For some small businesses, a simple wire bound receipt book is the key to substantiating your income.

Now some people may be wondering, “Why would I want to prove I have more income than I have to?”   But for many small business owners, that’s exactly the problem—you have income, you want to report it to the IRS, and you’re having a hard time proving it.  This post is for you.

The number two reason for reporting your non-1099 income  (number one of course being basic honesty) is qualifying for the Earned Income Tax Credit.  2011 sort of hit small business owners who normally qualify for EIC with a one-two punch.  We had the new 1099 reporting requirements that upped the ante for so many businesses, and we had the new EIC tax preparer due diligence rules with one of the questions being “Do you have forms 1099-MISC to support the income?” With the next  question being, “If not, is it reasonable that the business type would not receive Form 1099-MISC?”  Here’s a clue:  if you answered NO to the first one, you have to answer YES to the second.

So what types of businesses wouldn’t normally receive a 1099?  Bunches of them!  Face it, if you’re reading this—I’m guessing that your business doesn’t receive 1099s.  Generally, it’s reasonable to expect that anybody who works for other people, as opposed to other businesses, would not receive a 1099.  House cleaners, dog walkers, handymen, lawn mowing services, daycare  providers, interior decorators, and even income tax preparers are all types of business that could easily never see a 1099.   (Yeah, me too!  Although I’m now getting 1099k forms because I take credit cards, I don’t get 1099-MISC for preparing personal tax returns.  Maybe I’ll see some 1099-MISC forms from some of my business clients this year, but I never used to get them in the past.)

So, how does a small time personal service provider prove his or her income to the IRS?  There are a couple of things you can do.  I’m going to start with my favorite:  the business bank account.  This is what I do and several of my clients do it too.   (Okay, because I’m their accountant and this is what I tell them to do.)   Get an Employer Identification Number (EIN) for your business and set up a separate bank account for your business in your business name.  Only business income goes in, only business expenses go out.  You may have to put some of your own money in for a start up, and once you’re making money you’ll take out a draw, but you’ll label those as such.  Other than those two items, your business checking account is pretty much your profit and loss statement as well.  Now for a bigger company that would be over simplifying things, but for us little folks–I’m spot on.  See this post for more information about getting an EIN number:  Free EIN

Why does this make good proof?  Because you’ve got a monthly record of your income and expenses.  I also have deposit slips to back it up:  Mary Jones paid me $200, Fred Smith paid $250.   It’s a good solid audit trail.  Here’s another post about bookkeeping and your business bank account:  Banking and Bookkeeping

But what if you don’t have a separate account?   Maybe your business is just too small to bother with the expense of an extra account.  What if you’ve just got something really simple like watching the little neighbor kid for a couple of hours after school every day.  There’s no contract, no business cards, no advertising.   You get $100 a week from your neighbor friend.  She pays you in cash—it never sees the inside of a bank because that’s your grocery money.   It’s not much but it supplements your child support.  How do you prove that kind of income?

The easiest way to prove your income if you provided child care is to have the person you provided it for claim your services on their tax return.  You make them a daycare receipt, just like the ones regular day cares do showing the name of the child, how much they paid you and your EIN number.  (You can use your social security number but I never recommend that.  You can get an EIN number for free.  Protect yourself.)  This is doubly good because the IRS will get confirmation of your income from an outside source.  You prove income, your customer gets a tax deduction, it’s a win/win situation.
But what if your business isn’t day care?  What if you did something like mow lawns around the neighborhood and shoveled snow in the winter?  Nobody’s going to be claiming you on their tax return, what can you do?  In your case, I like receipt books.  You can find different kinds at Office Max or any office supply store.  I like the ones with a carbon copy—one for you, one for your customer.

Now if you have just one customer and you’re always going to the same place—you can just use the little one that just has a couple of lines and the amount on it.  You might write, “Mowing, Mr. Jones, $30, 5/15/2012” on it.  You know what you did, who you did it for, how much you got paid, and when.  If you have multiple customers you’ll want the larger receipt books that include the address and phone number of the customer.  If you do different types of jobs for different people, you might need the bigger ones so you can write down the type of work that you did for them as well.

You don’t have to have a 1099-MISC to prove your income to the IRS.  You just need to have a system in place to document your income and you’ll be fine.

If the IRS has been filing your tax returns for you, it's a good idea to hire a professional to fix them.

Did you get one of those notices by the IRS that says you owe money for 2005, 06, and 07 but you never even filed a return in the first place?  You’d be surprised, you’re definitely not alone.  Lots of those notices have gone out lately.  If you’ve got several years of back taxes that need to be filed, I recommend hiring a professional to do it for you.  (Okay, namely I think you should hire me, but then again this is my website.)
But seriously, there’s a reason you didn’t file your taxes in the first place; maybe they were too complicated, maybe you were going through a divorce or suffering from a death in the family, or maybe you were just being lazy.  Whatever the reason, the problem has gotten to the point where the IRS is threatening you– so you need to get yourself a buffer zone.  Someone to put a little distance between you and the IRS, it keeps it a little less personal.  Plus a professional will know all those funky little tax law changes:  2007 was the telephone tax credit, 2008 had that $300 recovery rebate credit you missed because you didn’t file, and stuff like that.  You don’t want to lose out on those things.
If you hire a tax professional that’s worth her salt, the first thing she’s going to do is to contact the IRS and get all of the information they have on you.  That will include your wage and income transcripts, your account transcripts, and any return transcripts they may have.  Even though you didn’t file tax returns, the IRS filed one for you, that’s how they came up with what they’re assessing you for.  It’s a waste of time trying to negotiate with the IRS if you don’t know what information they’re using.  Remember, when the IRS files for you, it’s always the worst possible tax status and you get no deductions.
The next step is to prepare all of your income tax returns.  Not just for 2005, 06, and 07—in order to be in compliance (that’s the term the IRS uses for someone who’s in good graces with the IRS) you must have all of your tax returns filed and up to date.  You can’t set up a payment agreement to get yourself out of an IRS levy if you haven’t filed all of your returns.
If you’ve been a good doobie and responded to the first IRS notice immediately, they’ll give you 30 days to file and then you can usually get another 30 day extension before you have to deal with any consequences.  If you’ve blown off the IRS a couple of times already, they will not be so willing to wait for you.  The problem is that you might not know that you’ve blown them off, especially if you’ve moved and they have the wrong address for you.   Don’t assume you’ve got 30 or 60 days unless the IRS tells you they’re giving you that much time.
Each tax return must be mailed in a separate envelope.  People mess that up all the time.  Older returns go to one address, current returns go to another.  And the addresses vary depending upon where you live.  (Another reason it’s a good idea to get professional help.)  Even if you’re sending two or three returns to the same address, you still need to put them in separate envelopes.  (Think of a little kid going through a box of cereal looking for the prize.  Once the prize is found, he sort of forgets about the cereal.  It’s the same with tax returns and envelopes.  Once an IRS agent opens the envelope and finds a tax return—everything else is forgotten, that other return does not exist, only the first one he finds is real.)
Once you figure out what your real tax liability is (remember there will be penalties for late fling, late payment, plus interest), then you can negotiate a payment agreement or perhaps an offer-in-compromise if you qualify.  It all depends upon how much you owe and what you’re able to pay.  A simple payment agreement can be negotiated in about 10-15 minutes, while an offer-in-compromise can take 6 months or even longer.
On the “fun” scale, filing back taxes is right up there with root canals and colonoscopies.  Nobody wants to do it, but you reach a certain point and you just have to.  And, not unlike a colonoscopy or root canal, you want someone you trust doing the work.   If you’re in the “back tax” situation, the sooner you just get it done, the better off you are.  On the bright side, you’ll feel better when it’s all over.

Photo by Timetrax on flickr.com

I write a lot about what to do if you can’t pay the IRS, but this is new stuff just for 2011 taxes.   If you’re out of work, or if you’re self-employed and your income is lower than last year, you may be able to apply for an extension of time to pay your 2011 income tax–so you don’t get hit with late payment penalties.

• First, your adjusted gross income (that’s line 38 on form 1040) must be less than $100,000 (or $200,000 if you’re married filing jointly.)
• Second, you need to owe the IRS less than $50,000.

• Losing your job, for one.  If you were unemployed for at least 30 consecutive days in 2011 or the first part of 2012, then you can apply for relief.
• Or, if you’re self employed, if your business income is 25% or more less than what it was in 2010, then you also can qualify.

• The relief is only good for your 2011 taxes.
• It only helps with the failure to pay penalty, you’ll still have to pay the interest on your late payment (about a 3% annual interest rate.)  You’ll also have to pay any other penalties that you might owe.
• If you don’t pay the amount of tax you owe in full by October 15, 2012–then you’ll still wind up paying the penalty and it will be back-dated to April 15^th.
• If you apply for the late payment relief, you must have your tax return or extension filed on time.

And maybe you’ve wondered if they could help you too. Well no, they can’t. They’ve both filed for bankruptcy and their doors are shut. Part of the problem being was that their advertising was a little misleading.

Does that mean that you can’t settle your debt with the IRS for “pennies on the dollar”? No, that option is still available–it’s called an “Offer in Compromise”, but it’s not an option for everyone. An offer in compromise is only for people who genuinely can’t pay their tax bill–when all of their assets and future earnings are taken into account.

In 2010, there were over 57,000 Offer in Compromise applications submitted to the IRS–only 14,000 of them were accepted. Most of the problem with those rejected applications is that many people submitting Offers in Compromise don’t know the rules regarding spending and assets. When you’re filling out the form, you may say that your monthly mortgage payment is $2000, but the IRS has specific guidelines on what’s an allowable housing expense–if your payments don’t fall within the IRS guidelines, they don’t count. So if you live in an area where the IRS says that your monthly housing payment should only be $1500–that means you have $500 a month that the IRS says you can pay towards your tax bill–an offer would be unlikely. Now you don’t have an extra $500 a month, I get it–but to the IRS, if you owe them money, then you should live in a smaller house.

And although the IRS is rather generous about medical expenses–many of the alternative medicines and treatments are not considered to be “legitimate” medical expenses in an Offer in Compromise. So while the IRS would count your payments for your chemotherapy, they would take off the costs of the holistic vitamin program that you use. You need to keep that in mind if you’re using any kind of “unconventional” treatment. It doesn’t matter that it’s saving your life, if it’s not in the IRS book–it’s not a legitimate medical expense.

For an Offer in Compromise, there are national charts showing what you’re allowed to pay for food and clothing. There are charts for how much your housing should cost broken down by county. And there are different expense rules for senior citizens and younger folks as far as medical expenses are concerned. And you’ll have different rules for bus riders, car owners, and people who are still paying off their car. There’s a labyrinth of tax codes and charts to go through.

And I know this sounds harsh–but I want to make sure you understand how difficult it is to win an Offer in Compromise–if you have equity in your house–the IRS basically assumes that you can sell it for 20% less than what it’s worth and use that money to pay your tax bill. So basically, an Offer in Compromise isn’t usually a good option for homeowners with any equity.

If you don’t know the rules before submitting your application–you could lose before you even begin. That’s why it’s important to get professional help when submitting an Offer. And this is where it’s helpful to have someone who can meet with you in person, understand your situation, and fight for you because they know you’re a person and not just some file sitting on a desk. And if an Offer in Compromise isn’t the right choice for you then you can work together to come up with the best option that is available. And isn’t coming up with the best solution for you the whole point in the first place?

Photo by Ben Lakeyon flickr.com

The Retirement Saver’s Credit sounds like an old person kind of tax credit, but, for the most part, it’s really more of a young person’s credit and it gets totally ignored. The coolest part about the Saver’s Credit is that it’s a credit, not a deduction. That means that it’s a dollar for dollar reduction of your tax liability. A $100 tax credit would reduce your taxes by $100. A $100 tax deduction would reduce your taxes by $10 to $35 depending on your tax bracket. See the difference? Tax credits are better than deductions. The Saver’s Credit is for people with lower incomes so we’re looking at 10 to 15% tax brackets.

The Saver’s Credit can be worth up to $1,000 ($2,000 if you’re married filing jointly), so it’s pretty valuable. Basically, it’s like the government is giving you money for saving for retirement – how cool is that?

Who’s eligible?

1. You have to be 18 or over
2. You can’t be a full time student
3. You can’t be claimed as a dependent by someone else

So what are the income limitations?

• Single, married filing separately, or qualifying widower – $28, 250
• Head of Household – $42,375
• Married filing jointly – $56,500

So what do I have to invest in to get this tax credit? That’s the easy part, you can invest in any of the following:

1. A traditional or Roth IRA
2. Most any employer sponsored retirement plan

The one thing that doesn’t qualify is rollover contributions. Also, if you’ve taken money out of a retirement plan, it could reduce your ability to qualify for the credit.

So if I put $1,000 into an IRA the government is going to give me a $1,000 tax credit? No. I said it’s easy, but it’s not that easy. It works on a sliding scale: the lower your income, the larger the percentage you get, somewhere between 10% and 50% of your contribution. The form you need is form 8880. Here’s a link: http://www.irs.gov/pub/irs-pdf/f8880.pdf

Let’s say you’re single, you made $18,000, and you put $2,000 into a Roth IRA. You’d qualify for a $400 tax credit. You can figure that out by looking at the chart and you’ll see you qualify for a 20% tax credit.

The coolest thing about the Retirement Saver’s Credit is that you can play with it. Let’s go back to the example above – you’re single and made $18,000. You have until April 15th to put money into an IRA, so you don’t have to have this all done before tax time. At $18,000 income, you qualify for a 20% tax credit, but at $16,999 you qualify for a 50% tax credit. So if you put $1,001 into a traditional IRA (instead of the $2,000 you were going to put into the ROTH), it will lower your overall income, making your “adjusted gross income” or AGI, $16,999. Now, instead of getting a $400 tax credit on $2000, you get a $500 tax credit on $1,001 – and you still have another $999 left over to save or spend.

So you might be thinking, “Cool, I’ll just put it all into an IRA!” And you can, but you reach a point where the credit doesn’t do you any more good. The Retirement Saver’s Credit is what’s called a “non-refundable” credit. That means that once you zero out your tax liability, you don’t get anything more.

Let’s go back to our example: you’re single, you make $18,000. This time you put the whole $2,000 into a traditional IRA. Now your AGI is $16,000, that means your taxable income is $6,500 and your tax liability is now $658. So you complete form 8880 and you see that you qualify for a 50% credit which is $1,000 but since your tax liability is only $658—that’s all the credit you get.

Now if you have $2,000 to put into savings, I am 100% behind you saving the full $2,000. But, you may be better off putting some of that money into a regular savings account instead. It’s something to play with. Never sneeze at a 50% return on your investment. Let’s be real, that’s what this is. Even the 10% and 20% return is a good deal. But once you’ve maxed out that return, then you need to look at what other options you’ve got. That’s why I like IRAs. You can figure out your tax return first before make the investment. The absolute best part – you can make the investment with your income tax refund! You can actually do your tax return, plan out your IRAs, and not fund them until after you’ve gotten your refund.

Not everyone will qualify for the Credit for Qualified Retirement Savings Contributions, but if your income is anywhere close, you’ll definitely want to at least look into it.

Photo by Ed Yourdon on flickr.com

About once a year, after preparing a tax return I’m asked, “Does my husband/wife have to see this?” Well, the answer is, “Yes, and he/she has to sign it too.”

A lot of people never really look at their tax returns, but it’s important that you do, even if you’re not the bread winner. Your tax return has a lot of information about you and your financial situation. If your spouse is in trouble, and you sign the return, then you’re in trouble too.

Here’s the number one thing to look at so you don’t get caught unaware: Adjusted gross income. That’s going to be the number at the top of page 2 of your 1040 tax return (line 38). (It’s also at the bottom on page 1, line 37.) That’s all the money you make, including wages, business income, interest, gains from stock – everything. This is the number that should match your lifestyle. It’s the single most important number on your tax return (and you thought it was the refund didn’t you?) If you live in a million dollar mansion and drive a Porsche, and the adjusted gross income is only $20,000, you’ve got yourself a serious problem. Flip side, if you’re living in a shack and subsisting off of peanut butter sandwiches but the adjusted gross income number is $300,000, you need to ask yourself where all the money is going. It’s quite possible that your income numbers and lifestyle don’t match up and there could be a very legitimate reason for that, but you need to know what that is.

Of course, I recommend that you look at everything, and ask questions about anything you don’t understand. Here are three issues for you to check where you don’t need to know any math:

1. Look at the address on the return. If it’s not yours, you need to be asking questions.
2. Look at the names of the dependents. Do all the kids live with you? If not, does your spouse have a legal right to claim any children that are listed? Earned Income Credit Tax fraud is a big deal, and if you sign the return, it’s your problem too.
3. Also, look at the back of the return. Is the refund being direct deposited into your joint checking account? If not, where’s the money going and why?

One more thing that might give you pause to think would be on line 21: Other Income. This could be just about anything, but it’s where the gambling income goes. Most gamblers have a number on their Schedule A for the same amount to claim gambling losses, it would go on line 28. You can’t claim a bigger deduction than the amount of gambling money you win. If your lifestyle isn’t matching your adjusted gross income and you’ve got gambling on your tax return – your spouse’s losses could be much larger than what’s reported on your taxes.

In today’s economy, it’s important to be aware of your family’s full financial picture. For some couples, talking about money is difficult. You can use your tax return as a convenient way to open up the discussion. If there are money problems, you should come up with solutions as a team. That’s what marriage is supposed to be about anyway.

Photo by Rande Archer on flickr.com

One of the more interesting tax returns Bill and I worked on last year was for an employee of a private security firm in Afghanistan. While I’m the expert on foreign income, Bill’s our “go to” guy for all things military. While our client wasn’t working for the US military, he was clearly working with the US military and was definitely working in a combat zone.

Our goal of course was to make sure he didn’t pay more income tax than he was required to pay. I realize we’re not supposed to give preferential treatment to clients, but I gotta confess, we do tend to go the extra mile for our service members and for people who are working to keep our service members alive. (Plus he was just a really nice guy.)

My tactic was to claim a foreign income exclusion (Form 2555). While it reduced the guy’s taxable income, it still left him owing the IRS and we were trying to eliminate that balance due. Bill, coming from the military side, was trying to exclude the income under something called Internal Revenue Code Section 112. This basically excludes income that was earned in a combat zone, so we were thinking we might have something there. But here’s the actual rule:

“Gross income does not include compensation received for active service as a member below the grade of commissioned officer in the Armed Forces of the United States for any month during any part of which such member served in a combat zone.”

The key issue here, we decided, was that the person had to be a member of the Armed Forces to qualify for the income exclusion. And so we advised our client to pay the tax.

What we didn’t know at the time was that a similar case was being heard in Tax Court while we were working on the return. In the court case, Nathaniel J. Holmes v. Commissioner (TC Memo 2011-6), the Tax Court ruled that a civilian working for a private company doesn’t qualify for the combat zone income exclusion. So it turns out, we had been right. Had the case gone the other way, of course, we’d be amending our client’s tax return for FREE!

The bottom line though is – if you’re a private contractor in a foreign country, you won’t be able to exclude your income under the Section 112 rules for income earned in a combat zone. You still may be able to exclude your income (or a portion of your income) under the Foreign Income Exclusion on a Form 2555. Or, if you’re paying tax in the foreign country, there’s also the credit for foreign tax paid on Form 1116. There are options out there, you just have to make sure you’re using the right one.

Photo by North Charleston on flickr.com

Retired public safety officers may be eligible to exclude up to $3,000 from their pension distributions for money that was used to pay the premiums for accident or health insurance or long-term care insurance. Public safety officers include law enforcement officers, firefighters, chaplains, and members of a rescue squad or ambulance crew. In order to qualify for this deduction, the payment for the insurance must be made directly from the pension plan to the insurance provider. Basically you exclude the smaller of the amount of your insurance or the $3,000. If you’re excluding the insurance from your pension income, then you can’t include it as a Schedule A deduction.

So if you’re making this deduction, how do you show it on your tax return? First, I guess I should be using the right words. It’s not really a deduction – you are “making an election to exclude the insurance premiums from your income.” Now you’ve just had a lesson in tax geek semantics. I know you don’t care, but I’m supposed to use the right words. For what it’s worth, a reduction in income is better than a deduction.

Anyway, if you look at your 1099R, which shows your pension distribution, the box 2a which shows what part of your pension is taxable doesn’t show your insurance payment, so the exclusion isn’t automatic. Here’s what I mean – let’s say that you receive a public pension for $25,000 a year. $5,000 of it isn’t taxable so your 1099 shows $25,000 in box one (your gross distribution) and $20,000 in box 2a (the taxable amount). But if you paid $4,000 for your health insurance, you’re allowed to exclude $3,000 of that money from your income. So really your true taxable amount is $17,000.

If you are doing this by hand, you’d just write it on the 1040 like this: On line 16a you’d write $25,000 for the total amount of the pension, and on line 16b you’d write $17,000 for the taxable portion. You’d write PSO next to it so that the IRS would know why the number on line 16B didn’t match the number in box 2a of your 1099.

It’s really important that the numbers on your tax return match the numbers in the boxes on your 1099. When they don’t, you get little letters from your friends at the IRS. Writing PSO on your tax return basically tells them that you’re not just arbitrarily changing their tax figures for them.

So how do you do this if you’re using a computerized tax program? That’s a little trickier because you can’t just go and change the numbers without somehow notating it. If you just type in $17,000 in box 2a instead of the $20,000 number, I guarantee you you’ll be hearing from the IRS. And we don’t want that do we?

If you’re using the 1040.com program, it’s really easy. When you’re in the 1099 input screen, you’ll see at the top there’s a little phrase in blue letters: “Special Tax Treatments.” You’re going to want to click on that button. It will take you to a new page with other items that also require special tax treatment. The “public safety officer” insurance is at the very bottom. All you have to do it type in how much you paid into the little box and the program will handle the rest.

Other tax programs should have something similar. If you can’t find a “special tax treatments” page, call the phone number listed with your program and they should be able to tell you how to get there. And if they can’t, come back here and use my 1040.com site (sorry for the shameless plug but a girl’s gotta eat.)

Special thanks go out to Mr. A—– in California for the idea for this post.