5

INCOME

It’s just as easy to love a rich man as a poor man.

—YOUR MOTHER

Money In, Money Out, Wave Your Hands All About

You’d think income would be the easiest concept for a business owner to grasp. It seems completely obvious to you, right? Income is the money that came into the business. Clearly, it’s all the money that was deposited into your account.

But what if you don’t have a business account? Or you use your personal account most of the time instead? Then, how much is income?

The following question is typical of a new business owner:

I am self-employed as a carpenter. When someone pays me for a job I’ve done, and he pays me by check, how can I keep “supply” costs separate from “labor” costs? For example, if I charge $500 to do a job and spend $800 in supplies, I’ll get a check for $1,300 in payment. I don’t want the IRS to think I’ve earned $1,300 when in fact I’ve only earned $500. Help!

Other troubling concepts involve understanding the difference between income and deposits to the business account. They’re not necessarily the same thing. Let’s take a little test. All the following are examples of items deposited in your business account. Can you tell which ones are income?

•  Client reimbursement of your out-of-pocket expenses

•  Customer’s payment for completed work

•  Your money, deposited to prevent an overdraft

•  Cash advance from a credit card or your home equity

•  Royalty for the oil under your home

•  Money from investors or partners

•  Money you borrow from Mom (Shhh. Don’t tell Dad.)

•  Insurance settlement for your pain and suffering arising from a work- related auto accident

•  Money you took from your IRA to cover payroll

•  Repayments of advances you took earlier

Which ones are business income? Only the first two. All the rest are often deposited into business bank accounts, but they have nothing to do with the income from your business.

It’s really important to get this right because most small business owners don’t bring their bookkeeping with them to their tax appointments. Instead, many only bring their profit and loss statements, some neat printouts on a spreadsheet, or a couple of scribbled pages of data. Your tax professional generally never gets to see your income records. So when you overstate your income, he or she has no way of knowing. The good news is that if you’ve reported these deposits as income, your audits will result in refunds.

A Capital Idea

If eight of these sample transactions aren’t income, then what are they? Most of them are capital transactions. The rest are strictly personal and never belong in a business account at all. Money you receive for personal reasons, such as the royalties related to your residence and personal injury settlements, should be deposited into your personal bank accounts. That income is taxable on your personal tax return—probably on Schedule E. If your business really needs that money, fine—write a check and lend it to the business. Then you’ll have an audit trail of a loan transaction.

Capital transactions are things that belong on the balance sheet side of your financial statements. They include loans, credit card debt, and investment assets bought or sold for business use.

Investor’s Money

How do you report the money you receive from an investor? It depends on the nature of the investment. If an investor lent you money, which your business must repay, it’s a loan. Sometimes the money an investor lends you is a hybrid of a loan and profit sharing: You’re going to pay the money back to the investor, plus 6 percent interest, plus 10 percent of profits. It’s still a loan. Report the funds as a debit to the bank account and a credit to a loan account. Be smart. Use the name of the person as the name on the account, for example, Loan from Rich Guy Malone.

To make it an investment, as opposed to a loan, the investor must have bought a percentage of your business—not just a percentage of your profits. We discussed the nuances of this in Chapter 3. Record this as a debit to the bank account where the money was deposited. The credit will go to stock if it’s a corporation. It will go to owner’s equity—George Generous—if it’s a partnership.

What if you’re a sole proprietor? Well, if you sold part of your business, you’re no longer alone. If you file no formal paperwork, you’re automatically a partnership. Remember to get your federal identification number for the new entity.

Did I tell you the best thing about investor’s money? If everything falls apart, you don’t have to repay it. That’s the big difference between a loan and an investment. Lenders avoid risks. Investors share the risk with you. You succeed—the investors get a windfall. You fail, and so do they.

So if these eight transactions weren’t income, what is?

What Is Income?

Income is all the compensation you receive for your goods or services. Note the word compensation, as opposed to money. Sometimes you don’t get money—you get stock or a share in a partnership or LLC. Perhaps you trade your expertise for services or two chickens or a pig (remember Doc Hollywood?), or you get a painting or your lawn mowed.

To determine whether an unfamiliar transaction is income, ask yourself this—“Would the person have given this to me if I didn’t provide them with a product or service?”¹ If the answer is no, you have income.

If the answer is yes, you probably have a gift. Of course, what if your family and friends are using your services just to help you out? Well, even if it’s a pity sale, it’s still a sale.

Look back to Chapter 3 to review which IRS forms to use to report your income.

Timing of Income

Chapter 4 explained the difference between accounting on a cash basis and accounting on an accrual basis. Most small businesses are on a cash basis. Essentially, you report your income when you get the money. But even for cash basis businesses, there are times when money received is not income, such as the following:

•  As a landlord, you receive a security deposit; that’s not income. It’s not your money. You must return that money to the tenants if they leave the premises in good condition when they move out. But last month’s rent is rent. So that is income.

•  You’re an attorney and receive a settlement from an insurance company for your client. That’s not your money. It belongs in your trust account until you pay all the costs and all the parties. Once the case is settled, the fee is income. When you draw money from the trust account specifically as fees, it’s income. Note: If you don’t draw the money, but could have drawn it—it’s income when the money was available to you.

•  You’re a contractor and receive a third of the project cost from your client for the building you’re erecting. That money might be required to last several months as the construction progresses. You’re only entitled to draw money for yourself at certain stages of completion. You’ll be reporting that income on a “percentage of completion” basis. However, if you have been reporting all your income using the “cash basis” as your accounting method, you will need to file a Form 3115 to request IRS approval before switching to “percentage of completion.” Try to file that request early in the year so the IRS has time to respond before you file your next tax return. This does not come with automatic approval—and may require some other adjustments to your accounting system. Work with a tax professional who has experience getting these accounting method changes approved.

•  You’re a retailer, and someone buys something on layaway. The money isn’t yours until the person finishes paying for the merchandise and picks it up. If the person never does, how much of that money are you entitled to keep before you refund the difference? There may be a processing fee at the time the transaction is canceled. The fees will depend on your layaway contract. Until then, the money is a deposit. Deposits are liabilities.

•  You put on seminars or workshops for which people must pay in advance. People pay an attendance fee weeks or months ahead of time. They are entitled to a refund, less a cancellation charge, at any time before the event. Before the event, the only part of the money you’ve received that is considered income is the cancellation charge. Once the event takes place, naturally, the rest of it is realized as income.²

You’re getting the idea. Money isn’t treated as income until you earn it.

TaxMama Tip

The abbreviated explanation of income: when there are strings attached to money, it becomes income when the strings are gone.

A Brief Note About Accrual Basis

Small businesses that work on the accrual basis report the income as it is invoiced.³ You only send invoices when you’ve earned the money. So when people pay you a retainer or advance for services to be rendered, you record the money received as a debit to cash and a credit to accounts receivable instead of as a credit to income. It gets treated as income when you work off your obligation. When you issue your invoices for this work, you’ll be crediting income and debiting accounts receivable.

Sales Taxes Received—Are They Your Money?

Bookkeeping can frequently be a messed-up area, but it’s actually much simpler than it looks. You want your books and your deposits to balance to the income reported on your tax return. To do that, you must include the sales tax you collect as part of your income. Simple. Yes, include it.

Then, see the line of your tax return that asks about tax expenses? Deduct the sales taxes you paid to your state on that line. In fact, this is one of those expenses you get to deduct even before you pay it. Since you received all the sales taxes with your sales by December 31 (or your fiscal year-end), you deduct it in the year the taxes were collected. You’ll be paying it by January 31, or the alternate due date if January 31 falls on a weekend. This is true even if you operate on a cash basis.

Income Rarely Reported

There are three kinds of transactions most people either forget to report or don’t bother to—illegal income, offshore income, and barter. I’ll cover each of these briefly, just so you know the issues associated with these types of income.

Illegal Income—Can’t Report It?

If you’re engaged in criminal activities, the last thing you want to do is report your income to the IRS and turn yourself in. You’re not an idiot. Well . . . you are a criminal, so there’s room for doubt.

Remember, the arm of the IRS is all-powerful. Before Homeland Security was created, the IRS was the only agency of the U.S. government that operated on the Napoleonic Code—guilty until proven innocent. The IRS has the distinction of catching Al Capone, where the relentless pursuit of the FBI brought no results. In fact, the documents related to his case are one of the most frequent requests to the IRS under the Freedom of Information Act (FOIA). You can read all about it at http://iTaxMama.com/IRS_Capone.

So, yes, if you’re a drug lord, a thief, an illegal prostitute (it’s legal in some states), an embezzler, whatever—report the income. You’re welcome to call it “other” income. But report the income. Since being a criminal is a business, report it on Schedule C and pay the self-employment taxes on it. Enter 999999 as the activity code on Schedule C—it stands for unclassified establishments, or unable to classify. If you consider yourself a professional, use 541990—all other professional, scientific, and technical services.

Unfortunately, although you must report the income, you are not allowed to take any deductions for business expenses. The only costs you can actually deduct are those for costs of goods sold. This is particularly touchy in a certain semilegal industry—marijuana (especially as related to medical marijuana). Most of the states in the United States have now legalized some form of marijuana use. But the Drug Enforcement Agency (DEA) still classifies it as a Section I substance. If this is your business focus, consider taking TaxMama’s course on the business of marijuana—“Marijuana’s Tax Paradox (or the Uncanny Cannabis Controversy),” http://www.cpelink.com/teamtaxmama.

Oh well, go ahead, pay the tax. Just because you’re a criminal doesn’t mean you can’t be a good citizen, too. Or . . . consider switching to a legal business—then all your costs will be deductible.

Offshore Income and Abusive Tax Schemes

Offshore income⁴ means income generated outside the United States. Sometimes you have transactions with businesses outside the United States. As a U.S. citizen or resident, your business is taxed on its worldwide income, not just on its domestic revenues. With the Internet, it’s easy to open a bank account in another country without ever setting foot there. You can deposit your offshore sales into that account and keep it as a secret nest egg until you’re ready to retire. Or just have the bank issue you a debit card, and you can spend the money here at home. Most people think that the IRS will never see a record of that money, but those people aren’t thinking straight.

The world is getting smaller and smaller. The IRS already has arrangements with Visa and MasterCard (your debit cards) to audit their offshore accounts. The unprecedented arrangement with the Swiss government shocked the world! Small countries often rely on U.S. financial assistance or tourism. When the U.S. government starts threatening to withhold those benefits, countries often elect to enter into treaties that effectively rat you out.

There are some very heavy fines, penalties, and even jail time if you’re caught. The IRS is making a powerful effort to make the public aware of this—and paying rewards for information. So beware. Your friends who don’t have money offshore might just get irked enough that you’re flaunting your wealth. That reward is really nice.

Seriously, don’t go there. It’s not worth the price.

There are legitimate ways to legally set up businesses and partnerships with people or businesses in other countries. If your business is heading that way, go for it. Be sure to report all your earnings when you do. It’s done all the time. You’ve seen Coca-Cola, Motorola, McDonald’s, Apple, FedEx, and many other very successful international businesses do it. When you reach this point in your business, add an expert in international taxation to your advisory team. Otherwise, you’re bound to step on the toes of other countries’ tax systems, too. If you don’t know where to find an international tax expert, Team TaxMama may be able to help.

Bartering—You May Not Even Know You’re Doing It

Barter happens more often than you realize. It’s not just a function of formal barter clubs or exchanges.

You do it without even thinking. Barter is older than speech. It’s the foundation of civilization. Barter made it possible for people to specialize since they no longer had to do everything themselves. I cook and feed you. You weave and clothe me. I farm—and give you food. You shoe my plow horse and make my tools.

How does this translate into today’s world? You have skills and trade your services for someone else’s products. When each side of the transaction has equal value, and both sides are providing something related to business, it’s not nearly such a problem when you don’t report it. There would be no net tax effect.

The advertising industry commonly gets columns, space, or air time in “trade.” Instead of paying for the ads, the client provides goods or services. When I was working for a radio station, in exchange for ads, FTD delivered flowers to each office every Monday. On Fridays, we’d all get Winchell’s doughnuts. Licorice Pizza provided records (what, you were expecting pizza pie?). When the Shubert Theatre opened in Century City, we were all invited to a private, press-only performance of Grease. For the most part, both sides of the transactions were business oriented. Even though it may look personal, the station received certain merchandise and used it in the course of business. Staff benefited from all the goodies we were given, so we could spread word-of-mouth recommendations.

However, barter isn’t usually done by contract. It’s usually a casual exchange of a business product or service for a personal one. For instance, you’re a plumber with a shop on Main Street. You provide $1,200 of plumbing services to your gardener at his home. In exchange, your gardener mows your home’s lawn and maintains your landscaping for a year. You must record the value of your plumbing services as a sale. You have $1,200 in income.

Since the gardener is providing you with a personal service, you don’t get to deduct the cost of the gardening. The gardener must report the $1,200 he would have been paid for his services as income. May the gardener deduct your plumbing bill? Perhaps a part of it. The gardener has an office using 33.3 percent of his home. He’ll be able to deduct one-third of the expense. As a result, the gardener has net income of $800 from this transaction.

When you add them together, that’s $2,000 worth of income never reported to the IRS. The IRS understands this. Wherever the IRS stumbles across barter during an audit, it assesses taxes. Your innocent remarks may incriminate you, even when you didn’t realize you’d done anything wrong.

So please be careful. When trading with people, be sure to think through the details of the tax implications of your transaction.

The IRS Has a Cash Audit Guide

Since there is such a healthy, abundant cash-based economy prospering in the United States, the IRS decided to develop an audit guide to train its examiners to “cherchez le cash.” It targets specific industries and ways cash is transferred—digitally and in person. It addresses online businesses, as well as Laundromats, bail bonds, car washes, salons, head shops, and so on. Is your business income mostly via cash, or do you cash your clients’ checks at their bank or check-cashing establishments? It is in your best interest to read the IRS Cash Audit Guide (http://iTaxMama.com/IRS_Cash_ATG).

1099s Your Business Receives

1099-MISC forms are sent only to sole proprietors and partnerships. Corporations don’t generally get them at all, except for medical and legal practices. All businesses must be issued 1099s when they are paid $600 or more. While a business might get an assortment of 1099s, here are the principal kinds to expect, in order of frequency:

•  1099-MISC. Your company provides $600 or more worth of services to another company or person in a given year.

•  1099-INT. Your company lent money to another company or person. You are receiving $10 or more in interest income. (Or your business bank account earns interest income.)

•  1099-DIV. Your company used some excess cash to invest in stocks. This might also come when you receive income from a corporation whose stock your company owns. Note: If your business is a C corporation, the corporation might be entitled to exclude 70 percent of those dividends from the corporation’s income if the corporation owns less than 20 percent of the stock in the company. (Which would be typical for investment in a publicly traded corporation.) The corporation would be able to exclude 80 percent of those dividends if the corporation owns 20 percent or more of the stock in the corporation issuing those dividends. This is called a dividends received deduction (IRC 243).⁵

•  1099-B. Your company sold stock or engaged in barter transactions.

The IRS’s computer receives millions of 1099s from all over the country and matches up the amounts with everyone’s tax returns. If a 1099 was issued to you, the IRS is going to be looking for that number on your tax return. You’d be wise to include the full amount shown on that 1099—even if it’s wrong. Chapter 13 explains what happens when the numbers don’t match. Here are some tips to ensure you don’t get those nasty notices.

What If a Company Sent You a 1099 for More Money Than You Received?

Of course, a person would be daft to pay tax on money he or she has never received. How can you fix the problem without getting yourself into trouble? You have two choices—contact or correction.

Contact the company that issued the 1099 and ask it to issue a correction. Or, as I always like to do, ask the company to pay you the difference. Pity, it rarely does.

If the company is smart enough to hold off filing the 1099s with the IRS until it has received feedback from recipients, the company will be most agreeable. Simply provide some proof or documentation explaining why the 1099 is too high. The company will be happy to help—or it will show you why you’re wrong. See how easy that is?

I wish it were so. Unfortunately, this avenue usually results in an argument with some closed-minded bureaucrats who stubbornly refuse to help. They get defensive because they didn’t have the foresight to wait for feedback from the recipients. They’ve already submitted the 1099s and don’t want to file amended forms. Amending them attracts attention. The 1099s also are used in audits or court cases when examiners are looking for evidence of fraud. One of my longest, nastiest audits started when a corporation was audited and the examiner happened across an amended 1099 with my client’s name on it. He jumped on that amended 1099, deciding he’d found fraud. (We had asked the company to void the 1099-MISC and include his bonus in payroll, where it belonged.) In fact, the auditor was so aggressive, he was shooting for a RICO audit.⁶ But . . . that’s a story for another day . . . and another book.

What If the Money Is from Last Year?

Be aware that sometimes the 1099 will be right—as far as the sender is concerned. It’s a timing difference. Take the example of my client, Eddie the Entertainer. Eddie is on the road most of the year. He does his darnedest to keep up with his bookkeeping, but it’s tough when you’re rarely home. As a result, my office always calls Eddie’s agent to verify his earnings for the year. In 2009, the agent reported $20,000 more than Eddie had on his books. That’s a large sum. Eddie couldn’t really account for the difference. Tracking down the payments, we learned the agency issued some checks at the end of 2009 that Eddie didn’t receive until 2010. That accounted for the difference. As far as the agency was concerned, it paid the bill in December of 2009—it wanted the deduction. There was no error.

How can you fix this when it happens to you? When the money was sent out in one year, but you received it the next, report the full income, but adjust your expenses to account for the difference in income. The tax code, when it comes to cash basis taxpayers, operates on the doctrine of “constructive receipt.” You don’t report the income until you receive the money in such a way that you can actually use it. (For example, a postdated check received on December 20 that is dated January 15 is considered received in January. The bank won’t accept the deposit until January 15.)

As far as I am concerned, this is the easiest and fastest course of action. If the amount in dispute is really large or if it’s a substantial part of your overall income for the year, it would be wise to attach proof with your deduction.

To prove you received the money in the following year, here are some things you can use:

•  A copy of the postmarked envelope the check arrived in will help. If the envelope was postmarked on December 31, no matter where you are, you didn’t get it until the following year. If it was postmarked earlier, maybe the 28th or 29th, it will depend on how far you are from the sender. So be prepared to describe the normal travel time for letters between your locations. If the envelope has stamps or notations about being misdelivered, that will also help demonstrate that you got it later.

•  A copy of the check and the deposit slip can also prove your case. In Chapter 4 you were advised to make copies of all deposits, with the deposit slips. Here’s a perfect example of an instance when you’ll need it.

•  A signed statement from your bookkeeper or accountant that states you didn’t receive the check until the following year can help. If the person doesn’t really have firsthand knowledge, don’t put him or her on the spot. Be kind to your staff.

•  When all else fails, you can use your bank statement. Circle or highlight the deposit in the following year. I don’t like providing bank statements if I don’t have to. It gives the IRS too much information about your bank account. And there might be some innocent deposit of a loan or something that the IRS will jump on as unreported income. So use this as a last resort.

There’s one timing issue that may be a gray area with respect to constructive receipt. Suppose the check was sent so that it arrived at your business before December 31, but you were out of town or the office was closed. There was no one to receive or deposit the check until January. When do you report it?

Use your best judgment. The answer to this question will depend on how well you can support your position that you didn’t have constructive receipt.

Incidentally, if you don’t include that income on your tax return in the year shown on the 1099-MISC, make sure that you do report that income in the year you did receive it. Remember, it won’t be included on that year’s 1099-MISC. Omitting a significant amount on the following year’s tax return could generate more than additional taxes, if you’re audited. Understatement penalties of 25 percent or more, plus interest, could be assessed, so be conscientious.

When the Issue Is Not a Timing Difference

Suppose you flat-out disagree with the amount on the 1099. You know you keep good records, and you know you never got that money. What do you do?

First, let’s examine why the 1099 is wrong. Did the company you worked with report that it paid your whole invoice, but didn’t really pay you? Check with the company’s accounting department. It may have a check that never cleared, got lost in the mail, or is sitting in someone’s drawer, forgotten. All these scenarios are common. Who knows, perhaps you just found some money. Collect the money—and include the adjustment to your tax return. Regardless, ask the accounting department to give you a printout of checks it paid to you. Sometimes you’ll catch a posting error. Perhaps the department posted someone else’s payment to your name.

If the company you are working with refuses to cooperate and the difference is substantial, you may want to pursue the issue. After all, the company might owe you money. Most likely, you’re no longer working with that company.

At the very least, you should look into why the company is so insistent on reporting a larger amount. Does the company do this to others, too? What other fraud is going on? Send a letter via certified mail, return receipt requested, asking for the detail on all the payments to you. Give the company 10 business days to respond. If it doesn’t, be prepared to go to small claims court, or superior court depending on the amount, to collect the difference. Clearly, if the company says it paid you that much money, but you didn’t get it—the company owes it to you. You’d be surprised how quickly a company will cooperate with you once it’s been served with a lawsuit. You’ll either get your information—or get your money.

If it’s not a lost check and not unpaid bills but simply a completely wrong number, it will be up to you to convince the IRS you’re telling the truth. In this case, be very sure that all your bookkeeping is up to date and that you’ve identified all your mystery deposits. (Yes, even I have those—when my filing hasn’t been done for a while and I can’t find my copies of the deposits where they should be.) Attach a statement to your tax return, containing a list of the checks you did receive from that company, with the dates and check numbers. Include some words about the steps you took to straighten out the problem and the company’s lack of cooperation.

Then there are those cases where the amounts reported are flat-out lies. Unfortunately, we do get complaints about this happening from people writing to Tax Mama. There may be several reasons for those lies.

•  Identity theft—someone is using your Social Security number on the job.

º  This could be a total stranger.

º  Instances where family members use a relative’s Social Security number without permission or notification. (Yeah, this really does happen!)

•  An error in the Social Security number on the company’s books. Perhaps a transposition when someone typed in the number. Or just some other innocent error.

•  Theft. Someone in the company is stealing money by creating payroll checks in the name of real people—often people who no longer work there, but whose identity information is in the payroll department’s database.

•  Someone vindictive in the company simply wants to cause you trouble.

To What Do You Attach All These Statements?

The tax return you use will depend on the business format you’ve chosen. Chapter 3 gives the details and the forms. For our purpose, you need to know where on those forms to put your adjustments. Bear in mind, you will probably not be e-filing. Your best bet is to file a paper tax return.

Frankly, the easiest way to deal with incorrect 1099-MISC forms is to report the income they show on your tax return exactly as each Form 1099-MISC shows. Why? Because the IRS computer will be looking for that number on your tax return. So whichever box is shown on that 1099-MISC, report it where the IRS computer expects to see it.

Does that mean you’re going to pay taxes on income you never received—or that is flat-out fraudulent? Heck no!

Sure, you’re going to appease the IRS computers—then you’re going to deduct the erroneous amount from your tax return. How do you do that without getting into trouble? Simple. Disclose, disclose, disclose!

How do you disclose? Follow these two simple steps:

Step 1. You will include a Form 8275 Disclosure Statement with your tax return. You will include a detailed explanation of why that Form 1099-MISC is incorrect. Include as much detail as necessary so someone reading your explanation can understand the situation. Do not rant. Explain concisely. If there are only one or two documents that can clear this up, include copies. Never send originals.

Step 2. Make the adjustment on the appropriate form. This is where you will be deducting the erroneous amount.

•  Sole proprietorships. Look at page 2 of your Schedule C. There are empty lines in “Part V Other Expenses.” On one of those lines, enter “1099 income in error. See Form 8275 and Statement XXX attached.” Replace the XXX with the heading you put on the statement. Incidentally, if you run out of lines on Part V, you’re welcome to attach a list of expenses. Simply save one line for this purpose and on it write “See additional expenses on Schedule XXX attached.” After you’ve listed the overflow of expenses, put the total on the line you saved for this schedule.

•  Partnerships or LLCs filing as partnerships, and corporations. There is a line on Form 1065 and on Forms 1120 and 1120S for “Other deductions (attach schedule).” Most business expenses end up on that attached schedule. On one line of that list of other deductions, simply enter “1099 income in error. See Form 8275 and Statement XXX attached.”

You can add the statements even when you file electronically. Simply be sure to check the box on your software that says the note or statement is to be printed or included with the tax return. All the major software providers give you this option.

If you’re worried about this getting you audited, don’t be. I’m going to give you some really great news. The IRS hardly ever reads these statements—especially not when you file electronically. Your electronically filed return is rarely touched by human hands.

What about that difference you just adjusted? The IRS’s computers only match up to the income reported on line 1 of your Schedule C and line 1a of your Form 1065. So be sure to include the full amount of the 1099 on those lines. The computers doing the matching have no way of cross-referencing your miscellaneous expenses.

What Should You Do If the 1099 Never Showed Up?

The purpose of the 1099 system is for the IRS to catch cheaters. It’s not designed for you to have someone else do your bookkeeping, though many small business owners rely on 1099s for just that purpose. If you’re already doing everything right by keeping proper books, the way you were taught in Chapter 4, you already know your income. Don’t wait for the 1099s to come in. Use your own records. For you, the only purpose of the Forms 1099 is to ensure that your business’s gross income is as high as, or higher than, the 1099s you receive. That might be the only reason to hold off filing your tax return until they all come in—to make sure there are no errors on those forms.

Generally, when companies send out 1099s, they tend to be correct. If you get one later and it’s wrong, be prepared to amend your tax return solely to report the additional income and deduct it back out at the bottom. (See the two steps above.) Usually, that’s not a problem. Then again, if you’re working with a spouse, partner, or boss who doesn’t remember to tell you everything, here’s what might happen to you.

One of my clients, the Big Macher, is the embodiment of the entrepreneurial spirit. He’s the golden boy who everyone trusts and loves. You probably know someone like him—or are like him yourself. Family and friends gave him lots of money to invest in real estate. In the 1980s, Mr. Macher was the limited partnership king. He was the general partner in dozens of partnerships, owning millions of dollars of property across the country. His management company wasn’t incorporated—he filed on a Schedule C. He operated his business on a handshake. While emotionally satisfying for him, it was a nightmare to his accountant—me! Trying to get the details of agreements and contracts was harder than holding on to a snowflake. Not surprisingly, Macher received an audit notice. The IRS was concerned about him because he never reported $33,000 of interest income from a company in Long Beach, California. That made no sense. I logged in each 1099 meticulously. If it wasn’t reported on Big Macher’s tax return, we never received that 1099. Besides, if we’d received $33,000, I’d know about it. It never happened.

The auditor faxed me a copy of the incriminating document. I asked Macher if he knew anything about this. He just shrugged it off, saying, “I don’t think so.” Furious, I called the company that had issued the Form 1099-INT. Bob explained what it was. Macher was a partner in one of Bob’s partnerships. The venture came up short, and it had to borrow money. Macher was responsible for his share of the interest payments. However, Bob happened to owe Macher a chunk of money. So Bob wrote a check to Macher for the $33,000 interest. Macher endorsed the check back to Bob to pay his own obligation. That’s why I had never seen the income. Bob sent me a copy of the front and back of the check Macher had received and endorsed. He also sent me paperwork on the interest Macher was paying. (He never explained why he didn’t send us a copy of the 1099 in the first place.)

Net tax effect? There was $33,000 interest income received and $33,000 interest expense paid. Taxable total: 0!

Cost to Macher? Plenty! Lots of fees. Despite the fact that there was clearly no taxable error, the auditor insisted on auditing three years’ worth of tax returns. He felt this was a big enough omission that he wanted to see what else was missing. After months of work, he found—ta-daaaa!—a couple of thousand dollars of expenses he disallowed. There was no tax due—just a minor reduction of the net operating loss carryforward.

The key points of this story are:

1.  No matter how careful you are, there’s always something outside your control.

2.  For heaven’s sake, if you’re the Big Macher, have pity on your support staff and debrief them at the end of each day. If you’re not a report-and-staff- meetings kind of person, set up a voice mailbox you can call, using your voice-activated, hands-free cell phone (no accidents or distractions, please). You can tell the story of your last meeting. Be sure to brag and include all the details and nuances you’re so proud of. Your assistant will be able to check the messages throughout the day. One of those offhand remarks will alert your assistant to ask you about a contract, order, or whatever.

So What the Heck Is Income?

And you thought this was easy. Income is more complex than you think it is. Some funds you intuitively consider income aren’t. Other things you’d never dream of as income really are. If you’re not sure, call your tax advisor.

The best thing to do to keep yourself on track is to have your accountant or tax professional review your books each quarter. Errors will be caught before they cost you money or penalties.

Income Resources

•  IRS Publication 334, Tax Guide for Small Business. https://www.irs.gov/publications/p334/, (800) 829-3676. Order this book; it is a must-have reference source, covering all the tax-related aspects of your business. (You can remember the phone number more easily if you see the letters: TAX FORM = 829-3676.)

•  IRS Form 3115—Application for Change in Accounting Method. https://www.irs.gov/pub/irs-pdf/f3115.pdf.

•  IRS Form 8275—Disclosure Statement. https://www.irs.gov/pub/irs-access/f8275_accessible.pdf.

•  IRS on Barter. https://www.irs.gov/taxtopics/tc420.html.

•  IRS on Barter Clubs and Exchanges. http://iTaxMama.com/IRS_Barter.

•  IRS Cash Audit Guide. http://iTaxMama.com/IRS_Cash_ATG.

•  TaxMama on Barter. http://taxmama.com/barter-category/unreported-barter-income. An overview of how and why barter is taxable using a real case that the IRS took to court.

•  FreshBooks.com. https://taxmama.freshbooks.com/signup. Collect your accounts receivable more quickly by e-mailing a more professional-looking invoice with a variety of payment options.

•  Chapter 2 of this book—“Business Plans You Know and Trust.” Devote some time to understanding your income and how to increase it.

•  Marijuana’s Tax Paradox (or the Uncanny Cannabis Controversy). http://www.cpelink.com/teamtaxmama. TaxMama’s course on the tax issues faced by the marijuana industry.

•  TaxMama’s Quick Look-Ups. http://iTaxMama.com/TM_QuickLookUp. You will find all kinds of useful reference materials, webinars you can replay, e-books, and more.

•  Your Business Bible. http://www.yourbusinessbible.com. Look for worksheets, printable checklists, and other goodies and resources.

1  Read the income chapter of IRS Publication 334, http://www.irs.gov/publications/p334/ch05.html#d0e3424.

2  Realized in tax lingo means the event has now taken place or the income is now earned.

3  Accrual basis means that you report income when you send out the invoice. You report expenses when you receive the invoice or when the merchandise you bought is received into your office or warehouse. See the glossary in Chapter 4.

4  The IRS’s Abusive Tax Schemes warning is available at http://iTaxMama.com/IRS_Abusive.

5  IRC 243—https://www.law.cornell.edu/uscode/text/26/243.

6  RICO is the acronym for the Racketeer Influenced and Corrupt Organizations Act—we’re talking about organized crime here!