Chapter 6
Satisfying the Tax Man
IN THIS CHAPTER
Filing sole proprietor and partnership taxes
Filing taxes for corporations
Reporting and paying sales taxes
Staying on top of tax rules and strategies
Paying for help with your taxes
Paying taxes and reporting income for your company are very important jobs, and the way in which you complete these tasks properly depends on your business’s legal structure. From sole proprietorships to corporations and everything in between, this chapter explains how taxes are handled for each type. You also get some instruction on collecting and transmitting sales taxes on the products your company sells as well as guidance on keeping up with tax rules and paying for tax help. (See Book 2, Chapter 6 for in-depth information on what’s what with all the different forms of business structure and for choosing the right legal structure for your business.)
Go to www.irs.gov to see the latest and greatest versions of the federal tax forms discussed in this chapter.
Tax Reporting for Sole Proprietors
The federal government doesn’t consider sole proprietorships to be separate and distinct legal entities, so they’re not taxed as such. Instead, sole proprietors report any business earnings on their individual tax returns — that’s the only financial reporting they must do for income tax purposes.
Most sole proprietors file their business tax obligations as part of their individual 1040 tax return using the additional two-page form Schedule C, Profit or Loss from Business. On the first page of Schedule C, you report all the company’s income and expenses and answer a few questions about your business. The second page is where you report information about Cost of Goods Sold and any vehicles used as part of the business.
Sole proprietors must also pay both the employee and the employer sides of Social Security and Medicare (self-employment tax) — that’s double what an employee would normally pay, because the employer matches what is withheld from the employee’s wages. Table 6-1 shows the drastic difference in these types of tax obligations for sole proprietors.
TABLE 6-1 Comparison of Tax Obligations for Sole Proprietors
Type of Tax |
Amount Taken from Employees |
Amount Paid by Sole Proprietors |
Social Security |
6.2% |
12.4% |
Medicare |
1.45% |
2.9% |
Social Security and Medicare taxes are based on the net profit of the small business, not the gross profit, which means that you calculate the tax after you’ve subtracted all costs and expenses from your revenue. To help you figure out the tax amounts you owe on behalf of your business, use IRS form Schedule SE, Self-Employment Tax. On the first page of this form, you report your income sources, and on the second page, you calculate the tax due.
If you’re the bookkeeper for a sole proprietor, you’re probably responsible for pulling together the income, Cost of Goods Sold, and expense information needed for this form. In most cases, you then hand off this information to an accountant to fill out all the required forms.
Filing Tax Forms for Partnerships
If your business is structured as a partnership (which, by definition, has more than one owner), your business doesn’t pay taxes. Instead, all money earned by the business is split up (passed through) among the partners — who then pay personal income taxes.
The bookkeeper for a partnership or an LLC choosing to be taxed as a partnership needs to provide the financial data necessary to prepare Form 1065, U.S. Return of Partnership Income. Typically an accurate income statement and balance sheet are all that is necessary. These financial statements should be provided to the company’s accountant, who prepares Form 1065.
The partnership’s income and expenses from Form 1065 are used to generate a Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc. for each partner. The partnership’s tax results will “pass through” to the individual partners based on the partnership agreement. The Schedule K-1 reports to each partner his or her respective share of the partnership’s tax results. Using the K-1 information, each partner is then required to report the tax results on his or her tax returns.
Individuals use page 2 of Schedule E (Form 1040), Supplemental Income and Loss to report the K-1 information on their Form 1040. Note that Schedule E is used for other reporting purposes such as income rental real estate, income from S Corporations, and so on. Your accountant can help you with preparing Schedule E as well as making the passive and non-passive distinctions.
Paying Corporate Taxes
Corporations come in two varieties, S Corporations and C Corporations; as you may expect, each has unique tax requirements and practices. In fact, not all corporations pay taxes. Some smaller corporations have elected to be taxed as S Corporations and pass their earnings through to their stockholders. Both C and S Corporations have the same legal requirements and protections; they only vary in tax treatment.
Check with your accountant to determine whether incorporating your business makes sense for you. Tax savings aren’t the only issue you have to think about; operating a corporation also increases administrative, legal, and accounting costs. Be sure that you understand all the costs before incorporating.
Reporting for an S Corporation
An S Corporation must have 100 stockholders or fewer, have only one class of stock, and only have shareholders who are individuals, certain trusts, and estates. (See a professional for other, less common eligibility requirements; find out how to hire tax help later in this chapter.) An S Corporation functions like a partnership but gives owners more legal protection from lawsuits than traditional partnerships do. S Corporations still file a corporate tax return, on Form 1120S. However, the tax return is for informational purposes only, with the income on each shareholder’s Form K-1 passing through to the individual’s tax return on Schedule E of Form 1040, just as in the previous partnership example.
Reporting for a C Corporation
The type of corporation that’s considered a separate legal entity for tax purposes is the C Corporation. A C Corporation is a legal entity that has been formed specifically for the purpose of running a business.
The biggest disadvantage of structuring your company as a C Corporation is that your profits are taxed twice — as a corporate entity and based on dividends paid to stockholders. If you’re the owner of a C Corporation, you can be taxed twice, but you can also pay yourself a salary and therefore reduce the earnings of the corporation. Corporate taxation is very complicated, with lots of forms to be filled out, so it’s impossible to go into sufficient detail here about how to file corporate taxes. Be sure to consult a professional (with the help of information later in this chapter).
You may think that C Corporation tax rates are a lot higher than personal tax rates, but in reality, many corporations don’t pay tax at all or pay taxes at much lower rates than you do. As a corporation, you have plenty of deductions and tax loopholes to use to reduce your tax bites. So even though you, the business owner, may be taxed twice on the small part of your income that’s paid in dividends, with a corporation, you’re more likely to pay less in taxes overall.
Reporting for Limited Liability Companies (LLC)
LLCs, or Limited Liability Companies, are now being used extensively in business. LLCs can elect or choose their tax classification, such as being taxed as a C Corporation or as a partnership. LLCs have the same reporting requirements and file the same tax returns discussed earlier in this chapter, depending on their chosen classification.
Taking Care of Sales Taxes Obligations
Even more complicated than paying income taxes is keeping up-to-date on local and state tax rates and paying your business’s share of those taxes to the government entities. Because tax rates vary from county to county, and even city to city in some states, managing sales taxes can be extremely time-consuming.
Things get messy when you sell products in multiple locations. For each location, you must collect from customers the appropriate tax for that area, keep track of all taxes collected, and pay those taxes to the appropriate government entities when due. In many states, you have to collect and pay local (for the city or county governments) and state taxes.
An excellent website for data about state and local tax requirements is the Federation of Tax Administrators (www.taxadmin.org). This site has links for state and local tax information for every state.
States require you to file an application to collect and report taxes even before you start doing business in that state. Be sure that you contact the departments of revenue in the states you plan to operate stores before you start selling and collecting sales tax.
All sales taxes collected from your customers are paid when you send in the Sales and Use Tax Return for your state — you must have the cash available to pay this tax when the forms are due. Any money you collected from customers during the month should be kept in an account called Accrued Sales Taxes, which is actually a Liability account on your balance sheet because it’s money owed to a governmental entity. (See Chapter 3 in Book 3 for an introduction to balance sheets.)
Keeping Up with and Researching Tax Strategies and Rules
By the time you actually get around to filing your annual income tax return, it’s too late to take advantage of many tax-reduction strategies for that tax year. And what can be more aggravating than — late in the evening on April 14, when you’re already stressed out and unhappily working on your return — finding a golden nugget of tax advice that works great, if only you’d known about it last December!
Whether you’re now faced with the daunting task of preparing your return or you’re simply trying to increase your tax intelligence during the year, you’re probably trying to decide how to do it with a minimum of pain and taxes owed. As you find out in the following sections, you have several options for completing your return and gaining knowledge. The best choice for you depends on the complexity of your tax situation, your knowledge about taxes, and the amount of time you’re willing to invest.
A minority of taxpayers may run into some nitpicky tax issues caused by unusual events in their lives or extraordinary changes in their incomes or assets. This chapter (and book) may not be enough for those folks. In such cases, you need to consider hiring a tax advisor, which is covered later in this chapter.
Using IRS publications
In addition to the instructions that come with the annual tax forms that the good old IRS prints every year, the IRS also produces hundreds of publications that explain how to complete the myriad tax forms various taxpayers must tackle. These free materials provide more detail than the basic IRS publications and are available in printed form by mail if you simply call and order them from the IRS (800-829-3676) or digitally through the IRS’s website (www.irs.gov; see the later section “The Internal Revenue Service” for more on what the site has to offer). Examples of these pamphlets include
- Publication 17: “Your Federal Income Tax” is designed for individual tax-return preparation.
- Publication 334: “Tax Guide for Small Business” is for (you guessed it) small-business tax-return preparation for individuals who use Schedule C or C-EZ.
- Publication 583: “Starting a Business and Keeping Records” is also an excellent resource.
Additionally, the IRS provides answers to common questions through its automated phone system and through live representatives.
If you have a simple, straightforward tax return, completing it on your own using only the IRS instructions may be fine. This approach is as cheap as you can get, costing only your time, patience, photocopying expenses, and postage to mail the completed tax return (unless you choose to file electronically).
One danger in relying on the IRS staff for assistance is that it has been known to give wrong information and answers. When you call the IRS with a question, be sure to take notes about your phone conversation, thus protecting yourself in the event of an audit. Date your notes and include the IRS employee’s name you spoke with, employee number, office location, what you asked, and the employee’s responses. File your notes in a folder with a copy of your completed return.
The IRS also offers more in-depth booklets focusing on specific tax issues. However, if your tax situation is so complex that this book (and Publications 17 and 334) can’t address it, you need to think long and hard about getting help from a tax advisor (covered later in this chapter).
IRS publications present plenty of rules and facts, but they don’t make finding the information and advice you really need easy. The best way to use IRS publications is to confirm facts that you already think you know or to check the little details. Don’t expect IRS publications and representatives to show you how to cut your tax bill.
Buying software
If you don’t want to slog through dozens of pages of tedious IRS instructions or pay a tax preparer hundreds of dollars to complete your return, you may be interested in computer software that can help you finish your IRS Form 1040 and supplemental schedules. If you have access to a computer and printer (unless you choose to file electronically), tax-preparation software can be a helpful tool.
Tax-preparation software also gives you the advantage of automatically recalculating all the appropriate numbers on your return if one number changes. Tax programs can be helpful in doing complex calculations such as determining whether you’re subject to the alternative minimum tax or calculating allowable real estate passive losses. The best tax-preparation software is easy to install and use on your computer, provides help when you get stuck, and highlights deductions you may overlook.
Before plunking down your hard-earned cash for some tax-preparation software, know that it has potential drawbacks:
- A tax return prepared by a software program is only as good as the quality of the data you enter into it. (Of course, this drawback exists no matter who actually fills out the forms; some human tax preparers don’t probe and clarify to make sure that you’ve provided all the right details, either.)
- Subpar tax-preparation software programs may contain glitches that can lead to incorrect calculating or reporting of some aspect of your tax return.
TurboTax is a leading program and does a solid job of helping you through the federal tax forms. TurboTax Home & Business is designed for sole proprietors and single owner LLCs, and TurboTax Business is intended for S corporations, partnerships, C corporations, and multiple-owner LLCs.
Accessing Internet tax resources
In addition to using your computer to prepare your income tax return, you can do a number of other tax activities via the Internet. The better online tax resources are geared more to tax practitioners and tax-savvy taxpayers. But in your battle to legally minimize your taxes, you may want all the help you can get! Use the Internet for what it’s best at doing — possibly saving you time tracking down factual information or forms. The following sections describe some of the better websites out there.
On the Internet, many websites provide information and discussions about tax issues. Take advice and counsel from other Net users at your peril. Don’t rely on the accuracy of the answers to tax questions that you ask in online forums. The problem: In many cases, you can’t be sure of the background, expertise, or identity of the person with whom you’re trading messages.
The Internal Revenue Service
When you think of the Internal Revenue Service — the U.S. Treasury Department office charged with overseeing the collection of federal income taxes — you probably think of a bureaucratic, humorless, and stodgy agency. Difficult as it is to believe, the IRS website (www.irs.gov) is well organized and relatively user-friendly.
The IRS site also has links to state tax organizations, convenient access to IRS forms (including those from prior tax years), and instructions. To be able to read and print the forms, you need Adobe Acrobat Reader, which you can download for free from many Internet sites, including the IRS site or the Adobe website at www.adobe.com. To download forms from the IRS site, start browsing at www.irs.gov/forms-instructions.
You can complete your tax forms online at the IRS site using Adobe Acrobat Reader. The IRS site even features a place for you to submit comments on proposed tax regulations, with a promise that the comments are “fully considered.” Is this the IRS we know and love?
Tax preparation sites
A number of websites enable you to prepare federal and state tax forms and then file them electronically. Many of these sites allow you to prepare and file your federal forms for free if you access their site through the IRS website. Just go to www.irs.gov and click the “File” and then the “Free File” links to see whether you qualify. If you access a tax-preparation site directly instead, you may have to pay a fee for a service that would be free through the Free File program.
If you don’t want to use Free File, a reasonably priced alternative worth your consideration can be found at the eSmart Tax website (www.esmarttax.com), where you enter data on interview forms and calculate your tax. The premium edition, for $54.95, is designed for small business owners and self-employed folks. The service also includes tax support from professional tax advisors.
Keep in mind that if you’re simply after the tax forms, plenty of the sites mentioned in this chapter offer such documents for free, as do some public libraries.
TaxTopics.net
A number of sites on the Internet claim to be directories — collections of all the best stuff on the Internet on a particular topic. However, many of these sites lack objectivity and expertise. The worst of these sites simply provide links to other sites that are willing to pay them a referral fee.
TaxTopics.net (https://taxtopics.net/) is a comprehensive Internet tax resource compendium organized with links by topic. It appears to be run by a California CPA and is a great online tax directory resource.
Research sites
For true tax junkies, the U.S. Tax Code On-Line (www.fourmilab.ch/ustax/ustax.html) is a search engine that enables you to check out the complete text of the U.S. Internal Revenue Code. Hyperlinks embedded in the text provide cross-references between sections at the click of a mouse.
And, if you really have nothing better to do with your time, check out the government sites with updated information on tax bills in Congress:
Wolters Kluwer Tax & Accounting (https://taxna.wolterskluwer.com/) is geared toward tax and legal professionals who need to keep up with and research the tax laws. Access to most of the site’s resources comes by subscription only.
Paying for Tax Help
Simply stated, the nation’s tax code is complicated and confusing. So it should come as no surprise that legions of tax preparers and advisors stand ready to be hired by you to assist you with your tax quandaries and tasks.
You can hire various types of tax pros, with varying credentials and qualifications. You want to identify possible folks to hire through trusted sources, and then you should ask them some tough questions. This section helps you make sense of your options and gives you pointers on whom to hire for what tax jobs. You also discover how to find possible candidates and get key questions that you should ask them before hiring them.
The more you know before you seek a tax advisor’s services, the better able you’ll be to make an informed decision and reduce your expenditures on tax preparers.
Deciding to hire tax help
Odds are quite good that you can successfully prepare your own return. Most people’s returns don’t vary that much from year to year, so you have a head start and can hit the ground running if you get out last year’s return — which, of course, you kept a copy of, right? However, preparing your own return may not work as well whenever your situation has changed in some significant way — if you started your own business, for example.
Don’t give up and hire a preparer just because you can’t bear to open your tax-preparation booklet and get your background data organized. Even if you hire a tax preparer, you still need to get your stuff organized before a consultation.
As hard and as painful as it is, confront preparing your return as far in advance of April 15 as you can so that, if you feel uncomfortable with your level of knowledge, you have enough time to seek help. The more organizing you do before hiring a preparer, the less having your return prepared should cost you. If an annual compilation of tax records is too daunting, try monthly or quarterly. A more frequent effort can help if you have lots of business expenses, auto use, and charitable deductions. Avoid waiting until the last minute to hire an advisor — you won’t do as thorough a job of selecting a competent person, and you’ll probably pay more for the rush job. If you get stuck preparing your own return, you can get a second opinion from one of the resources discussed in this section.
If you decide to seek out the services of a tax preparer/advisor, know that tax practitioners come with various backgrounds, training, and credentials. One type of professional isn’t necessarily better than another. Think of them as different types of specialists who are appropriate for different circumstances. The four main types of tax practitioners are unenrolled preparers, enrolled agents, certified public accountants, and tax attorneys.
Unenrolled preparers
Among all the tax practitioners, unenrolled preparers generally have the least amount of training, and more of them work part time. H&R Block is the largest and most well-known tax-preparation firm in the country. In addition, other national firms and plenty of mom and pop shops are in the tax-preparation business.
The appeal of preparers is that they’re tend to be relatively less costly than the other major categories — they can do basic returns for $150 or so. The drawback is that you may hire a preparer who doesn’t know much more than you do! As with financial planners, no national regulations apply to tax-return preparers, and no licensing is required, although this may change in the future. Several states (for example, California, Maryland, New York, and Oregon) require licensing of such tax preparers. In most states, almost anybody can hang a tax-preparation shingle and start preparing. Most preparers, however, complete some sort of training program before working with clients.
Preparers make the most sense for folks who don’t have complicated financial lives, who are budget-minded, and who dislike doing their own taxes. If you aren’t good about hanging on to receipts or don’t want to keep your own files with background details about your taxes, you definitely need to shop around for a tax preparer who’s going to be around for a few years. You may need all that paperwork someday for an audit, and some tax preparers keep and organize their clients’ documentation rather than return everything each year. (Can you blame them for keeping your records after they go through the tedious task of sorting them all out?) Going with a firm that’s open year-round may also be safer, in case tax questions or problems arise. (Some small shops are open only during tax season.)
Enrolled agents
A person must pass IRS scrutiny to be called an enrolled agent (EA). This license enables the agent to represent you before the IRS in the event of an audit. The training to become an EA is longer and more sophisticated than that of an unenrolled preparer. Continuing education also is required; EAs must complete at least 16 hours of continuing education each year (and 72 hours per three years) to maintain their licenses, which are renewed every three years. Some EAs offer bookkeeping and payroll tax services, and some even do financial planning.
Enrolled agents’ fees tend to fall between those of an unenrolled preparer and a certified public accountant (see the next section). If you require tax return preparation and related advice and representation, and nothing more (no corporate audits or production of financial reports), an EA can provide the expertise you need for a reasonable cost.
The main difference between enrolled agents and CPAs and tax attorneys is that EAs work exclusively in the field of taxation. Not all CPAs and attorneys do. In addition to preparing your return (including simple to complex forms), good EAs can help with tax planning, represent you at tax audits, and keep the IRS off your back. You can find names and telephone numbers of EAs in your area by contacting the National Association of Enrolled Agents (toll-free 855-880-6232; www.naea.org).
Certified public accountants
Certified public accountants (CPAs) go through significant training and examination to receive the CPA credential. To maintain this designation, a CPA must complete 40 hours of continuing education classes per year.
As with any other professional service you purchase, CPA fees can vary tremendously. Expect to pay more if you live in an area with a high cost of living, if you use the services of a large accounting firm, or if your needs are involved and specialized.
Competent CPAs are of greatest value to people completing some of the more unusual and less user-friendly schedules, such as Schedule K-1 of Form 1065 for partnerships. CPAs also are helpful for people who had a major or first-time tax event during the year, such as the child-care tax-credit determination. (Good EAs and other preparers can handle these issues as well.) CPA firms are often a good choice for business owners because they’re usually larger than EA firms and can offer software services beyond tax and bookkeeping, such as computer consulting.
Whenever your return is uncomplicated and your financial situation is stable, hiring a high-priced CPA year after year to fill in the blanks on your tax returns is a waste of money. One CPA bragged that he was effectively making more than $500 per hour from some of his clients’ returns that required only 20 minutes of an assistant’s time to complete.
However, paying for the additional cost of a CPA on an ongoing basis makes sense if you can afford it and if your financial situation is reasonably complex or dynamic. If you’re self-employed and/or you file many other schedules, hiring a CPA may be worth it. But you needn’t do so year after year. If your situation grows more complex one year and then stabilizes, consider getting help for the perplexing year and then using other preparation resources discussed in this chapter or a lower-cost preparer or enrolled agent in the future.
If you desire more information about CPAs in your area, use the “For the Public” link on the American Institute of Certified Public Accountants’ website at www.aicpa.org/forthepublic/findacpa.html. If you’re considering hiring a CPA, be sure to ask how much of his or her time is spent preparing individual income tax returns and returns like yours.
Tax attorneys
Unless you’re a super-high-income earner with a complex financial life, hiring a tax attorney to prepare your annual return is prohibitively expensive. In fact, many tax attorneys don’t prepare returns as a normal practice. Because of their level of specialization and training, tax attorneys tend to have high hourly billing rates — $200 to $400-plus per hour isn’t unusual, and rumor has it that some attorneys in a major metropolitan area have just crossed the $1,000-per-hour threshold.
Tax attorneys sometimes become involved in court cases dealing with tax problems, disagreements, or other complicated matters, such as the purchase or sale of a business. However, other good tax advisors also can help with these issues.
Who’s best qualified?
Who is best qualified to prepare your return? That really depends on the individual you want to hire. The CPA credential is just that, a credential. Some people who have the credential try to persuade you not to hire someone without it.
What about all the non-CPAs, such as EAs, who do a terrific job helping prepare their clients’ returns and tax plans throughout the year?
If you can afford to and want to pay hundreds of dollars per hour, hiring a large CPA firm can make sense. But for the vast majority of taxpayers, spending that kind of money is unnecessary and wasteful. Many EAs and other tax preparers are out there doing outstanding work for less.
The more training and specialization a tax practitioner has (and the more affluent the clients), generally the higher the hourly fee. Select the tax pro who best meets your needs. Fees and competence at all levels of the profession vary significantly. If you aren’t sure of the quality of work performed and the soundness of the advice, get a second opinion.
Finding tax advisors
Your challenge is to locate a tax advisor who does terrific work, charges reasonable fees, and thus is too busy to bother calling to solicit you! Here are some resources to find those publicity-shy, competent, and affordable tax advisors:
- Friends and family: Some of your friends and family members probably use tax advisors and can steer you to a decent one or two for an interview.
- Coworkers: Ask people in your field what tax advisors they use. This strategy can be especially useful if you’re self-employed.
Other advisors: Financial and legal advisors also can be helpful referral sources, but don’t assume that they know more about the competence of a tax person than you do.
Beware of a common problem: Financial or legal advisors may simply refer you to tax preparers who send them clients.- Associations: EAs and CPAs maintain professional associations that can refer you to members in your area. See the relevant earlier sections for EAs and CPAs.
Never decide to hire a tax preparer or advisor solely on the basis of someone else’s recommendation. To ensure that you hire a competent advisor with whom you’ll work well, take the time to interview at least two or three candidates (with the help of the following section).
Interviewing prospective tax advisors
When you believe that your tax situation warrants outside help, be sure to educate yourself as much as possible before searching for assistance. The more you know, the better able you’ll be to evaluate the competence of someone you may hire.
Ask the right questions to find a competent tax practitioner whose skills match your tax needs. The following questions/issues are a great place to start.
When all is said and done, make sure that you feel comfortable with a tax advisor. If you’re feeling uneasy and can’t understand what your tax advisor says to you in the early stages of your relationship, trust your instincts and continue your search.
What tax services do you offer?
Most tax advisors prepare tax returns. This chapter uses the term tax advisors because most tax folks do more than simply prepare returns. Many advisors can help you plan and file other important tax documents throughout the year. Some firms can also assist your small business with bookkeeping and other financial reporting, such as income statements (covered in Chapter 2 of Book 3) and balance sheets (covered in Chapter 3 of Book 3). These services can be useful when your business is in the market for a loan or if you need to give clients or investors detailed information about your company.
As a small business owner, seek out tax advisors who work with a large number of small businesses. Doing so should comprise a significant portion of their practice.
Ask tax advisors to explain how they work with clients. You’re hiring the tax advisor because you lack knowledge of the tax system. If your tax advisor doesn’t explore your situation, you may experience “the blind leading the blind.” A good tax advisor can help you make sure that you don’t overlook deductions or make other costly mistakes that may lead to an audit, penalties, and interest. Beware of tax preparers who view their jobs as simply plugging your information into tax forms.
What are your particular areas of expertise?
This question is important because you want to find an advisor who’s a good match for your situation. For example, if a tax preparer works mainly with people who receive regular paychecks from an employer, the preparer probably has little expertise in helping small business owners best complete the blizzard of paperwork that the IRS requires.
Find out what expertise the tax advisor has in handling whatever unusual financial events you’re dealing with this year — or whatever events you expect in future years.
What other services do you offer?
Ideally, you want to work with a professional who is 100 percent focused on taxes. It may be difficult to imagine that some people choose to work at this full time, but they do — and lucky for you!
A multitude of problems and conflicts of interest crop up when a person tries to prepare tax returns, sell investments, and appraise real estate all at the same time. That advisor may not be fully competent or current in any of those areas.
By virtue of their backgrounds and training, some tax preparers also offer consulting and financial planning services for business owners and other individuals. Because such preparers already know a great deal about your personal and tax situation, they may be able to help in these areas. Just make sure that this help is charged on an hourly consulting basis. Avoid tax advisors who sell financial products that pay them a commission — this situation inevitably creates conflicts of interest.
Who will prepare my return?
If you talk to a solo practitioner, the answer to this question should be simple — the person you’re talking to should prepare your return. But if your tax advisor has assistants and other employees, make sure that you know what level of involvement these different people will have in the preparation of your return.
It isn’t necessarily problematic if a junior-level person does the preliminary tax return preparation that your tax advisor reviews and finalizes. In fact, this procedure can save you money in tax-preparation fees if the firm bills you at a lower hourly rate for a junior-level person.
Be wary of firms that charge you a high hourly rate for a senior tax advisor who then delegates most of the work to a junior-level person.
How aggressive or conservative are you regarding interpreting tax laws?
Some tax preparers, unfortunately, view their role as enforcement agents for the IRS. This attitude often is a consequence of one too many seminars put on by local IRS folks, who admonish and sometimes intimidate preparers with threats of audits.
On the other hand, some preparers are too aggressive and try tax maneuvers that put their clients on thin ice — subjecting them to additional taxes, penalties, interest, and audits.
Assessing how aggressive a tax preparer is can be difficult. Start by asking what percentage of the preparer’s clients gets audited (see the next question). You can also ask the tax advisor for references from clients for whom the advisor helped unearth overlooked opportunities to reduce tax bills.
What’s your experience with audits?
As a benchmark, you need to know that the IRS audits about 1 percent of all taxpayer returns. Small business owners and more affluent clients can expect a higher audit rate — somewhere in the neighborhood of 2 percent to 4 percent.
If a tax preparer proudly claims no audited clients, be wary. Among the possible explanations, any of which should cause you to be uncomfortable in hiring such a preparer: She isn’t telling you the truth, she has prepared few returns, or she’s afraid of taking some legal deductions, so you’ll probably overpay your taxes.
A tax preparer who has been in business for at least a couple of years will have gone through audits. Ask the preparer to explain her recent audits, what happened, and why. This explanation sheds light not only on her work with clients but also on her ability to communicate with you in plain English.
How does your fee structure work?
Tax advisor fees, like attorney and financial planner fees, are all over the map — from about $50 to $300 or more per hour. Many preparers simply quote you a total fee for the preparation of your tax return.
Ultimately, the tax advisor charges you for time, so ask what the hourly billing rate is. Alternatively, you can ask for a time estimate to complete your tax return. If the advisor balks at answering such questions, try asking what his fee is for a one-hour consultation. You may want a tax advisor to work on this basis if you’ve prepared your return yourself and want it reviewed as a quality-control check. You also may seek an hourly fee if you’re on top of your tax preparation in general but have some specific questions about an unusual or one-time event, such as making some major purchases for your business or possibly selling your business.
Clarify whether the preparer’s set fee includes follow-up questions that you may have during the year or covers IRS audits on the return. Some accountants include these functions in their set fee, but others charge for everything on an as-needed basis. The advantage of the all-inclusive fee is that it removes the psychological obstacle of your feeling that the meter’s running every time you call with a question. The drawback can be that you pay for additional services (time) that you may not need or use.
What qualifies you to be a tax advisor?
Tax advisors come with a variety of backgrounds. The more tax and business experience they have, usually the better. But don’t be overly impressed with credentials. As discussed earlier in this chapter, tax advisors can earn certifications such as CPAs and EAs. Although gaining credentials takes time and work, these certifications are no guarantee that you get quality, cost-effective tax assistance or that you won’t be overcharged.
Generally speaking, more years of experience are better than fewer, but don’t rule out a newer advisor who lacks gray hair or who hasn’t yet slogged through thousands of returns. Intelligence and training can easily make up for less experience.
Newer advisors also may charge less to build up their practices. Be sure, though, that you don’t just focus on each preparer’s hourly rate (which of course can change over time). Ask each practitioner you interview how much total time she expects your tax return to take. Someone with a lower hourly fee can end up costing you more if she’s slower than a more experienced and efficient preparer with a higher hourly rate.
Do you carry liability insurance?
A tax advisor making a major mistake or giving poor advice could cost you thousands of dollars. The greater your income, assets, and the importance of your financial decisions, the more financial harm that can be done.
Your tax advisor needs to carry what’s known as errors and omissions or liability insurance. You can, of course, simply sue an uninsured advisor and hope the advisor has enough personal assets to cover a loss, but don’t count on it. Besides, you’ll have a much more difficult time getting due compensation that way!
You may also ask the advisor whether he has ever been sued and how the lawsuit turned out. Asking this type of question doesn’t occur to most people, so make sure that you tell your tax advisor that you’re not out to strike it rich on a lawsuit!
Another way to discover whether a tax advisor has gotten into hot water is by checking with appropriate professional organizations to which that preparer may belong. You can also check whether any complaints have been filed with your local Better Business Bureau (BBB), although this is far from a foolproof screening method. Most dissatisfied clients don’t bother to register complaints with the BBB, and you should also know that the BBB is loath to retain complaints on file against companies that are members.
Can you provide references of clients similar to me?
You need to know that the tax advisor has handled cases and problems like yours. For example, if you’re a small business owner (and it’s assumed that by picking up this book, you either are or want to be), ask to speak with other small business owners. But don’t be overly impressed by tax advisors who claim that they work mainly with one occupational group, such as retailers or physicians. Although there’s value in understanding the nuances of a profession, tax advisors are ultimately generalists — as are the tax laws.
When speaking with a tax advisor’s references, be sure to ask what work the advisor performed and what the client’s satisfaction was with it.