Top Tax Planning Tips for Small Businesses
“Huh?”
My sister asked again. I'd used a word I picked up in a book, and she didn't know what it meant.
This happened a lot when I was a kid. Over time, I learned to use common words to get the same message across.
In essence, that's what translation is. It's taking one idea and making it understandable to your audience. Especially, for fields full of jargon like accounting, you want a translator!
Fast forward to now and the tax code can make anybody's eyes cross! Everyone would like to pay less in taxes, but actually reading those laws and figuring out how is too much.
Especially for business owners, it's painful to pay taxes. Individuals have it easy(ier) because their taxes are withheld from their employer. They never see that money in their bank accounts. It's taken away little by little every pay period. Entrepreneurs have to save up and write checks to Uncle Sam in big quarterly batches.
You need to pay taxes, but there are steps you can take to pay as little as legally possible. This is called tax mitigation or tax planning. There are some easy ways to save money on your small biz taxes that apply to most entrepreneurs, and here are my top tax-saving tips for small businesses.
The Lay of the Land: Businesses Owners Pay Taxes Differently Than Employees
The first thing business owners need to know is that they don't pay taxes like employees pay taxes.
If you've ever worked for someone else and received a paycheck, your taxes are withheld. The employer deducts that money from your paycheck and sends it to the government. With a few exceptions, you pay taxes on everything you receive.
But businesses are different. A business does not pay taxes on everything it receives. Total sales isn't taxable income. A business can deduct expenses made to earn those sales. Thus a business owner pays taxes on the net income (sales minus expenses).
In summary, an employee cannot deduct expenses from their salary, but a business can deduct expenses from their sales.
1. Become an S-Corporation (S-Corp)
Via an S-Corp, you can save thousands of dollars (or more!) every year on self-employment taxes.
Once a business makes a certain amount of profit, they may want to consider converting to an S-Corp. This is not the legal status of your business, although it does have some legal requirements similar to a regular C-Corporation. Instead, this is a tax status.
An S-Corp requires the owner(s) to be on payroll and, for sole proprietors and single-member LLCs, a second tax return. The owner must pay themselves a “reasonable salary” and they will pay the self-employment taxes via the payroll. Any profit left over after normal expenses and payroll is only hit with the income tax. Effectively, you save 15.3% in taxes on the profit. This is a complex structure to set up, but easy to maintain once you understand the requirements. Later this month, I’ll release another blog only on S-Corps and how you can beat the IRS and save money on taxes.
If this is a strategy you’re interested in, please reach out to me now. The clock is ticking. Existing businesses can elect S-Corp status up until March 15th each year. This is something I’ve helped many clients with and saved them lots of money!
2. Contribute to a SEP IRA
Too often, self-employed people do not fund their retirement. This is a huge risk for their futures, plus a huge loss on their taxes.
One of the most popular retirement vehicles for the self-employed is a SEP IRA (literally, Self-EmPloyed IRA). You’re allowed to contribute massive amounts to your retirement compared to employees.
The cap on the deduction is $57,000 (in 2020, inflation adjusted) or 25% of your income, whichever is lower. If you’re on payroll (as an S-Corp owner & employee), then the 25% is based upon your salary. If you file your taxes as a sole proprietor or partnership, you can deduct 25% of your net income.
On your taxes, you’ll deduct this as a business expense. The contributions aren’t taxed as personal income so you don’t pay income taxes, social security, medicare, or self-employment taxes. After you retire, you’ll pay income taxes when you take out the money.
3. Log Your Mileage
In Connecticut, you need a car to go anywhere. Where I lived, it felt like it took half an hour to get anywhere. I put a lot of miles on my car the first couple of years in business!
Depending on your work, you may need to drive for business often or occasionally. You’re allowed to take one of two deductions. You can either deduct the actual expenses incurred, like for oil changes or gas, or take a standard amount per mile. In 2020, the standard amount is $0.575 per mile. If you drive a lot, then this is a big deduction! I’ve had clients go from owing thousands to getting substantial refunds!
Nonetheless, you may be better off taking the actual expenses. This will depend on how expensive the vehicle was and the costs of upkeep. You cannot switch methods for a vehicle in subsequent years, but you do not have to treat all of your vehicles the same. To figure out what will give you the best deduction, you’ll need to make some estimates and run the numbers.
4. Split Your Business & Personal Expenses
You are allowed to split expenses between business and personal use. A great example of this is your cell phone. If you have only one account and you use it for both business and personal, you can deduct part of the expense. You’ll need to estimate what percentage you use it for business.
Other items you may have bought for your home originally, but now use exclusively for business. For example, the desk you work at every day. And the chair. Estimate how much you could sell the item for and the percentage of time going forward that it’ll be used for business. You can claim that amount on your taxes.
If you worked at an office, you’d need a printer, phone, and desk. You need these too if you work from home. You can buy new or use what you already had. You may be surprised by the number of items you use for business now. The stuff adds up!
5. Deduct Your Home Office
Similar to the split expenses just mentioned, if you work from home and have a space that you only use for business, then you can claim the home office deduction. In particular, for entrepreneurs with expensive living situations, this deduction can get pretty big.
The space doesn’t have to be an entire room; it could be just a corner. Also, you can count storage space, like for equipment or supplies.
There are two methods to calculate the deduction. The first is based on actual expenses and the second is the simplified method. The latter gives you a standard amount per square foot. You’re allowed to deduct $5 per square foot, up to 300 square feet (for a max $1,500 deduction).
For the actual method, you tally up all the costs to maintain your home and any costs specific to your business. The specific costs include items like a second phone line for your office, repairs to a squeaky door, or an extra insurance policy. These costs that you incur only for the office are called direct expenses. But for the office, you wouldn’t have that service or expense.
Other costs, like utilities and insurance, are shared personal and business expenses. These are called indirect expenses. Next, the business percentage by measuring your work space and your entire home. Then you calculate the percentage of your home that is work space. You can deduct the business percentage times the total indirect expenses amount.
Bonus tip: Keep Your Finances Up To Date
Since businesses may deduct expenses, it behooves them to keep a close eye and not miss any. The biggest culprit for missing expenses is not keeping your books up to date. You need to have a system in place to catch all business expenses. Especially if you use cash.
Using a business bank account will help. Accounting software like QuickBooks Online makes it even better. To make sure you don't forget what some transaction was for, you need to have a weekly finance date.
Wondering what’s a finance date? Check it out here.
I guarantee, if you think you will remember the details and skip a finance date, you're likely to skip the next one too. Don't get into this bad habit. Because, by the time you do your books, all the things you thought you’d remember will be muddled in your mind.
Speaking of mud, you do not want to mix business and personal expenses. Use your business bank accounts for business only. Use your personal accounts for personal uses only. Check out two times at the store if necessary so you can pay with the right account. This will keep your books clean. This is another golden habit to have in place.
It wasn't a love of reading that helped me learn big words and then how to speak more simply. It started in third grade when a class contest brought out my competitive spirit. Every month, the winner was whoever read the most pages.
I read everything I could find. From the Dr. Seuss books from my toddler days to every Boxcar Children book I could find. I won several months. This may not be a surprise, because you have to be competitive to start a business. I suspect you are too. You must find some joy in playing the game of business to be a biz owner.
Figuring out how to lower your taxes is like a game too. There are so many pieces and avenues you can try out.
Taxes are complex, no doubt.
The tax code is a fun read, said no one.
But, it's awesome when you find what works and calculate the tax savings! I hope a few of these tips will help you reduce your tax bills.
Your business exists to make you a living and make an impact. Paying less in taxes is smart, and allows you to choose where to spend those dollars instead.
Instead of the government deciding how to spend your money, you decide. You can use the tax savings to invest in your family, team, community, a rainy day fund, or even your favorite charity.
*DISCLAIMER* This is not tax advice upon which you can rely. The information does not include all of the IRS or state nitty-gritty details that you must comply with. For specific advice based on your information, I’d be glad to advise you. Otherwise, consult your regular tax professional.