The Elephant in the Room

Let’s start off with the elephant in the room: Almost nobody likes to do paperwork. Especially the business person starting out whose sole objective is to get enough clients to pay the bills.

And yet, if you truly want to Protect the Profits that your business makes from runaway expenses or getting overly taxed - then we need to talk about bookkeeping, creating reports, and hiring people - and why they are so important to have a general understanding of.  They are  the glue that holds the whole thing together.

Transcript

Episode 7 - The Elephant in the Room 
 

Welcome back. In the last couple of episodes, we've talked about all the different legal formats that businesses can have and the tax consequences of which business format you choose, but there's a few more things that you need to be aware of that concern the logistics of a business. And a lot of people, well, they don't pay attention to it or they just flat out don't know it, and so I thought I'd discuss those today. 

Let's get started.  

You are listening to the Mastering Business Basics Podcast, where we discuss how to build a solid foundation under your small business to improve your chances of success. And now here is your host, Roger Pearson. 

Let's start off with the elephant in the room. Almost nobody likes to do paperwork. Especially the business person starting out whose sole objective is to get enough clients to pay the bills, and yet if you truly want to protect the profits that your business makes from runaway expenses or getting overly taxed, then we need to talk about bookkeeping. 

What I would like to achieve is to show you how to organize the financial aspects of your business in a easy, understandable way. So let's start off with a question. 

What is the best accounting system to use? And yet, that's really the wrong question to ask if you don't want to have to spend your time correcting everything later. The question you need to ask yourself is, what do I need to learn about accounting before I choose what type of system is best for me? And there's a whole long list of things that would be good for you to know, but I certainly don't have time to go over all of them today, we would be here two or three hours. What I do wanna point out is a few things that you should be made aware of when you're evaluating a software program or evaluating an accountant to do it for you. 

Now, so many people just go out there and they buy a software program, choose to use one of the default example businesses that they provide. For example, QuickBook usually gives you a choice of starting with a service business or a product business, and then you can customize it from there. The problem is that most small business people don't have a clue on how to customize the software, much less know what a chart of accounts is or balance sheet is, or profit and loss statement is. 

They don't see the need to take the time, but you need to. This is really important stuff. 

The way you organize your paperwork is to produce two results. The first is to provide you with the data to let you know if you're making a profit. And how much so you can make the proper adjustments. The second is to document things in a way that will allow you to legally pay the least amount of taxes on your profits. 

And those two things are the focus of what we're gonna talk about today. One of the first things that taxpayers should do when starting a business is open a business checking account to be used for the business purposes only. I mean, the worst thing you can possibly do is co-mingle your business and your personal expenses in one checking account because it can lose you money if your business should be audited and I've represented people that were audited that had that happen. it cost them thousands of dollars. The business checkbook may serve as a backup record keeping system for business purposes, but only as an extra validation, not as an accounting system. I've had people bring in their checking account statements for 12 months and say, here you go, do my taxes. 

And that doesn't do it. I mean, if your checking account statement shows a purchase at Home Depot and you don't have the actual receipt. Then who's to say it wasn't just a personal expense? You need to have the proof. You just can't use your statements as a bookkeeping system. 

If you receive cash payments, then it should be deposited daily. Deposit slips should list the details of the items deposited with copies kept for documentation. It is a best practice to reconcile the bank statements each month to ensure the checkbook, financial books and the bank accounts agree. And yet you'd be surprised how many small business people do not do that. 

Now, before the advent of computer accounting software, most small businesses just used handwritten ledgers or spreadsheets. In fact, many small businesses still use. Spreadsheets today, and I ran my businesses for years and years and years on spreadsheets. 

Unfortunately, there are still those that like to throw everything to a box and worry about it later, and that's the biggest way to lose a lot of money. 

While a simplified method of record keeping may work for some small businesses, it's not gonna provide the financial statements that are beneficial to all businesses and necessary for tax return preparation for certain entity types like partnerships or corporations. I mean, these financial statements such as income statements, balance sheets, profit loss statements, allow business owners and possible investors to determine the health of your business. 

I'm not gonna go into the definition of all the income categories and all the deduction categories. In fact, the IRS has listed the 35 most common business expense categories they look for. If you'd like to take a look at them to get you started, then you're gonna find them in IRS Pub 5 35 business Expenses. 

What I want to get into today is discussing the special situations of bookkeeping that you need to know. Now, once you determine all of the income and expense categories, these categories are used in both single entry and double entry accounting systems. Businesses such as sole proprietorships, which do not need or require balance sheets, may use a single entry system. 

Single entry system is something like you'd see on a spreadsheet. You get your columns for income. You got your columns for expenses, that's it. But some businesses like partnerships and corporations are actually required by law to use what's known as double entry systems, but it's really good business procedures, even for those who aren't required to. 

It's really hard to do double entry accounting by hand, and it's now standard to use software to keep track of all the debits and credits required. After you install your software and you enter all your company information, and before you enter any transactions you need to go in and adjust your chart of accounts. 

And this is one thing most people don't do or don't understand why. The chart of accounts is designed to be a map of your business and its various financial parts. It should let you make better decisions, give you a more accurate snapshot of your company's financial health, and actually make it easier to follow financial reporting standards. 

Fortunately, most accounting software will start you out with a generic chart of accounts and give you a choice between a retail business and a service business. You just need to tweak it for your business. But to do that, you need to understand what you're looking at, which is what we're going to examine here. 

Now, a chart of accounts is a list of all your company's accounts together in one place. It's like a list of all the names of the columns and a single entry bookkeeping system. Then you add in the debt you owe, the money you have put into your business, the money people owe you, and you put it all together in a way that produces financial statements. Like balance sheets, income statements, profits, loss statements, or cash flow statements. 

These statements are important if you're talking to possible or current investors in your business if you're going to a bank talking about loans and things, because they wanna know how much profit your company's making and it makes it much easier to do your business taxes on top of that. 

The accounts listed are going to depend on the nature of your business. For instance, a taxi business will include certain accounts that are specific to the taxi business, in addition to the general accounts that are common to all businesses. In this case, the taxi business will include a fuel expense account that is not common to all the businesses, but it's going to leave out an inventory account, since the taxi business is a service that does not hold inventory. 

While you can add to your chart of accounts as your business grows, and you probably will by taking the time to properly set up your chart of accounts when starting your accounting system, it's gonna save you time in the future by minimizing changes. 

It's also gonna give you a better way to compare year to year profitability and see how your business is doing in a longer term. And even if you're hired an accountant to take care of the bookkeeping for you, they probably don't know how your business works. So it's good practice to give them a custom chart of accounts so that the reports you receive reflect how you want to view the profitability of your business. It's also gonna help them understand the type of expenses that your company incurs so they can be properly entered in the company books and do a better job for you. 

Now there's five sections in the chart of accounts. The first three sections are used to create the balance sheet. They are the assets, liabilities, and equity. 

The other two sections are used to create the income statement or profit and loss statement. They are income and expenses. The expense accounts will probably be the section that you customize the most to tailor them to your business. Because while the income accounts are generally the same on most businesses, the different businesses have different types of expenses, and that's the part that's gonna be the most customizable. 

So how do you adjust your chart of accounts as your business grows? The rules for making tweaks to your chart of accounts are simple. Feel free to add accounts at any time of the year, but wait until the end of the year and your final year end reports are printed before deleting old accounts. If you delete account in the middle of the year, it's probably gonna mess up your books royally. 

Now if a new expense account is what you're adding, you just add the new account and you start assigning your purchases to the new account expense. But what if you decide you wanna split out some expenses from an account you already have been entering into during the year? You need to make a journal entry, and this is often the part that really confuses people. 

So we're gonna briefly cover it here. Let's take another example. If you're in the construction business and have been adding everything you buy at Home Depot to an expense account called construction supplies, the price of wood then suddenly goes through the roof and you decide that you need to have a better handle, and how much of your budget is going towards buying wood? 

How would you handle that in the accounting system? First you go to the chart of accounts and you create a new account under expenses. Now, all the wood that you buy would be assigned to the wood account and all the rest of the nails and screws would be assigned to the construction supplies. 

But what about the wood that you entered under construction supplies in the first part of the year? How do you move it over to the New Woods account so you can run a report and see how it's affecting your business? Again, you make a journal entry. And since you're using a double entry accounting system, two entries are needed for any transaction. 

The software reads the chart of accounts and does this automatically for you, except when we need to adjust something in the books like this. The confusing thing in a journal entry is the terminology. Essentially a debit adds to the account and a credit reduces the account, which is backwards to the way most of us think about these words. 

If you're looking at your checking account, a debit reduces your balance, but, in a journal entry, a debit increases the account. In Your checkbook credit usually increases your account, but in a journal entry, it reduces the account. It took me a while to learn all of that. You gotta kind of think backwards. 

Can you imagine before computers, when accountants had to make a double entry by hand for every single sale and every single purchase a business made. They definitely earned everybody that they charged. 

The next thing I want to talk to you about is reports. Now depending on the degree of detail that you've set up in your chart of accounts, there's a lot of reports that you can create with your accounting software to look at your business dynamics in different ways. 

These financial statements are used by investors, market analysts, and creditors to evaluate a company's financial health and earnings potential. And the three major financial statement reports, of course, are the balance sheet, the profit and loss, or income statement, and the statement of cash flows, as we mentioned previously. 

Now the balance sheet provides an overview of the assets, liabilities, and stockholders equity as a snapshot in time. It's usually run at the end of the fiscal year or the end of the calendar year, whichever your company uses, and it usually has at least two years worth of data on it so that you can compare this current year to a previous year to see how your company has progressed. 

The profit and loss statement primarily focuses on a company's revenues and expenses during a particular year, and once the expenses are subtracted from the revenues, the statement produces a company's net profit for the year. This is the main document that you also use to do your taxes. 

The cash flow statement measures how well A company generates cash to pay its debt obligations, fund its operating expenses and fund investments. And this was a one that's mainly used by investors and bankers to see how your company is doing. Now, while all of these reports have their place, the profit and loss statement is the most important one in helping you keep on track from a day-to-day standpoint. 

And by learning to create and to read it, you're able to tell what your net profit is at any day of the year. And I always said, anytime we go into training people, a good businessman will be able to tell me what their net profit is year to date. Anytime I ask, then I know that they have a handle on their business if they're reading their p and ls on a regular basis.  

The last thing I wanted to mention is about hiring help because a lot of people really have a lot of misconceptions about the legalities of this, and there are a lot of legalities when it comes to hiring help. Eventually, as your business goes, you're gonna probably, we need to find some people to help you. 

So let's review the basics of what you need to know about the legal requirements and the paperwork involved in doing this. They can be treated one of two ways. They can be treated as employees, they can be subcontractors. And treating somebody as employee means that you control the way they work. 

You tell them where to work, how to work, when to work, just as if you were working for somebody else. You have to have the new employee filled out two forms, a form W four. Which tells you how much tax they want, withheld and the form I nine, which verifies that they're legally in the United States and allowed to work. 

You must then withhold the income taxes from each employee according to how they filled out their W four. You must also withhold the employee share of Social Security Medicare tax and also pay the employer's share of Medicare and social Security tax known as fica. You've gotta pay federal unemployment taxes. You gotta pay state unemployment taxes. You gotta pay workers' compensation premiums. And these are normally remitted monthly, quarterly, depending on the size of your business, along with all the appropriate forms. 

Since the employee pays only 50% of their Social security Medicare taxes, you need to figure into your budget the other 50% that you as the employer must pay. Now, both halves, currently total, 15.3% of the gross income, plus the unemployment taxes and the workers' comp premiums. 

There have been businesses out there that started to have cashflow problems and stop sending these in when they were due, and you never want to do that. The IRS is the worst debt collector in the world, and they never forget. They will not go away. So be sure to put these things in your budget. 

Quite frankly, even though I know how to fill out all of those payroll forms, I find that the small cost of hiring someone to do it or a subscription to a payroll service is worth the peace of mind. 

Just don't use one of the big firms without checking out some other options because they charge a lot. And they're made for corporate structures, not for small business people . You need to check around. You need to check prices, you need to check referrals. Some of the accounting software on the market also provide payroll services for an additional fee. And you may find small business services department at your local bank, or credit union also has payroll services at a very good rate. So I would check those first. 

Now you must transmit your W2 information with the corresponding W three cover sheet to the Social Security Administration by January 31st of each year to avoid penalties. And if you're mail it in, it has to be postmarked by January 31st. And you have to use these pre-printed official government forms and you usually find them at like the the major office supply stores. And if you have state income tax, you're also gonna have to send the appropriate forms to your State Department of revenues. 

So the other way that you can hire help, of course, is subcontractors. Now treating somebody as a subcontractor means that the person owns their own business and are responsible for their own taxes and for their tax reporting requirements. You may hire them to a job for you, but you cannot tell them how or when to work like you do employees. 

You're hiring their business. Probably the best example of using subcontractors is in the construction industry. A general contractor brings in a framing crew, plumbing crew, electrical company, painting company, and so forth, and then the general contractor gets paid for the entire job and in return pays each subcontractor from that. 

I mean, it'd be a nightmare to hire all of these trades as employees and have direct control of them all. The general contractor just contracts with the other businesses and gives them timeframes to get the job down. It's important that you get the difference between employee and subcontractor correct. 

If the tax authorities audit your return and determine you have expensed your labor as a subcontractor, but treated them like employees. They will reclassify them and hit you with the bill for all the back taxes you should have paid, plus penalties, plus interests. That hurts. 

Before a subcontractor works for you, you need them to fill out a IRS form W-9. This form accomplishes two things. First, it gives you their identification number, their name, their address to fill out the form, 1099-NEC, which is your responsibility. 

Second, they attest to the fact that you don't have to withhold taxes from the money you pay them. In essence, they're responsible for paying their own taxes, which helps protect you. Any subcontractor you pay more than $600 a year to must be given what's known as a form 1099-NEC, and NEC stands for non-employee compensation and it states the amount you paid them and it lists their identification number, whether it be their Social security or EIN. 

And their address. A copy of the 1099-NECs, along with their 1096 cover sheet is then transmitted to the IRS, showing that they're responsible for their own taxes and thus helping protect your business from reclassification. And again, these must be transmitted or sent by January 31st of each year. 

Now, many small businesses give 1099-NEC forms to all their subcontractors. They hire even those that they're paid less than $600 just to have a paper trail in case of an audit. Whether to hire employees or subcontractors really comes down to the type of business that you're in and how much control you wish to have over those who work for you. 

And knowing these guidelines should help you make better decisions on the right course of action for you. Be sure to follow them. 

One of the things that really has aggravated me when it comes to this classification thing is I see kids coming out of high school and they'll go out and they'll get a job, whether it's at a food truck or there's all kinds of different things, and they'll come in and they are doing taxes for the first time. 

This is great. And they're expecting a refund. And they hand me a 1099-NEC and I say, congratulations, you're in business for yourself. And they go, what? You mean I'm not getting a refund? I said, well, no, because you only get a refund if you're a W2 employee and they have withholding on it. You get back your withholding. 

When you get a 10 99 NEC, you're considered self-employed, so you actually are gonna owe taxes because you gotta pay your own taxes on the money you earned. And they freak out. I think it's absolutely horrible that there are unscrupulous people out there that are hiring people and not explaining this properly to them. 

They'll say Hey, you gotta sign this form, this W-9 if you wanna go to work for me. Fine. They just sign their name. They don't want it, it's not explained to them. They don't understand what they're signing. And this happens to them, and I hate to see it, but it's out there. So don't be one of those people. Okay. I'll get off my soapbox there. 

I'd like to take a moment to tell you about an experience I had this week. I spent two years writing a book and it explains all of this stuff in detail. I just barely touched the surface today on what could be learned. But when I wrote the book, I said, okay, my objective is to help people find a better way of building their business. And I recently had a father buy seven copies of the book. He bought one for himself and one for each of his children, and one of his children. And one of his sons is in business for themselves. 

And his dad was talking to me, he says, you know. I wish I had this book six years ago when I started my business. It would've made such a difference. I haven't made it all the way through the book yet, and what I have learned is saved me a lot of money on my taxes this year. And when he told me that, I says, wow, that's amazing. I mean, the 5 star reviews and everything else is nice, but when you actually hear from somebody that's read the book. And has gained from it and has been able to improve their business structure from it. It made it all worthwhile. I'm amazed by that and that's why I did it and I'm glad it worked. Anyway. 

Next week I'm going to get into ways people try to make. Extra money because over 70% of the people in this country say that they need a way to find some extra money. And there's all kinds of things out there from ride shares to delivering groceries, to multilevel marketing and all kinds of other things, which is a big waste of time. And you're not gonna make very much money or you're gonna lose money. And I'm gonna talk about why. It should be an interesting discussion, and I hope you'll join me for it. 

You have been listening to the Mastering Business Basics Podcast with your host, Roger Pearson. For more information about all of the business education options that are available, we invite you to visit seagulltechnologies.com and continue your journey.