Income Definition, Tax Penalties, and Record Keeping

The key learning points in this segment of the video are focused on owner withdrawals, the tax obligations of business entities, and the accounting for prepaid assets.

Owner's Draw and Equity

• An owner taking money out of a business for personal use is considered a withdrawal or an owner's draw, not a business expense.

• A withdrawal can involve taking cash out of the bank account or using the business account to pay a personal credit card.

• An owner's draw decreases the business's cash (an asset).

• The draw increases the owner's draw account.

• An owner's draw decreases the owner's investment (equity) in the organization.

• If too much capital is withdrawn from an entity like an S-Corp, the business can end up with negative equity, emphasizing the need to watch how much is taken out.

• An owner's draw for personal use is a transaction separate from the owner's official salary or payroll.

Taxes Paid by Business Entities

• Entities pay different types of taxes, including payroll taxes (federal and state), income taxes, and sales taxes.

• Business owners sometimes confuse sales taxes with income taxes, which are entirely separate.

• Payroll Taxes:

• Payroll taxes are based on earnings.

• Both the employee and the employer pay payroll taxes.

• For a sole proprietor or single-member LLC, the owner is both the employer and employee and must pay the entirety of the self-employment taxes (usually 15%).

• There are two portions of collected payroll taxes:

• The fiduciary (or trust) portion is the employee's part, which is collected by the employer on behalf of the government and does not belong to the employer.

• The employer's portion is what the employer owes.

• The IRS is more likely to work with an employer who fails to remit their portion of payroll taxes if they have remitted the employees' trust portion.

• Penalties and interest for unremitted payroll taxes are compounded over time.

• Employers must file forms such as the federal 941, state income tax return, and unemployment tax return, usually three to four tax forms at the end of each quarter.

• Sales Tax and Nexus:

• For online stores selling throughout the United States, nexus (physical or economic) determines where sales tax must be collected and remitted.

• Physical nexus exists if a business has a building in a state.

• Economic nexus may be created if a business sells a certain value (e.g., $100,000) of items to a state, requiring the business to file and remit sales tax there.

• In Iowa, services are generally not taxed unless they are "enumerated services" specifically listed in the Iowa code (e.g., cosmetology).

• In Iowa, sales tax returns must be remitted monthly unless the business qualifies for annual remittance. Once filed, the sales tax permit is active in perpetuity until the business requests closure or the state revokes the permit.

• Personal Income Taxes:

• Individuals generally file tax returns (1040s) annually.

• If an individual owes money and hasn't filed, there are taxes and penalties.

• If an individual files late (e.g., three years later) and the IRS owes them money, the IRS also owes interest (about 8%) on that money.

Accounting for Prepaid Assets

• Paying for an expense, like liability insurance, three months before it is due or earned creates a prepaid asset.

• A prepaid asset represents paying a future liability today.

• The transaction to create a prepaid asset by paying cash involves an asset-to-asset transaction: the cash asset decreases (credit), and the prepaid asset account increases (debit).

• As the benefit of the prepaid asset is used up each month (e.g., $500 of insurance used in January), two things happen:

• The prepaid asset is reduced (credit).

• An expense is created (debit).

• The prepaid asset account is reduced (zeroed out) by the end of the term.

• Association dues paid in advance, even if they include liability insurance, are considered a prepaid asset (prepaid dues or deposit) that is expensed monthly until fully used up. If the association itemizes the dues, the prepaid amount can be broken down and expensed as utilized.

Balance Sheet and Financial Analysis

• The balance sheet is a financial statement and tracker that summarizes assets, liabilities, and equity.

• The fundamental accounting equation is: Assets equals Liabilities plus Owner's Equity.

• Financial ratio analysis is used to analyze the relationship between accounts on the income statement and the balance sheet.

• A key relationship is between Accounts Receivable (AR) (a balance sheet account) and Revenue (an income statement account).

• An increase in revenue is expected to correlate with an increase in AR because the revenue is earned but not yet collected.

• An unexpected trend (e.g., revenue decreases while AR increases) suggests a potential problem or accounting error.

• Understanding the balance sheet and the income statement together is vital for making informed decisions for an organization.