The year 2020 has been quite a ride. For some small business owners, the end of 2020 is a chance to put a chaotic year behind them, and look forward to a bright 2021. For others, it’s stressful. Tax season 2021 is coming, and as you adapt to the effects of COVID-19 on small businesses, 2020 may have been an interesting year for bookkeeping. Plus, there are new tax considerations to take into account due to government relief.
But have no fear. Based on input from our team of experts at Bench, we’ve got the five steps you need to take to make tax season stress free and prepare you for the year ahead.
1. Organize your bookkeeping
Getting your bookkeeping organized for the year that’s ending will help you rest easy at night. You’ll know that all your numbers for the year add up, and that the information on your year-end financial statements is correct. That makes for a less stressful tax season.
One of the easiest ways to take care of your bookkeeping is to sign up for a remote bookkeeping solution. If you’re looking for a service provider to take care of your bookkeeping year round, and to help you skip the tax season crunch, I recommend Bench.
Double check all your transaction categories
Go back and make sure that every transaction you’ve recorded for the year is correctly categorized. If you made a categorization error in February, and then kept repeating that error, it could have a major impact by the end of the year.
For instance—let’s say you’ve been incorrectly categorizing credit card processing fees for your store as part of your overhead. That could give you a fluctuating monthly overhead expense; use it to make financial projections for the new year, and your numbers will be off. Fixing the problem now will save you trouble once the books are closed.
Balance the books
If you use the double entry method of bookkeeping, it’s essential that all your credits and debits match up. Otherwise, some accounts may actually hold less value than your books say.
You can do this at the same time you’re double checking your transaction categories. Each time an account is credited, make sure that another account is debited the same amount—and vice versa.
Reconcile your bank accounts
When you reconcile your bank accounts, you make sure your bank statements match up with your books. It’s how you ensure your books reflect reality—the real, tangible cash you have to work with.
Reconciling bank accounts is not complicated. Having said that, there are steps you need to follow to do it accurately. Bench has a helpful guide to bank reconciliation for your business.
Talk to a professional
Especially if this is your first time filing taxes for your business, it’s wise to enlist the help of a CPA. They can double check your books and make sure everything adds up, so your tax filing is accurate. What’s more, they may be able to identify tax deductions you’ve overlooked. That means your business will save more money in the new year.
Close the books on Dec. 31st
On the last day of the year, close the books. That means adding up all your numbers for the year, making sure everything is balanced, and preparing year-end financial statements. You’ll use those statements to file your tax return.
If you have a bookkeeper, they’ll close the books for you. They’ll also complete other preparation steps, like checking transaction categories and balancing the books.
2. Back up your itemized deductions with paperwork
If you’re claiming itemized deductions on your tax return, you need to make sure that each tax deduction is backed up by documentation. You’ll need those receipts to support your claims in the event that you’re audited. If you can’t prove that your deductions were valid, the IRS can penalize you.
Make sure you hold on to the following:
- Cash register tapes
- Deposit information (cash and credit sales)
- Canceled checks or other proof of payment/electronic funds transferred
- Credit card receipts
- Bank statements
- Petty cash slips for small cash payments
- Accounts payable and receivable
- Payroll records
- Tax filings
- Previous tax returns
- W2 and 1099 forms
- Any other documentary evidence that supports an item of income, deduction, or credit shown on your tax return
Receipts for business purchases are one of the most common types of business records. You should hold on to every receipt for at least three years. That’s the length of the statute of limitations—the amount of time the IRS has to audit you.
On every receipt you keep, be sure to list:
- The date
- What you paid for
- What the purchase was
If you’re writing off a business meal, be sure to list on the receipt who attended the meal, and the business-related topics you discussed.
The best way to keep track of expense records
A shoebox is not a filing cabinet. If you’re forced at the end of the year to sort through all your receipts and put them in order, it’s time to switch to a new system.
Going paperless cuts down on clutter and helps make sure nothing slips through the cracks. Apps like Expensify allow you to photograph and categorize your receipts, then upload them to the cloud—where they’ll be organized by type, and protected from hazards like sudden gusts of wind.
3. Set aside money for taxes
When you’re self-employed, it’s up to you to figure out how much you owe in taxes, and pay it to the IRS.
That may sound like a big responsibility. But don’t worry: A few shortcuts can help.
Follow the 30% rule
Generally speaking, be prepared to pay about 30% of your gross income to the IRS as taxes. If you’re going back retroactively to put together money for tax payments, get together 30% of your income for the year. (This is when it’s handy to have year-end financial statements—so you can easily see how much you earned for the year.)
Next year, save yourself the hassle of sorting out taxes retroactively: Set them aside as you earn.
Set aside taxes well in advance
There are three methods for setting aside taxes as you earn income: Per-payment, monthly, and yearly.
Per-payment works well if you invoice clients. Every time a client pays you, take 30% and set it aside for taxes.
Monthly is best if your business goes through a lot of transactions every month—for instance, if you run a bustling ecommerce business. In that case, each month, set aside 30% of your gross income.
The yearly approach only makes sense if your business is small, you earn income infrequently, and you don’t need to make estimated quarterly payments. If your business is still in its side hustle phase, it may be okay to go back and set aside cash at the end of the year. Still, there’s no reason you can’t start using the monthly or per-payment method now—it’ll establish good habits for later on, when your business grows and your income is higher.
Create a separate account
Dipping into your tax savings is a major no-no. You don’t want to come up short at the end of the year, unable to pay your taxes. The best way to keep your tax withholdings separate from the rest of your income is to create a separate savings account. That way, you’ll know exactly how much you have—and you’ll be less tempted to spend it.
4. Get up to date on 2020 tax changes
“May you live in interesting times,” goes the old curse. For all Americans, including small business owners, 2020 has been an interesting time. And it even affects your tax filing.
Depending on how much COVID-19 relief you received this year, you may have some extra steps to complete when you calculate your how much tax you owe. On top of that, the IRS has introduced a new tax form for contractors—The 1099-NEC.
Meet Form 1099-NEC
Up until 2020, if you hired a contractor at some point during the year and paid them for than $600, you’d report that pay by filing a Form 1099-MISC. Two copies, in fact.
Copy A would go to the IRS. And Copy B would go to your contractor—they’d use it to calculate their tax obligations at the end of the year.
In 2020, instead of filing a Form 1099-MISC for contractors, you need to file a Form 1099-NEC. This new form covers all of the same functions as the old one, reporting the money you paid to a contractor during the year.
Form 1099-MISC is still around—but you use it for different, non-contractor income, like rent.
If you’re already familiar with filing Form 1099-MISCs, then this new form shouldn’t give you a headache. But to make sure you understand all the ins and outs, be sure to take a quick jaunt through our 1099-MISC and 1099-NEC guide.
Delayed tax filings in 2020
Because of the pandemic, the IRS changed tax filing and payment deadlines for 2020. On top of that, the deadline for paying your 2019 taxes was pushed to July 15, 2020.
Most of the changes applied to your first and second quarterly estimated payments for 2020—and those are long past. But to make sure you’re on the right track, check out this guide to New US Tax Deadlines for 2020.
How to report COVID-19 relief on your taxes
If you received COVID-19 relief this year, you’ll have to report the income. Whether you’re taxed on this income, and how it otherwise affects your filing, varies from payment to payment. The three big COVID-19 relief payments are the Paycheck Protection Program (PPP), the Economic Injury Disaster Loan (EIDL), and the Employee Retention Credit.
We’ll touch on each of these below, but for the full rundown, check out Bench’s full guide to COVID and 2020 taxes.
Reporting PPP on your taxes
The PPP is attractive because it can be totally forgiven, providing you spend most of it on payroll, and the rest on mortgage interest, utilities, and rent.
The money you receive from PPP isn’t taxed, that’s why it’s attractive. But there’s a catch.
Nothing you spend from PPP can be reported as a tax deduction. For instance, normally you’d be able to deduct rent as an expense on your taxes. But if you use the PPP to cover six months of rent during 2020, you can’t report that money as a tax deduction.
In the future, this may change—some lawmakers are opposed to this provision. They’re pushing to let small business owners benefit from both the tax-free PPP money and the cash they’d normally saved on deductions. It’s hard to say what the future will look like. But, for now, it’s best to follow the rules.
Reporting EIDL on your taxes
As a loan, the EIDL doesn’t impact your taxable income. There’s one exception, though: The EIDL advance.
The EIDL advance is effectively a grant to your business of $1,000 per employee, up to a total of $10,000. And, while the EIDL as a loan isn’t taxable, the money you receive in grant form is.
This isn’t 100% certain at the moment. The IRS hasn’t made any official announcements about EIDL grants specifically. But they’ve been clear that any forgiven Small Business Association (SBA) loans should count towards your total income, and the EIDL is an SBA loan. It’s wise to play it safe.
There’s a silver lining: You can report deductible expenses you pay for with your EIDL advance. In this way, it doesn’t suffer the same limitations as PPP.
The Employee Retention Credit and your taxes
If you have fewer than 500 employees, and in 2020 your business either
- Had to suspend operations due to an enforced lockdown, or
- Experienced a 50% decline in gross receipts compared to the same period last year
You can take advantage of the Employee Retention Credit. This credit reduces your tax burden on a dollar-by-dollar basis. It’s calculated per employee, and is up to 50% of qualified wages per quarter (to a max total of $10,000.)
You won’t have to wait long on this one, either. You can claim the tax credit on your quarterly filings with IRS Form 941.
Unemployment and your taxes
If you collected unemployment benefits in 2020, their value is taxed as income. Your state labor office will give you a 1099-G slip. This lists how much you were paid and how much—if anything—was automatically withheld as taxes.
You can pay taxes on unemployment two ways. One is to make quarterly payments throughout the year, as you would with any other income. The other is to file a Form W-4V, and have the government automatically withhold tax payments for you.
COVID relief and your 2020 bookkeeping
Regardless of what kind of relief you may have received this year, you still need to be 100% on the ball when it comes to tracking income and deductions. Disorganized bookkeeping can lead to all kinds of pitfalls that could lend you in hot water with the IRS, or with lenders like the SBA.
Talk to one of our in-house professionals about how Bench can set you on the right track for 2021.
5. Get the new year off to a great start
This New Year’s Eve, make a resolution to run your business more smoothly and effectively than you did the year before. Here are a few simple steps you can take to make it happen:
- Do an internal audit.
Don’t let the word “audit” scare you. An internal audit looks at your accounting processes and operations, and makes sure that everything is running as efficiently and cost-effectively as possible.
Taking time to review your standard practices—how and when you record transactions on the books, how you store your business records, your invoicing cycle—can highlight ways to improve. That could mean entering sales on the books nightly, instead of weekly. Or, it could mean putting a whole new accounting system in place. Either way, your business will benefit.
- Prepare financial reports
If you haven’t been disciplined about preparing financial reports, now is the time to start. Make sure that, by the end of January, you’ve got an income statement, cash flow statement, and balance sheet for the month. Then rinse and repeat: Your aim is to have accurate, up to date financial reports for every month of the year.
These taxes won’t only make it easier to file your taxes at the end of the year. You’ll have all the information you need to make informed business plans—like deciding how to reinvest income, or where to reduce expenses. That could mean more profit for your business in the long run.
- Put together a financial forecast
When you create a financial forecast, you look at how your business has performed in the past, then project that performance into the future. It helps you prepare for events to come, and see where your business will end up depending on which business moves you make.
Once you’ve created a financial forecast, you can refer to it throughout the year to help you make business decisions. For instance, a forecast can help you identify your busy and slow seasons, and how investments in your business will pay off. That could affect everything from your operating hours during certain times of the year, to whether you take out a loan to expand your business.
Bench’s guide to financial forecasting is straightforward, and includes examples you can use to create your own forecasts.
This year has presented some challenges. But by taking five straightforward steps at year end, you can make sure 2021 goes smoothly.
Part of your job is wrapping up the previous year’s accounting neatly, and making sure everything adds up and makes sense. Then you’re ready to file your taxes, or have BenchTax do it for you. Get 30% off your first 3 months when you sign up for Bench using this link.
The other part is putting processes in place to make sure next year is off to a good start.
Author: Bryce Warnes
Bio: Bryce is a writer for Bench, the online bookkeeping service that pairs you with a team of professional bookkeepers who do your bookkeeping, so you don’t have to.