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Category: Accounting Terms & Definitions

Running a construction business involves much more than just overseeing projects; it requires diligent financial management and accurate accounting to ensure the company’s financial health and success. In the construction industry, where profit margins can be narrow, efficient construction accounting is essential. This article outlines eight crucial steps to help construction companies navigate the complexities of construction accounting effectively.

How Construction Accounting Differs

Accounting for Construction Companies

Accounting in the construction industry presents unique challenges compared to other businesses due to the intricacies of the field. These differences stem from the nature of construction work, specific revenue recognition methods, per-project pricing structures, job costing intricacies, fluctuating operating expenses, and various aspects inherent to construction projects.

Construction companies face a range of distinct requirements, necessitating the ability to meticulously track precise costs, competitively bid on projects, adhere to prevailing wage regulations, and manage a host of other accounting responsibilities. Here are the key distinctions that set construction accounting apart from other forms of accounting:

Project-Based

Construction enterprises operate on a project-by-project basis, often managing multiple projects simultaneously. Unlike businesses where payment typically aligns with the completion of a transaction, construction projects follow diverse payment schedules. Some may require upfront deposits, while others might entail full payment upon completion, or settlements that occur months after project finalization. Consequently, construction companies may find it necessary to generate individual profit and loss (P&L) statements for each project.

Diverse Services

In contrast to conventional businesses that usually offer a limited range of products or services, construction companies provide a wide spectrum of services. This can encompass service work, design services, consulting, engineering, material sourcing, and more. This diversity makes it challenging to track expenses accurately and calculate profits associated with each service category.

Fluctuating Overhead Costs

Construction firms experience fluctuating overhead expenses encompassing insurance, travel, workers’ compensation, materials, subcontractor fees, equipment, and various other factors. These costs must be meticulously considered in construction accounting, both at the project level and for the overall business.

Cost of Goods Sold

Unlike many businesses that primarily record the cost of products sold, construction companies have a more complex landscape. Each project incurs both direct and indirect costs that can fall into a wide array of categories. Consequently, contractors must employ effective methods for monitoring income and expenses while ensuring meticulous reconciliation of every financial transaction.

Long-Term Contracts

Construction companies often manage contracts with varying durations, including both short-term and long-term commitments. This diversity in contract timelines means that income may not arrive at consistent monthly intervals. To effectively manage cash flow and maintain accurate financial records, construction businesses require a flexible yet organized accounting system.

How to Do Construction Accounting

1. Understand Construction Accounting

Construction accounting is a specialized branch of accounting that caters to the unique financial needs of construction companies. It involves tracking construction project costs, managing revenue recognition, handling cash flow, and complying with industry-specific accounting methods and regulations.

2. Set Up Your Accounting System

To kickstart your construction accounting journey, you need a robust accounting system. This system should allow you to track business finances accurately. Key components include:

     

      • Business Bank Account: Open a separate business bank account to keep your personal and business finances distinct.

      • Accounting Software: Consider using construction accounting software tailored to the industry’s needs. Several options are available that can help streamline bookkeeping and financial management.

      • Chart of Accounts: Develop a comprehensive chart of accounts that categorizes income, expenses, assets, and liabilities specific to construction.

    3. Choose an Accounting Method

    A construction company can use either the cash method or the accrual method for accounting. The cash method records transactions when money changes hands, while the accrual method records transactions when they are incurred, regardless of when the payment is received. Select the method that aligns with your business operations and financial goals.

    4. Implement Job Costing

    Job costing is a fundamental concept in construction accounting. It involves tracking all costs associated with individual construction projects. This includes material costs, labor costs, equipment costs, and overhead costs. Job costing enables you to monitor the profitability of each project and make informed decisions to protect your profit margins.

    5. Recognize Revenue Accurately

    The construction industry often uses two revenue recognition methods: the percentage of completion method and the completed contract method. The percentage of completion method recognizes revenue based on the project’s progress, while the completed contract method recognizes revenue only when the project is completed. Choose the method that best suits your business and complies with industry standards.

    6. Track Project Expenses

    Managing project expenses is critical for maintaining financial health. Keep a close eye on direct and indirect costs, such as labor costs, material costs, administrative costs, and mobilization costs. Accurate tracking of expenses allows you to monitor project profits and make necessary adjustments.

    7. Monitor Cash Flow

    Cash flow management is essential in construction accounting. Since construction projects often involve substantial upfront costs, it’s vital to ensure you have the necessary liquidity to cover expenses. Regularly review your cash flow statements to identify potential cash shortages and plan accordingly.

    8. Stay Compliant

    Construction companies must adhere to various regulations and prevailing wage requirements, which can vary by location. Stay informed about these requirements and ensure your accounting practices are compliant with industry and legal standards.

    Construction accounting plays a pivotal role in the financial success of construction businesses. With accurate accounting, you can track project costs, manage cash flow, and make informed decisions to protect narrow profit margins. By understanding the unique challenges of construction accounting and implementing these eight essential steps, you can set your construction business on the path to financial stability and long-term success.

    Strategies for Effective Receipt Management

    Tips for Managing Your Construction Accounting Processes

    Here are some valuable steps to kickstart your construction accounting journey, ensuring that your bookkeeping and financial management stay on the right track:

    1. Segregate Personal and Business Expenses

    For construction firms, the initial crucial step is to establish a separate business bank account exclusively dedicated to your business finances. This separation streamlines financial management and organization. To initiate a business bank account, you will typically require a social security number or employer identification number (EIN), personal identification (such as a driver’s license or passport), a copy of your business license, and relevant organization documents filed with the state.

    2. Break Down Project Costs with Job Costing

    Given the project-centric nature of construction accounting, adopting a job costing system is essential. Job costing allows you to meticulously track, categorize, and report financial transactions for each project. This method ensures accurate accounting for profitability on a per-contract basis, helping you ensure that your service prices adequately cover all overhead expenses. Job costing involves calculating the cost of labor, materials, and overhead for each specific project, represented as Total Job Cost = Direct Materials + Direct Labor + Applied Overhead.

    3. Record Day-to-Day Financial Transactions

    Use various tools such as journals, spreadsheets, or construction accounting software to document daily transactions, encompassing accounts payable, accounts receivable, labor costs, and material expenses. Ensure that each transaction includes a description, transaction date, and revenue received. Utilizing construction invoice templates can simplify billing for clients and maintain a comprehensive paper trail of all construction projects and generated revenue.

    4. Select Appropriate Revenue Recognition Methods

    Revenue recognition in construction accounting differs from regular business accounting due to the industry’s nature. For companies handling long-term contracts, two primary revenue accounting methods exist:

       

        • Completed Contract Method: Under this method, contract revenue recognition occurs upon project completion.

        • Percentage of Completion Method: Revenue recognition is based on the percentage of project completion within the fiscal year, calculated by comparing incurred expenses allocated to the contract during the year to total estimated costs. Generally, construction businesses with gross receipts exceeding $10 million must use the percentage of completion method for tax purposes. Those with gross receipts below $10 million can apply the completed contract method for projects lasting less than two years but must use the percentage of completion method for longer projects. Generally accepted accounting principles recommend using the percentage of completion method for financial statements.

      5. Track Business Expenses

      Categorize expenses by service and individual job to facilitate tracking of both income and expenditure. Employ an expense tracker and keep receipts to monitor expenses and project profits for each job. Common construction industry expenses encompass

      • business registration and licensing,
      • bank fees,
      • tools and equipment,
      • travel expenses (including fuel),
      • electronics,
      • trade school tuition,
      • vehicle maintenance,
      • phone and internet costs,
      • lodging,
      • software subscriptions,
      • membership fees (unions and associations),
      • mileage (for tax purposes),
      • insurance, lease payments,
      • safety equipment and uniforms,
      • subcontractors,
      • employee payroll,
      • advertising, and marketing.

      6. Reconcile Bank and Supplier Statements

      Regularly reconcile bank statements with your own accounting records, invoices, and payments. This process involves comparing bank records to expense receipts, identifying any discrepancies, and ensuring alignment between your construction accounting system and your bank account. Address any inconsistencies by contacting your bank.

      7. Pay Estimated Taxes

      Construction companies typically pay estimated quarterly taxes, with various methods available, including Electronic Federal Tax Payment System (EFTPS) enrollment, online payments via the IRS website, debit or credit card transactions, or mailing checks or money orders to the IRS.

      Your choice of a tax calculation approach can include a “completion percentage” method, which calculates taxes based on quarterly income and expenses, or a “completed contract” method, which assesses taxes owed on each individual contract. A reliable accounting strategy should be chosen to minimize confusion during tax time, and professional assistance may be advisable.

      8. Consider Hiring an Accountant (Optional)

      While managing construction accounting independently is possible, the complexities of owning a construction company may lead to costly accounting errors. Similar to having project managers overseeing job sites, employing a professional accountant to handle various transactions across different jobs and services can be beneficial.

      Accountants provide clarity on financial data, manage books, generate reports, estimate quarterly tax payments, maintain cash flow, and safeguard narrow profit margins. 

      9. Leverage Construction Accounting Software

      To elevate your construction accounting beyond manual methods and spreadsheets, consider utilizing construction accounting software. This software streamlines tasks such as online invoicing, expense tracking, payment monitoring, financial report generation, and more. Clients tend to have greater trust in businesses employing accounting software due to its secure and convenient online payment capabilities. Additionally, construction accounting software equips you with the necessary tools to manage accounting effectively and make informed financial decisions.

      Efficient construction accounting is imperative for the success of construction companies. It goes beyond project oversight, serving as the linchpin for financial health and long-term viability in an industry known for its tight profit margins and intricate project intricacies. The unique challenges of construction accounting, from specialized revenue recognition to complex job costing, demand meticulous attention and adherence to industry standards.

      To navigate these complexities, construction companies should adhere to the eight crucial steps outlined in this article, which include understanding construction accounting nuances, setting up a robust accounting system, choosing the right accounting method, implementing job costing, and monitoring cash flow.

      Additionally, practices like segregating personal and business expenses, reconciling statements, and utilizing construction accounting software can bolster financial stability and foster trust with clients.

      Reconcile Bank and Supplier Statement

      Construction accounting is the backbone of a thriving construction business, safeguarding profit margins and ensuring long-term prosperity. By embracing its intricacies and following the prescribed steps, construction companies can fortify their financial foundations and thrive in this dynamic and challenging industry.

      Frequently Asked Questions (FAQs) on Construction Accounting:

      1. What makes construction accounting different from other forms of accounting?

      Construction accounting differs due to the project-based nature of work, diverse revenue recognition methods, fluctuating operating expenses, job costing intricacies, and the need to manage revenue recognition across long-term contracts.

      2. What are the primary challenges faced in construction accounting?

      Construction accounting faces challenges like managing diverse services, fluctuating overhead costs, accurately tracking costs of goods sold, dealing with long-term contracts, and reconciling project-based revenue recognition.

      3. How do construction companies manage project-specific finances effectively?

      To manage project finances, construction companies employ job costing to track costs associated with individual projects, recognize revenue accurately based on project completion, and monitor cash flow meticulously.

      4. Which accounting methods are commonly used in construction accounting?

      The two primary revenue recognition methods in construction accounting are the percentage of completion method (recognizing revenue based on project progress) and the completed contract method (recognizing revenue upon project completion).

      5. Why is segregating personal and business expenses crucial in construction accounting?

      Separating personal and business expenses is essential to maintain financial clarity, streamline accounting processes, and ensure accurate financial reporting, especially for tax purposes.

       

      What Is the Hobby Loss Rule?

      If your business goes too many years without making a profit, it can be classified as a hobby. When it becomes a hobby, you can no longer claim losses as business deductions. Any expenses associated with your business in an effort to make a profit may be deducted.

      In order to determine if you are running a business or a growing hobby, the Internal Revenue Service (IRS) looks at the following qualifications:

      • Do you put in the time to turn a profit?
      • Have you made a profit in the past?
      • Do you have the necessary knowledge to succeed in your field?
      • Do you depend on the income from this activity?
      • Were your losses beyond your control?

      If your business doesn’t turn a profit for 3 out of 5 years (except in specific industries, like horse racing) then it is classified as a hobby, according to the hobby loss rule, and you can no longer claim tax deductions against other revenue.

      If you want to reverse the IRS’s decision about your business, then you have to prove your intention was to make a profit. Keep extensive files showing where you spent your money and how it was imperative to your business.

      If you try to claim your hobby as a business then it could trigger an IRS audit. Only claim deductions if you are actually running a business. For more clarification on what constitutes a business or a hobby, the IRS has put out a helpful guide you may want to read.

      Who Does the Hobby Loss Apply To?

      The hobby loss rules work to prevent any hobbyists from taking advantage of the tax benefits of businesses. Business entities that the Hobby Loss Rule applies to are S-corporations, individual business owners, business estates, and partnerships. Most companies that possess the responsibilities for any liabilities incurred by the business that land on the owner of the business can be affected by the Hobby Loss Rule. C-corporations are exempt from the Hobby Loss Rule because of the adjusted gross income threshold of 2 percent for C-corporations.

      Hobby Loss Rule Scenario: When Does the IRS Consider Your Business a Hobby?

      To better illustrate the impact of the hobby loss rule, I have a scenario that many of our clients can relate to.

      Janet is the blogger and owner of a lifestyle blog. She’s been blogging for 5 years. Over those years she’s claimed her blog as a business on her taxes. The first 2 years she did not make a profit. The third and fourth years she did bring in some money from her blog. This year Janet is hoping to make a profit again so that her blog isn’t classified as a hobby.

      Janet’s blogging expenses for her fifth year in business were:

      • Website hosting
      • Website domain
      • WordPress theme
      • Purchased ad space on other blogs
      • Blogging conference tickets and travel expenses
      • 3 online courses
      • Photoshop subscription

      Janet brought in money from the following avenues:

      • Selling ad space on her blog
      • Several sponsored campaigns
      • Paid social media posts

      Unfortunately, Janet’s expenses outweighed her income and she reported another loss. According to the hobby loss rule, her blog is now considered a hobby, not a business.

      Janet still wants to run her blog like a business. She is going to try to prove that she ran her blog with the intent to make a profit. Janet will show that she intended to make a profit by attending a conference to increase her knowledge. She also kept strict records showing her business expenses. She can submit these to try and still claim her deductions.

      The IRS will have to determine if Janet’s blog can still be considered a business, but her careful records will benefit her in making a case.

      Prevent Your Business from Becoming a Hobby

      If you are an owner of a newly established business, keep track of your business plans, receipts, and records. While we all hope to start turning a profit after the first few years in business, life can be unpredictable. Having these records in place can help you make your case that your business is a legitimate business, and you deserve the benefits that come with it.

      If you need help with your business taxes or finances, reach out to our team. We specialize in helping small business owners save time, money, and stress on their taxes and accounting.

       

       

      We work with small business owners and entrepreneurs. Some are seasoned, others are just growing their side hustle. Their skills are varied and they have a wide variety of talents. We often get asked to explain the ins and outs of financial reports and have found that providing our favorite clients with a working knowledge of accounting terms is helpful. With that end in mind, we’re sharing that expert knowledge with you. So if you’re looking to get a better grasp on your small business books, want to understand your financial reports so you can make better business decisions, or even are just starting out and want to do it right… you can check out our word of the week and start expanding your working financial knowledge.

      What Are Cost of Goods Sold (COGS)?

      The Cost of Goods Sold (COGS) is is simply the amount it costs to produce your product or provide your offered services. You may have even heard your bookkeeper or accountant refer to COGS as the cost of sales or services. COGS include both the material and labor expenses that go into production of each good or service sold, so be sure not to leave either piece out.

      COGS don’t include indirect expenses like utilities for your building, your marketing expenses, or shipping fees – it’s merely the cost of what it takes to make your product – we’re talking raw material and direct labor on this one. Here’s a simple formula that will give you COGS:

      COGS = Beginning inventory + Purchases During the Period – Ending Inventory

      Beginning inventory is whatever is left over from the previous accounting period (usually monthly).

      Purchases during the period is on the direct labor or raw materials that were paid for during the accounting period.

      Ending Inventory is whatever product you haven’t sold by the end of the accounting period.

      We mention monthly accounting above, but your particular business could run accounting periods either monthly, quarterly or by calendar years. Make sure you know and take that into account as you’re figuring you’re COGS.

      How Does Knowing Your Cost of Goods Sold Help?

      To be able to know if you business is turning a profit, you’ll need to know your COGS. Additionally, knowing your COGS can help you better determine the pricing structure for your products or offered services. You’ll also be able to use the number you have for COGS to help you figure out your business’s gross profit or the amount your business earns from your products and services before taking out taxes and other expenses.

      If you’re not already tracking the numbers you need to computer your cost of goods sold, it’s time to start. Doing so will help you figure out your COGS as well as help you make your business incredibly profitable.

      We work with small business owners and entrepreneurs. Some are seasoned, others are just growing their side hustle. Their skills are varied and they have a wide variety of talents. We often get asked to explain the ins and outs of financial reports and have found that providing our favorite clients with a working knowledge of accounting terms is helpful. With that end in mind, we’re sharing that expert knowledge with you. So if you’re looking to get a better grasp on your small business books, want to understand your financial reports so you can make better business decisions, or even are just starting out and want to do it right… you can check out our word of the week and start expanding your working financial knowledge.

      What Are Operating Costs?

      Operating costs can fluctuate, but knowing what they are and tracking them month to month can do a lot when it comes to running your business. So what are operating costs?

      Operating costs are one of two types of business expenses. These costs are are closely related to making products and performing services and can include:

      • cost of shipping your products to a distributor or the shipping you pay to receive your raw materials
      • cost of your raw materials
      • manufacturing supplies (equipment or materials used to produce the product or service)
      • labor of employees (or your time if you’re a solopreneur)

      How Does Knowing Your Operating Costs Help?

      Just knowing your operating costs isn’t enough. As mentioned before, these costs can fluctuate and tracking it over time can help you see trends and plan for the upcoming year. In addition, understanding operating costs can help you determine the price for your product or service. Charging too little could mean that your profit would be small; or worse, that you’re operating with a deficit meaning you’re not making any profit at all. Plus, knowing and tracking your operating costs can help you claim some of them as a deduction come tax time – meaning you’re not only doing good business, but you’re being smart about it.

      We work with small business owners and entrepreneurs. Some are seasoned, others are just growing their side hustle. Their skills are varied and they have a wide variety of talents. We often get asked to explain the ins and outs of financial reports and have found that providing our favorite clients with a working knowledge of accounting terms is helpful. With that end in mind, we’re sharing that expert knowledge with you. So if you’re looking to get a better grasp on your small business books, want to understand your financial reports so you can make better business decisions, or even are just starting out and want to do it right… you can check out our word of the week and start expanding your working financial knowledge.

      What Is An Overhead Expense?

      First things first. If you’re wanting to know more about your business expenses we have to start at the beginning. You can read more about Expenses here. An overhead expense is one of two types of business expenses and includes the costs of running your business. These costs could include but aren’t limited to rent, utilities, employee wages and more. These type of costs ARE NOT related to the COGS but instead are things that do not generate revenue. Overhead expenses are costs that have to be paid even if business is slow and a smart business owner keeps some cash to fulfill these obligations just in case there’s a month or two that go by where profits might not be what they’d like.

      How Does Knowing Your Overhead Expenses Help?

      Knowing your overhead costs can help you set your prices for the products you sell or the services you render so that you’ll end up with profits. Factoring in the overhead will show you just how much money your business needs to bring in so you can stay afloat or even grow. You can also use your overhead expenses to help you figure out your net profit or bottom line. Knowing what you’re spending on overhead expenses can be the first step in strategizing a way to bring those costs down. Simply reducing the amount you put towards overhead expenses can increase your net profit.

      As we approach tax season, it is important to understand different types of tax forms, and why we need them.  If you’re hiring a new employee, or trying to report your income tax returns, you have come to the right place!  Tax forms are essential for all small businesses and must be filled out properly.  The Internal Revenue Service (IRS) is constantly on the move and requires every small business to file their taxes.  Tax forms can be complicated and cause major headaches.  To make sure you are prepared for the future success of your small business, here are some of the important tax forms you will need to know about:

      1120 Form:

      Form 1120 is used to report business taxes to the IRS. With these forms, you’ll report income, gains, losses, deductions, or credits associated with your business.


      1099 Form:

      The 1099 form is an IRS tax return document used to report income from self-employment earnings, government payments, dividends and interest and more.  Basically, a 1099 form is used to record money that an entity or person, not your employer, paid you.

      1040 Form:

      Is used by U.S. tax payers and a standard IRS form used for individuals to file their annual income tax returns. It is also used to claim tax deductions and credits.  It calculates the amount of tax refund or tax fill for the year.

      W2 Form:

      Is a document an employer is required to send to each of their employees and the IRS at the end of the year.  Also known as the Wage and Tax Statement, the W-2 form reports the employee’s annual wages and the amount of taxes withheld from his or her paychecks.

      1040-ES Form:

      Is used by independent contractors or freelancers to estimate the federal tax they owe from their income.  This is used to figure and pay your estimated tax.

      941 Form:

      This reports income taxes, social security tax, or Medicare tax withheld from employee’s paychecks.  Typically, most small businesses file this form if they have employees.  The 941 form is filed quarterly and is the employers federal tax return.

      SS-4 Form:

      This form is used to apply for an employer identification number or an EIN.  This is a 9-digit number assigned to sole proprietors, employers, corporations, partnerships, trusts, and other entities for tax filing purposes.

      W-4 Form:

      The purpose of the W-4 form is for new employment.  When you are hired for a new job, one of the many documents needed is your W-4 form, which determines the amount of tax your employer will withhold from your paycheck.

      W-7 Form:

      Is used to apply for an IRS individual taxpayer identification number.  This ITIN form can be also be used to renew an existing ITIN that is expiring or has already expired.

      4506-T Form:

      This document is an IRS document that is used to gather past tax transcripts that are in the IRS’s files.

      9465 Form:

      This document is an installment payment plan, and IRS application form.  Taxpayers who owe less than $50,000 in taxes, interest and taxes may be able to complete an online payment agreement (OPA) application.

      4506 Form:

      This is a form that is filed by tax payers to request copies or transcripts of previously filed tax returns and tax information.  You can request a range of different types of previously filed tax returns.

      So, no matter your type of business—whether you are a blogger, online retailer, or an attorney—small business owners must file with the correct tax forms.  At Vyde, it’s our goal to help you stay compliant with the IRS. Reach out to our team for any of your tax related questions.

      Here at Vyde, we know financial statements are important for running a small business.  There are three basic financial statements; the balance sheet, income statement, and the statement of cash flow. A balance sheet is a description of a company’s assets, liabilities and equity at a specific point in time.  This is a snap shot of the business of what it owns, owes, and the amount of investments it has.

      Balance sheet equation: Assets = Liabilities + Equity

      The balance equation must be perfectly equal, which is why it is called the “balanced” sheet.  Similarly, your company’s liabilities and equity must equal the same amount as your assets.

      Assets: In this section, assets are listed in order of their liquidity (assets that can be converted into cash the easiest).

      • Current assets: These are assets that are expected to be converted into cash within one year such as accounts receivable and inventory.
      • Long-term assets: These are assets that are not intended to be converted into cash within one year such as long term investments, property, plant and equipment.

      Liabilities: This is what the company owes. Liabilities range from salaries owed to essential bills.  The Liability section has two categories:

      • Current liabilities: These are short term obligations due within one year.
      • Long-term liabilities: These are financial obligations due one year in the future.

      Equity: Also known as shareholders equity.  This is what remains after subtracting assets and liabilities.

      • Retained Earnings: This is the amount of net income left over after dividends have been paid to its shareholders.

      Still have questions about your business’ balance sheets? Vyde takes care of your accounting, bookkeeping and tax information.  In addition, we also take care of your financial statements on a monthly, quarterly or annual basis.  We are here to answer any of your questions after we have completed your financial statements. Above all, we can go over each section of your balance sheet so you can be at ease and focus on your business!


      What is the Widow’s Exemption?

      The widow’s exemption reduces the tax burden on widows by reducing the amount of a widow’s taxable income. States individually determine the widow’s exemption rules and laws for themselves. It is not a federal exemption.

      Most commonly, the widow’s exemption effects the state inheritance taxes. When one spouse dies, he or she typically leaves all, or most, of his or her estate to the surviving spouse. The widow is then exempt from paying state inheritance taxes on his or her dead spouse’s estate.

      Because it is a state by state exemption it’s important to understand what the laws are in your state. Federal laws don’t regulate what each state can do. If you don’t understand the widow’s exemption in your state, it’s best to talk with a tax professional.

      Some states apply the widow’s exemption to property taxes. Florida is one of the states that give widows an exemption from property taxes.

      The Widow’s exemption is only available to widows who remain unmarried after his or her spouse dies. This applies to exemptions from inheritance and property taxes. In the eyes of the government, you are no longer a widow when you remarry; therefore, any remarried widows would have to pay taxes.

      Widow’s Exemption Scenario

      Mindy’s husband passed away six months ago. When Mindy met with her Certified Public Accountant (CPA) after her husband’s death, she learned that she was able to take advantage of tax breaks for widows.

      Mindy will still file last year’s taxes as married filing jointly because her husband would still need to pay any taxes owed. However, going forward she can file as widowed, unless she gets remarried.

      She can also take advantage of the widow’s exemption. In Mindy’s husband’s will he left his entire estate to her. Mindy isn’t currently working, so she doesn’t have the funds to pay the taxes on the inheritance. With the widow’s exemption she can keep the inheritance to live on without having to pay taxes she can’t afford.

       

      What is Underwithholding?

      Underwithholding is when you haven’t had enough income taxes withheld during a year. If a tax payer’s incomes taxes are underwithheld, it does not mean that tax payers doesn’t have to pay the taxes. Tax payers pay the underwithheld taxes when he or she files a tax return.

      The withholding amount is determined by how many credits you claim on your W-4. Claiming too many credits is what causes underwithholding.

      Underwithholding isn’t necessarily a bad thing. Some people prefer to have more money now and pay their taxes later. In that case, underwithholding could be a good thing. However, if you know you are underwithholding, then it’s smart to set some money aside to pay taxes. If you underwithhold by mistake, you would need to pay the government those taxes. If you can’t pay your taxes all at once, you can set up a payment plan with the Internal Revenue Service (IRS) to make your payments slowly.

      Underwithholding Scenario

      A mid-sized company employs Bill Jones. When Bill was hired he filled out a W-4 form and claimed as many credits as he could in order to lower his taxes. This worked really well for Bill because he had more income coming in. However, when he began filing his tax return in March, he realized that he hadn’t paid enough in taxes. Because he took so many credits his employer had underwithheld his income taxes.

      Bill ended up having to pay taxes with his tax return. He decided to change the number of credits he was claiming so that he wouldn’t have to pay taxes with his return again next year. Instead of claiming as much as he could, Bill decided to only claim 2 credits. Bill won’t know if he withheld enough taxes until next year when he files his tax return.

       

      What is a Tax Credit?

      A tax credit reduces the amount of tax a business or individual has to pay. The government uses tax credits to encourage or reward behavior that they find beneficial. For example, the government can give a tax credit to people for replacing old appliances with new, energy efficient ones. Most tax credits are given to benefit the economy or environment; however, the government can create tax credits for any reason.

      Tax Credits cover expenses that you have paid during a tax year. In most cases, you have to meet certain requirements in order to qualify for a tax credit. Because there is such a wide range of tax credits, it is good practice to check with your accountant before you make purchases that could be tax credit. Once you are aware of the qualifications for each credit, you can follow the regulations so you can claim the tax credit.

      Both tax credits and tax deductions reduce the amount of tax liability, but there is a difference between the two. Tax credits directly reduce your taxes. Tax credits are “dollar-for-dollar,” meaning that if you owe $1,000 in taxes, but have $1,000 of tax credits, then you would owe zero dollars in taxes. A tax deduction, on the other hand, decreases your taxable income. If you made $100,000 but had $20,000 in tax deductions, you would only be taxed on the $80,000 for that tax year.

      Tax Credit Scenario

      Derek is a doctor of chiropractic and owns his own business. As a small business owner, Derek tries to take advantage of as many tax credits and deductions as he can. After reviewing the business tax credits, he’s decided to make some changes in his business so that he can take advantage of these credits.

      First, Derek is going to start a retirement plan so that he can take advantage of the Credit for Small Employer Pension Plan Startup Costs. Most employers with fewer than 100 employees don’t have retirement plan options. The government encourages business owners to start pension plans by offering a tax credit. The Pension Plan Startup Costs tax credit offers a credit of 50% or $500 a year for three years. This should help offset the costs of setting up a plan and educating employees about it,

      Another tax credit Derek can take advantage of as a small business owner is the Credit for Employer-Provided Childcare Facilities and Services. Derek has a few working mothers on his staff. To help ease the burden on them he has decided to pay for some of their child care services. The employer-provided childcare services tax credit offers small business owners a 25% credit or up to $150,000 a year.

      Finally, Derek is going to take advantage of the Credit for Small Employer Health Insurance Premiums. The small employer health insurance tax credit rewards small business owners who pay for insurance coverage for their employees. However, it is a little harder to take advantage of. You must have at least 10 full-time (or full-time equivalent) employees. Those employee must have wages under a certain amount, which changes each year. Small business owners must purchase plans through the Small Business Health Options Program (SHOP.) Finally, you can only claim the credit for two consecutive years.

      When Derek does his taxes for the next year these tax credits will be deducted from the taxes he owes and will lower what he pays in taxes.