Estimated reading time: 4 minutes, 6 seconds

trap artEnsuring you don't fall victim to these tax traps will help you avoid hefty IRS fines, whether you're just starting out or running your business day-to-day.

1. Contractor Conundrums
Finding ways to cut costs without sacrificing quality is the entrepreneur's credo. But what you consider a cost-savings the IRS may deem noncompliance, and issue penalties accordingly.


Misclassifying employees as contractors can cost you. At first glance, contractors are appealing. They are responsible for paying all 15.3 percent in Federal Insurance Contributions Act taxes, whereas employees only pay 5.65 percent in FICA taxes (7.65 percent in 2012) and the business owner is responsible for matching 7.65 percent. One fewer employee on payroll also means smaller state unemployment insurance (SUI) and Federal Unemployment Tax Act (FUTA) payments.

Many small business owners are misclassifying workers, and may pay the price. The IRS has a laundry list of what constitutes a contractor. If you think you're employing contractors yet dictate when and where they do their work, provide their training and tools, and pay them according to a regular pay schedule then you should most likely pay them as employees.

This advice can save you from hefty fines. The 2010 federal budget planned to generate $7 billion in additional revenue over the next 10 years from stricter enforcement of proper worker classification. According to a recent New York Times article about trimming future deficits, half of the states are ramping up their own classification crackdowns, hoping to cover their budget donut holes from the nation's estimated 3.4 million misclassified workers.

The solution is to "bite the bullet," and classify them correctly and put them on payroll. The money you pay in FICA and unemployment taxes is usually less than what you'll pay in IRS penalties.

Adding another person to payroll may sound like a bigger burden versus simply cutting a check to a contractor, but payroll services alleviate the pain of calculating and deducting withholdings. Some payroll services also handle paying and filing all federal, state, and local payroll taxes and allow you to process payroll online 24 hours a day, seven days a week. The average customer's payroll takes two minutes to process.

2. LLC Lessons and S Corp Snafus
Your business' IRS status dictates how you must pay certain payroll taxes. As a Limited Liability Company, you're obligated to pay payroll taxes on your employees' incomes and manage their payroll, or you can use a payroll service. However, you cannot put yourself on the payroll if you own more than two percent of the company.

Many small business owners learn this the hard way when they don't pay FICA on net profits and IRS notices start piling up. Art Troast, a New York City-based CPA and owner of Troast Consulting, noted the solution isn't always easy to swallow.

"The FICA rate is 15.3 percent and an effective income tax rate when you combine federal, state and local is often 25 percent," said Troast. "New business owners never imagine they have to set aside 40 percent of their net profit for taxes."

Unfortunately, they do. Letting a payroll service handle the payroll tax paperwork and working with a CPA to create an estimated tax regimen is the best route for avoiding IRS or other agency penalties. This will let you know how much net profit you can invest in your business and use as your income, while ensuring those taxes get paid and filed in a timely fashion.

The other popular small business status, an S corporation, carries its own tax nuances. Whether you place yourself on payroll or use net profits for your own income is your choice. In hopes of reducing the FICA and income tax burden, some S corp owners will place themselves on payroll and set their salaries very low. What they don't realize often hurts them: The IRS and state revenue agencies can "re-categorize" the net profits owners dip into as wages.

Adding yourself to a payroll service is a quick and easy way to guarantee paying the right FICA amounts. But it only works if you give yourself a fair salary. The IRS is good at noticing when you don't.

3. Workers' Compensation Complications
Workers' compensation and disability insurance are mandatory. The only businesses exempt are those where the owner is the sole employee. The minute you add that first employee, you're obligated to purchase workers' compensation and disability insurance.

Yet many small business owners go without, either assuming they're exempt or hoping no one will check into it. Yet fines for workers' comp noncompliance, in particular, can be devastating, and not knowing isn't an excuse in the eyes of the state.

Everyone with employees needs workers' compensation. Luckily for small business owners, the Internet has enabled services to make it simple to add a convenient, pay-as-you-go workers' comp plan so you can avoid the fines and headaches that operating without the proper insurance policy can create.

While these three pitfalls are the most common and easy to avoid, others will surface. And remember: When in doubt, seek advice.

Last modified on Sunday, 02 June 2013
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