Hi I'm Ned and I'm a social media consultant.
I started my company this year
and I'm having a little difficulty keeping up
with all this business recordkeeping.
What is this EIN?
What does EIN stand for, anyway?
Entrepreneur Something Number?
That doesn't sound right.
Receipts, receipts, receipts!
I don't know what to keep and what I can get rid of.
This is just a taxi receipt, I couldn't need that.
Maybe I should have kept that.
I'm not even sure I have all the information I need.
I'm definitely a sole proprietor,
but maybe a Limited Liability Company.
Maybe I should just incorporate.
Maybe I should just get through this mess first.
And I still need to make sure
I'm using the right accounting method.
Cash, I guess...
or maybe accrual is better.
I don't know.
How long do I have to keep all of this stuff?
Maybe I should just pay someone to do it for me.
Let's see if we can help bring some order to the chaos
that Ned is experiencing.
Welcome to What You Need to Know about Federal Taxes
and Your New Business.
In this lesson, we'll provide a basic overview of what you need
to know about successfully operating your business
as well as provide you with some resources
for additional information.
In this lesson, we'll explain the purpose
of the employer identification number,
describe basic recordkeeping requirements for tax purposes,
define basic bookkeeping and accounting methods,
explain the forms of business organizations,
and finally, suggest how to select a paid tax preparer.
Before we begin, however, we want to remind you
that you need to understand federal, state,
and local tax reporting requirements.
As you begin your business,
review your state and local tax reporting requirements
in accordance with the state requirements.
Throughout this lesson we'll also be hearing from Ned,
a small business owner,
as he learns how to organize his business
to meet his federal tax obligations.
Employer Identification Number, or EIN
Employer ID Numbers (EINs)
Let's start first
with the federal Employer Identification Number, or EIN.
An EIN identifies tax returns filed with the IRS,
and, as a business owner, you may be required
to get an EIN.
Okay...Why or when would a business owner
need an EIN?
Ned, you will need an EIN if you pay wages,
have a self-employed retirement plan,
operate your business as a partnership or corporation,
or if you are required to file any of these tax returns:
employment; excise; fiduciary;
or alcohol, tobacco, and firearms.
if you are a sole proprietor with no employees
and don't meet any of these requirements,
you don't need an EIN?
Well....You may need an EIN
for dealing with other businesses, including banks,
that require an EIN to set up business accounts.
The IRS will give you an EIN even if you don't need it
for IRS purposes.
Apply for an Employer Identification Number (EIN) Online
Okay...What is the application process
to obtain an EIN?
Ned, the fastest- and easiest-way
to get an EIN is online.
Just go to www.irs.gov
and type in the keyword EIN.
From there, you'll find more information,
including the application.
Although the IRS calls this a provisional EIN,
the EIN is actually the permanent federal employer
identification number for your business.
This EIN may be canceled
if the name and social security number of the principal officer
do not match the social security administration records
or if your business already has an EIN.
Now, let's discuss recordkeeping for your business.
What records does a business owner need to keep?
Ned, you must keep receipts, sales slips, invoices,
bank deposit slips, canceled checks,
and other documents to substantiate items
of income, deductions, and credits.
Although it may sound like a lot of work,
unless you have records showing the sources of your receipts,
you may not be able to prove
that some are non-business or non-taxable.
Remember, recording these items will help you pay
only the tax you owe.
How in-depth and how long to keep records
How long should I keep records?
How in-depth do records need to be?
And how long do business owners need to keep them?
Records must support the claimed amount,
the time and the place, the business purpose,
and your business relationship to any other person involved.
If your records are incomplete,
they may not support your deductions.
You must keep your records as long as their contents
may be material in the administration
of any Internal Revenue Service law.
Usually, the statute of limitations
for an income tax return expires
three years after the return is due or filed
or two years from the date the tax is paid,
whichever is later.
To support items of income or deduction on your tax return,
you must keep records until the statute of limitations
for that return expires.
What records do I need to keep if I have employees?
Employment Tax Recordkeeping
If you have employees, then you have to keep
employment tax records, too.
You must keep all employment tax records
for at least four years after the date on which the tax return
becomes due or the tax is paid, whichever is later.
Are there any records that I need to keep longer?
Are there other circumstances in which records
may have to be kept longer?
And what if an owner loses them?
If you change your method of accounting,
records supporting the necessary adjustments
may be material for an indefinite time.
Additionally, you must keep records relating
to the basis of property for as long as they are material
in determining the basis of the original
or replacement property.
For example, you must keep these records to figure
any depreciation, amortization or depletion deduction,
and to figure your basis for computing gain or loss
when you sell or otherwise dispose of the property.
What if I lose my records?
Burden of Proof
If you lost your records due to circumstances
beyond your control, such as a flood or an earthquake,
you may substantiate a deduction by reasonable reconstruction.
Wow...This is a lot for new business owners to remember.
Where can I find more information?
Publication 583 - Starting a Business and Keeping Records
For more information about recordkeeping,
see Publication 583,
Starting a Business and Keeping Records.
Publication 15 - (Circular E) Employer's Tax Guide
For information about employment tax records,
see IRS Publication 15, Employer's Tax Guide.
You can find these at www.irs.gov.
Now...onto our third topic: bookkeeping systems.
Many people who operate their own one-person business
never bother to set up a business bookkeeping system.
Their personal checking account
serves as both a personal and a business account.
The IRS, however, recommends that you open
a separate business bank account.
What are the types of bookkeeping systems?
Well Ned, there are two types of bookkeeping systems:
single entry and double entry.
Single entry system
The single entry system is the simplest to keep:
with the single entry system, you record a daily
and a monthly summary of business income
and a monthly summary of business expenses.
This system focuses on the business's profit
and loss statement and not on its balance sheet.
While single entry is not a complete accounting system,
it shows income and expenses in sufficient detail
for tax purposes.
Double entry system
The double entry system is more complex:
it has built-in checks and balances, is self-balancing,
and is more accurate than the single entry system.
Because all businesses consist of an exchange
of one thing for another, double entry bookkeeping
is used to show this two-fold effect.
Once you've selected a bookkeeping system,
you'll also need to select an accounting method.
Your accounting method is a set of rules that you use to decide
when and how you report your income and expenses.
Common accounting methods
What are the common accounting methods?
The two most commonly used accounting methods
are the cash method and the accrual method.
On your tax return, you must use the same accounting method
you used to keep your records.
Under the cash method, you report all income
in the year you receive it.
You usually deduct expenses only in the tax year
in which you pay them.
Under the accrual method,
you report income in the year you earn it,
regardless of when you receive payment.
You deduct expenses in the tax year you incur them,
whether or not you pay them that year.
Businesses that have inventory for sale to customers
must generally use an accrual method for sales and purchases.
However, many small businesses with gross receipts
averaging less than 10 million dollars a year
may use a cash method for sales and purchases.
Test your knowledge
Now, up to this point we have covered quite a lot,
and it's time for you, the viewer,
to test your knowledge.
Let's hear from Sandy about her business
and then you decide
whether she is using the correct accounting method.
Hi, I'm Sandy.
I have a Website where I sell custom-ordered
and handmade knitted goods- hats, scarves, and socks.
Customers order online,
but because it could take a few weeks
or even a few months to get the supplies
and finish the order,
I don't charge them until the product actually ships.
I use the accrual method of accounting.
I record the sale in the month when I ship the product,
not in the month that the person orders it.
Is Sandy correct in using the accrual method?
Is Sandy correct in using the accrual method?
Sandy can use the accrual method of accounting.
She records revenue when she earns it;
that is, when she ships the product.
Actually, Sandy can use the accrual method of accounting.
Because there can be some length of time
between when a customer places an order and when it ships,
Sandy records revenue when the customer is charged;
that is, when she ships the order.
For more information on accounting . . . .
Publication 538 - Accounting Periods and Methods
For more information on the differences
between the cash and the accrual methods of accounting,
see IRS Publication 538, Accounting Periods and Methods.
Do business owners have to do all of this bookkeeping
and accounting by hand?
Not at all, Ned.
There are computer software packages that are very useful,
relatively easy to use,
and require very little knowledge
of bookkeeping and accounting.
If you use software . . . .
But be careful, if you use software
you must be able to produce records from the system
to support what is on your tax return.
And, always keep a backup copy in a safe place.
Now, let's turn our attention to business structures.
Early in the life of your small business,
you'll need to decide on the structure of ownership.
There are five common types of business organizations:
limited liability company
or limited liability partnership,
Let's look at the advantages and disadvantages of each.
A sole proprietorship is the simplest type
of business organization.
It is an unincorporated business that one person owns.
The business does not exist apart from its owner,
and it is the owner who assumes the risks of the business
to the extent of all his or her assets,
even if the owner does not use his or her personal assets
in the business.
Additionally, the ability to finance the business,
known as capital, is limited to whatever the owner
can come up with.
Schedule C - Profit or Loss from Business (Sole Proprietorship)
What kind of forms does a sole proprietor need to file?
A sole proprietor files his or her taxes
Schedule C EZ - New Profit from Business (Sole Proprietorship)
using either a Schedule C or a Schedule C EZ,
Net Profit from Business.
The Schedule C is included with the Form 1040
to report the profit or loss from operating the business.
Schedule SE - Self-Employment Tax
The sole proprietor also files Schedule SE,
to report the Social Security and Medicare taxes
on net profits of the current year's threshold.
If you or your spouse jointly own and operate
an unincorporated business in a non-community property state
and share in the profits and losses,
you are partners in a partnership
and not a sole proprietorship;
so, you should not use a Schedule C
or a Schedule C EZ.
But, there are exceptions to this.
For example, if you and your spouse wholly own
and operate an unincorporated business as community property
under the community property laws of a state,
you can treat the business either as a sole proprietorship
or a partnership.
Qualified joint venture
Election for Husband and Wife Unincorporated Businesses
There's another exception for Qualified Joint Ventures
If you and your spouse each materially participate
as the only members of a jointly owned and operated business
and you file a joint return for the tax year,
you can make a joint election to be treated
as a "Qualified Joint Venture" instead of a partnership.
This allows you to avoid the complexity
of partnership Form 1065,
US Return of Partnership Income,
but still gives each spouse credit
for social security earnings
on which retirement benefits are based.
The second type of business organization is a partnership.
A partnership is a relationship between two or more persons
who join together to carry on a trade or business.
Each person contributes money, property, labor, or skills,
and each expects to share both in the profits
or the losses of the business.
Any number of persons may join in a partnership.
The advantages of a partnership
are that it is easy to organize,
it has a definite legal status,
and it may have a greater financial strength
than a sole proprietorship.
What are the disadvantages?
The first disadvantage
is that decision authority is divided.
The other disadvantage to a partnership
is that the liability of the partners is usually unlimited;
that is, each partner may be held liable
for all the debts of the business.
For example, if one partner does not exercise good judgment,
that partner could cause not only the loss
of the partnership's assets,
but also the loss of the other partner's personal assets.
How are partnership profits and losses reported?
Form 1065 - US Return of Partnership Income
Partnerships report profits or losses
on Form 1065, US Return of Partnership Income.
Form 1065 summarizes the business activity
of the partnership.
A partnership does not pay tax on income from daily operations,
and all income, losses, deductions, and credits
generated by a partnership pass through to the partners.
Form 1065, Schedule K-1
Each partner gets a Form 1065 Schedule K1,
Partner's Share of Income, Deductions, Credit, etc.,
and the partners report these items
Publication 541 - Partnerships
on their personal income tax returns.
If you would like more information about partnerships,
see IRS Publication 541, Partnerships,
as well as the instructions to Forms 1065 and 1040.
Limited liability company (LLC)
Limited Liability Company (LLC)
The third type of business entity
is a limited liability company,
also known as an LLC.
LLCs are popular because owners have limited personal liability
for the debts and actions of the LLC,
without many of the formalities of a corporation.
Other features of LLCs are more like a partnership,
providing management flexibility and the benefit
of flow-through taxation.
How are LLCs treated for tax purposes?
For federal incomes tax purposes,
an LLC may be treated as a sole proprietorship,
a partnership, or a corporation,
which we'll discuss soon.
Form 8832, Entity Classification Election
If you want to tell the IRS how to treat your business
for federal income tax purposes,
you need to file Form 8832, Entity Classification Election.
If you do not file Form 8832,
for tax purposes the IRS will treat your business
as a sole proprietorship if it has a single owner
or as a partnership if it has two or more members.
Note that even though the LLC is treated as a sole proprietorship
for tax purposes by the IRS,
the single member owner of the LLC generally maintains
limited personal liability protection
from the debts and actions of the LLC,
unlike an actual sole proprietorship,
where the owner would be equally liable
for the debts and actions of the sole proprietorship.
There are instructions with the form
that explain the classifications.
If you disagree with the default classification,
you can file Form 8832 to request a change.
The fourth business entity is the S corporation.
An S corporation is a small business corporation
whose shareholders elect to have corporate income taxed
like a partnership.
Partnerships are taxed once.
Corporations are taxed at the corporate level;
then, when the income is distributed as dividends,
it is taxed again at the shareholder level.
Form 2553, Election by a Small Business Corporation
Organizing shareholders of a corporation
who wish to avoid double taxation can file Form 2553,
Election by a Small Business Corporation.
This election must be submitted by the 15th day
of the 3rd month of the 1st S corporation year.
Can you give an example to help clarify the process?
If your 1st S corporation tax year begins on January 1st,
you must submit Form 2553 by March 15th;
otherwise, the election is effective for the next tax year.
The IRS will send you a CP261 notice,
Notice of Acceptance as an S Corporation,
to let you know it received and approved your election.
You should receive your approval in 60 days.
If you do not, contact the IRS campus
where you filed your Form 2553.
Form 2553 Instructions
For more information, see the instructions on Form 2553.
How does an S corporation pay taxes?
An S corporation does not pay tax on income
from daily operations.
All income, losses, deductions, and credits
generated by an S corporation
pass through to the corporate shareholders.
The shareholders, then, report the items
on their personal income tax returns.
However, there are situations where an S corporation
is subject to an entity, or corporate, level tax.
For example, S corporation officer shareholders
who provided services to their corporation are employees,
and their compensation is subject to employment taxes.
By law, officers of corporations are employees
for employment tax purposes and their compensation is wages.
An S corporation must pay reasonable compensation,
or wages, to a shareholder employee in return
for the services the employee provides the corporation
before a non-wage distribution may be made
to that shareholder employee.
In other words, they have to be compensated first;
then, they get the distribution.
An S corporation has the combined advantages
and disadvantages of partnerships
and regular corporations.
And what forms do S corporations need to file?
Form 1120S - U.S. Income Tax Return for an S Corporation
S corporations file Form 1120S,
U.S. Income Tax Return for an S Corporation.
Form 1120S - Schedule K-1
The S corporation provides each shareholder
a Form 1120S Schedule K1,
Shareholder's Share of Income, Deductions, Credits, etc.
Form 1040 - Schedule E
The shareholder uses the Schedule K1 to complete Part Two
on Form 1040 Schedule E, Supplemental Income and Loss,
as well as any other forms and schedules the shareholder
must file with the individual return.
Now, for the last type of business organization,
Corporations are treated by the law as legal entities;
that is, the corporation has a life separate
from its owners and has rights and duties of its own.
The owners of a corporation are known as stockholders
or shareholders, and, it may be worth noting,
one person can be the sole shareholder of a corporation.
Managers of a corporation may or may not be shareholders.
Forming a corporation involves the transfer of money
or property or both by the prospective shareholders
in exchange for capital stock in the corporation.
For the purpose of federal income tax,
corporations include associations,
joint stock companies, and trusts
as well as partnerships that actually operate
as associations or corporations.
What are some of the advantages and disadvantages
of structuring a business as a corporation?
The advantages of a corporation
are that the stockholders have limited liability
for corporate debts or actions, transfer of ownership is easy,
stock can be sold, and raising capital
and expanding the business may be easier.
The disadvantages are that the corporation is subject to tax
on its income at the corporate level and,
when the income is distributed as dividends,
that income is taxed again at the shareholder level.
It is wise to consult an accountant
and an attorney specializing in corporate law
as corporations may be more difficult and expensive
to organize than other business structures.
Additionally, the corporate charter filed with the secretary
of your state restricts the types of business activities
and is subject to many state and federal controls.
How is a corporation formed?
In forming a corporation,
a business must organize by applying for a charter
through the state government,
usually in the state where the principal business activity
To increase its financial ability,
the charter permits corporations to sell stock
to numerous shareholders.
Furthermore, the corporation is empowered
to create debts separate from the shareholders.
A corporation takes the same deductions for expenses
as the sole proprietor,
and special deductions are also available to corporations.
Form 1120, U.S. Corporation Income Tax Return
Profits of the corporation are taxed to the corporation
on Form 1120, US Corporation Income Tax Return,
as well as to the shareholders if the profits are distributed.
However, shareholders cannot take a loss
if the corporation does not operate at a profit.
We've just covered the five common types
of ownership structures:
limited liability companies or LLCs,
As a small business owner, you have many factors to consider
when you choose the structure of your business,
and your decision will be based
on your individual circumstances.
Choosing a paid preparer
Points to Keep in Mind When Choosing a Tax Preparer
Now, for the last topic for this lesson:
choosing a paid preparer.
Do you have any advice?
There seem to be so many options.
If you do decide to use a paid preparer,
the IRS has some information for you to consider.
And remember, even if you decide to use a paid preparer,
you are still legally responsible for the information
on your own tax returns.
Let's review some points you need to be aware of
when selecting a tax preparer.
First, avoid preparers who claim
they can obtain larger refunds than others.
Second, avoid preparers who base their fees
on the amount of your refund.
Third, look for a preparer who signs the tax return
and gives you a copy for your records.
Fourth, never sign a blank tax return
and never sign a completed form without reviewing it
and making sure you understand the return.
And finally, consider whether the preparer will still
be available to answer questions about the return
for months or even years after the return is filed.
The IRS now has a registration
and certification process for preparers.
To ensure that you are working with an honest
and reputable preparer, make sure that the preparer
has a valid Preparer Tax Identification Number,
also known as a PTIN.
All preparers, whatever their professional designation,
must have a valid PTIN.
There are variations, however,
in the type of return preparer,
the testing they must undergo,
their continuing education requirements,
and their practice rights before the IRS.
For the purpose of this lesson,
we'll be focusing on three types of preparers:
An enrolled agent is a person who has earned the privilege
of representing taxpayers before the IRS.
Most enrolled agents have passed a three-part comprehensive
IRS test covering individual and business tax returns
and client representation rules.
They must adhere to ethical standards
and complete 72 hours of continuing education courses
every three years.
Enrolled agents have unlimited practice rights,
which means they are unrestricted
as to which taxpayers they can represent,
what types of tax matters they can handle,
and which IRS offices they can represent clients before.
Enrolled Agent Information
To learn more about enrolled agents,
see Treasury Department Circular 230 or visit
Some individuals become enrolled agents
through experience as a former IRS employee
instead of passing the three-part test.
These individuals may be limited in their practice rights
to only the matters they have expertise in
as a former employee.
Both Certified Public Accountants,
also known as CPAs,
and attorneys have their own professional requirements
for continuing education
and both groups have unlimited practice rights before the IRS.
That's the end of this lesson,
but before we close, let's see how Ned is doing now.
I think I have a better understanding
of what I need to do.
Can I have a review, though?
Here's a review for everyone.
In this lesson, we explained the purpose
of the employer identification number and how to obtain one,
defined basic bookkeeping and accounting methods and terms,
reviewed the different forms of business organizations,
and suggested criteria for selecting a paid preparer.
There's a lot to learn when you start your own business,
and we hope this lesson has provided you with an overview
of what it takes to start your business off right.
I want to thank Ned for helping us out through this lesson,
and I want to thank you for joining us.
Best wishes on your new business.