Bookkeeping – Tracking Income Taxes (Lesson 58)
It is important for the bookkeeper to track income taxes for the business and the owners. Tracking includes apprising management of current status and pending obligations. In addition, the bookkeeper must make sure the payments are made to the correct authority for the proper amount and assigned to the appropriate federal identification number.
To fully understand this tracking process you must first gain an understanding of the different tax entities and how their income taxes are handled. Next, I will illustrate how the taxes are calculated and accounted for in the books of record. This provides the necessary information for status and pending obligations. Finally, I’ll explain the correct documentation procedure and payment process.
Income Taxes – Taxation of Different Entities
There is a mountain of literature on this subject matter. For the purpose of this lesson I will keep it concise and to the issue at hand. Each of the below entity statuses has certain tax attributes and a tax collection process.
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Sole Proprietorship
The most simple business entity status is the sole proprietor. It is designed for very small, single owner business operations and/or simple endeavors. Income taxes are paid at the individual level as there is no separate tax return filed. The owner simply attaches a Schedule C to his/her return explaining how the business performed. Any net income is taxed for both income and self-employment tax. This form of entity status can only have a single owner and income taxes are paid at that owner’s tax rate for both federal and state purposes.
Partnerships
One step up from the sole proprietorship is the partnership. It is by far the most flexible of all business entity forms. Partnerships are customarily owned by two or more individuals. But it is not unheard of for other entities (partnerships, corporations and trusts) to have an ownership position. This form of business files its own tax return (Form 1065) explaining to the government how it performed for the year. This entity format does not pay income taxes. The entity assigns its earnings or losses to the respective owners (partners) via Form K-1 based on the terms of the partnership agreement. Income taxes are paid by the owners at their respective tax rates. Those owners that actively participate in the day-to-day operations must also pay self-employment taxes.
S-Corporations
The S-Corporation is legally a regular corporation (which provides a veil of civil protection) with pass-through status for tax purposes. Similar to partnerships the corporation files an annual tax return, Form 1120-S, and submits Form K-1 for each shareholder to the IRS and to the Shareholder. Each shareholder is assigned their respective percentage of income or losses in accordance with their ownership position. There are more restrictions placed on management to maintain this tax status. Each shareholder pays income taxes at their personal tax rates on income assigned to them.
Corporations
Corporations are treated as an actual citizen in their state and therefore must be recognized as a taxable entity by the IRS. It must pay income taxes on its earnings. The company files a Form 1120 each year identifying its net income and gains generated. Both the federal government and state tax this income. There are several nuances involved with corporations but in general this type of entity is uncommon in small business due to double taxation.
Limited Liability Corporation
Limited Liability Corporations (LLC’s) are the newest and latest fad in ownership. In general, I do not endorse this form of existence because of the many legal complexities involved. However, lawyers are the biggest advocates and therefore they are everywhere now in small business.
The Internal Revenue Service doesn’t have a separate code section for LLC’s. During the application process for an employer identification number via Form SS-4, the owners or agent identify the tax entity desired. The authorized methods are as follows:
* Single member (owner) can request tax status as a sole proprietor or S-Corporation.
* Two or more members (owners) may select any one of the tax entity statuses except sole proprietorship. Depending on the industry involved, there are financial advantages for one form over another.
Trusts
This form of entity in small business is rare and extremely complex for tax purposes. With the goal of accounting for taxes, the trustee (manager) of the trust should consult with the CPA for advice in handling the tax issues.
Calculation and Accounting for Income Taxes
With the above variations of tax status almost every one of them has taxes paid at the individual level at that person’s personal income tax rate. For most citizens earning up to $100,000 per year in income, the tax rate is approximately 15%. Any money earned in excess is taxed at rates of 25% and higher. Think of it as a two tier formula.
In addition, if the owner does not receive a salary or some form of traditional compensation his income is also taxed for self-employment at 15.3%. Add in state income taxes and the cumulative tax rate can exceed 50% per this schedule:
Federal Income Tax @ 28% (2nd Highest Rate) 28%
Self-Employment Tax @ 15.3% 15.3%
State Income Taxes @ 6% 6%
Local Income Taxes (New York City) 1.25%
Total Cumulative Tax Rate 50.55%
Naturally 50% is the exception and not the rule. For those new business operations, I always encourage 35% to 40% as the minimum payment which includes 6% to the state. There are seven states that do not tax income at the individual level. Ask your CPA for your state’s maximum income tax rate.
Over time the individual rate will be based on the prior year’s maximum rate paid.
As an example, if the prior year’s federal income tax rate was 19%, then the minimum income tax payment for the current year is 19% on the net profit. Don’t forget to add 15.3% for self-employment taxes. Remember, there is most likely two different governmental entities paid – IRS for federal and the state’s department of revenue or taxation for state income taxes.
Now that you have been introduced to the tax formula, it is time to understand how the payments are accounted for in the books of record. There is a basic fact you need to understand, it is perfectly legal for a business to pay income taxes for the owners. Actually it is encouraged. The bookkeeper must properly calculate and document the payments. Before continuing, please read the following three terms and the definitions as they are used with the payment process.
Draws
Draws are payments made by either the sole proprietorship or partnerships (including LLC’s that chose either form of tax status) to the owner(s)/partner(s) or on behalf and directly benefiting (constructive receipt) the owner(s)/partner(s). A check written by the business to the IRS or to the state for that partner/partner’s tax obligation is considered a draw.
Distributions
Corporations pay out profits to shareholders by issuing dividends. S-Corporations do not use the term dividends, instead the IRS has dictated the use of the term distributions. Therefore, any payment made to a shareholder of an S-Corporation or to a third-party to benefit a shareholder is a called a distribution. Just like draws, a check written to the IRS or to the state as a payment for income taxes for a particular shareholder is a distribution.
* A side note to Distributions
Shareholders, especially owner/operators of S-Corporations, are often written checks for reimbursements, repayment of loans or for use of personal property. These dollar amounts are not considered distributions.
In principle draws and distributions are payments made from earned profits. They are recorded in either the income statement or in the equity section of the balance sheet. If recorded to the income statement, it is always after the final profit point. Since almost every small business is not a traditional C-Corporation for tax purposes, the income statement format is used for interim reporting to assist management in evaluating cash flows. Look at the following summary income statement for an S-Corporation with the distributions section in more detail.
XYZ, INC.
Summary Income Statement
Interim Report Date (Ex. End of Month/Quarter)
Revenues $ZZZ,ZZZ
Cost of Sales ZZZ,ZZZ
Gross Profit ZZZ,ZZZ
Expenses ZZ,ZZZ
Operational Profit ZZ,ZZZ
Costs of Capital Z,ZZZ
Profit $ZZ,ZZZ
Distributions (In Detail)
Shareholder ‘A’:
– Traditional Distributions $Z,ZZZ
– Tax Payments Z,ZZZ
Subtotal Shareholder ‘A’ Z,ZZZ
Shareholder ‘B’:
– Traditional Distributions Z,ZZZ
– Tax Payments Z,ZZZ
Subtotal Shareholder ‘B’ Z,ZZZ
Net Profit (Retained) $Z,ZZZ
This presentation format is never used for year-end reports or for financial statements provided to third parties (banks, creditors etc.). It is restricted to management and shareholder reports only.
The other method and most widely used and accepted is to report the information straight to the equity section of the balance sheet. Review the following equity section for the same company.
XYZ, INC.
Balance Sheet – Equity Section Only
December 31, 2015
EQUITY
Stock
Common Stock Par Value $1,000
Capital Paid in Excess 99,000
Subtotal Common Stock $100,000
Retained Earnings (Accumulated Thru 12/31/2014) 281,400
Current Earnings $207,149
Distributions
Shareholder ‘A’ (60% of Shares)
– Traditional Payments ($44,000)
– Tax Payments (52,000)
Subtotal Shareholder ‘A’ (96,000)
Shareholder ‘B’ (40% of Shares)
– Traditional Payments (29,333)
– Tax Payments (34,667)
Subtotal Shareholder ‘B’ (64,000)
Subtotal Distributions (160,000)
Retained Earnings (2015) 47,149
Total Equity $428,549
Most bookkeepers record distributions to one account to summarize the report presentation. A separate spreadsheet is used to provide details or the bookkeeper may set up the distributions account as a control account and design a separate report to break distributions out as illustrated.
No matter which method is used, the payments are debits to the respected account and typically a credit to cash. Use the chart of accounts to set up and organize the accounts. My experience has taught me that both methods should be used. During interim reporting periods the income statement method is ideal in providing month to month information. Use the 8000 or 9000 series account numbers to report draws/distributions.
At year-end, as a function of final adjustments, transfer the dollar values to a similar structure over in equity. This way the balance sheet is used to compare year to year shareholder distributions. The entry is a simple credit to the income statement account and a debit to the same account over in equity for the same shareholder.
As explained above, each owner/partner/shareholder have their own tax rates. To maintain equality between the owners/partners/shareholders use the highest tax rate amongst the group to calculate any tax payments. Typically tax payments are made in the current interim period (I recommend monthly) for the prior period’s profit.
To illustrate this, look at the following partnership schedule, their tax rates and the corresponding tax payment.
Partnership Schedule Profit for March 2016 – $39,741
Partner ‘A’ ‘B’ ‘C’ Total
% of Ownership 37% 13% 50% 100%
Federal Tax Rate 28% 15% 34% N/A
State Tax Rate 7% 7% 7% N/A
Self-Employment Tax 15.3% N/A 15.3% N/A
Totals 50.3% 22% 56.3%
Assigned Profit $14,704 $5,166 $19,871 $39,741
Federal Tax Payment 7,249 2,547 9,796 19,592 Note A
State Tax Payment 1,029 362 1,391 2,782 Note B
Traditional Draws 4,820 2,257 6,513 13,590 Note C
Retained Capital $1,606 -0- $2,171 $3,777
Note A – The federal tax payment is always at the combined rate of self-employment and the regular income tax rate. In this case partner ‘C’ has a combined rate of 49.3%. Therefore payments to the IRS are at this rate.
Note B – The state tax is equal across the board as a percentage of profit assigned.
Note C – The partnership agreement stipulates that active partners (‘A’ and ‘C’) may take 75% of any remaining balance of their earnings. The remaining 25% is retained for growth and investment. The retired partner (‘B’) is paid all remaining balance after taxes as a function of the partnership buyout. In effect, partner ‘B’ is retired and did not actively participate in earning revenue for the business.
In the above example, these payments are made in April 2016 based on March’s profit. Three different checks or payments are made for each partner for a total of nine entries. The following are Partner ‘A’s entries recorded to the general journal.
General Journal
Date ID Ledger Description DR CR
4/10/16 90041711602 ‘A’ Tax Payments Fed Tax Payment Online 7,249
5310101040 ‘A’ Tax Payments State Tax Online 1,029
2171 ‘A’ Draw Schedule P33116 4,820
2171 Checking April ‘A’ Draw 4,820
90041711602 Checking IRS Online ‘A’ Taxes 7,249
5310101040 Checking State Online ‘A’ Taxes 1,029
13,098 13,098
Notice the three separate entries; one for the IRS with the IRS transaction code as the ID; two, the state online payment with its online transaction ID and three, the actual check number written for the monthly draw. All three entries have a checking account credit as the offset.
In addition, at the end of each month, create a schedule similar to the draw schedule above for all the pending payments to be paid in the following month.
One of the interesting aspects of the draw schedule above is how all partner tax payments are at the highest partner’s rate. Some partnership agreements dictate this pattern and any overpayment of taxes are refunded to the respective partner each year after filing their tax return. But in many small businesses, especially professional firms, the tax withholding for the junior or smaller percentage owner is overwhelming and onerous for net draws (take-home pay). Some ownership agreements use a draw/distribution formula to pay taxes and traditional payments so that the combined amount equals the maximum profit draw/distribution amount allowed.
To calculate this correctly the accountant must first determine allowed amounts in accordance with the schedule above. The second step is to recalculate the allowed traditional draw/distribution based on the owner/partner/member’s tax rate. Look at the reformulated payments for the three partners:
Reformulated Tax and Draw Schedule
Partner ‘A’ ‘B’ ‘C’
Assigned Profits $14,704 $5,166 $19,871 Note D
Federal Tax Rate 43.3% 15% 49.3% Note E
State Tax Rate 7% 7% 7%
Federal Taxes $6,367 $775 $9,796 Note F
State Taxes $1,029 $362 $1,391
Allowed Draw $13,098 $5,166 $17,700 Note G
Final Net Draw 5,702 4,029 6,513 Note H
Retained Capital $1,606 -0- $2,171 Note I
Note I – Assigned profits are the amounts from the partnership schedule.
Note E – Carry forward from the partnership schedule, equals federal income tax rate plus self-employment tax rate.
Note F – Federal taxes are calculated at that partner’s (owner’s) tax rate on total assigned profit.
Note G – Allowed draw is equal to total taxes and traditional draw amounts per the partnership schedule.
Note H – Actual final draw is allowed draw less tax payments made at that partner’s (owner’s) tax rate.
Note I – Retained capital is allowed draw less all payments. It must match the retained capital per the partnership schedule.
With the reformulated tax and draw schedule notice both ‘A’ and ‘B’ take home more money? The net amount more closely matches a realistic and reasonable net compensation used in traditional payroll. Partner ‘B’ is retired and not actively involved in the business and therefore self-employment tax is not applicable to him. The above schedules are also used for distributions with S-Corporations. The only difference is that the active owners should already have payroll taxes withheld via the payroll. For more information on shareholder compensation read: Reasonable Shareholder Compensation. Therefore self-employment tax is not applicable in the formula and final calculations.
Income Taxes – Proper Documentation and Payment Process
When making payments to the IRS, simply go to their website irs.gov and click on making payments. The government uses a direct debit authorization process to complete the transaction from the company’s account. The owner or finance director must approve and authorize the payments. In the past I simply printed the payment schedule and hand wrote ‘I, Printed Owner’s Name, authorize the tax payments on MM/DD/Year for transfer to the respective tax authorities’. Then the owner signs. This authorizes the transfer.
The documentation process is straight forward. Once the actual transfer is complete, print a PDF and a physical copy. The PDF is stored in the shareholder’s directory for that respective year in either the federal tax payments folder or the state’s tax payments folder. Be sure to store a copy of the PDF in the draws/distributions folder under the accounting folder. The physical copy is presented as a batch to the owner for a recognition and confirmation signature. The owner should verify the correct name, social security number, dollar amount and sign both the federal and state payment vouchers. This takes care of two documentation requirements. First it reconfirms his authorization and secondly, the verification is an acknowledgement of the correct social security number. This way nobody can claim that you paid taxes for somebody else, a form of embezzlement. Scan this verification signature to your own personal directory and to the draws/distributions schedule for tax purposes. Mail the original to the owner’s CPA for their records.
If the payment is for the owner/partner/shareholder it is critical the social security number is correct. Verify the number forward and backwards several times throughout the payment process. Taxes paid for the company use a nine digit number but is organized with two digits as the prefix and seven digits as the extension. This number is called the Federal Employer Identification Number (FEIN) or EIN for short. Payments for the company are handled via the EFTPS (Electronic Payment System) and not directly at the IRS website.
A final step is to have a master draw/distribution Excel workbook with a separate spreadsheet for each owner/partner/shareholder. This sheet identifies all payments made on behalf of that owner. Record all payments made, date, online transaction ID number and amounts. Link to the stored document.
Summary – Tracking Income Taxes
There are many different legal and tax entity statuses in business. For the small business, all the income is passed from the company to the respective owners. The company reports this information using the Internal Revenue Service Form K-1. It reports income and other tax attributes to the owner/partner/shareholder and member.
Each person has their own tax rate (bracket) based on their personal situation. Taxes are different between the owners. It is wise for the business to track and pay these taxes on behalf of the owners as a function of their draws or distributions. The bookkeeper uses a two schedule system whereby the tax obligation is calculated at the highest rate among the owners. The the actual authorized draw/distribution sets the total amount each owner is allowed for the share of profits. The taxes are then calculated at that owner’s rate and paid to the Internal Revenue Service and their state. Any remaining balance of the allowed amount is paid directly to the owner.
It is important for the bookkeeper to properly track the tax payments made for each owner and convey this information to management, the owners and the CPA. ACT ON KNOWLEDGE.
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