Please understand that these eight features represent the minimum for an adequate bookkeeping system.  The nature and type of business dictates what other features or customization should occur.  In fact, many business types customize their systems; restaurants, automotive businesses, manufacturing, and others have their own particular nuances that need to be considered in setting up a system.

IRS Reporting Requirements for Payments
Businesses may be required to send notification to the IRS and state tax authorities for payments made in diverse areas.  These are usually called "information returns" in which the business discloses to the government the nature of the payment, the amount, and to whom the payment was made.

Generally, these forms are required to be distributed to the recipient of the payments as well as to the government.  For IRS purposes, they are usually due on or before February 28 of the year following the year of payment.  There may be penalties charged to any business that fails to file these information returns.  Some of the most common filings are:

Form 1099 Misc: Payments in excess of $600 per individual for services rendered (such as subcontractors, landlords, other nonemployee compensation).
Form 1098:  For payments of mortgage interest in excess of $600 to individuals on loans owed by the business.
Form 1099 DIV:  Payments in excess of $10 per recipient for dividends, and stock dividends.
Form 1099 INT:  For payments in excess of $10 to recipients of interest income.
Form 8300:  Report of cash payments received by a business in excess of $10,000 per transaction or related transactions.
Form W-2:  Payments to employees for wages, tips, and other compensation.  No dollar limitation.

There are many other possible information returns that may be required for different business activities and business types.  However, these are the main ones that tend to impact most average businesses.  When in doubt as to the ones required in your business, check with the appropriate professional before the year ends.

A Word on Computerized Systems
With today's explosion of the use of data processing systems, more and more businesses of all sizes are using computerized recordkeeping systems.  There are no government restrictions or limitations on these systems as long as they meet the same tests and requirements as manual ones do.

The IRS position is that you must be able to show records that provide the necessary information to determine correct tax liability in a way that the auditors can track.  The documentation must show the applications performed, the procedures used in each application, and the controls at hand.  In other words, the computerized system must provide an adequate audit trail back to the original source of entry.

Using Outside Accounting Services
Many firms elect to use outside bookkeeping and accounting services to handle the major aspects of the recordkeeping–especially as it relates to government tax filings.

This may be the most efficient use of a business owner's time.  To try to be an expert in accounting, and to try to keep up with the changes that occur in the field can be prohibitive for a business owner.  So the use of a professional to help design, change, and implement the necessary bookkeeping systems is certainly a viable option.   

Conclusion
Decisions on accounting and bookkeeping issues are important for businesses, especially in the early stages.  The purpose is twofold:
1) To meet government tax filing requirements, AND, 
2) To increase the business chance for success by providing timely, efficient, and informative data with which to make comparative choices.

While it is usually easier to make these choices at the start of the business operation, this is not always possible.  Businesses change along the way.  In fact, running a business is not a static event; rather, it is a dynamic.  These changes may necessitate corresponding changes in the accounting method, year, or bookkeeping system being used.

With few exceptions, it is strongly recommended that a business owner consider using an outside professional for at least some of the decision-making process here.  The expeditious use of this type of assistance in the earlier stages of development can go a long way toward achieving the maximum business success possible.

Reference:  Practice Enhancers, Able & Co.

Audits - Instructions and Steps, How The Audit System Works

Audits - Instructions and Steps
How The Audit System Works
For most businesses, the chance of an audit is fairly low.  On average, less than 1% of all business returns filed in a given year are audited.

Your audit chances also vary according to the region in which you file your return.  This is based on IRS data which indicate that businesses in some parts of the country are more "aggressive" than others in their tax deduction claims.  Filing the exact same return in each IRS region can result in a different audit probability as follows: 

IRS Region	Audit Percentages
North Atlantic	0.75%
Mid-Atlantic	0.45%
Central	0.65%
Southeastern	0.65%
Southwestern	1.15%
Midwestern	0.68%
Western	1.25%

If one were to break this down into states, the audit percentages would vary even more dramatically.  Maine has an average audit probability of .5% while Connecticut businesses have over three times that probability!

Within these income and geographic categories the audit probability will vary according to still more issues, such as certain schedules and deductions taken, types of businesses, specific issues the IRS has chosen to focus on, and how fully staffed the local IRS office is, to name a few.

In general, tax returns are chosen for audit by the IRS DIF program (Discriminant Income Function), which is a highly secretive way of grading various issues on a tax return.  Once the computer "scores" the return for this DIF score, an IRS agent then manually reviews these higher scores to decide which ones should be actually audited, and which items should be audited.

Some "Red Flag" Areas
While the overall DIF function is kept quite secret, there are a number of areas that clearly increase your chance of audit.  Some of these are:

• Office-in-home deductions
• Casualty losses
• Bad debt write-offs
• IRS perceived "Hobby" businesses with losses
• Certain Tax Shelter write-offs
• Part-time Sole Proprietorships
• Heavy entertainment and miscellaneous business deductions

Does this mean you shouldn't take these deductions out of fear of an audit?  Absolutely not.  If you are entitled to them, go for it.

However, with any of these "Red Flag" areas, if you are potentially vulnerable to an audit, you can greatly reduce your chances by attaching to the return proof of the substantiation and deductibility of the item in question.

If You Are Audited
There is a great deal of fear by the average business owner in this regard.  While an audit is nothing to be taken lightly, it does involve a system that has a number of checks, balances, and rights for the taxpayer.  A quick overview of the process is as follows:

The Notice
Usually, your first inkling of an audit comes via the Post Office:  a letter from the assigned IRS office and auditor.  This letter identifies the tax year in question, a proposed meeting date, and the general scope of the examination. It also includes information on your rights as a taxpayer, one of the most important of which is your right to have representation.  In fact, for the vast majority of the audits, you don't even have to attend if you so elect.  Instead, you can have a representative go for you.

The Procedure
The auditor will require adequate proof of the deductibility of the items in question, and/or proof of income reported for the business.  Usually an auditor will disallow a write-off if you cannot prove the actual expense claimed via a cancelled check and copy of invoice; also, a deduction can be denied "on theory" if you were not entitled to it according to law(a common example would be for casualty losses, or educational expenses, to name a few).

Once the issues are dealt with, the auditor will follow-up the examination with a written report detailing the findings.  If there are proposed changes, the report will make the adjustments to the tax return as originally-filed and a tax bill will be sent to you.

At this point, your options are to agree to the findings, or to fight further on.  You can ask for a secondary conference with the original auditor to provide further proof.  You can ask for a supervisory review–a talk with the auditor's supervisor.  Finally, you can ask for an appeal to a higher level, usually at the Regional Appeals Office.  This division's purpose is to "settle out of court."  The appeals officer has wide-ranging authority to make decisions and compromises if it is felt that the original auditor may have a weaker case than you do.

In many cases, you have a better chance at this level than not.  However, if there were other weak areas on your tax return which were not originally audited, or which the auditor skimmed over in your favor, keep in mind that an Appeals Officer can "re-open" the case, or raise other issues as well.  So this must be considered in deciding if an appeal is in order.

Your final option is to take the case to court, either Tax Court, or a Civil Court.  In terms of expense, this is frequently the most expensive option to take.

Conclusion
Getting audited is one of the most common taxpayer fears.  However, it varies considerably with a number of items.  Further, there are a series of protective steps a taxpayer can make to reduce the chance of audit.  If audited, there are a number of further steps a taxpayer can take to protect one's rights and preserve one's deductions.

By having a general understanding of what leads to an audit, and how to defend yourself if you are audited, it helps to minimize the potential damage and aggravation in this particularly distasteful part of business taxation.

Reference:  Practice Enhancers, Able & Co.

Payroll Issue Basics

Payroll Issue Basics
EMPLOYER PAYROLL ISSUES
It's important to have a basic understanding of your tax obligations as an employer since Federal and State laws have numerous requirements that must be met from both a legal and a tax standpoint.

Keep in mind that most of these laws also apply to the business owner if the owner is set up as an employee of a corporation.  If the business is a sole proprietorship or partnership, legal owners do not register as employees.  However, for purposes of the following discourse, an owner is the same as an employee.

A Quick Overview Of Some Labor Law Guidelines
As of the present year, federal labor laws revolve around 15 main Congressional Acts; the most prevalent one is the Federal Fair Labor Standards Act (FLSA).  Not all employers must meet all the provisions of these Acts, and not all employees of covered employers must necessarily be included.  However, employees may also be covered under numerous state labor laws which tend to mirror many of the federal laws.  Therefore, a working knowledge of the main requirements from a tax standpoint are in order.

Exempt vs Non-exempt employees:  The Federal and State labor laws tend to vary in some areas between these two classes of employees. Exempt employees are those who do not have to be covered under different provisions such as overtime pay.  An exempt employee falls under the "laws of exception" so it is always important to get a ruling if there is any doubt about the exemption status.  Generally, exempt employees are as follows:

♦ Managerial types such as executives, professionals, outside sales people, other highly compensated individuals.

♦ Certain employees in retail, seasonal, farming, domestic help, and transportation fields.

These exemptions can vary between the Federal and State levels and are based on criteria such as the type of business, nature of work, and customs of the particular industry.  The difference between an exempt and non-exempt employee can be very difficult to determine, so unless you are 100% sure the employee is exempt, assume the opposite.

Therefore, the following guidelines (unless otherwise noted) will deal with non-exempt employee situations.

Minimum Wage Laws: The federal government and most states have minimum hourly wage amounts you must pay. The federal minimum wage provisions are contained in the Fair Labor Standards Act (FLSA). The federal minimum wage is $7.25 per hour effective July 24, 2009. Many states also have minimum wage laws. Some state laws provide greater employee protections; employers must comply with both.

Overtime Pay:  All non-exempt employees must be paid one and one-half times the regular hourly rate for any hours worked in excess of 40 in a week.  The employer cannot average the weeks, so even if the employee worked only 20 hours the week before, overtime must be paid if the work hours exceed 40 the next week.  Also, the hours are calculated based on the full week, not per day.  Thus, in this case the hours are averaged for the week.  If an employee works 10 hours one day it doesn't mean overtime is required so long as the total hours for the week do not exceed 40.

Vacation Pay, Other Fringes:  Normally there are no set requirements forcing you to pay for items such as vacation time, sick pay, premium pay, meal money, or other fringe benefits such as medical insurance, life insurance, etc.  You may elect to do so as part of the employer package, but it isn't covered under Federal laws.  However, if you are providing any of these to any employees, there may be various "nondiscriminatory" testing rules to meet if you aren't covering ALL of your employees.  This is a very complicated part of the compensation regulations.

Travel Pay:  Unless it is part of an employee's job to travel between required job sites or meetings, you normally do not have to pay for travel time.

Workers' Rights Notices:  The employer is required to post various notices listing workers' rights and grievance procedures.  The particular notices to be posted vary with the type of employment and employees.  If your employee files for unemployment benefits, the State will notify you and request information regarding the nature of the separation from employment.  These notices should not be ignored if you are challenging the unemployment claim.  Incidentally, your state unemployment rate you can rise with incidents of employee unemployment claims, so don't ignore any situation you feel is unwarranted.

Worker's Compensation Requirements:  With very few exceptions, an employer should obtain Worker's Compensation coverage for all required employees.  The rate that will be charged for the coverage varies with the type of work involved, and employees covered. Without this coverage, however, the employer is extremely vulnerable for damages should an employee receive job-related injuries.  This coverage is obtained on the State/local level rather than the Federal level.

Employee Tax Registration Forms Needed
Employees must record certain information for income and payroll tax validation purposes.  These forms are:  W-4 Form, I-9 Form, and related State Withholding Allowance Certificates.

W-4 Form:  This form records the employee's name, address, social security number, and number of "withholding allowances" to be claimed.  These allowances help to determine how much income tax should be withhheld from one's pay.  The employee signs this form. The employer keeps this W-4 on file.

State Withholding Allowance Certificate:  Similar to the W-4 Form, this helps to determine how much State income tax should be withheld from an employee's pay(in States where an income tax  exists).

I-9 Form:  This is now a required form for nearly every employee. There are few exceptions, and since the potential penalty for failing to have one of these on file can be upwards of $20,000 per violation, you should make this mandatory for all employees.  The purpose of this form is to verify an employee's eligibility for employment according to Immigration laws.

The "citizen vs alien" status is recorded, and a section containing identity and employment eligibility verification is checked off. Both employer and employee sign this I-9 Form, and it is kept on file with the W-4.  In effect, the purpose of this form is to ascertain that the person is not an "illegal alien" for job purposes.

Types Of Payroll Taxes That Must Be Paid
As an employer, you must take on the task of being a type of collecting agent for the government.  You are required to properly withhold and/or pay various Federal and State payroll taxes.  Failure on your part to properly do this can result in heavy penalties.

Some of these taxes are paid by the employee, and therefore withhheld from pay. Others are paid by you, the employer. The main taxes paid by the employee are Federal Income Tax, Federal Social Security Tax, Federal Medicare Tax, and State Income Tax. The main taxes paid by are the the employer's share of Federal Social Security Tax, Federal Medicare Tax, Federal Unemployment Tax, State Unemployment Tax, and State Worker's Compensation.

These employer/employee taxes are collected by you, the employer, and sent to the government or a designated agent on a periodic, timely basis.  Failure on the employer's part to do this can result in very heavy penalties and interest.  For the Federal government, the normal procedure is to make these deposits using a set of pre-printed Tax Deposit Coupons(Form 8109) which are obtained by applying on Form SS-4.

On a timely basis you fill out one of these coupons designating the type and amount of the tax payment; usually it is brought to an authorized depository bank(most commercial banks are authorized). States have similar types of coupons to use for State withholding purposes; however most businesses are allowed to send these coupons directly to the State instead of going through the bank.

Payroll Deposit Rules:  The size of the calculated payroll tax liability usually determines the frequency with which you must make these deposits.  It can get quite complicated as the payroll liability grows.  The government offices want the money as soon as possible!  On the State level the payment usually is based on a monthly or quarterly schedule except for very large businesses. However, the Federal requirements are either monthly or semi-weekly deposits for the average business.

The two main exceptions to this are:  If the total of payroll tax liability (FUTA excluded) for a 3 month period is less than $1,000. then this amount can be paid when the quarterly payroll tax return is filed.  If the tax liability reaches $100,000. the deposit generally must be made the next banking day after this threshold is reached. FUTA tax must be deposited once the liability reaches $100.

State Unemployment Tax:  This is generally calculated on a quarterly basis and paid subsequently.  Since this is a State employer-paid tax it doesn't come under the previously-mentioned deposit due dates.

Special Note On Payroll Tax Liability:  The government views the employer as a collecting agent with fiduciary responsibilities to forward these payroll taxes.  It is important to keep current with them since you can be held personally liable for any deficiencies. If your company becomes unable to pay these taxes, the IRS can impose this obligation on any responsible party.  Also, bankruptcy does not absolve you of these particular tax obligations.

Tax Returns That Must Be Filed
Above and beyond collecting the required payroll taxes, an employer is required to file periodic Federal and State payroll tax returns. These are filed on a quarterly basis.  The returns are actually due by the end of the following month of the quarter in question.  In addition, yearly W-2 Forms must be filed to summarize the payroll numbers.  A brief description of the tax returns and forms is as follows:

Federal Form 941:  A quarterly tax return which summarizes the Federal income tax withholding, Social Security tax, Medicare tax, and tax deposits made.

Federal Form 940:  A yearly tax return which summarizes the Federal Unemployment Tax owed and paid on behalf of all appropriate employees.

Federal and State W-2 Forms:  Yearly forms to be given to employees and copies to be sent to the governments detailing the wages and taxes per employee.

Federal and state W-3 Transmittal Form:  A yearly form which summarizes the totals of the individual W-2 Forms for federal and state income tax, and Social Security Administration purposes.

State Unemployment and/or withholding Tax Return: Usually a quarterly tax return which calculates the unemployment tax and/or withholding tax the employer must pay on behalf of each qualifying employee.

Worker's Compensation Reporting:  This employer-paid expense is not truly a payroll "tax" but it is a direct result of having employees, so it is listed here.  This is payable on the State level, usually to an authorized State agency/ carrier.  The report is usually in the form of a yearly review by the appointed agent.  Since Worker's Compensation rates are based on the type of employee and nature of the work, this report categorizes the payroll and size to determine if any additional liability is due.

Required Recordkeeping
Having employees means keeping good records for a number of reasons. First, it's the law. Second, in the event an employee challenges you regarding pay or overtime or worker's compensation issues, the burden is oftentimes on you to prove your case instead of the employee's claims.

With the exception of the previously mentioned Federal and State Withholding Allowance forms, records may be kept in many ways. 

However, the minimum requirements are:

Personal information:	name, address, birth date, social security number.
Workweek information:	hour and day week begins, hours required to be worked for the week.
Pay Calculations:	hours worked per day and week, hourly pay rate, straight-time and overtime rate calculations, deductions from wages, pay period date, and payment date.

Most employers do this with a form of a payroll register.  While time cards are not legally required, most employers also have employees fill out some type of record of hours worked.

Payments to the employee should detail how the gross and net pay has been calculated, and a form of a "pay stub" should be given for each pay period.  Obviously employees should be paid by check whenever possible.  In situations where this is not possible, a signed receipt from the employee should be obtained.

Payroll records should be kept for a minimum of three years beyond the year of occurrence. However, due to possible State or Social Security Administration inquiries, a more widely used time frame is 7 years.

Put Your Payroll Policies In Writing
Even if you may have no legal requirement to have written personnel policies, it is a good idea to at least have pay policies in writing.  It can avoid serious misunderstandings with employees, and it can bolster your case against any challenges by authorities.

If you are going to offer any extra benefits like vacation pay, sick pay, holiday pay, insurance, retirement funding, etc., you should put your policy in writing--especially if these benefits will not be available to all employees.  Disclosing in advance how you will handle severance pay can save you from a disgruntled employee's challenge down the road.  Legally clarifying Exempt vs Non-exempt employees is practically mandatory.

Here are some tips on a written pay policy:

• Be as specific as you can be for each issue.  If you are paying for 
holidays, which holidays?  How many vacation days?  What type of 
insurance coverage?

• Get a receipt from the employee acknowledging a copy of the pay policy was received.

• If certain employee categories are excluded from certain benefits detail these variances clearly.

• Have a qualified legal advisor go over it before you give it to anybody.

Conclusion
Payroll issues for a business can get complicated--and expensive. You take on fiduciary responsibilities,and legal responsibilities. The forms, reports, and returns that must be timely and properly filed can be quite a challenge.  There is added expense above and beyond the actual cost of paying the employee wages.  First, there is the extra cost of the employer's share of various payroll-related taxes.  Then there is the cost of filing the required Federal and State tax returns, W-2's, and so forth.

Unfortunately, this complexity is a "necessary evil" if you want the business to operate on a legitimate level.  The positive aspects are that you can deduct the qualified business expenses associated with payroll, so you are sharing some of the expense with the government. In addition, if you do this properly instead of cutting corners you can have peace of mind and protection for yourself, your business, and your employees.

Reference:  Practice Enhancers, Able & Co.

Incorporation Basics - S vs. C

Incorporation Basics - S vs. C
SOME MAJOR ISSUES TO CONSIDER WHEN INCORPORATING
Once the decision to incorporate has been made, there are a number of important issues that require consideration.  Like most things in life, incorporating involves making choices on options.  Sometimes it means trying to look into the future as well as the present to effectively make these choices.  However, it is important for a business owner to have a working knowledge of some of the major issues that must be faced in this incorporation decision-making process, hence the purpose of this report.

What Is A Corporation And How Is It Formed?
For income tax purposes, a corporation is a separate legal entity which is organized according to state statutes to transact business. It is authorized to perform primarily all the business activities an individual can, including such things as paying taxes, signing contracts, loan agreements, and filing its own tax returns.  In effect, a corporation conducts business activities, pays taxes on the realized taxable net income, and is allowed to distribute profits to shareholders.

The creation of this legal association is done through the issuance of stock to the shareholders who contribute capital.  These shareholders own the corporation.

Since state laws and statutes control the formation of a corporation, the prospective organizers/shareholders apply to the chosen state and pay the required filing fees.  This application process is usually handled by the combined efforts of professional advisors such as attorneys and accountants.  Usually the most successful and efficient formation of a corporation involves coordinating numerous legal and financial/tax implications so these advisors can play a valuable role before, during, and after the process.

The actual state process involves filing so-called "articles of incorporation" for approval of the state corporate charter.  These are usually signed by all of the original shareholders or incorporators.  These articles identify the incorporators, the business purpose, the the initial capitalization details, the officers and directors. Once the state issues formal approval for the proposed starting date, the corporation is in existence.

With few exceptions, a corporation must then file with the state on a periodic basis (usually annually) to reaffirm certain aspects of its charter including such things as disclosures on directors, officers, and any changes for the year related to organizational or operational changes in the original charter.  Failure to timely file this type of report can lead to a technical dissolution of the corporation, so corporate owners should make sure this does not slip between the cracks after the corporation is formed.

Four Main Features Of A Standard Corporation
Businesses look to a corporate structure for the potential benefits. Although there may be many, the major ones from a legal and long-term planning aspect are:

Limited Liability:  If handled  correctly, shareholders may enjoy the protection of limited liability in which their main risk is the stock investment.  In regard to closely held corporations, however, this advantage may not always hold true.  If the corporate veil is pierced, if negligence is proven, if unpaid withholding taxes develop, or if personal guarantees have been granted by shareholders, this limited liability protection goes out the window.

Continuity:  Since a corporation is a separate legal entity, it has no finite end so it can survive the shareholders and continue indefinitely until a legal dissolution occurs.

Transferability Of Interest:  Since the corporation is formed with stock and securities, a shareholder can transfer shares in one form or another.

Centralized Management:  A board of directors is elected by the shareholders to manage the corporation.  This is a technical separation of ownership and management, and is called centralized management.

Tax Treatment Of A Corporation
As mentioned, for tax purposes a corporation is considered a separate legal entity that is responsible for filing appropriate tax returns on the federal and state level.  Gross income and allowable expenses are recorded to arrive at a net income figure for tax calculation purposes.

Once this net income figure for tax purposes is calculated, the actual process of paying federal and state income taxes may vary according to the type of corporation that was established.  This will be discussed in more detail shortly, but for now, the issue is whether or not the corporation is a regular "C" type or a special "Sub S" type.  On the federal level, a regular corporation pays its own taxes on the net income, but a Sub S type passes this net income and tax liability onto the shareholders instead.  In effect, it is a form of a conduit for the income and deductions. On the state level the treatment follows the same pattern for those states that also recognize Sub S status.

For the corporation type that pays its own income taxes, this is done by paying estimated taxes on a periodic basis.  The obligation of the corporation is to estimate its tax liability for the coming year, and make payments accordingly to the federal and state governments. Failure to properly make these estimated taxes can result in penalty and interest charges for underpayment of estimated taxes.  Basically, the governments want the use of this tax money in advance, and this is their way of encouraging the corporation to comply.

The corporation tax return is usually due on or before 2 1/2 months from the close of its accounting year, unless allowable extensions of time to file are used.  In the case of an extension, an extra 6 months is usually granted.  Note that, unlike an individual, a corporation does not necessarily have to use a calendar year ending December 31 for tax return filing purposes.  It may be allowed to use a fiscal year instead, depending on the type of qualifying corporation set up.

Types Of Corporations
There are two primary types of corporations:  Regular "C" types, and "Sub S" types.  A regular C type is just as it states.  It's a stand alone tax-paying corporation as we have seen. Technically, there is actually a further division within a C type if the "personal service corporation" rules apply.  In this case, although it still falls within the C type definition, the corporation may face limitations in certain areas (such as passive loss deductions, choice of tax year, and cash method of accounting, related party losses, and tax rates that may apply).  However, it is not a true division from a legal entity position.

A Sub S corporation is a regular corporation that has qualified under an election(for federal it is a Form 2553 Election) to be taxed in a way different from C corporations.  The corporation elects to pass through to the individual shareholders the income, losses, deductions and credits.  Thus, instead of the corporation paying the tax liability, it is shifted to the individual shareholders in an allocation that is prorated based on ownership percentage for the year in question.

The tax effect of this is somewhat like that of a partnership whereby the S corporation becomes more of a conduit.  Unlike a general partnership, however, the S corporation provides some degree of limited liability and continuity to the shareholders.

To qualify for this "Sub S" election, certain parameters must be met according to the current year tax codes:

• It must be a domestic US corporation.

• There can be no more than 75 qualified shareholders.  In this regard, a 
husband and wife (and their estate if deceased) are considered as one.

• There can only be one legal class of common stock, although voting right 
differences can exist as long as the same ownership rights are maintained.

• The shareholders must be US citizens, or residents.  Under certain 
provisions, estates and some trusts may also qualify.

• The Federal election on Form 2553 must be signed by all of the shareholders.   If any shareholder refutes the election, it may cause a termination of the  status for all.

• The corporation agrees to use a permitted or regular tax year which is 
generally a calendar year basis.  There are some exceptions to this where 
IRS permission may be obtained to use another fiscal tax year, but it is 
not the norm.

• The election to qualify as a Sub S corporation must be filed on or before the 15th day of the third month of the tax year for which the election is to apply.  If it is filed later than that, the election would take effect for the next applicable year.

• Once this election has been achieved, it doesn't mean it has to be forever.  Situations may occur where the Sub S status no longer has benefit.  In that case, a revocation procedure exists, and the corporation reverts to a regular C type.

Advantages/Disadvantages Of S Corporations Compared To C Corporations
Deciding on which type of corporation to have requires a knowledge of present and future details in a number of areas to fully maximize the benefits.  Within the lifetime of the corporation many changes may develop along the way which would necessitate changing from a C to an S or vice versa.  In some ways this means you almost need a "crystal ball" at the beginning to fully anticipate all the changes.  While this may not be practical, there are some general guidelines to follow when making the choice.

Advantages Of An S Corporation Vs A C Corporation
Since the S Corporation is a conduit unlike a regular corporation, any qualified losses from the business get transferred to the shareholders individual tax return.  This can save a considerable amount of taxes, especially if the shareholders are in higher tax brackets.  Since many businesses are in loss situations (especially in the early stages), this can be a good tax-saving opportunity.

• Cash basis accounting may be more possible which can make for easier tax planning opportunities in regard to deferring income.

• There is no major threat of a corporate alternative minimum tax trap since it doesn't effectively apply to an S Corp. in most normal situations.

• Since the income, or corporate earnings, is passed along to the shareholders, there is usually no problem with an IRS accumulated earnings tax which can be heavy for certain corporations.

• Unlike a C type, there is no threat of a personal service tax "penalty" rate for businesses that provide services (like architects, consultants, accountants, lawyers, etc.).

• With proper planning, income from the business can be effectively split among family members to reduce the income tax bite.

• Since the income is passed along to shareholders, there is little chance the IRS would attack the corporation on the basis of paying "excessive compensation" to controlling shareholders.

• Regular corporations may face a double taxation issue in that the corporation pays taxes on the earnings, and then the shareholders pay tax on corporate dividend/distributions from these earnings.  A Sub S does not pay taxes on the earnings since it is a conduit.

• Less chance of getting hit with a constructive dividend tax charge. If a regular corporation is audited and certain deductions are denied, the IRS may take the position that these deductions benefited the shareholders in such a way that they were really "disguised dividends."  The result is a denial of a deduction for the corporation (which results in more taxes to be paid), and a forced increase in income that the shareholders must report(with more taxes to be paid again).  This is a form of double taxation.

• Deductions such as travel and entertainment, auto write-offs, and fringe benefits are prime candidates for this type of IRS attack. For a Sub S corporation, however, even if the IRS wins in denying the deductions, there can only be one tax charge, not two.  So if the corporation is particularly aggressive in these deduction areas and/or has poor records, the Sub S corporation is more advantageous.

• A possible savings of social security and medicare tax may exist on money taken out of an S corp compared to a C corp.  A C corp normally has to pay shareholders compensation in the form of a salary which is subject to social security and medicare taxes up to certain limits. This can amount to over 15% of the compensation in extra taxes for both the recipient and the corporation.  However, an S corp may be able to make distributions from earnings without it being coded as a salary, thus saving this 15% for the same amount of money using the present year tax rates.  There are caveats, and it may be an aggressive position to take, but it is possible in numerous cases.

Disadvantages Of An S Corporation Vs A C Corporation
An S corp cannot have multi classes of stock so it limits the control aspects, estate planning possibilities, and tax-savings of selling off portions of the stock.

• Non-US citizens or residents cannot participate in an S corp.  Thus, existing shareholders of an S corp may be limited to whom they can transfer/sell their shares without jeopardizing the Sub S status.

• Since S corps are limited to 75 shareholders, it prohibits a wider distribution of ownership that is possible with a C type corporation.

• You can't borrow out of an S corporation pension plan like you can with a C corporation.

• If the S corporation realizes losses from "passive type" investments like realty, the deductibility of these may be more restricted.

• Certain fringe benefits are not available to shareholders with 2% or more stock from a similar tax-free standpoint compared to a C corp. These are fringes such as accident, health, disability, and life insurance, medical reimbursement plans, cafeteria/ flexible spending accounts, and job-condition meals and lodging payments.

• If the Sub S corp net income is high, and the shareholders are in high tax brackets, there is less chance of reducing or equalizing the taxes since the money is automatically taxable to the shareholders whether they take it or not.  S corps and their shareholders cannot benefit from retaining earnings.

• There are limitations on using other than a calendar year accounting period, so tax deferring techniques in this area are limited unlike many C type corporations that can elect fiscal tax years for filing purposes.

• The S corp cannot take advantage of the C corp deduction (which can amount to a savings of up to 80%) on dividends received from other domestic corporations.

An Overview Of Selected Other Issues When Incorporating
Once the decision to incorporate has been established, there are a number of pertinent issues to consider in the process.  Some of these may be governed by the type of corporation that has been selected-- that is, Sub S or C corporation.  But in general terms, a list of the major issues to consider follow:

SELECTING AN ACCOUNTING METHOD:  The two main types are the accrual and the cash method.  Unless it qualifies for IRS exceptions, a corporation generally uses an accrual method of accounting.  In this method, income is reported in the year it is earned, not necessarily received, and expenses are deducted in the year incurred, not necessarily paid.  As we have discovered, most Sub S corporations are precluded from using this method--they must use a cash method instead (unless inventory is a significant factor in the business, or special permission is granted from the IRS).

The cash method is the more well know possible option.  In this case, income is reported when actually or constructively received, and expenses are deducted when actually paid or legally charged.  Unless inventory is a significant factor, most S corps will use this method, and many C type corps can also qualify if the gross average annual receipts are under $5 million dollars, or if it is a qualified personal service corporation.

SELECTING AN ACCOUNTING YEAR:  The two options here are a Calendar year or a Fiscal year.  A calendar year is a 12 month period ending with December 31.  A fiscal year is a 12 month period ending in a month other than December.  A Sub S corporation is usually limited to the use of a calendar year, although some exceptions may exist if the IRS approves.  These exceptions relate to the tax year of the major shareholders, and if a "business purpose" for an alternative tax year can be justified.  Regular C corporations can elect either fiscal or calendar year periods.

SELECTING AN ACCEPTABLE BOOKKEEPING SYSTEM:  Since one of the purposes of a corporation is to try to limit the personal liability of the shareholders, it is essential that the corporation be run properly so that this liability limitation cannot be challenged.  A failure to maintain an acceptable set of books is possible grounds for a legal challenge.  Further, good, timely recordkeeping helps a business survive and thrive in the competitive world.

Since most corporations must file balance sheets with their tax returns, a double entry type of bookkeeping system is generally used. It is designed to be self-balancing, and every entry involves both a debit and credit to balance.  This system involves the use of journals, and ledgers--either manually or computerized--to track  profit and loss, and balance sheet items to ascertain assets, liabilities, and capital items.  While a double entry system is not required, single entry systems (which concentrate mainly on the recording of income and expense items) make the accurate calculation of corporate balance sheets more difficult.

At the very least, a corporate bookkeeping system should have the following components:  Income Register, Disbursements Record, Travel & Entertainment Reports, Equipment Register, Petty Cash Voucher System, Payroll Register, and Accounts Receivable Control Ledger. Because of some of the complexities associated with bookkeeping/accounting for a corporation, and because of the desire to protect the limited liability features, many corporations elect to have some or all of the recordkeeping done by an outside professional.

SHAREHOLDER AGREEMENTS: This should actually be done before officially incorporating.  Many businesses with more than one owner dissolve because of misunderstandings about basic issues that weren't adequately spelled out in the beginning. So a "Shareholders' Agreement" should be drafted up to make for provisions regarding these issues such as:  work responsibilities, capital contributions, management authority, profit distributions, voting issues, buy-sell agreements, change in ownership issues, arbitration dispute methodology, expense account policies, etc.

CAPITAL STRUCTURE:  The capitalization of a corporation involves deciding on how much money should be contributed as actual capital or as loans instead.  This relationship between debt and equity is significant.  The more that the corporation is set up with loans, the "thinner" its capitalization is.  There may be some advantages to a "thin" corporation:

1)  It's easier to get your money back out; normally, corporate capital cannot be drawn back out without major tax or organizational consequences while loans can be repaid tax-free in most cases.

2)  A corporation is allowed to accumulate earnings to repay debt, so a thin corporation has less chance of an IRS challenge resulting in a stiff accumulated earnings penalty tax.

3)  If the business fails, and a liquidation must occur involving outside lenders, the shareholders may have a better chance of getting their money back if it is loaned to the corporation instead of invested as capital.

4)  The corporation can pay a wide range of interest rates back to the shareholders; if done properly, this can be a way of taking money out of the corporation not subject to social security, medicare, and state unemployment taxes--a possible savings of over 15%.

Some possible disadvantages:
1)  The balance sheet on the business does not look as strong to outside lenders, so borrowing may be more difficult.

2)  Above the $10,000 limit, the IRS requires that loans be paid back with statutory interest.  Although this interest is deductible by the corporation, it is also taxable to the shareholder in question, and if the shareholder's tax bracket is higher, there could be an unequal tax savings/tax payment swing.

3)  If the corporation fails, any losses on the debt would have to be written off as nonbusiness bad debts which are capital losses subject to a maximum of $3,000 per year on a stand alone basis.  If it were capital instead and the corporation qualified for Section 1244 small business stock treatment, the loss would be considered ordinary, and not limited to just $3,000 per year.

CONSIDER SETTING UP WITH 1244 STOCK: If the corporation is capitalized properly, it will normally qualify for this special treatment.  The main benefit here is if the corporation fails and the shareholders lose their investment.  If it is a Section 1244 stock corporation, the loss on the shareholders investment may be eligible for ordinary loss write-off treatment as opposed to capital losses. This would mean they could deduct up to $50,000 ($100,000 if married filing jointly) immediately, not merely $3,000 like a capital loss using today's tax rules.

The corporation will qualify for Section 1244 stock if it meets the following criteria:  The corporation was formed after 11/6/78; shareholders cannot be other corporations, estates, or trusts; it must be a small business with total capital contributions of less than 1 million dollars; stock was issued for money or property only; original shareholders must retain stock; basis of the 1244 stock is limited to original capital contributions; less than 50% of corporation's receipts are from investments vs regular business activities.  Since these criteria are fairly commonplace, the bulk of most small corporations will qualify for this special treatment.

AVOID THE PERSONAL HOLDING COMPANY TRAP:  If trying to achieve limited personal liability is one of the reasons for incorporating, it is imperative that the corporation be run correctly from a legal and tax perspective.  If it isn't, you can be attacked on the basis that it wasn't a true corporation, but a personal holding company instead--and the "corporate veil can be pierced."  That means the attackers can go after your personal assets as well.

While you cannot absolutely guarantee this type of attack won't occur, you can go a long way towards stopping it by effectively running the corporation with "arms length transactions."  Even though you may own it, view it as a separate entity, as if it were actually another employer.  Therefore, account to it in writing for all the major activities.  Keep the books, records, and tax filings current, and according to adequate accounting rules and regulations.  Do all required minutes of meetings on a contemporaneous basis.  Properly handle money that you put into it, and take out of it.  Properly account to it for the use of its assets whether it be for business or personal.  Keep your role as a shareholder separate and distinct from that of an employee/officer/director.

TAKING MONEY OUT OF A CORPORATION:  A big mistake many people make when they incorporate is in forgetting that it is not like a sole proprietorship where you can draw money out, and put it in with relative abandon--because it is classified as a drawing account.  A corporation is not eligible for this drawing account.  You are required by law--and limited accordingly-- to take money out in designated ways, the majority of which are:  salary/compensation; dividends; stock distributions; loans, loan paybacks and interest payments; expense reimbursements; lease or rental payments; and fringe benefits.

You must properly account for how this is done, and handle the tax consequences (which will differ accordingly) for each. If you improperly take money out of the corporation, and it is challenged, it can result in a denial of the deduction for the corporation, increased income taxable to you personally, possible civil or criminal penalties, and possible loss of the corporate charter privileges  and protections.  If in doubt about how to take money out of the business, always check with your financial advisor first--not after the fact.

TRANSFERRING ASSETS TO A CORPORATION:  There are occasions when a shareholder/owner will want to transfer assets into the corporate structure--equipment, furnishings, realty, etc.  Ordinarily the IRS considers the transfer of property in exchange for stock or increased value in a corporation a possible taxable event if there is a gain or loss differential between the two values.  However, there is a possible exception to this under IRS Code Section 351 which allows for transfer without immediate tax consequences.

To qualify, the nonrecognition of gain or loss must be from a transfer of property solely in exchange for the corporation's stock or qualified securities if the transferring party is in control of the corporation immediately after the exchange.  No additional money or property can be received from the corporation.

The property that is allowed to be transferred in this regard includes:  real estate and personal property, and cash/cash equivalents.  Services to the corporation (current or future) in exchange for stock do not qualify.

The parties involved must record this transaction in the form of a statement listing all the pertinent details, including any liabilities that have been assumed.  These statements are generally filed with the tax returns of the corporation and the shareholders.

This Section 351 transfer provision can be very significant in the situation where an ongoing business is converting into a corporation.  An example would be a sole proprietor or a partnership converting into a corporation.  Without Section 351, there could be major problems with capital gains, or depreciation recapture because the law would then treat the transaction as if the business property had been sold.  It could make the reorganization to a corporate structure cost-prohibitive.

Conclusion
Incorporating a business involves understanding the options and how they interact with each other, and with the tax and financial details of the shareholders.  Some of the choices also would benefit from being able to see into the future so they may require more careful thought than just a look at the immediate concerns.

Once the decision to incorporate has been made, deciding on the type of corporation, accounting methods, and accounting tax year become priorities.  If assets are being transferred in from an existing business, or from shareholders, how this is handled requires timely decision making as well.  Hopefully a good shareholders' agreement was already established before the actual incorporation.  If not, it should be done before any disputes among owners arise, not after.

The type of bookkeeping system has far-ranging implications from a tax, management and analysis perspective.  Even if you are intending to do the bookkeeping "in-house" you should still consider getting professional advise up front before the checks start being written and the income starts being posted.

In situations where a corporation is being formed to provide liability protection to the shareholders/owners, one of the more critical aspects is to run the business in such a way as to avoid falling into any personal holding company traps.  Otherwise, the corporate "veil" may be pierced, defeating the whole purpose.

As you can see, setting up a corporation effectively involves numerous decisions which must be made on a timely basis.  Although this set-up process can be complicated and running a corporation can be complicated from a tax accounting standpoint, if done correctly with proper forethought it can play a major roll in the success of your business.

Reference:  Practice Enhancers, Able & Co.