How Do I Read An Income Statement and Why Is It Important?

How Do I Read An Income Statement and Why Is It Important?

This is Part 5 in our “All About Bookkeeping” series.

If you missed our first four articles check them out here:

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

What Is Cash and Accrual Accounting?

What Is An Income Statement vs Balance Sheet?

Now we get to start diving into the financial statements. First we are going to talk about the Income Statement or Profit and Loss.

1. What Is a Income Statement (also known as Profit and Loss) Recap?

Shows you how profitable your business is over a period of time.

  • Account Types: Revenue and Expenses
  • Time Frame: Any period you would like, however typically: monthly, quarterly, or annually.
  • What Does the Income Statement Tell You? How much money you made, how much money you spent, profitability of your business

2. What Are the Different Parts of An Income Statement?

Income, Cost of Goods Sold, Gross Profit, Operating Expenses, Opearting Income, Non-Operating Activity, and Net Income

SAMPLE INCOME STATEMENTIncome Statement - Demo Company

  • Income or Revenue: This area represents your earnings or sales of the business. You can have multiple line items so lets say you have a service but also sell some product, you could break those out but either way it would all be located in that income or revenue section. If you have refunds, returns or discounts, they can often times be found here too.
  • Cost of Goods Sold or Cost of Sales: Many call this COGS for short. This represents the price you pay to create your product or service. These are items that would be directly related to the revenue that comes in and NOT just normal operating costs. These are costs that are directly tied to the sales and would not occur if you did not have sales. Example: Lets say you are an electrician and purchase cable wire for a job you are working on, this would be a COGS item.
  • Gross Profit: This is simply a calculation of Income or Revenue less Cost of Goods Sold. Essentially it is your income for your business before factoring in the other opearting expenses.
  • Operating Expenses: These are all of the other indirect costs associated with running your business. Examples include Advertising, Automobile Expenses, Consulting & Accounting, Meals, Office Expenses, Rent, Repairs and Maintenance, Utilities, etc. You will have a good bulk of your expenses in this section. There are a few types of operating expenses:
    • Fixed Expenses: These are the same every month or period. Examples could be rent or certain software subscriptions.
    • Variable Expenses: These are items that can change from month to month. Examples could be advertising costs or meals.
  • Operating Income: This again is simply a calculation of Gross Profit less Operating Expenses. This is essentially the income (or loss) from your business before factoring in non-operating related items.
  • Non Operating Income or Expenses: This would include things that do not play into the normal day-to-day operations of the company. This could include interest income, interest expense, income tax expense, etc. If you have significant items in this area it is nice to separate these out so that can get more clarity from your financials.
  • Net Income (or Profit/Loss): This is the final stopping point that factors in everything we discussed to come to your “bottom line”, whether your business had a profit or a loss.
  • Simply Way To Think About Income Statement: You start at the top and it starts with a positive number, your sales/revenue. As you go down your Income Statement there were will various types of negative numbers or expenses that are cutting against your sales. Finally at the bottom you will see what your profit was after factoring in the income you received and expenses you paid.

3. Why Is An Income Statement Important? What Can I Do With the Information From a Profit and Loss?

It is important to not just complete bookkeeping and then move on, but to actually take the data that comes from the bookkeeping, including the income statement and utilize that to cut costs and grow your business!

  • Think Deeper Than Just Net Profit: So many business owners we talk to think only about profit. While this is an important number it is just as important to dig deeper than that.
    • Sales/Revenue: Look at this area, is this number dropping? Why is it dropping? Has it been increasing, how do we continue that? What can we do to increase this on an on-going basis?
    • Cost of Goods Sold: Are we paying too much for our product? If we buy in bulk can we get a deal?
    • Operating Expenses: Are we still utilizing these items? Are we paying too much for anything? Have we shopped insurance or cell carries? Are these expenses all necessary? How are we trending here?
    • Non-Operating Activity: Can we move our savings to a CD to gain more interest income? Can we refinance to lower interest?
  • Utilize Comparative Periods: It is best to compare periods to prior periods. This can help spot areas for savings or ideas for future growth. Put a marketing plan together in Q1, how did that change sales in Q2? How are your sales compared to last year?
  • Create Forecasts / Projections: Prior data is great to see performance in the past and see where cost cutting opportunities exist. However, you have to take actions on prior data because your business is moving forward. Using this data we have we can easily create future projections and forecasts or budgets. We can take a month by month income statement and have a general idea of trends that we can predict into the future. This can help you be better prepared and plan for things that matter in your business.
  • Plan / Consult / Execute: Simply put, USE THIS INFORMATION. Income statements and financials can be so valuable for the growth and future of your business but if you just let it sit on the table it doesn’t do much good. Use the information to plan for the future to plan on ways to cut costs or  increase revenue. If you are unsure in certain areas, consult someone to help you on this journey. Finally take what you’ve learned and execute. Too often business owners get wrapped up in the day-to-day and their business goes stagnant. Execute to grow your business and reach the goals you want.

4. Final Items Related to the Income Statement

Some additional things to consider.

  • Accrual vs Cash: Remember in a previous article we discussed cash vs accrual accounting. You can run an income statement using both methods. As a refresher, cash basis is you record income as it is received and expenses as they are paid. On an accrual basis you report income as it is earned and expenses in the period they are associated with (regardless of when money is received or spent).
  • Asset Purchases/Depreciation: Last week we discussed that major asset purchases go to the balance sheet and then they are depreciated which is when they come to the income statement. This is often something that happens during tax season. Make sure you understand this throughout the year. You may have bought a new business vehicle for $50k but depending on the depreciation method you may not expense that all in year 1, instead it may be depreciated across multiple years. It will not show up on the income statement until actually depreciated since the initial purchase is booked to the balance sheet.
  • Owner Draws/Distributions: If you are taking money from the business as an owner that is not processed through payroll, generally this would be considered an owners draw, distribution or dividend and this it NOT an expense to the business, instead it is also a balance sheet item.
  • Loans: The only loan related items on the income statement would be the interest portion. Incoming loans and outgoing loan payments are balance sheet items, not sales or expenses.

This article was meant to give you a deeper look into the income statement (profit and loss). Next week we are going to be diving into the balance sheet with coincides with the income statement in reporting.

If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

What Is An Income Statement vs Balance Sheet?

Income Statement vs Balance Sheet

This is Part 4 in our “All About Bookkeeping” series.

If you missed our first three articles check them out here:

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

What Is Cash and Accrual Accounting?

Now that we have a solid foundation of what bookkeeping is and the basics on debts, credits, cash vs accrual, and the chart of accounts, lets talk about the two most popular financial statements, the income statement and balance sheet.

These two statements are the core of your financials and the very first output you typically will get from your bookkeeper.

1. What Is a Income Statement (also known as Profit and Loss)?

Shows you how profitable your business is over a period of time.

  • Common Accounts: An income statement contains all your sales (revenue) and expenses. These can include but are not limited to: Sales, Cost of Goods Sold, Bank Service Charges, Contact Labor, Consulting, Travel, Wages & Salaries, etc.
  • Time Frame: Any period you would like, however typically: monthly, quarterly, or annually.
  • What Does the Income Statement Tell You?
    • How much money you made
    • How much money you spent
    • Profitability of your business
  • Format
    • Start with Revenue
    • Next Record Cost of Goods Sold
    • Next Record Operating Expenses
    • End with Profit or Loss

2. What Is a Balance Sheet?

Shows the financial condition of your business on a specific date in time.

  • Common Accounts: A balance sheet contains assets, liabilities, and equity accounts. These can include but are not limited to: Checking Account, Furniture, Equipment, Credit Cards, Loan Payable, Owners Contribution, Owners Draw, Current Year Income (or Loss), etc.
  • Time Frame: A balance sheet is always one specific date in time. For example, you could create a balance sheet as of September 30th and it will very likely be different if you use October 1st the next time you run it. That is because it is a snapshot at a specific point in time.
  • What Does the Balance Sheet Tell You?
    • What You Own
    • What You Owe
    • What’s Left Over
  • Format
    • Start with Assets
    • Next You List Liabilities
    • Finally You Have Equity
    • Remember Accounting Equation: Assets = Liabilities + Equity

3. Differences Between Income Statement and Balance Sheet

It is important to know the difference between the two because this can often be confusing for business owners.

  • Know Whether It Hits Income Statement or Balance Sheet – When you spend money it does not necessarily always go to your income statement and reduce profit.
    • Asset Purchase: If you purchase a $10,000 piece of equipment you would not deduct it on the income statement right away. Instead you would add it to your balance sheet as an asset and then expense it over time via depreciation which is when you get the actual expense for it.
    • Loan: If you have a loan you only deduct your interest expense, principal payments are not deductible and simply lower your loan payable on your balance sheet. On that same not when you received the loan money it is not considered income, instead it would just increase your loan payable amount on your books.
    • Owners Contribution or Owners Draw: When you contribute personal money into the business that is not included as income to the business, instead it is recorded as an owners contribution. In the same note when you withdrawal money as an owners draw or distribution, that is not an expense to the business.
    • Normal Income and Operating Expenses: These are the items that hit the income statement and factor into your profit or loss which in the end is what you pay taxes on.

This article was meant to give you a deeper look into two major financial statements for every business. In the next couple articles are going to dig into each financial statement a little deeper to give you a better understanding of each.

If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

What Is Cash and Accrual Accounting?

Cash vs Accrual

This is Part 3 in our “All About Bookkeeping” series.

If you missed our first two articles check them out here:

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

Before we dig into the good stuff, financial statements, we want to discuss two types of reporting, cash vs accrual.

1. What Is Cash Basis Accounting/Bookkeeping?

Recognize revenue and expenses when cash comes or leaves your account.

  • Basic Understanding: Recognize revenue when you receive cash in your account. Recognize expenses when cash leaves your account. Example: Deposit a check for April services in May, you would report that income in May (when deposited). Or, pay a contractor in June for work they did in May, that would be considered an expense in June (when paid).
  • Accounts Receivable and Accounts Payable: Not recognized on a cash basis. So, if you were to have provided services for a client in May but it is outstanding, you will not recognize income until actually paid.
  • Benefits to Cash Basis
    • Easier to Maintain
    • Easy to Understand
    • You have a better idea on money available to spend
    • Income not taxed until it hits the actual bank
  • Downfalls to Cash Basis
    • Reporting may be less reliable (Ex: Big deposit in one month with a lot of expenses at a later time)
    • Less insights into invoices outstanding or bills needing to be paid

2. What Is Accrual Basis Accounting/Bookkeeping?

Recognize revenue and expenses when earned.

  • Basic Understanding: Recognize revenue when it is earned, regardless of when it is received. Recognize expenses in the period they are related to, regardless of when it is paid. Example: Provide services for a client for the month of April, you would report income in April even if you do not actually receive payment until May. Or you have a contractor that did work for you in May you would record that expense in May even if you did not pay until June.
  • Accounts Receivable and Accounts Payable: You will utilize to properly record income and expenses in the period they are earned. As you provide services or sell a product you will create an invoice (accounts receivable) to match that to the period in which you performed those services or sold that product. Once you are paid it will clear your outstanding invoice but the income would have already been recorded. Same thing with expenses, if you have a utility bill for a month you will enter that as a bill (accounts payable) in the month its related to. Once you pay that bill it will clear out your accounts payable.
  • Benefits to Accrual Basis
    • More reliable reporting (Income and expenses match to the same period)
    • Clearer financial picture
  • Downfalls to Accrual Basis
    • Harder to Maintain
    • Hard to Understand
    • Doesn’t match cash activity
    • Taxed on income not yet received

3. Should I Use Cash or Accrual Basis?

It Depends… You can potentially do both as well!

  • There is no straight answer as to which option is best for your business. You will want to talk to your accountant. With that being said we want to outline some typical guidelines we discuss with clients.
  • Cash Basis Best For:
    • Smaller Businesses
    • No Inventory
    • Service Based Businesses
  • Accrual Basis Best For:
    • Bigger Businesses
    • Businesses w/ Inventory
    • Shareholders/Investors
    • Complex
  • Hybrid/Combo
    • Most accounting software allows you to switch between cash and accrual accounting. So you have the ability to run on a cash basis but still track accounts receivable and accounts payable for internal purposes so you are keeping track of outstanding items.

4. Example / Walk Through

Lets put the learning into perspective!

  • Facts
    • Send invoice for $10,000 for services in August
    • Receive a bill for $2,500 for contractor fees for August
    • Pay $500 for bill related to July in August
    • Receive partial cash payment of $6,000 for invoice in August and remaining  $4,000 in September
    • Pay bill for contractor in September
  • Cash Basis Profit/Loss
    • July: $0
    • August: $5,500 Profit ($6,000 – $500)
    • September: $1,500 Profit ($4,000 – $2,500)
  • Accrual Basis Profit/Loss:
    • July: $500 Loss
    • August: $7,500 Profit ($10,000 – $2,500)
    • September: $0
  • Main Difference: Timing

We did this article prior to financial statements because your financial statements depend on which method you choose.

Now that we have an overall understanding of bookkeeping down, we can dig into the fun stuff in our next article, income statement and balance sheet!

This is just the start of our series, be sure to check back for future posts!

If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

This is Part 2 in our “All About Bookkeeping” series.

If you missed our first article check it out here:

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

Now that we have a solid foundation of what bookkeeping is, we want to dig a little deeper.

What are debits and credits and why do they matter?

What is a Chart of Accounts (COA)?

Any prior knowledge you have around debits and credits (usually associated with bank accounts and credit cards) needs to be thrown out. When it comes to bookkeeping the meaning is a little different.

1. What Are Debits vs Credits?

Simply Put: Debit = Left and Credit = Right

  • T Accounts: In bookkeeping classes they always start with a “T” account. Basically you take a piece of paper and write a big “T”. If you have a debit it goes on the left side of the line in the “T” and if you have a credit it goes on the right side of the line in the “T”.
  • Every Transaction Has Both a Debit and Credit: Every transaction you have uses a minimum of two accounts, at least one account is debited and at least one account is credited. For example, if you buy a package of paper clips you will have a debit to expenses and a credit to your bank or credit card account. Total Debits Must Equal Total Credits
  • Accounts That Increase With Debits:
    • Assets
    • Expenses
    • Owner Draws
    • Consequentially these accounts decrease with credits.
  • Accounts That Increase With Credits:
    • Liabilities/Loans
    • Income
    • Owner Contributions
    • Consequentially these accounts decrease with debits.

2. What Is a Chart of Accounts?

A listing of the account names that every transaction can be coded to.

  • Accounts Available for Coding: As we discussed last week, a bookkeeper will take the transaction types we discussed and assign them to their respective accounts (or categories) which is what the Chart of Accounts (COA) is made up of.
  • Types of Accounts on COA:
    • Assets – Examples: Bank Account, Office Equipment, Vehicles, etc. Assets generally carry a debit balance.
    • Liabilities – Examples: Credit Card, Loan Payable, Sales Tax Payable, etc. Liabilities generally carry a credit balance.
    • Equity – Examples: Owners Contribution, Owners Draw, Current Year Profit (or Loss), etc. Equity accounts can have both debit and credit balances, depending on the account.
    • Income – Examples: Service Sales, Product Sales, Refunds, etc. Income is generally a credit.
    • Expenses – Examples: Bank Service Charges, Office Expenses, Payroll Tax Expense, Postage, Rent Expense, Wages & Salaries, etc. Expenses generally are debits.
  • Accounting Equation: Assets = Liabilities + Equity
    • As we mentioned earlier, every transaction must have both a debit and credit that will balance the equation.

3. Examples

To help better understand debits vs credit and the chart of accounts, lets go through a few examples.

  • Receive Income for Services
    • If you deposited a check for income you would debit cash (increase cash) and credit revenue (increase revenue). If we look at the accounting equation, cash is an asset and revenue is part of the equity section (P&L) which balances the equation.
  • Pay Rent
    • You write a check to pay rent, you will credit cash (decrease cash) and debit rent expense (increase rent expense).
  • Transfer Money from Business to Personal Account
    • This is an example of an owners draw. You would credit cash (decrease cash) and debit owners draw (increase owners draw).
  • As you can see with these examples, every one has an account that is debited and also an account that is credited for the same transaction. Every transaction must have both a debit and credit.
  • You’ll also notice that the accounting equation balances for each one, Assets = Liabilities + Equity

This article was meant to give you a deeper look into what bookkeeping is. Now that we have learned this part we can dig deeper into bookkeeping and financial statements which we will do in the next article!

This is just the start of our series, be sure to check back for future posts!

If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

What Is Bookkeeping?

This is Part 1 in our “All About Bookkeeping” series.

We hear from business owners often:

“What is Bookkeeping?”

“Why do I need to do bookkeeping in my business?”

Most do not understand the true value that bookkeeping can bring to your business so we are set out on a mission to explain to you through a multi part series what you need to know about bookkeeping and why it is vital in your business.

1. What Is Bookkeeping? Simplified Definition

Bookkeeping is the process of keeping track of (or recording) every financial transaction within your business. This is then used to create financial statements. Every business needs bookkeeping.

Types of Transactions:

  • Bank and Credit Card Transactions: Every transaction (spend money or receive money) that goes through your bank account or credit card needs to be assigned to an account or category. Ex: $150 credit card transaction to Apple for a new keyboard would increase your credit card balance and increase your office expense account.
  • Invoices: Although not required to complete bookkeeping, many businesses send invoices to their clients to ensure they get paid. Ex: Client XYZ owes you $500 for services, you would create an invoice for $500 and send that to XYZ.
  • Bills: Although not required to complete bookkeeping, many businesses enter bills to keep track of who they owe and when it is due. Ex: You owe money for an electricity bill, payroll, or accounting services, you would create a bill to record the amount due and when it is due.
  • Non-Cash or Credit Card: This could be something like an asset purchase or a loan your business took out. Ex: You purchase a new Ford F-150 and take a loan out. You would record a new asset (vehicle) and corresponding loan related to the purchase.

2. What Is a Bookkeeper Responsible For?

Completing the bookkeeping process (transaction recording) to create financials that can be used to help the business.

  • Gather Supporting Documents: A bookkeeper will often gather necessary supporting documents for business transactions. This could include: bills, invoices, receipts, purchase orders, statements, etc.
  • Record/Classify Transactions: A bookkeeper will take the transaction types listed above and assign them to their respective accounts (or categories) and record them in the bookkeeping software.
  • Reconcile Accounts: Once the recording is done the bookkeeper will complete a reconciliation. A reconciliation is basically just taking the data that was recorded and ensure it matches the actual balances. Think of it like a check book. You need to ensure that the balance you have recorded in the “books” matches the actual bank, credit card or loan statement/balance. If they do not match that indicates something may have been missed or entered wrong.
  • Create Financial Statements: Finally, based on the activity recorded and reconciled we can create financial statements that can be used to help your business. Type of financial statements include: Income Statement (Profit & Loss), Balance Sheet, Statement of Cash Flows, and more.

3. Why Do I Need Bookkeeping?

I could go on for days on why every business NEEDS bookkeeping but here are some of the major items to consider.

  • Ensure Correct/Accurate Tax Filings: Tax time does not need to be stressful!
  • Clarity: Helps you understand how your business is performing. Judging performance simply by cash in the bank is the wrong way to do it.
  • Track Profit (or Loss) and Liabilities Outstanding
  • Cash Flow Assistance
  • Cost Cutting: With so much activity going on within your business there may be items that are unnecessary or setup on recurring terms. Bookkeeping helps you analyze that and see where you can cut costs.
  • Better Decision Making
  • Easy Reporting to Investors/Bankers (or other third parties)
  • Peace of Mind: Breathe easy knowing you’re doing things the right way and have good record keeping of everything going on within your business.
  • Avoid/Win An Audit

Earlier this year we did an article on the Top 4 Bookkeeping Rules to Follow. Be sure to check out that article (and Podcast episode) for more information there.

This is just the start of our series, be sure to check back for future posts!

If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

On A Positive Note: A Grand Perspective

On A Positive Note: A Grand Perspective

AUTHOR: Chris Gorman – JETRO Accountant

This idea came without much personal forethought…

During our JETRO annual retreat (held virtually this year) we toss around ideas to help inspire our clients or help inspire us!  My idea was to provide a blog or writings that would help with motivation or productivity or positivity or a combination of all three.  Due to the current climate all three attributes are in high demand but low supply.  Honestly when I brought up the idea I wasn’t quite prepared to be the one to launch it….

It has taken several weeks to get up the courage to put pen to paper.  Why?  Well I felt like a charlatan.  I didn’t have true positivity, or motivation and as a result wasn’t very productive, so who am I to post something pertaining to attributes I felt I sorely lacked? Well as they say, whoever “they” are, the 1st step is the hardest, so here goes.

“We all have growing to-do lists as a result of work and home life.”

How many of you feel overwhelmed?  We all have growing to-do lists as a result of work and home life.  If you are like me the “to-do” list is always longer than the “done” list.

Often times this consumes my thoughts, “what should I do next”, “how much time should I set aside for this or that task”, ”should I redo my list, my calendar”, “how will I ever get all this done and get enough sleep / time with my husband and son / time for myself”?  At times I admittingly get stuck in the thought process and ruminate on what I need to get done rather then actually putting in the time to get the work done.  It is exhausting and I am left mentally tired, with a to-do list without much crossed off, and a feeling of personal defeat. 

At JETRO we are a connected team and every Friday someone will ask “What fun things are you doing this weekend?”  I normally cringe when this is mentioned.  “Fun” things – who has time for that?  My fun will be catching up on the work I didn’t do because I was mentally stuck.  My fun will be the house work or house projects that are leftover from the prior 3 weeks / weekends..  My next thought…”ugh what is wrong with me”?

“I vowed I wouldn’t bring my computer and I would spend the time with family and the Grand Canyon..”

This year, in the midst of the craziness, we decided to take a family vacation to Flagstaff AZ.  In true form, I had my to do list of all the items I wanted to get done before vacation to have peace of mind on vacation.  I vowed I wouldn’t bring my computer and I would spend the time with family and the Grand Canyon and whatever experiences Flagstaff had to offer.

Well I fell short and my laptop came along with me…..I had just a “few” more things I had to do before I could relax…..  Afraid to admit this, but my laptop is kind of like a security blanket.  I did do a little work on the plane and the first night in Arizona, but unlike other vacations, the computer became a desk decoration. 

“…but unlike other vacations, the computer became a desk decoration.”

I put away all my to-do list thoughts, after all, what wasn’t done wasn’t earth shattering, and guess what, it would still be there to tackle after I got back.  The time that I would normally spend stuck was spent with a cup of coffee sitting on a balcony viewing the mountains in the distance, taking a walk on a trail, or…wait for it…..taking a nap!  For the first couple days I felt incredibly guilty but for the remainder I felt at peace and with each passing day I was recharging. 

“Who knew that by taking a break I was actually accomplishing something?”

Who knew that by taking a break I was actually accomplishing something?  My vacation resulted in a decluttering of my mental space and the result I came back ready to tackle things and I have been productive!

I resolved not to work on the weekends unless absolutely necessary, so today when asked what fun things are planned for the weekend, I may not have a plan but I have an intention to do something fun without guilt.

My productivity level was enhanced by letting go and taking a vacation.  Now I know that this is not feasible for all but I challenge you to take a break and do something different of something you have wanted to do for some time but felt that you couldn’t because of other more pressing obligations.  Clear your mental space and the productivity will flow. 

“My productivity level was enhanced by letting go and taking a vacation … Clear your mental space and the productivity will flow.”

Everything You Need To Know About S Corporations

Everything You Need To Know About S Corporations

We get so many questions on S Corporations so we decided to do a 6 part series on everything you need to know about them, on both our Blog and Small Business Tax Savings Podcast.

Outlined below is an easy access guide to each topic, blog post, and Podcast episode.

1. What Is a Pass Through Entity?

Initial introduction on entity types and how they are taxed.

2. What Is An LLC and How Is It Different From An S Corporation?

Introduction to an LLC and how that relates to the S Corporation.

3. What Is An S Corporation and Why Should I Elect To Be One?

Introduction to S Corporations and why it may be beneficial for you.

4. What Are The Requirements For An S Corporation and How Do I Set One Up?

We got through what the requirements are to be an S Corporation and how you go about electing to be taxed as one.

5. What Is A Reasonable Compensation For An S Corporation Owner?

As you may now know, owners of an S Corporation are required to take a reasonable compensation. We discuss how you can go about determining that and running payroll.

6. I Have An S Corporation, Now What Do I Need To Know?

Now that you understand the S Corp and have it setup and are running payroll, we discuss what else you need to know!

That’s it! Hope you found that helpful.

 

If you don’t have a tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

I Have An S Corporation, Now What Do I Need To Know?

I have an S Corp, Now What Do I Need To Know?

This is Part 6 in a series of ours. If you have not read our previous articles do that first:

What is a Pass Through Entity?

What Is An LLC and How Is It Different From An S Corporation?

What Is An S Corporation And Why Should I Elect To Be One?

What Are The Requirements For An S Corporation And How Do I Set One Up?

What Is A Reasonable Compensation For An S Corporation Owner?

In this article we are going to talk about what you need to know now that you are organized and operating as an S Corporation.

1. Recap

Lets recap where we have been the past couple weeks.

  • Pass Through Entity: An S Corp is a pass through entity meaning that you pay taxes on the profit from the business on your personal return.
  • Annual Business Tax Return: You file S Corp activity on Form 1120S which will have a K1 to report that activity on your personal return.
  • Benefit of the S Corp: Eliminate a portion of the self employment tax you pay. Instead of paying self employment tax on 100% of your income you only pay it on your salary.
  • Electing S Corp Status: To elect S Corp status you would need to meet a few requirements and then file Form 2553.
  • Reasonable Salary (Payroll): The owners of an S Corporation are required to take a reasonable salary (W2 Payroll as an Employee)

2. S Corporation Owner Health Insurance

As the owner of an S Corporation you need to treat health insurance payments for yourself in a special way to ensure you get the deduction.

  • Step 1 – Have The S-Corp Pay the Insurance: This should be done directly out of the business bank account. You will deduct the expense as wages on the business side.
  • Step 2 – Gross Up Payroll: You will take that insurance expense paid and gross up the payroll wages for the owner(s). If the plan is non-discriminatory then no FICA needs to be withheld. This will also help you hit that reasonable salary amount. Note: You will need to ensure your payroll provider knows about this so it can be included in your W2. Typically we make this adjustment at year-end.
  • Step 3 – Deduct On Personal Tax Return: Finally, that income that was reported to you in wages for the insurance will now be deducted on your personal tax return.

As you can tell there are a few hoops you need to jump through but the net result is you get a deduction for it.

You deduct on the business side, include in wages on payroll, and then deduct on the personal side.

3. Accountable Plan (aka Reimbursement Policy)

A way to get a business deduction for expenses paid personally or expenses that are a mix between both business and personal.

  • Expenses that are 100% business related, simply run them through the business.
  • If you mistakenly run a 100% business expense on your personal account, use the accountable plan to reimburse yourself.
  • For items that are not 100% business related (Example: Home Office, Automobile, Travel, etc) you use an accountable plan to reimburse yourself for the business portion (Business Use Percentage x Amount).
  • To implement an accountable plan you just need to create a plan agreement and put it on file for your business.
  • We also recommend using an accountable plan worksheet to help track those items that are business and personal mix.

It is important to reimburse yourself through an accountable plan because if you do not, that money may be considered taxable income.

That’s it! This concludes our series on S Corps where we walked through all aspects surrounding this tax election and what you need to know.

If you don’t have a tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

What Is A Reasonable Compensation For An S Corporation Owner?

What Is A Reasonable Compensation For An S Corporation Owner?

This is Part 5 in a series of ours. If you have not read our previous articles do that first:

What is a Pass Through Entity?

What Is An LLC and How Is It Different From An S Corporation?

What Is An S Corporation And Why Should I Elect To Be One?

What Are The Requirements For An S Corporation And How Do I Set One Up?

In this article we are going to talk about the reasonable compensation aspect of electing S Corporation status.

1. What Is A Reasonable Compensation For An S Corporation Owner?

That is the $1,000 question. Unfortunately the IRS does not give us clear guidance in this area but they are able to point us in a direction at least.

The IRS states this:

  • S Corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.
  • The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation by looking to the source of the S corporation’s gross receipts.
    • Services of shareholder
    • Services of non-shareholder employees or
    • Capital and equipment
  • Some factors in determining reasonable compensation:
    • Training and experience
    • Duties and responsibilities
    • Time and effort devoted to the business
    • Dividend history
    • Payments to non-shareholder employees
    • Timing and manner of paying bonuses to key people
    • What comparable businesses pay for similar services
    • Compensation agreements
    • The use of a formula to determine compensation

As you can tell the IRS is not very clear as to what constitutes a reasonable salary but based on the information made available, along with court cases we studied, we have determined some optional methods for determining this reasonable salary.

2. Strategies To Determine S Corporation Owner Reasonable Salary

There is no magic bullet to determine a salary that the IRS will label as reasonable but here are two options we often discuss as starting points with clients.

  • Option 1 – Easy Method but Harder to Defend: Use a percentage of net income prior to owner salary. This percentage should be at a minimum 30%, but can often range from 30%-50%+. Example: Net income prior to salary of $100k, using this method you would be in the $30k-$50k range for a reasonable salary, with closer to 50% being less risky.
  • Option 2 – Harder Method but Easier to Defend:
    • Determine the amount of hours you spend doing various tasks in your business, on a yearly basis: Your Specific Job (Lawyer, Marketer, Plumber), Administrative Duties, and Marketing Duties
    • Find the rate someone doing those various tasks in your city and state gets paid (You can use BLS data from the government here).
    • Multiply that rate by your yearly amount of hours worked.
    • Add in any adjustments for special training, licenses, certifications, etc that you have.
    • Add in any other special considerations (highly compensated, non owner employees, etc).
    • Take all of that data and land at your final reasonable salary.

Option #1 is obviously easier to complete but the biggest downfall is you do not have any substantiation to back up your salary in the event of an audit. Option #2 take a little more leg work but in the event of an audit you have backup to support your determination of your salary. We have a calculator for Option #2 that you can reach out to us for if you would like a copy for yourself.

Note: Both options are simply starting points to figuring a reasonable salary. Each tax payer is different and you’ll want to sit down with a tax professional to really drill down to the salary that makes sense for you and your business.

3. What Happens If I Take Too Low Of A Salary?

The IRS has the authority to reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes).

  • Basically in the event of an audit you would need to provide support that backs up the salary you took as a business owner.
  • If the IRS determined your salary was too low, they would reclassify distributions you took into wages and you would need to pay back taxes, interest, penalties, and fees.
  • Example: You take a reasonable salary of $50k but the IRS determines $80k is reasonable and you had distributions of $60k. The IRS would take $30k of your distributions and reclassify them as wages.

Note: If you took zero distributions in a specific year there would be nothing to reclassify. However if you took a distribution the next year the IRS would require you to pay the salary you should have taken in the prior year when you took no distributions.

4. How Do I Run Payroll To Myself?

We recommend a payroll software called Gusto for your payroll processing needs because they handle all tax payments and filings on your behalf.

If you need an introduction to our rep over at Gusto, contact us and we can invite you into the software!

When it comes to running payroll you have a few different options:

  • Option 1: Setup a regular payroll schedule (weekly, bi-weekly, monthly, etc) and run payroll to yourself on a normal basis.
  • Option 2: Take distributions as you need money and then at the end of each quarter run an off-cycle pay-run for your reasonable compensation amount. This will move a portion of distributions that you took into wages and you can then just pay the tax portion at that time.
  • Option 3: If you elected a late election you will need to get caught up on payroll for the part of year already missed. In that case you can run an off-cycle pay-run for the tax portion and then move to Option 1 or 2 moving forward.

In our next article we are going to discuss “So I am an S Corporation, Now What?”.

If you don’t have a tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.

What Are The Requirements For An S Corporation and How Do I Set One Up?

What Are The Requirements For An S Corporation and How Do I Set One Up?

This is Part 4 in a series of ours. If you have not read our previous articles do that first:

What is a Pass Through Entity?

What Is An LLC and How Is It Different From An S Corporation?

What Is An S Corporation And Why Should I Elect To Be One?

In this article we are going to talk about what the requirements to be an S Corporation and how you set one up.

1. What Are The Requirements For An S Corporation?

To be classified as an S Corporation there are a few requirements that must be met.

  • Must be organized initially as an LLC or Corporartion. Remember this is simply a tax election so you must first have a company open. If you are currently operating as a Sole Proprietor you will need to open an LLC or Corporation and then elect S Corp status. Any activity under the sole proprietorship will need to be filed as such and cannot be claimed under the S Corp.
  • Shareholders may be individuals, certain trusts, or estates. May NOT be a: partnership, corporation, or non-resident alien.
  • Cannot have more than 100 shareholders.
  • Can only have one class of stock.
  • All shareholders must consent to the election.

Although these requirements may seem scary, the majority of clients we talk to do not run into any of these issues.

You may have noticed that partnerships or other corporations cannot be shareholders. If you are in a situation where you are working with other owners with various corporate setups, check out our article: “How Should I Structure My Business With Multiple Owners?

2. How Do I Elect S Corporation Status?

To elect S Corporation status you will need to file Form 2553.

  • Form 2553 must be filed within two months and 15 days from the date your business starts or if you already have an existing business within two months and 15 days from the beginning of the tax year you wish S Corp election to be effective.  Example: You want S Corp status effective tax year 2021 would need to file Form 2553 by 3/15/2021.
  • If you do not file Form 2553 in the required time frame you can request relief for a late election by:
    • 1) Writing on top of Page 1 of Form 2553 “FILED PURSUANT TO REV. PROC. 2013-30”
    • 2) Filling out Section I of Form 2553 for reason of request.
    • Note: The IRS typically accepts late relief in the majority of cases as long #1 and #2 are completed.
    • Example: It is August 2020 and you want S Corp status effective 1/1/20. You can still request relief for a late election and then just get caught up on the payroll since the beginning of the year.

Note: To obtain S Corp tax treatment for state taxes, you may need to file additional documents with your state.

You’ll notice that Form 2553 is a pretty straight forward form to fill out, just ensure you fill it out completely included signatures and information from all owners.

In our next articles we are going to discuss what a “reasonable salary” means and how you can go about setting this up.

If you don’t have a tax advisor (or you need assistance with this election), click here to book your complimentary strategy session with JETRO.