As owners of small technology firms prepare to file their 2012 tax returns, some small-business analysts are reminding them of the IRS’s “Reasonable Compensation” rule. If your firm is classified as a partnership or sole proprietorship, you run the risk of being audited if you don’t pay attention to certain guidelines, which we’ll outline here.
The Double-Tax Problem
First, some background. Businesses that are classified as partnerships and sole proprietorships must pay two kinds of taxes:
- Income taxes. These are taxes everyone pays as part of being employed. The tax rate depends on your income level.
- Self-employment taxes. These are additional taxes levied on small-business owners to pay for Social Security and Medicare. The tax rate for this is 15.3 percent and can amount to a significant increase in the total amount of taxes a small-business owner owes the government.
One way to avoid paying self-employment taxes is to incorporate your business. However, incorporation is a complex legal process and does not make financial sense for everyone. Before making a reorganization decision, consult with your accountant and lawyer.
When You Risk a Tax Audit
Naturally, small-business owners have discovered that by (ahem) adjusting certain numbers in their tax returns, they can demonstrate a salary for themselves of close to zero, with a hefty profit for the company, which technically would allow them to avoid paying most taxes.
The IRS, however, is on to this scheme and sources suggest that it will be paying particular attention this year to suspicious compensation reports from sole proprietorships and partnerships.
Specifically, the IRS…
- Looks for “reasonable” compensation. This is defined by comparison. If you’ve reported an income that’s similar to non-self-employed professionals in your industry, chances are your numbers won’t trigger any red flags.
- Checks for discrepancies in your compensation and your company’s revenue. If the compensation you report is unusually low for your industry, the IRS may check to see how your business did. If you had a lean year with low business profits, you’re probably okay, tax-wise. If, however, your business shows a hefty profit, the IRS may become suspicious.
- Reclassifies income when necessary. Assuming the IRS found big profits for your business, it will likely count those as your personal earnings and tax you accordingly.
- Charges fines. If the IRS finds that you violated the Reasonable Compensation rule, it may add penalizing fines to your total tax bill.
Working with an accountant on your 2012 tax returns is an excellent way to minimize the risk that you’ll face an audit this tax season.
Writtten by Brenna Lemieux - check her out at Google+ or Twitter