By Barbara Weltman

One of the least fun things about running a business is filing your annual income tax return and paying what's owed. As you embark on this task, don't make mistakes that can lead to needlessly overpaying your taxes or, even worse, becoming the target of an IRS audit.

1. Recognize your vulnerability. There is a $345 billion tax gap the spread between what the government actually collects and what it thinks it should be collecting. Much of this, in the IRS's view, is attributable to sole proprietors who underreport their income or overstate their deductions. Be prepared: Report your income correctly (for example, report all income that has been reported to you on Form 1099-MISC) and keep great records to back up any deductions you claim.

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2. Classify your workers properly. Another hot issue for the IRS is making sure that businesses treat workers as employees, rather than as independent contractors, if sufficient control is exercised over the workers. If you have the right to tell a worker when, where, and how the work is to be done, likely he's your employee and you must pay employment taxes (e.g., withhold income tax and the employee share of FICA from his wages, pay the employer share of FICA, and pay federal and state unemployment taxes). You can't simply label a worker an independent contractor if the situation makes him an employee. If the IRS finds out that you've misclassified a worker, you can owe substantial back taxes and penalties.

3. Don't overlook deductions to which you're entitled. Most of your expenses in running a business are deductible, but you may need special records and/or receipts to claim them. For example, taking a customer to lunch is deductible (up to 50% of the bill), but you need a receipt and a written record in a diary, expense account statement, etc. showing the name of the customer, where and when you ate, and what you discussed. If you were profitable, you can shelter income in a qualified retirement plan. The contribution is deductible up to set limits (e.g., a maximum of $45,000 for contributions to a profit sharing plan or Simplified Employee Pension, or SEP, in 2007), earnings grow on a tax-deferred basis, and you create a retirement nest egg for your future. Even if you didn't set up a plan for 2007, you have until the extended due date of your return to set up and fund an SEP. Factor in the cost of covering employees, where applicable. If you made, constructed, grew, or extracted something in the U.S., you may be eligible for a special deduction, called the domestic production activities deduction. For 2007, this is 6% of your net income from a qualified activity, which can mean substantial savings for you.

4. Don't overlook tax credits. There is an array of tax credits you may claim to reduce your tax bill dollar for dollar
Examples:

  • If you started a qualified retirement plan, you can claim a credit of $500 per year for the first three years to offset the administrative startup costs (e.g., educating your employees about their participation in the plan).
  • If you conducted scientific research, you may qualify for a 20% tax credit for these research activities.
  • If you hired someone from certain targeted groups, such as a disabled veteran or long-time family assistance recipient, you can claim a credit for a portion of their wages.
  • If you purchased a hybrid vehicle, you may be entitled to a tax credit, the amount of which is fixed by the IRS. However, no credit is allowed for any Toyota or Lexus hybrid purchased after August 31, 2007.

5. Avoid tax penalties. What a waste of your hard earned money if you owe tax penalties that could easily have been avoided.

  • File your return on time or ask for an automatic six month filing extension by the due date of your return to avoid late filing penalties (which can be 25% or more if taxes are owed). However, a filing extension does not give you more time to pay what you owe. If you request an extension, be sure to pay as much as you can along with your extension to minimize or avoid late payment penalties.
  • Don't let your inability to pay your tax bill keep you from filing on time. If you file by the due date (including the extension), you won't owe late filing penalties. You can deal with your tax bill by requesting an installment agreement from the IRS (if you pay in full within 10 days, there's no interest or penalties). If you need more time, you can have up to three years if the balance is no more than $10,000 and you meet certain conditions you'll owe interest but the late payment penalties are cut from 0.5% per month to 0.25% per month. You can also charge your tax bill to a major credit card, but you'll pay a 2.49% convenience fee to the IRS approved processor, plus interest on any credit card balance you carry.
  • Don't fail to pay estimated tax if you need to. Business owners don't have tax withholding on their profits and can't wait until they file their returns to pay what they owe. For sole proprietors, for example, estimated tax must cover the income tax on net earnings from the business as well as "self employment tax" (to cover Social Security and Medicare taxes). Estimated tax is paid in four installments for the year: for 2008, these payments are due April 15, June 16, September 15, and January 15, 2009 (don't include your first installment with your 2007 income tax return).

Being smart about your company's taxes can have a significant impact on your financial bottom line. If you don't have the expertise to handle this on your own, or the time to use software for this purpose, be sure to consult with a tax advisor as soon as possible.

Barbara Weltman is one of the nation's leading authorities on small business. She is a contributing writer for Inc.com, PINK magazine and New York Enterprise Report, and is a sought after media commentator who has been featured in The New York Times, The Wall Street Journal, The Washington Post, Reuters, Forbes.com, Marketwatch.com, WABC-TV, Fox News, CNNRadio and CNBC.

Prior to relying on any legal, tax or financial advice or recommendations provided herein, you are advised to consult with your attorney, financial adviser and/or tax professional to verify the information provided and to determine the applicability of any federal, state or industry specific laws and/or regulations that may apply to you. Bank of America shall have no liability for legal, investment, finance and/or tax decisions based on the information provided.

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