Help Wanted: Tax Considerations When Adding Workers

Preface: Employee or subcontractor classification is often an ambiguous area of the tax code. In this blog, relationship factors relevant to the tax classifications are considered, e.g. should Eli be an employee or a subcontractor?

Credits: Jake Dietz

Help Wanted: Tax Considerations When Adding Workers

Has your business grown so much that you are ready to bring in more help? If so, consider if you should hire employees or get independent contractors to assist you. The IRS cares about how you classify workers. They do not want you to merely classify a worker as an independent contractor to save on taxes without first determining if the worker is truly an independent contractor.

Determining the classification of your new worker may take some thought, but the IRS provides some guidance and factors which should be considered. For some workers, certain factors might point towards the employee classification, while other factors point towards the independent contractor classification. Although it can be unclear at times, employers should make a good faith effort at classifying correctly.

There are three factors that the IRS considers. These factors are behavior control, financial control, and type of relationship. We will drill down on each of these three categories.

Behavior Control

For the behavior consideration, the IRS looks at whether or not the employer may control what work is done and how it is done by the worker. The IRS asserts that a worker is an employee if the company has the right to tell the worker how to do the work, regardless of whether or not the company actually does tell the worker how to work.

Let’s look at an example. If you own a farm and hired a new employee, you can tell him exactly how to do the work. You may tell him to bale hay using a specific tractor with a certain baler, even in a certain gear. You may give detailed instructions on what to do, how to do it, and when to do it. Even if the new employee is experienced and you do not need to give as many instructions, you still have the right to give the instructions.

On the other hand, if a custom operator comes to your farm to bale hay, you may not have the right to give as many instructions to him. The custom operator may choose which tractor, which baler etc. to use. If the custom operator runs out of twine, then the custom operator, not the farm owner, gets to decide where to buy twine and how much to buy.

If your company is providing training to the worker, that indicates an employee. You don’t need to train the custom operator how to bale hay. If the custom operator needs training, it is the operator’s responsibility to get it.

Financial Control

The IRS also looks at financial control. How much investment does the worker need to do the job? If the worker needed a significant investment in tools, software, etc., then that is evidence pointing towards an independent contractor. Our hay baling employee had no investment in the equipment, but our custom baler operator had to purchase a tractor and baler and supplies. Certain jobs, however, may require investments of workers who are employees. Construction worker and mechanic are two such jobs.

Does the worker regularly incur expenses that you don’t reimburse? Is it possible that the worker will lose money on the job? Is the worker paid by the job instead of by the hour? If these questions can be answered “Yes” it points toward a contractor. If our custom operator has too many breakdowns, it could lead to a loss for the year. If the employee has breakdowns, they still receive the same hourly rate as if there were no breakdowns.

Type of Relationship

Does the relationship look like a long-term relationship between an employer and employee? If so, that points to an employee classification. If the relationship is a based on a contract to do a certain job, then that points to a contractor. Just because a contract is signed, however, does not guarantee that the worker is an independent contractor.

Another factor is if the work provided is a product or service of the business. For example, an accountant doing work for an accounting firm is likely an employee of that firm.

Unfortunately, there is no bright line rule for determining if someone is an employee or independent contractor, but fortunately the IRS does give guidance. For additional guidance, please contact our office.



Keogh or SEP for the Self-Employed Person?

Preface: Retirement planning or tax savings? Self-employed business owners can save on tax dollars, or more appropriately, defer the tax expense with the right plan.

Keogh or SEP for the Self-Employed Person?

If you’re self-employed and contemplating setting up an easy-to-administer retirement plan, you have a few options available. You can set up a Simplified Employee Pension plan (known as a SEP), or one of two different types of Keogh plans, either a profit-sharing plan or a money-purchase plan. Which is best for you depends upon your particular circumstances. To help get you started, we’re highlighting some of the differences among the different types of plans.

What’s the easiest plan to set up? There’s no question that the SEP wins hands down. A SEP can be set up easily at a bank or brokerage house, with separate accounts for each participant. A simple IRS form can be used to establish a model SEP. Setting up and administering a Keogh plan is a little more complicated, and in most cases returns have to be filed periodically.

How much can you contribute and deduct? If you’re looking to make the biggest deductible contributions possible, the money purchase Keogh has the edge. You can contribute as much as 100% of your earnings, up to a maximum of $53,000 for 2016 and 2015, as adjusted for inflation. With a profit-sharing Keogh or SEP, the percentage is lower. In either event, contributions can’t be based on annual earnings over $265,000 for 2016 and 2015 ($260,000 for 2014), as adjusted for inflation. The down side of the money-purchase plan is that you must make set contributions every year. With the profit-sharing Keogh or the SEP you can vary contributions from one year to the next, depending upon how the business is doing.

Do you have to cover employees? With any plan, you generally must if they are age 21 or older. However, with a Keogh plan, you don’t have to cover employees who haven’t completed at least one year of service (two years in some cases). Because of the way a year of service is defined, many part-timers don’t have to be covered at all. With a SEP the rules are a little different: You only have to cover employees who have worked for you during three of the past five years. But once that condition is met, even most part-timers have to be covered.

When do benefits vest? A Keogh plan can be set up so that employees aren’t entitled to their accrued benefits unless they have been plan members for a certain number of years (sometimes three, sometimes five). Or they can become entitled to their benefits gradually over a seven-year period. If the employee quits or is fired, he or she is only entitled to “vested” benefits. No such waiting period is allowed for SEP participants.

Profit-sharing Keoghs can have cash or deferred arrangements allowing employee pre-tax contributions, which can help keep employer costs down. The rules are slightly different for each type of plan.

If you find you haven’t made a decision by year-end there is a feature of a SEP that is useful. It can be set up and funded by the tax return due date. Contributions can be made after year-end to a Keogh plan only if the plan was actually set up by the end of the previous tax year.

After you’ve considered these points, you might want to consult with a CPA about some of the finer points; we would be happy to help you plan that decision, and the retirement expense that will work best for you.

Accounting for Long-Term Contracts

Preface: Construction accounting – unbeknownst to many in the industry,  contains special accounting rules for long-term contracts. Businesses with annual construction contracts in excess of $10m are required to apply long-term contract accounting. What is it, and what should you know?


Accounting for Long-Term Contracts

Long-term contracts for tax law recognition-of-income purposes are contracts for manufacturing, building, installing or constructing property that are not completed in tax year in which they are entered into.  A contract is considered to be for building, installation or construction of property if it provides for the erection of a structure, such as a building, oil well or other improvement, bridge, railroad or highway, or large industrial machine.


Taxable income from long-term contracts generally must be determined using the percentage of completion method.   Under the percentage-of-completion method, gross income is reported annually according to the percentage of the contract completed in that year. The completion percentage must be determined by comparing costs allocated and incurred before the end of the tax year with the estimated total contract costs (cost-to-cost method or simplified cost-to-cost method).  A taxpayer who has entered into a small construction contract or home construction contract, however, may use an exempt contract method of accounting.


Direct-benefit services. Income and expenses attributable to engineering or architectural services are accounted for as part of the long-term contract if they enable the taxpayer to construct or manufacture the qualifying subject matter of the long-term contract.  Other income and expense items, such as investment income, expenses not attributable to such contracts, and costs incurred with respect to any guarantee, warranty, maintenance or other service agreement relating to the subject matter of such contracts, including engineering activity performed after the delivery and acceptance of the subject matter of the contract, must be accounted under the taxpayer’s normal accounting method.


Construction management contracts. One type of construction contract that primarily involves the performance of services is a construction management contract. In a typical construction management contract, the construction manager coordinates the construction project for the owner. The construction management firm does not have a contractual relationship with the contractors or subcontractors and is not at risk for defects in the materials or for mistakes in the construction. The construction management firm will oversee and coordinate the construction activity, may provide engineering and design services, may negotiate with contractors, subcontractors or suppliers on the owner’s behalf, and may perform some construction services.


The IRS has inferred in a number of private rulings that a taxpayer may be able to carve out a portion of the income from a construction management contract and report such portion using the percentage of completion method in limited circumstances. The taxpayer would need to show that the separate construction activities qualify as long-term contract activities, that a reasonable amount of revenue has been allocated to the construction portion of the contract as opposed to the construction management portion, and that the proper costing techniques have been utilized in determining the annual percentage of completion for the construction portion of the contract.


Real property construction contracts. The requirement that income be computed using the percentage of completion method or the percentage of completion-capitalized cost method and the requirements concerning the allocation of costs to long-term contracts do not apply to construction contracts entered into by a taxpayer:

  1. who estimates, at the time the contract is entered into, that the contract will be completed within the two-year period beginning on the contract commencement date, and
  1. whose average annual gross receipts for the three tax years preceding the tax year the contract is entered into do not exceed $10 million.


However, the rules for allocation of production period interest to long-term contracts apply to the long-term construction contracts. A construction contract for this purpose is any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property.


Home construction contracts. Proposed IRS regulations provide that a contract for the construction of common improvements is considered a contract for the construction of improvements to real property directly related to and located on the site of the dwelling units, even if the contract is not for dwelling unit construction.  For example, a land developer that sells individual lots (and its contractors and subcontractors) might have long-term construction contracts that qualify for the home construction contract exemption.  These regulations also permit an individual condominium unit to be considered a “townhouse” or “rowhouse” under the exemption, so that each condominium unit can be treated as a separate building in determining whether the underlying contract qualifies.


If you have any questions about the tax rules related to long-term construction contracts or their application to your business, please  contact this office.

The Affordable Care Act and Individual Taxes

Preface: Compliance with the Affordable Care Act is easier with an understanding of the options. Here what you need know if you’d like an option for compliance beside health insurance.

Credits: Jake Dietz, CPA

The Affordable Care Act and Individual Taxes

It is tax time again. You may be wondering how the Affordable Care Act (ACA) affects your tax return. The ACA generally mandates taxpayers to have what the IRS calls “minimum essential coverage” for health insurance for every month of the year, claim an exemption from health coverage mandate, or pay a Shared Responsibility Payment or tax.

If you and everyone else on your tax return, such as a spouse and children, had minimum essential health coverage for the full year, then you can check the box on Line 61 of the 2016 Form 1040 stating that you had coverage. Do not check the box if you had other coverage, such as through a church, that was not insurance.

If you did not have minimum essential coverage, you may be able to claim an exemption on Form 8965. The IRS lists various exemptions in their instructions to Form 8965. Several of these exemptions will be covered in this article.

The IRS allows an exemption for “members of certain religious sects.” The IRS instructions define these religious sects as a “sect in existence since December 31, 1950, that is recognized by the Social Security Administration as conscientiously opposed to accepting any insurance benefits, including Medicare and social security.” Essentially, this exemption can be granted to church members whose church is approved for members to have Form 4029 Social Security exemptions. The member can still get the ACA exemption, however, even if they do not have a Form 4029 exemption. The taxpayer should probably not apply for this exemption if they hope to apply for Medicare later in life.

To claim the religious sect exemption, the taxpayer must apply to the Marketplace for an Exemption Certificate Number (ECN.) This application for exemption can be found at the website of the Health Insurance Marketplace. You may also be able to get a copy from a deacon or other church leader, and you could always ask your accountant for a copy.

Another exemption listed in the IRS instructions is for American citizens living outside the U.S. for at least 330 days in a timeframe of 12 consecutive months. For example, suppose that you were an American missionary living in Paraguay for 2016, except for a 3-week furlough in the United States. In this scenario, you would qualify for an exemption to the ACA health coverage mandate because you were living outside the U.S. for at least 330 days. This exemption can be claimed on the tax return without filing for an ECN.

Another exemption that can be claimed on your tax return is for members of a qualified health care sharing ministry (HCSM.) Not all ministries that share medical expenses, however, qualify for this exemption. If you belong to a sharing ministry and are unsure if it qualifies, please ask leaders of the ministry if it qualifies before you file your taxes. This exemption can be claimed on the tax return without filing for an ECN.


Generally, the ACA requires you to have a compliant coverage plan, qualify for an exemption, or pay a tax. If you are wondering if you qualify for any of the other exemptions not mentioned in this article, contact your CPA.

Form 4797 – Sale Of Business Property

Preface: Form 4797 easily could sound like a part of the national export strategy compliance reporting from the Department of Commerce or Customs and Borders Protection. It is an IRS workpaper for sales of business assets. Business property is typically either Section 1231, 1245 or 1250 property and the sale is listed on a 4797.

Form 4797 – Sale of Business Property

When your business sells a company vehicle, or a customer list, how does your tax accountant report the gain? Answer: On Form 4797 “Sale of Business Property.” The IRS tax code requires the reporting of a sale of business property in a different section of the tax code than ordinary revenues, from say a sale of inventory (Section 471.) The most common gain and loss code sections for business property are Section 1231, Section 1245 and Section 1250.

Section 1231 gains and losses can be taxed as either ordinary income or loss, or capital gain, depending on the characteristics of the transaction. Section 1231 assets are the exchanges of 1) real property, e.g. leasehold improvements; or 2) depreciable property used in a business and held for more than a year, [typically property that is held for rental or royalties income] or 3) Section 197 intangibles such as goodwill, customer lists or copyrights. Note: the origin of the Section 197 intangible is a key factor in the tax attributes of the transaction, e.g. self-created intangibles are always ordinary income. Other section 1231 property include sales or exchanges of livestock, unharvest crops, or timber. To determine if your asset sale is ordinary or capital you must net all section 1231 gains and losses for the year. If you have a net section 1231 loss, it is an ordinary loss. If you have a net section 1231 gain, it is ordinary to the extent of non-recaptured section 1231 losses from prior years. Non-recaptured section 1231 losses are the net section 1231 losses from the previous five years. Therefore, if your business had a section 1231 loss in any of the five preceding tax years, the section 1231 gain is an ordinary gain to the extent of the non-recaptured losses.

To detail, if your business sold leasehold improvements four years ago with a loss of $15,000 and a customer list (a section 197 intangible) for a $10,000 gain in the prior tax year, a current year section 1231 gain of $20,000 would be netted with the prior five year section 1231 gains and losses ($15,000 loss from leasehold improvement+ $10,000 gain from customer list = $5,000 loss, the non-recaptured section 1231 loss). Therefore, $5,000 of the $20,000 current year gain would be treated as ordinary income, and $15,000 as a capital gain. Hotchpot complexities, such as this, are why you pay a tax accountant.

Section 1245 property is property that is  1) Personal – tangible or intangible 2) Tangible property for manufacturing, production, transportation, etc. Most business equipment, e.g. machinery, furniture, is classified as section 1245 property. Gains treated as ordinary income on the sale of section 1245 property include the lesser of depreciation and amortization on the asset, or the gain realized on the disposition. An example would detail the sale of a $75,000 backhoe with $40,000 of depreciation. The cost basis in the asset, net the depreciation allowance of $40,000 is a $35,000 book basis. Market value is most often different than book basis, e.g. gain or loss on disposition. If the asset is sold for $50,000, the gain is $15,000 ($50,000 sale price – $35,000 book basis = $15,000 gain.) The entire gain is ordinary since it does not exceed the depreciation of $40,000. If the asset was sold for $85,000, the gain would be $50,000 ($85,000 sale price – $35,000 book basis = $50,000 gain). $40,000 of gain, the depreciation recapture, would be ordinary income, and $10,000 in excess of cost basis would be a capital gain. Sales of section 1245 assets are listed on Part III of the form 4797. Section 1245 assets can also be sold in bulk and aggregated on the form 4797.

Section 1250 property includes real estate as business property or real property that is depreciated and has never been section 1245 property. Recapture income on section 1250 property is ordinary income and un-recaptured income (income in excess of cost basis) is taxed at a maximum 25% capital gains rate (lower capital gain rates in some instances.) If you own real estate in your business, such as an office building, the asset is section 1250 property. You should always talk with your tax advisor before buying real estate in your business, to plan proper entity structuring, and optimize future tax attributes.

Section 1231, 1245 and 1250 assets in your business should always be listed on a fixed asset report. You should have a fixed asset report for federal tax, state tax and AMT, (and if you have accountant prepared financials, such as a reviewed financial statement, a financial asset report.) Your tax accountant should periodically discuss the reports with you to determine the accuracy of cost basis and accumulated depreciation that is relevant to gain and loss reporting on asset dispositions.

Before you transact any sale of major assets in your business, speak with your tax advisor for proper calibration of the tax attributes.

Vendor Management And Negotiation

Preface: Optimizing vendor costs, or purchases, is an opportunity to increase profits for any business. Astute negotiating with vendors can often lead to an increase in gross profit and net income percentages. Consider yourself a good negotiator? Is that D10T the better deal in a box? Let’s say it practical.

Vendor Management and Negotiation

What would your business do without good vendors? Maintaining supportive affinity with vendors is vital to a successful business; albeit a top priority. Vendor terms, discounts and payment negotiations, can reduce your cost of goods sold and increase net income with a little extra effort; the greater your cost of goods sold, the more value your business can obtain from optimal vendor negotiations. For instance, if your cost of goods sold is $870,000, a savings of 2% on vendor terms is $17,400. If cost of goods sold is 60% of sales on $1,450,000, for either the month or the year, then your net income increases 1.2% from good cash management using vendor discounts. If cost of goods sold are say $2,500,000, a 2% cost reduction is $50,000. It’s easy to see, negotiating vendor terms can be as important as advertising to increase revenue.

Vendors are people, just like your customers. You should learn the names of those in the accounting department who send invoices and process payments. Who has key decision making authority at the vendors to negotiate discounts? Treat your vendors the same way you want your customers to treat you. If cash is restricted, tell your vendors, be proactive in communicating late payments; a good vendor will have stringent terms on payment, but most often understand if you communicate honestly the situation. Yet, if you can pay something towards the balance, it is always advisable to do so.

Before you begin negotiating vendor terms, research thoroughly the company and acquaint yourself with the products the vendor supplies. You may be aware that the vendor supplies stroopwafels, but do you know what other products they merchandise. One discipline, to manage vendor costs, is to research the vendor website and any marketing documents to gain an increased knowledge of their target market. Will your business be .05% of their yearly revenue or 5%?  Review competitor’s prices and payment policies to obtain industry options. If you want a line of stroopwafels for inventory, it may be more convenient to purchase from a distributor who can negotiate volume discounts than from the stroopwafel boutique. Yet, price is not always the key factor. If you are purchasing circuit boards, your due diligence is significantly more important. Price may be one component, but supply channel bandwidth, lag times, and quality, with an optimal in-the-field success rate may be more important. If you are purchasing commodities such as 2×8 lumber or propane fuels, vendor discounts can be valuable, significantly valuable. Don’t over negotiate, but put in the effort to get good deals.

Negotiating must include incentives. If you have your research in hand, you will know what incentive you can offer. Negotiating options include: (I) Referring new business, if you have contacts that you can refer to the vendor you have value to leverage, (II) Volume guarantees, if you can guarantee you will order $150,000 a year, a vendor may consider a valuable discount opportunity in entirety, (III) ACH or credit payment access, if the vendor has the comfort of having access directly to your checking account, and payment is certain, you add value to the relationship. Avoid being abrasive or negotiating vendor terms without an incentive plan in place; but combine new business referrals, volume guarantees, credit payment access, and additional values, and you gain stellar negotiating strength that can increase your revenue profitability.

Amortization Of A Businesses Intangible Assets

Preface: Amortization of intangible assets is similar yet different than depreciation. It is governed by a different Section of the IRC and methods are unique to the intangible asset based on the IRC code section relevant to various intangible. This blog is provide an explanation of amortization and namely IRC Code Section 197 relevant to the majority of small business intangible assets.

Amortization of a Businesses Intangible Assets

Amortization is the expensing of intangible asset costs ratably over the intangible assets life. Amortization is governed with Internal Revenue Code (IRC); including section 197 and 195. Section 197 assets have a three factor test 1. They must be listed in Section 197 descriptions, 2. They must have been purchased, 3. They must be held in connection with the conduct of trade of business or investment activity. Factor 1 assets in Code Section 197 include: goodwill, workforce in place, patents, copyrights, formulas, processes, designs, patterns, market share, customer lists, licenses, permits, governmental rights, covenants not to compete, franchise fees, trademarks, trade names, contracts for use of acquired intangibles, and information bases in a business. This is not a comprehensive list of Section 197 assets, but the majority of the typical Section 197 intangibles.

Intangibles in Section 197 are expenses ratably over 15 years, beginning with the month of the acquisition. In businesses where intangibles are purchases along with other business assets, the intangible assets are determined by subtracting the cost of Class 1, Class 2 and Class 3 assets from the purchase price. This information is listed on IRS Form 8594 Asset Acquisition Statement.  For example, if a business is purchases $150,000 of intangible assets, including goodwill and patents in a acquisition, the intangible costs would be expensed at say $10,000 for 15 years, and not depreciated at standard MACRS methods of say 7 years at say a 200% declining balance.

Other assets are also amortized that are not in IRC Section 197. These include interests in partnerships, corporations, trusts, and estates, interests in land, computer software, and professional fees incurred in corporate organizations or reorganizations, accounts receivable, and interest in a lease of tangible property, etc.

Start-up expenses can be amortized with IRC Section 195. Code Section 195 expenses require that the expense must be for investigating the creation or acquisition of an active trade or business; for creating an active trade or business, activities engaged in for profit and for production of income before the day business begins, the taxpayer must elect to amortize the start-up expense.

Amortization rules have a few nuances, including amortization of intangible drilling and development expenses of oil or gas wells over a sixty month period under IRC Section 59; IRC Section 171(a) (2) permits the amortization of bond premiums, and disallowed amortizations such as the elections to amortize expenses paid or incurred in creating or acquiring musical compositions or copyrights to compositions is no longer a permissible tax feature in tax years beginning after 2010. Amortization of lease fees can be amortized for the lifespan of the lease too, and not a set amortization span.

Summarized: Amortization expenses differ from depreciation, in the fact that they are in intangible assets vs. tangible assets. Intangible is key here. Typically amortization is on the straight-line expensing method and not MACRS methods applicable to tangible property. When amortizing assets, talk with your CPA for appropriate handling of the intangible.