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27 December 2019 / Accounting Tips

What is Tax Accounting? Everything You Need to Know

27 December 2019 > Accounting Tips

For United States citizens earning income, tax accounting is unavoidable. Investopedia defines tax accounting as “a structure of accounting methods focused on taxes rather than the appearance of public financial statements. Tax accounting is governed by the Internal Revenue Code, which dictates the specific rules that companies and individuals must follow when preparing their tax returns.” In other words, it’s a process that accounts for taxes owed and paid that must be calculated according to tax rules.

Accounting for taxes owed and paid sounds simple enough, but if you’ve skimmed through the Internal Revenue Code, you know there’s more involved. Tax laws are complex. Figuring out what taxes are owed can be challenging. There’s a reason it takes tax professionals several years to become adept at preparing returns for complex tax situations.

There are more than 800 tax forms and schedules, and you have to use the correct forms or your return will be rejected. For instance, simply withdrawing money early from a 401(k) can throw you for a loop if you’ve never had to file form 5329. If you’ve always done taxes manually, you’ll probably know your withdrawal counts as income but you won’t know about the 10% penalty. You might make the mistake of counting it as income on your 1040. Many individuals and small businesses have their returns prepared by experts to avoid these costly hassles. One mistake could flag someone for an audit, and if they prepared their own taxes, they’ll need to hire someone to help.

Tax accounting shows the government you’ve paid proper taxes

The government wants to know each tax payer has met their legal obligation to pay federal taxes. Tax accounting provides this proof.

The majority of U.S. citizens are required to file a federal tax return with the IRS to show how much money they made during the previous tax year, and how much federal income tax they paid. Most people are also required to file a state return, except for residents in states that don’t collect state income tax like Texas, Florida, Washington, and Nevada.

Not everyone needs to file a tax return. The Internal Revenue Service sets income thresholds that determine if a person is required to file. The income threshold is different for each filing status. For example, in 2019, the threshold for filing single is $12,000 and $25,300 for married couples 65 or older filing jointly. The threshold for the self-employed is $400. If a person makes less than the threshold for their filing status, they don’t need to file.

The nitty gritty of tax accounting

Tax accounting is focused on taxes and deals solely with financial transactions that affect taxes. It’s more involved than general financial accounting. For individuals, the process involves looking at income, qualifying deductions, and investment gains and losses. For real estate investors, this includes calculating income on all rental properties. If income and expenses don’t affect an individual’s tax liability, it’s not considered while preparing their return.

Individuals generally have an easier time with tax accounting compared to businesses, but many still choose to have a professional prepare their return.

For a business, tax accounting can be quite complex. Despite the complexity, businesses with a highly organized financial tracking system will have an easier time with their taxes. Company earnings, income, donations, and expenses all must be tracked to the penny. Qualifying business expenses are especially important to track since that’s what gets deducted to lower tax liabilities.

Businesses face additional situations that increase the complexity of their tax situation. Paying shareholders, contractors, employees, and making donations are all accounted for differently. The type of business entity makes a difference, too. For example, a business might be registered as tax-exempt, a C corporation, an S corporation, or an LLC, and taxes are handled differently for each.

Some business entities pay more taxes than others

With a C corporation, business profits are taxed at the corporate level first, then at the individual level. This is known as “double taxation.” For example, a C corporation must pay income tax at the corporate rate prior to distributing profits to shareholders. The 2017 Tax Cuts and Jobs Act reduced corporate tax from 35% to 21%. Once corporate tax has been paid, dividends are distributed to shareholders. Once shareholders receive their dividends, each shareholder must pay income tax at their individual rate.

An S corporation doesn’t require the corporation pay income tax before distributing profits, and neither does an LLC.

Critics say double taxation encourages businesses to use debt financing rather than equity financing since interest payments are tax deductible and dividend payments aren’t. They also say double taxation isn’t fair because it encourages businesses to hold onto earnings rather than distribute them to shareholders. Some businesses bypass the extra taxes by providing shareholders with profits in the form of wages, which are a deductible expense.

Tax-exempt organizations aren’t exempt from tax accounting

All organizations must file a return each year, even if they’re tax exempt. The government wants to know how much income a tax-exempt organization is generating in the form of donations, grants, and other funds. The government also wants to know how those funds are being used to make sure the organization is following state and federal laws pertaining to their tax-exempt status. According to the IRS, it’s easy for a 501(c)(3) organization to lose its tax-exempt status without trying. For instance, a non-profit organization will lose tax-exempt status for failing to file a return for three consecutive years. In 2011, the IRS published a list of 275,000 organizations that lost their tax-exempt status for this reason.

Many individuals and businesses hand off their taxes to a pro

A tax situation doesn’t need to be complex to be confusing. The 2017 Tax Cuts And Jobs Act changed the way everyone files their tax returns. For example, the personal exemption was removed and the standard deduction was nearly doubled. Self-employed individuals, including independent contractors, can still itemize business expenses, but employees can’t.

While many businesses and individuals could probably do their own taxes, it’s easier and safer to hand them off to a professional. Tax companies often provide guarantees that a return will be filed correctly, so if a mistake is made, the company takes on the responsibility of fixing it.

It costs money to have taxes prepared by someone else, and most tax firms charge by form. For example, if all you need to file is a 1040, you’ll pay the same amount as anyone else filing with just a 1040. However, if you need to file additional forms, your cost goes up. However, it’s a small price to pay for the peace of mind you’ll get knowing that company will fix mistakes and some will help you deal with the IRS in case of an audit.

Even professional accounting firms outsource tax return preparation

Individuals and corporations aren’t the only ones taking advantage of outsourcing their tax prep. Accounting firms have begun outsourcing tax return preparation, too. Tax preparation outsourcing provides firms with relief during the busy tax season, and frees up staff members for other important tasks. Outsourcing tax prep also allows a firm to continue taking on new clients without having to hire new employees. It makes a firm more profitable, while freeing up teams to focus on developing client relationships.

Outsourcing your tax prep with Taxfyle puts your clients’ returns in the hands of licensed professionals. We provide immediate pricing and time estimates based on answers to our onboarding questionnaire. Our prices are 40% cheaper than retail tax services. We can handle as many returns as you can send, and you can rest easy knowing everything you send us is fully encrypted.

Whether you’re a business or an individual looking for a quick and professional way to get your taxes done, contact us to learn more about how we can help.

Antonio Del Cueto

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