How to Reduce Your Small Business Tax Bill
In life, it's said that two things are certain – death and taxes. But in business there's only one certainty: taxes. Tax obligations go hand-in-hand with running a business. From the federal government on down to city hall, you need to be aware of which taxes your business needs to pay, how much in taxes you owe, and when you need to file. Make a mistake and your tax bill grows. At the same time, if you plan ahead, take the right available deductions, and prepare your tax returns properly, you can save on the amount of taxes your business must pay.
Taxes may be the least favorite topic for small business owners, but it's one of the most important. The steps you take before the end of the tax year can help your business save money almost immediately. At the same time, the beginning of the next tax year is a good time to review whether you are maximizing your deductions and maybe even get a second opinion on additional ways you can save on taxes. Knowing how to minimize the amount of taxes you pay means that you get to keep more of the money you earn. Failing to properly manage your taxes means that your business might wind up in trouble.
"You could sink your business," says Richard M. Colombik, an attorney and CPA based in Itasca, Ill., who has served as the State of Illinois Bar's liaison to the Internal Revenue Service (IRS). "It might put you in a position where your profitability is so small that it is not worth the effort that an entrepreneur has to put in to run their own company. They might be better off getting a job working for someone else."
The following pages will detail the different types of business taxes you need to be aware of, how to determine your deductions, and tips for how to save on taxes so your business -- and you -- can ultimately benefit.
Types of Business Taxes
There are a variety of taxes for business. "Understand your responsibilities to help you meet them on a timely basis and avoid costly penalties for failing to act on time," advises Barbara Weltman, a tax an business attorney and author of J.K. Lasser's Tax Deductions for Small Business and the Big Ideas for Small Business newsletter. Here is a rundown:
- Income taxes. There are federal and, in most cases, state income taxes to contend with, whether the business pays the tax (as in the case of a business organized as a C corporation) or the owner pays the tax on his or her share of business income and expenses (as in the case of a business organized as a sole proprietorship, partnership, limited liability company, or S corporation).
- Employment taxes. If you have employees, you must withhold income taxes and the employees' share of Social Security and Medicare (FICA) taxes. You must also pay the employer share of FICA, plus state and federal unemployment tax. If your business is incorporated, you are an employee if you work for the business and you owe these taxes even if you're the only employee. If you are self-employed, you owe self-employment taxes (the equivalent of the employee and employer share of FICA) on your net earnings from the business.
- Sales taxes. If you sell goods and services and you are based in a state with a sales tax, you may be required to collect sales taxes on your transactions. While the customers pay the sales taxes, you can be subject to penalties for failing to collect the taxes and pay them to the state.
- Excise taxes. Depending on what type of business you operate, certain businesses may pay excise taxes on fuels, highway usage by trucks, and for other activities.
Taking the Right Deductions
Set up books and records
Even though you may use a casual approach to recordkeeping for your personal taxes, you can't do this for business. "The tax law specifically requires certain records in order to take deductions," Weltman says. "Without these records, legitimate expenditures may not be deductible." Here's what you need to comply with tax rules:
- A system to track your income and expenses. This is easily done with computer-based recordkeeping solutions that enable you to handle this matter yourself.
- Procedures to collect and store required receipts and other proof of expenditures. Set up file systems to categorize your receipts (e.g., car-related expenses, meals and entertainment costs, and capital expenditures).
- Policies on certain recordkeeping. For example, if you use your personal vehicle for business, you need to track your business mileage in a diary or log book. If you have employees and reimburse them for their business-related car expenses, explain how to them how records must be kept.
Make smart tax elections
Under the tax law, most expenses incurred in business are deductible, while most income is taxable (there are, of course, some exceptions). The tax law gives you options on when and to what extent you claim certain deductions or report income. Here are some examples cited by Weltman:
- The cost of buying business equipment usually is deducted by claiming a depreciation allowance (fixed by law) over five or seven years, or longer periods. However, under certain conditions, you may qualify to elect first-year (Section 179) expensing to deduct the entire cost of equipment in the year it is placed in service. (See below information on changes to federal law regarding Section 179.) Making this election accelerates the deduction, giving you an immediate tax benefit for your outlay.
- The expenses of a personal car or truck used for business can be deducted in one of two ways: claiming actual costs or relying on an IRS standard mileage rate. If you keep good records of your costs, you can then choose the deduction method that produces the greater write-off.
- Selling property on the installment basis where at least one payment will be received in the year after the sale generally means that the gain will be spread over the period in which the installments will be received. However, you can elect to report the full gain in the year of sale, even though payments won't be received until later. This election makes sense when you have current losses that can be offset by the installment sale gain, meaning that the gain is fully sheltered from tax.
Keep current with law changes
The tax law is constantly changing, with major legislation, court cases, and IRS rulings appearing frequently throughout the year. Many of these developments present positive tax opportunities -- if you know they exist and you act on time. Often, waiting until the annual meeting with your accountant may be too late to learn about and act on these opportunities.
For example, starting in 2008, Congress passed a measure as part of the Economic Stimulus Act of 2008 that let businesses deduct the full price of qualifying equipment purchased or financed during that tax year. Usually, under Section 179 of the IRS code, businesses that buy qualifying equipment can write off those expenses in smaller increments spread out over a series of years. But the new measure allowed businesses to deduct the full purchase price for the year that they bought it in, a move that could let a business pay lower taxes in the current year and still buy or lease more equipment to write off in subsequent years. In addition, Congress raised the dollar limits on these deductions. The limits were $125,000 per item not to exceed $500,000. They were raised to $250,000 per deduction, not to exceed $800,000 for the total amount purchase. Congress extended this under the American Recovery and Reinvestment Act of 2009.
Another example came following Hurricanes Katrina, Rita, and Wilma in 2005. A number of tax-saving breaks were created to run for a short time. The charitable contribution limitation was raised for individuals and corporations, but only through the end of 2005.
Colombik says that a lot of new tax provisions aren't properly utilized by small and mid-sized businesses because they or their paid tax preparers aren't aware of the deductions. "No one knows everything about taxation because they keep changing the law," he says. "The tax law is so incredibly broad based. I don't believe that anyone could be an expert in every single area. It would take a lifetime just to be an expert on retirement plans."
When businesses ask their tax preparers if there is anything else they can do to save on taxes, most often the response is, "No. You're doing everything you can." Colombik says that isn't necessarily truthful. You're taking all the deductions that your tax preparer knows about and that's why you might want to get a second opinion. He recommends finding a dual degree professional from the American Association of Attorney CPAs, who can understand both tax planning and the law.
"A closely held company that is profitable should seek an outside tax planning firm just to take a second look at how they are structured and how they are treating all transactions," Colombik says. "That doesn't mean their accountant is bad or their attorney is bad. It's a way for someone to come in and recommend possible alternatives." Those alternatives can potentially help your business save a bundle.
How to Save on Taxes
One of the first questions you need to determine is whether you need to enlist the help of a professional to handle your business taxes -- and help you plan in advance so that you can take advantage of certain deductions. "I get asked frequently how to determine when you need to talk to a professional and there are two ways to gear it," Colombik says. "One way is to look at the tax and calculate whether it will cost me less to talk to a professional than to pay my tax bill. The other way is to consider that if you're not paying a lot of tax in that area now, but you know you are going to be in the future, you can find out if there is a way to plan properly."
Common ways to save on taxes
You can take advantage of some standard tax rules that can save your business money. Here are some examples:
- Contribute to a retirement plan. If your business is profitable, you can shelter income in a qualified retirement plan that will provide you with a tax deduction for your contributions, defer tax on earnings on contributions (tax is ultimately paid when you start taking money from the plan, usually at retirement), Weltman says. And, if you have employees, you can gain employee loyalty for providing them with a retirement savings opportunity. Learn more about your retirement plan options from IRS Publication 560, Retirement Plans for Small Business, at www.irs.gov.
- Adopt an "accountable plan." If you have employees and reimburse them for using their vehicles on company business, adopt an accountable plan to save them income taxes and save the company payroll taxes, Weltman says. This arrangement lets you reimburse an employee for business expenses without having to treat the reimbursements as income to them. Result: the reimbursements are not included in the employees' W-2 form (the employees are not taxed on the reimbursements) and the company saves payroll taxes (FICA and unemployment taxes) on these amounts. Learn more about accountable plans in IRS Publication 463, Travel, Entertainment, Gifts, and Car Expenses, at www.irs.gov.
- Defer income and accelerate deductions. There are several steps you can take near the end of the year to put off income into the next tax year and increase your deductions in the current tax year. "In the last month of the year, send your bills out a few days later," Colombik says. That means getting paid a few days later in January of the next year and being able to defer the income, instead of getting paid in December of the current year and having to declare that income immediately. Similarly, one way to accelerate your deductions is to see what bills you have due in January and pay them before the end of December so that you can take that deduction during the current year, Colombik says.
- Structure your business the proper way. Colombik says that this is the "single most overlooked aspect in tax planning." Most businesses that start out small don't change the structure of their business when they should. For example, if you have a closely held company in which the income passes through to you, the owner, those are usually set up as an LLC or an S corporation. While there is nothing wrong with those structures, you might be able to gain tax advantages by structuring your company as a C corporation, in which the first $50,000 of your income is taxed at a rate of 15 percent as opposed to a 35 percent rate if you're in the highest tax bracket, he says.
- Consider adding to employee benefits instead of raises. One way to save on taxes for you and your employees is to compensate them by increasing your contribution to their health insurance costs instead of giving them the same amount in terms of a salary increase, Colombik says. "The employer could give everyone a $400 a month raise but then the employee would have to pay income tax, FICA tax, and Medicare tax on those wages. The employer would have to pay the employer share of FICA, Medicare and may have to pay federal and state unemployment taxes as well," he says. "Let's say the employer went to employees and said, 'Instead of giving you $400 more, the company is going to pay $400 more for your medical insurance. That eliminates the income tax, FICA, Medicare and unemployment taxes." The employer saves and the employee saves.
American Association of Attorney-Certified Public Accountants
The only association in the country whose members are professionals dually qualified as both attorneys and CPAs.
Federation of Tax Administrators
The Federation of Tax Administrators provides services to state tax authorities and administrators including research and information exchange, training, and intergovernmental and interstate coordination.
Free Management Library
A library of publications regarding taxes for small, for-profit businesses.
Internal Revenue Service
View the government's Small Business and Self-Employed One Stop Resource on federal taxes. Find an A to Z index of topics for small business, business news, links to forms and publications, and guidance on tax-related responsibilities for businesses with employees
Small Business Administration
Link to a variety of business tax topics, including business taxes, e-file for business and self-employed individuals, state and local taxes, and employment taxes.
State and Local Government on the Net
Access a directory of state, county and city government websites to find information about state income taxes and state and local sales taxes.
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