Owning your own business can be difficult and ensuring the success of the company is not an easy task. Taxes can play a big factor in the success of an organization regardless of size, industry, and standing. For highly profitable firms, taxes can cut into large margins and take away a lot of profit. For firms that are struggling, taxes can be the nail-in-the-coffin that sends the firm under. Larger corporations tend to have the ability to hire professionals to lobby the government and obtain tax breaks, while small business owners do not share that same luxury. Therefore, the importance of utilizing tax savings strategies in the small business realm cannot be understated. This article will lay out some of the strategies people can think about when approaching the topic of small business taxation.
Introduction to tax planning
Tax planning can take place in several forms, but the ultimate goal is to minimize tax liabilities. Individuals and corporations alike undertake this process in order to preserve wealth and ensure financial longevity. A tax efficient plan is one that works properly to ensure all elements of a business owner’s strategy are operating together in order to pay the least amount of taxes possible. When discussing tax saving strategies, there is a key distinction that must be made is between the terms “tax reduction” and “tax avoidance.”
- Tax reduction refers to the subject in which this article will discuss; considerations that can be made in order to reduce taxable liabilities.
- The term tax avoidance refers to the same process of minimizing taxes, but it typically means to do so via evasive, and sometimes illegal, means.
It is important to understand the differences in these terms when discussing ways for small business owners to reduce their taxable burden as this will avoid confusion on how the process is undertaken.
Small business pain points & opportunities
Owning a small business grants an individual a lot of flexibility. From how day-to-day operations are handled, to hiring practices, to payment periods, and everything in between can be set and changed with vast variability. There are many positives and negatives that come with the freedom to operate how an individual pleases.
Pain points arise from the fact that there is typically not a huge team surrounding a small business owner, forcing them to learn through trial-and-error. A few of the key decision points for small business owners revolve around attracting customers, retaining them, implementing effective marketing strategies, and ensuring proper work and cashflow. The decisions made on these topics and present both opportunity and headache.
Small companies can adapt much more efficiently to fit their target market/space, but it is often difficult to become aware of where they need to be positioned. On a micro-organizational level, one key decision area that can be either very positive or negative is centered around hiring family members.
Hiring Family Members
This is a personal decision that every small business owner must make and it can have a rather large impact on success. When properly done, family and friends are great ways to ensure that your business has quality labor, reliability, unity, and that people looking out for the overall success of the operation. When hiring family members works out, it is great, but when it doesn’t, it can be awful.
Having too many people that think similarly can lead to complacency in strategy. There can also be conflicts between family members over what responsibilities belong to one another and who is in charge. The process of hiring family or others close to the business owner should be approached with meticulous organization; people must know up-front what their role is, what their expectations are, and who they report to.
Although this seems like standard practice for all hiring procedures, these are especially key elements when hiring family. Many small business owners will pay their family members under-the-table in order to avoid taxes, but this is a dangerous strategy as it can lead to serious tax penalties.
SMEs and taxes
Small and medium enterprises (SMEs) are businesses that meet certain requirements based on ownership structure, number of employees, earnings, and respective industry.
This group of businesses is vast, with over 32.5 million SMEs in the US alone in the year 2021, which accounts for 99% of all firms in the country. For tax purposes, the IRS does not explicitly categorize SMEs, but rather groups together self-employed persons and small businesses. Small businesses are classified as any company that has assets of $10 million or less.
Taxes are applied to small business depending on their entity type, but generally C corporations must pay a flat rate of 21%, while S corporations (which many small businesses try to become) are taxed as a part of the owners’ personal tax returns.
All businesses that file to incorporate must start off as a C corporation and may file with the IRS to become an S corporation later on. C corporations are sometimes “double-taxed,” as they must pay corporate taxes for their profits and then individual shareholders are taxed on their dividends.
Brick and mortar business management
People have long discussed the decline of brick and mortar businesses, yet there are countless examples of exponential success for this type of business across a variety of industries. Key considerations for a small business owner deciding whether to place their storefront online or at a physical location include:
- what good or service they are selling,
- how they are planning to market it,
- who their desired customer base is,
- and how a successful transaction is carried out.
If a small business owner decides that a brick and mortar location will be best for them, then there needs to be an even heavier focus on tax savings strategies due to the nature of physical store locations having increased overhead costs. Many of the costs can be written off by a business owner when filing their income taxes, including rent and supplies to fill their space.
The services industry and taxes
Owning a business in the service industry can be tricky when it comes to paying taxes due to the fact that there is typically no sale of tangible goods, which makes it harder for owners to keep exact tabs on cash flows.
Sometimes small business owners or their employees will be given cash for their service, which can lead to the money seeming like it is untraceable by the IRS. If an audit is performed on a small business, the IRS can typically spot gaps in earned income and there are fines levied on business owners that attempt to evade taxes through these methods.
If you are a small business owner in the service industry, it is advised to keep close track on cash flows to spot discrepancies and remedy them before it is too late.
Loans
There are two types of loans small business owners may want to consider when applying to borrow money, bank loans and Small Business Association (SBA) loans. There are many factors that play into which kind of loan a business should apply for, including:
- years of operations,
- revenue,
- and credit history, among others.
Generally speaking, individuals tend to seek bank loans for business because they offer lower interest rates and better terms than SBA loans. Bank loans require a business to be incorporated for at least two years, possess a strong credit history, and have a minimum annual revenue. These types of loans are typically offered to more established enterprises.
SBA loans have less favorable interest rates, but are easier to obtain.
An SBA 7(a) loan can be used as startup financing for a business. These loans can sometimes be obtained even with less-than-ideal credit conditions. It is important to inquire with a professional about the types of loans that are best with for your business before applying.
Health Care Tax Credit
Small business owners have the ability to receive large tax savings on healthcare for their employees as long as they meet certain requirements. Individuals that own a business have the ability to enroll in the Small Business Health Options Program (SHOP), which is generally the only way to receive the Small Business Health Care Tax Credit. This credit allows business owners to receive up to 50% back on premiums paid for employees or 35% if the business is tax-exempt (non-profit). To qualify for this credit, you must meet the following criteria:
- Have 25 or fewer full-time employees
- Pay employees, on average, $56,000 or less per year (adjusted yearly for inflation)
- Pay at least 50% of the cost of healthcare coverage for employees
- Offer SHOP coverage to all full-time employees (anyone working more than 30 hours per week)
What to do at the end of the year
The end of a fiscal year can bring about a lot of tasks for a small business and its owner(s). In order to properly wrap-up the previous year and set yourself up for success for the next, there are several key items that must be completed. This is an excellent time to create a detailed tax plan for the coming years in order to minimize avoidable burdens. Speaking with a professional will aid in this process significantly, but the following list should help a business get on the right track on its own:
- Run through previous years goals and handle any outstanding invoices.
- Review financial statements and run year end reports.
- Update and confirm payroll information.
- Update and verify vendors and suppliers.
- Conduct a check on all inventory.
- Back up all computer systems and financial records.
- Begin tax planning.
- Re-strategize and consider staffing needs.
- Create a comprehensive log of all business activities, changes, and successes.
Tax reliefs and benefits
The US Department of the Treasury offers several programs that aim to aid small businesses and keep them afloat during
turbulent economic times and following the COVID-19 pandemic. The Small Business Tax Credit Program extends relief, particularly for the Employee Retention Credit and Paid Leave Credit. This program enables small businesses to offset their payroll tax liabilities and earn money back on paid leave for employees.
The Emergency Capital Investment Program is a tax program that aims to aid financial institutions in low- and moderate-income areas in order to provide more loans, grants, and forbearance for small or minority owned businesses. While some of these benefits are set to expire, it is important to note that future issues facing US businesses could possible produce similar programs.
IRS Penalty Relief
The IRS offers three main types of penalty relief for individuals and small businesses alike:
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- Relief due to reasonable cause. Reasonable cause is defined by the ability to prove that you were unable file your return or pay your taxes on time even after exercising ordinary care and prudence. Some examples of permissible reasons for relief include natural disasters, inability to obtain records, death or serious illness, and system issues that cause delays.
- Relief due to first time penalty abatement or any administrative waiver. This relief is for taxpayers that have failed to file, pay, and/or deposit taxes in any given year. It is also applied to partnerships and S Corps. In order to be compliant, and therefore eligible for this relief, an individual must have filed the same type of tax return and not had penalties for the previous 3 years.
- Relief due to statutory exemption. There are four main exemptions that are recognized in order to garner this relief. The first is that an individual or business relied on incorrect written advice from the IRS. The second is if you mailed your tax return on time and still received a penalty. The third is if you are affected by a natural disaster and the fourth is if you are serving in an active combat zone.
Why Reducing the Adjusted Gross Income Helps
Later in this article, we will discuss the different types of business structures and the varying levels of liability that are associated with each of them.
For the purpose of this section, it is important to note that there are several entity types that allow business owners to pay profits and expenses through their personal income taxes. Adjusted gross income encapsulates all of an individuals’ personal and business profits minus their deductions.
It is important to keep AGI as low as possible, as this will allow for tax savings that can become rather large when factoring in all business cash flows. In order to have higher take-home profits year-over-year, this is a key factor to take a look at reducing.
How it can be done
A great way for an individual to reduce AGI is by starting a retirement plan. When a person becomes a small business owner, they lose out on their previous employers 401(k) match. In order to continue saving for retirement and reducing taxable income, a business owner can contribute up to $57,000 to several different vehicles including:
- A Simplified Employee Pension Plan,
- an IRA or Roth IRA,
- and 403(b) plans.
Deducting travel expenses can also be a great way to reduce a person’s taxable burden through their business. Business travel is fully deductible and in order to fully maximize this deduction, a person may combine personal travel with a justified business purpose.
The power of Carryover Deductions
A business that experiences net operating losses in any given year is eligible to carryover the losses for up to 20 fiscal years in the future in order to offset future profits via tax deductions. No business wishes to lose money during a year, but with this method, a business may be able to reduce their taxable burden when things are going well in the coming years.
A key consideration here is to completely separate personal and business losses during a given year. This will allow the IRS to properly assess the amount of carryover deductions a company may bring forward (or backward for up to 2 years).
Consider your business structure and entity type
The type and structure of a business can have serious implications on taxes, operating structure, and much more. The following is a general breakdown on four popular entity types and their coinciding tax and structural implications:
- Sole Proprietorships: Easy to start and enables high amounts of control over your business. Both business and personal assets and liabilities are lumped together, meaning the business owner is personally liable for any business debts.
- Partnerships: The most basic business structure for two or more people to form an entity. One partner typically takes on unlimited liability and has more control over the entity, while the other(s) have limited liability and, thus, less control. Self-employment taxes are applied to the unlimited liability partner (general partner), while all others must report profits on their personal tax statements.
- Limited Liability Companies: LLCs are a mixture of partnership and corporation business structures. They allow the business owner to relinquish personal liability from the business, meaning they are not responsible for the debts of the firm. Profits and losses are passed through an individual’s personal income taxes and the owner must also pay self-employment tax contributions, but they save on corporate taxes.
- C Corporation: A company that is its own entity, making it completely separate from its owners. This structure allows for the least amount of personal liability on business owners, but the costs of owning and operating this type of business are the highest out of any structure. Corporations pay taxes directly on their profits and can sometimes be double-taxed, meaning money is paid on their profits from the business and also paid in personal income taxes from the dividends paid to shareholders.
- S Corporation: This is a structure that is very similar to C Corps, but without the double taxation issue. They have the same structure and liability as a C Corp, but can allow profits and some losses to be counted on the owner’s personal income statements, instead of on both company and personal. Corporations must apply for S Corp status if they meet certain eligibility requirements and caps on single-taxed profit vary from state-to-state.
What makes LLCs a popular choice
Limited Liability Companies (LLCs) are a preferred structure amongst many small business owners for several reasons. First and foremost, it separates the business from the individual.
Unlike in other business structures, and an LLC allows a business to be independent from its owner(s), meaning that debts and other obligations follow the business itself instead of the individual. Personal assets, such as your home and bank account cannot be touched in order to pay debts. Another reason is to limit paperwork and recordkeeping. An LLC does not need to hold annual meetings for shareholders, produce annual reports, or have extensive records of meetings.
They also have favorable tax treatment as touched on in the previous section, but without the ownership restrictions that S corporations have to deal with. There is also no fixed management structure required and profit distributions have much more flexibility when compared to other organizational structures.
Debt
Debt is a natural function of owning a business, but there are certain methods to go about handling and carrying debt that will help your small business into perpetuity.
First, it is important to note that debt can be used as a financing option to help offset costs when a company is cash poor. Taking out a small business loan work well in early stages of company development for several reasons; the lender has no control over your business, loan payments do not fluctuate, and any interest you pay is tax-deductible. The downside to debt financing is the fact the money owed does not go away regardless of circumstance. A business will still have to pay back its loans regardless of the success of the firm or different economic conditions that may impact their bottom-line.
An ideal debt ratio for a small business is typically anything below 50%. This means that less than ½ of all profits should go to paying back debt. Banks and other lenders will look at this figure when considering whether to give you a loan. A percentage around the 36% mark is a very good sign for lenders as this signals a business’s ability to pay back loans in a reasonable time period.
Consulting with a tax advisor or financial planner
Meeting with a professional that has expansive knowledge on taxes and/or financial planning can make a massive difference for small business owners. Tax professionals, such as Certified Public Accountants, can help reduce the tax burden for a business and create a sustainable plan to increase take-home revenue in the future.
Financial advisors and wealth managers can also take a look at the direction of a firm from a different perspective and provide valuable insights, such as how to ensure financial stability for your firm or an individual portfolio that the firm is funding. Although each person differs, most advisors and planners will provide an initial consultation that is free of charge. This will allow individuals to take a holistic approach to their tax strategies for their business without worrying about the financial ramifications.
This is all to say- reach out for help! Owning a business is not an easy feat and there are professionals that will work with your financial situation to determine the best route forward for your company.
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