Even the most intelligent business leaders have trouble understanding small business taxes. They might not know how many different types of taxes they have to pay, how each rate is calculated, or which factors have the biggest impact on their final tax bill. The answer to each question isn’t entirely clear because it depends on a variety of factors, like business structure and location.
Fortunately, it’s the responsibility of tax professionals like lawyers and accountants, not business leaders, to know the intricacies of business taxes. But learning how tax rates are determined and how to lower your tax bill can help you make better financial decisions when growing your business. It’s also much easier to move forward with new strategies and investments when you are absolutely certain how much you’ll eventually have to pay in taxes.
In this guide, we’ll explain the answers to the following questions:
- Which Taxes Do Small Businesses Have to Pay?
- When Do Small Businesses Pay Taxes?
- What is the Tax Rate for Small Businesses?
- Which Factors Affect Your Small Business’s Tax Bill?
- What’s the Difference Between Tax Deductions and Tax Credits?
- How Do You Claim Small Business Tax Credits?
- What are the Most Popular Small Business Tax Credits?
- Which Tax Terms Should All Entrepreneurs Know?
- How Can Small Businesses Lower Their Tax Bill?
Which Taxes do Small Businesses Have to Pay?
A U.S. small business must pay up to six types of business taxes. Some businesses have to pay all six while others are only responsible for one. The criteria are highly specific, down to the kind of products you sell and annual income. Thus, you’ll probably have to do a little research to determine which of the following taxes apply to your business.
Here are the six types of small business taxes:
All individuals and business entities must pay income tax. Federal income taxes are paid in all 50 states, whereas 43 states have state income tax.
The way income tax is paid, however, differs tremendously between standard corporations and other types of businesses. Corporations, or C-corps, are subjected to what is known as “double taxation.” The business is first taxed on its net income, which is income that has been adjusted for expenses. If corporate income is distributed to shareholders as dividends, that money gets taxed as well. Each stage of double taxation has its own tax rate.
Sole proprietorships, general partnerships LLCs, and S-corporations, on the other hand, are categorized as “pass-through” entities. This means there is no income tax on the business itself. Instead, the business owners only have to pay taxes on the business income at their individual tax rate and report the business income when personal tax returns are due. The income “passes through” to the individual business owner, rather than being taxed as a business.
Any company with employees must pay payroll taxes, also known as employment taxes. Payroll taxes consist of federal and state income tax withholding, social security taxes, Medicare taxes, state and local payroll taxes, and federal and state unemployment taxes. Some of these taxes are deducted from employee paychecks while others are paid directly by the employer.
In addition to these two responsibilities, employers must also file payroll tax forms and make payroll tax deposits. You can see where payroll taxes got their reputation for being notoriously complicated. This is why many businesses outsource all payroll tax responsibilities to a private payroll company. They’d rather not risk forgetting to file or filing late, which can result in severe penalties.
As the name denotes, self-employment taxes are meant for self-employed individuals. They consist of just two taxes (social security and Medicare) and are only paid if your annual net earnings from self-employment amounted to at least $400. Certain types of self-employment, like working for a religious organization, may be exempt from self-employment taxes.
Excise taxes are only paid by businesses that engage in certain activities or sell certain types of products, like cigarettes, liquor or gasoline. Since excise taxes are an indirect tax, the money is already included in the price of the item. Businesses that apply excise taxes must collect the money and send it to the IRS. Some states also charge a separate state excise tax on top of the federal tax.
Welcome to one of the biggest headaches for entrepreneurs. Sales taxes are applied in every state except for Alaska, Delaware, Montana, New Hampshire and Oregon. If you determine that your products or services are subject to sales tax in your locality, you must collect sales tax whenever a customer makes a purchase.
As of 2020, 24 states require Ecommerce businesses to collect and pay sales taxes if they process more than 200 transactions or earn at least $100,000 in sales per year. Here’s where it gets complicated: Not only do sales tax rates vary from location to location, but some states also tax items based on the location of the buyer, not the seller.
Deadlines for reporting and paying sales taxes vary tremendously from state to state and business to business as well. In some states, sales taxes must be reported and paid each month. Other states require quarterly or annual payments.
The reporting and payment schedule also depends on sales volume. Businesses with higher sales must typically file sales taxes more frequently. For example, your state might require monthly payments from businesses that exceed a certain sales volume and quarterly payments from businesses that fall under that volume.
Property taxes are for businesses that own property, be it commercial property, land, or a physical storefront. Such businesses must pay property taxes based on the location of the property.
When Do Small Businesses Pay Taxes?
Most business owners must estimate how much income taxes and self-employment taxes they owe and pay those taxes periodically. Your accountant will help you figure out the amount of each payment, which are based on your estimated taxable income for the whole year.
If your accountant determines that you will most likely owe more than $1,000 in taxes for the year, you must make quarterly state and federal tax payments. These payments will then be deducted from the total amount you owe when you file your tax return. Failing to make estimated payments by the quarterly due date can result in penalties and incur interest on the total amount you owe.
What is the Tax Rate for Small Businesses?
The only tax rate that applies to all businesses from a single entity is the corporate income tax rate. Thanks to the Tax Cuts and Jobs Act, the corporate income tax rate went from a maximum of 35% to a maximum of 21%. This applies to all corporations, or C-corps. So, regardless of how much money a corporation makes, it won’t pay more than 21%.
As mentioned earlier, however, corporations are subjected to double taxation. If corporate shareholders take dividends or distributions from business income, that money is taxed at a separate rate. We’ll explain that rate in just a bit.
Most other business entities are pass-through entities. For that reason, business income is reported on the business owner’s personal tax return and taxed at the business owner’s individual income tax rate. In other words, there is no universal rate that applies to all S-corps, LLCs, etc. What we can tell you, though, is the current average income tax rate for certain pass-through entities compared to corporations:
Sole Proprietorships: 13.3%
Small Partnerships: 23.6%
Small S-corporations: 26.9%
Dividend Tax Rates for C-corps
There are two types of dividends: qualified and unqualified. A dividend is considered qualified if the shareholder has owned the stock for at least 60 days. The current rate for qualified dividends is 0% if you earn less than $38,601 per year and up to 20% if you earn more than $425,800. With unqualified dividends, a.k.a. “ordinary dividends,” the tax rate is equal to the shareholder’s regular income tax rate.
Income Tax Rates for Pass-Through Entities
Pass-through entities include sole proprietorships, general partnerships, LLCs, and S-corporations. The tax rate for these businesses is equal to the owner’s individual income tax rate.
Now that the Tax Cuts and Jobs Act is in effect, however, owners of pass-through entities can deduct up to 20% of their business income before determining their individual tax rate. This law only applies to single filers who earn less than $157,500 and joint filers who earn less than $315,000. Professional services, like medical practices and law firms, are also not eligible.
To demonstrate, let’s say a single owner of a pass-through entity reports $90,000 in net business income. This individual could therefore deduct $18,000, making the new net business income $72,000. So, instead of being taxed as someone who makes $90,000, the business owner would be taxed as someone who makes $72,000, which is an entirely different tax bracket.
Employment Tax Rates
Employment taxes include social security tax, Medicare tax and federal and state unemployment taxes. Here are the rates for all four:
- Social Security Tax: 12.4% on wages paid up to $128,400. Most business owners pay half of this amount with business income and take the other half out of employee paychecks. Since self-employed individuals do not have employees, they must pay the full amount on their own.
- Medicare Tax: 2.9% of all wages paid to an employee. Like social security, most business owners split this tax between business income and employee wages. Additional Medicare deductions may apply to certain employees who make more than $200,000 per year.
- Federal Unemployment Tax: 6.2% of the first $7,000 of employee wages. Business owners who pay their state unemployment taxes on time, however, typically receive a credit of 5.4%. Your new FUTA tax rate would therefore be 0.6%.
- State Unemployment Tax: This rate varies from state-to-state and depends on a variety of factors such as industry, employee turnover rate, and the size of your company. The amount of unemployment claims filed by former employees is a major factor as well. In summary, low employee turnover = low state unemployment taxes.
Excise Tax Rates
This rate varies tremendously depending on the type of product or service for sale. You can find the federal excise tax rates for each applicable product or service in the IRS’s Publication 510.
Sales Tax Rates
There are two types of sales tax rates: destination-based and origin-based. Thirty-eight states have the former, which means an item’s tax rate depends on the location of the buyer. So, if your business is based in New York but sells to a customer in Florida, that customer must pay the Florida sales tax because Florida is a destination-based state. You must also collect all local sales taxes for the customer’s location and file a Florida sales tax return before the state’s periodic due date. In summary, you must collect the correct sales tax for each customer located in a destination-based state.
As for the twelve states with origin-based sales taxes, the item’s tax rate depends on the location of the seller. District taxes, on the other hand, are based on the location of the buyer. If you only sell products in your state but in multiple cities or counties within that state, you must collect the correct amount from each locality.
Property Tax Rates
Property taxes rates depend on the property’s registered locality. After purchasing the property, your local tax authority will contact you about your property tax rates and due dates. If the assigned rate catches you off guard, remember that it’s based on the property’s assessed value, as opposed to the market value.
State Small Business Tax Rates
Aside from South Dakota and Wyoming, all states charge taxes on the income of all or certain business entities. For example, if a state does not have an individual income tax, that state likely has a corporate income tax or franchise tax. In other words, at least one business entity has to pay a form of income tax in all but two states.
Here are the three primary types of state small business taxes:
- Corporate Income Tax: Most states charge a corporate tax rate of 4% to 9% on net business income.
- Gross Receipts Tax: Five states have a gross receipts tax instead of a corporate income tax. This tax is based on a business’s total sales, as opposed to net income, which accounts for expenses.
- Franchise Tax: Fifteen states charge a franchise tax along with or instead of a gross receipts tax or an individual income tax. The rate is based on the value of the business’s stock or total assets and typically ranges from 0.1% to 0.9%.
As you can see, state business income tax rates vary tremendously from state-to-state. Thus, the only way to be truly 100% sure about your state’s taxes and rates is to contact your state’s business tax authority. This information is available online but, much like all other important business-related information, you can never be sure until you check with the most reliable source.
Which Factors Affect Your Small Business’s Tax Bill?
There are number of ways in which business owners can lower their tax bills or their taxable income. A good small business accountant is an expert in these tactics because applying them is often the individual’s primary responsibility. If you capitalize on the right deductions or credits, your business’s tax bill could be significantly lower than another business of a similar size and net income.
Tax deductions can be unbelievably advantageous. They lower your taxable income, thus making your business more profitable. Using an asset or expense to keep significantly more income almost feels like getting that asset or expense for free. In fact, many business owners would likely admit that they chose their industry primarily because of eligibility for more deductions.
Take Section 179 for example. With this deduction, you can deduct an asset’s total cost for the same year you bought it. Countless businesses capitalize on Section 179 by purchasing numerous expensive assets in the same year, even if they might not have use for them at this moment in time. Don’t have the money to make the purchase outright? Well, that’s what small business loans are for. If you rent your equipment or your office space, you can deduct your rent payments as well.
Ever wonder why so many people start businesses despite the massive upfront expenses waiting around the corner? That number would probably be a lot lower if it wasn’t possible to deduct up to $5,000 in startup costs. The vagueness of that term makes it increasingly applicable. You can even categorize the costs of researching an industry as “startup costs.”
We’ll go over some of the most popular tax deductions for small businesses later on.
Every year, the federal government awards tax credits to businesses in exchange for making decisions that will positively impact the economy, the environment, or certain types of people. These decisions are clearly geared towards helping the greater good, as opposed to the business itself.
What’s the Difference Between Tax Deductions and Tax Credits?
It’s easy to confuse tax deductions and tax credits. After all, they have the same general objectives: saving money and protecting profitability. But the two are actually very different.
The biggest difference is that compared to tax deductions, much fewer businesses can meet the requirements for tax credits. But this could change very soon, as the small business community becomes more progressive and altruistic.
Tax deductions and tax credits lower your tax bill in very different ways. The former directly impacts your taxable income. The less money you claim to make, the less taxes you will have to pay. If you report business income on your personal tax return, tax deductions can also lower your tax bill by putting you into a lower personal tax bracket.
With tax credits, on the other hand, you can literally subtract the dollar value of the credit from your final tax bill. For example, if you are awarded a tax credit of $10,000, you can just subtract $10,000 from your tax bill to determine how much you owe. The ability to deduct $10,000 in expenses doesn’t mean you will pay $10,000 less in taxes. That amount would instead be converted into a percentage.
Another major difference is that deductions usually come from very typical business expenses. This can include inventory, utilities, rent, and even advertising.
Also, while tax deductions can be big and small, virtually any tax credit can have a significant impact on your tax bill.
Credits vs Deductions: Example
The businesses that reap the greatest rewards from tax deductions do so by lowering their personal tax bracket. Let’s say you’re a sole proprietor and your business earns $95,000 in taxable income this year. When tax season rolls around, you find out you have $15,000 in business expenses that can be deducted from your taxable income. This would put your taxable income at $80,000.
According to the 2020 tax brackets, a sole proprietor who makes $80,000 pays a tax rate of 22%. A sole proprietor who makes $95,000 belongs to the 24% tax bracket. The deductions bumped you down to a lower tax bracket. This could save you thousands of dollars come tax season.
You would probably save more, however, with a tax credit valued much lower than $15,000, even with fewer deductions.
The example above would produce a tax bill of approximately $17,600. Let’s say you were only able to deduct $7,000 in business expenses, but you were also awarded a tax credit of $5,000. You would still fall into the 24% bracket at $88,000, which gives you a tax bill $21,120. When you subtract your tax credit, you’d get $16,120.
As you can see, the $5,000 tax credit and $7,000 in deductions allows you to save more than just $15,000 in deductions.
How Do You Claim Small Business Tax Credits?
Before exploring the criteria for different tax credits, you must first determine the amount of tax credits you can claim each year. To find your tax credit limit, start by adding your net income and alternative minimum tax. The latter can be easily calculated via most tax software tools.
You can use the same software to calculate tentative minimum tax, which you’ll need for the second part of the formula. After adding together your net income tax and alternative minimum tax, you must then determine which number is greater: your tentative minimum tax for the tax year or 25% of your usual tax bill that’s greater than $25,000.
Whichever number is greater; subtract that from the sum of your net income tax and alternative minimum tax.
Tax credits are claimed by submitting the forms attached to each specific credit alongside your tax return. If you discover that you are eligible for more than one tax credit, you must additionally submit IRS Form 3800 (a.k.a. the General Business Credit Form). On this form, you will add up each individual credit you are eligible for to calculate the total value.
If you are only eligible for one tax credit, you can simply submit the form required for that credit alongside your tax return.
What are the Most Popular Small Business Tax Credits?
Earlier, we noted that tax credits aren’t used as frequently tax deductions. This is largely because the federal, state, and your local governments issue new tax credits every year. Certain credits from the previous year are no longer available.
So, in order to figure out which credits you may be eligible for, you must keep tabs on the release of new credits as well as the expiration of old credits.
This is why we’ve compiled a list of tax credits that are very popular. The following credits probably aren’t going anywhere anytime soon:
1. Small Business Health Care
This product of the Affordable Care Act (a.k.a. Obamacare) is among the most popular tax credits at this moment in time. It is awarded to smaller businesses that provide health insurance to employees and cover half of the costs themselves.
In order to qualify, your business must have less than 25 full-time employees and pay those employees an average wage of less than $55,000 per year. This number will likely go up as the average full-time salary in the US does the same.
Qualifying businesses must have also purchased a qualified health plan from the Small Business Health Options Program (SHOP), and currently pay at least half of their employees’ health insurance premiums.
The Small Business Health Care Tax Credit’s dollar amount is equal to 50% of the combined costs of your employees’ health insurance premiums. This credit cannot be claimed more than two years in a row. You can claim it more than twice, just not two consecutive years.
2. Increasing Research Activities
“Research and Development” (R&D) is a notoriously vague term that can be applied to a host of activities. This credit usually goes to science, medical, and IT-related businesses. However, many other types of businesses engage in the activities required for eligibility.
These include developing new proprietary products and applying for patents, developing a new manufacturing system, improving the efficiency of a product or improving quality control processes. The aforementioned three industries are the most common recipients. They tend to release highly innovative and technical products requiring extensive research and testing. Any businesses that wishes to qualify must have documented evidence of their progress like notes, diagrams, or results from lab tests or trials.
Qualifying businesses can subtract up to 10% of their R&D costs from their tax bills.
3. Alternative Motor Vehicle, Electric Vehicle, and Alternative Fuel Credits
A number of tax credits are available for businesses that use or produce alternative energy sources. Examples of such energy sources include renewable diesel fuels, lithium batteries for electric cars, wind energy, solar energy, or even a vehicle that runs on alternative fuel.
Businesses that use electric cars can apply for The Qualified Electric Vehicle Credit. The value of this credit depends on the caliber of the vehicle’s lithium battery. Businesses that use renewable fuels can apply for the Biodiesel and Renewable Diesel Fuels Credit, the Alternative Fuel Vehicle Refueling Property Credit, or the Biofuel Producer Credit. These final four tax credits can carry very different values. For more details about eligibility, visit the website of the US Department of Energy.
4. Disabled Access
The Disabled Access Tax Credit is awarded to businesses that make their physical locations more accessible to disabled individuals. Examples of such improvements include building a ramp at your entrance, providing braille text to mark different parts of a store, or even spacing your shelves farther apart. These upgrades can be expensive. For this reason, the Disabled Access Tax Credit targets smaller businesses. To qualify, your business cannot earn more than $1 million per year and have more than 30 full-time employees.
Qualifying businesses can receive up to 50% of the costs of disabled access upgrades that cost up to $10,000. Thus, the maximum amount you can receive from this credit is $5,000 per year.
5. Family Leave Act
Though it’s only been available for two years, this credit will be discontinued in 2020. This is the last year you can take advantage of the Family Leave Act Tax Credit. It incentivizes small businesses to provide paid family and medical leave to employees.
In order to qualify, your business must have a documented policy that provides at least two weeks of paid family and medical leave to all full-time employees per year. The compensation must amount to at least 50% of the employee’s wages.
Qualifying businesses will receive the equivalent of 12.5% of the wages that were paid to employees who went on family or medical leave last year. If you paid more than 50% of your employees’ wages when they were on paid or medical leave, you’ll receive more than 12.5%. If you cover 100% of your employees’ wages during paid or medical leave, you can receive up to 25% of the employee wages you paid.
6. Employer-Provided Child Care
The Employer-Provided Child Care Tax Credit is awarded to businesses that cover their employees’ child care expenses. Examples of such expenses include the monthly costs of using a child care facility or paying the salary of a caregiver who looks after an employee’s child. Eligible businesses can also cover the costs of granting employees access to child care services.
Various types of expenses can qualify for this tax credit. They just have to go towards the costs of operating or expanding an existing child care facility. Businesses must also prove that the facility involved in the claim is in compliance with state and local licensing requirements.
If you qualify, you can claim 25% of employee child care expenses plus 10% of expenses associated with helping employees obtain child care services. The maximum credit is $150,000 per tax year.
7. Employer Social Security and Medicare Taxes Paid on Certain Employee Tips
If you run a full-service restaurant, many of your employees probably make most of their money from tips. Some restaurants actually pay social security and Medicare taxes on tips for certain types of employees. This tax credit allows businesses in the food and beverage industry to claim a credit on these payroll taxes.
For most recipients, the tax credit is the equivalent of the amount of social security and Medicare taxes that the employer pays on tips received by each applicable employee.
In order to qualify, however, your employees must also receive hourly salaries of at least $5.15 per hour. This was the federal minimum wage in 2007. Today’s minimum wage is obviously much higher. But for calculations’ sake, the requirements for this tax credit are still based on the 2007 minimum wage.
8. Small Business Pension Plan Startup Costs
This tax credit is worth a maximum of just $500. However, the requirements are arguably easier to meet than most other credits on this list. The Tax Credit for Small Business Pension Plan Startup Costs is designed to help cover the costs of implementing retirement packages for your employees. You may incur administrative costs and other expenses when informing your employees about the new package and their investment options.
In order to qualify, you must have had up to 100 employees who earned at least $5,000 in wages during the tax year. Eligible businesses also cannot have had a previous retirement plan set up for the same employees who will be receiving the new plan, unless that previous plan was set up more than three years ago.
Most types of retirement plans, such as 401(k) plans, SEP IRA plans, and SIMPLE IRA plans, can qualify.
9. New Markets Tax Credit
The New Markets Tax Credit has been renewed several times. Still, Congress could very well decide to change their minds at the end of 2020. In other words, this tax credit might not be available next year. It is awarded to businesses that invest in Community Development Enterprises (CDEs) and Community Development Financial Institutions (CDFIs). These are organizations designed to bolster the economy and quality of life in low-income areas. You can find CDEs and CDFIs closest to you through this tool provided by the Department of Treasury.
In order to qualify, you must have contributed to the construction and/or rehabilitation of certain types of community-oriented businesses. Examples include educational facilities, community centers, health facilities, industrial facilities, or facilities that provide services to underserved groups (minorities, veterans, ex-felons, etc.). These businesses must be located in areas with a poverty rate of at least 20%, or a median family income that is lower than 80% of the median income for the area as a whole.
10. Work Opportunity Tax Credit
The Work Opportunity Tax Credit encourages businesses to hire types of people who have historically struggled to get jobs. This includes veterans, food stamp recipients, family assistance recipients, ex-felons, individuals who receive Supplemental Security Income (SSI), and individuals who have been unemployed for long periods of time.
The size of the credit depends on which of these categories your employee belongs to, how many of those employees you hired the past year, and how many hours they worked. Businesses that employ veterans and long-term family assistance recipients reportedly tend to receive the highest credits.
For each employee, you can claim a credit of 40% of their first $6,000 in wages, which comes out to $2,400.
Which Tax Terms Should All Entrepreneurs Know?
It’s understandable for business leaders to balk at the idea of learning basic tax and accounting terms. “Isn’t that why I hired an accountant?” you might think. Yes, no one has to know this information better than your accountant or bookkeeper.
But consider how you’d feel about discussing your business’s finances if tax and accounting terms sounded like Greek to you. As if your life wasn’t already stressful enough, you now have one more very important task that induces confusion and discomfort. It’s safe to say that all business leaders would welcome anything that could significantly diminish the stress of their day-to-day routines.
Your taxable income is the portion of your income that gets taxed.
Employees fill out W-4 forms to tell their employers how much of their wages to “withhold” for taxes. Hence, a portion of their income goes to federal income taxes and Federal Insurance Contribution Act (FICA) taxes, which include Social Security and Medicare contributions. While employers can make additional deductions like health insurance, you’re technically not “withholding” that income.
When an expense reduces your total gross income, your new income is known as your adjusted gross income, or AGI. For this reason, anything that reduces your income (deductions, credits, etc.) is categorized as an “adjustment.”
Standard deductions are deductions that everyone can claim, as per the IRS. The point of standard deductions is to exempt a certain portion of income from taxation. In 2017, the Tax Cuts and Jobs Act increased the standard deduction to $12,000 per person.
Business owners can either take the aforementioned standard deduction or itemize their deductions. When you itemize expenses, you list them in separate categories on your tax return. This would allow you to subtract these deductions directly from your taxable income.
Hence, it’s up to your accountant figure out which route would result in a lower taxable income: standard or itemized deduction.
Your general ledger contains every single financial transaction that has occurred since your first day in business. Whenever a transaction takes place, it goes in your general ledger. You can consult your general ledger to create financial statements, prepare your tax returns, track interest payments, etc.
Having an indisputable source of transaction data has countless benefits. If something on your financial statements seems incorrect, for instance, you could just look at your general ledger for an answer. Your general ledger also clearly distinguishes deposits from regular income. Though it’s not recommended to mix personal and business finances, most business owners end up transferring personal funds into their business bank accounts for one reason or another. Thanks to your general ledger, you can mix personal and business finances without confusing one for the other.
Chart of Accounts
Your chart of account (COA) is in your general ledger. It lists every account currently registered in your bookkeeping system. Displaying your accounts in this manner allows you to quickly draw conclusions while reviewing the data. Hence, you and your accountant should always make sure your COA stays up-to-date.
The definition of liability depends on the context. In accounting, liability is almost synonymous with debt. In addition to loans and credit card debt, liabilities include sales and payroll taxes. Excluded is the money you owe your vendors every month. So, when assessing your business’s liabilities, you are assessing the combination of debts and these two taxes. Unlike your vendor bills, these debts are paid off over time.
Comparing your liabilities to your assets provides another useful insight your financial health. If you owe more money than you have, the next slow period could prove hazardous. You’ll also likely have trouble qualifying for financing.
How Can Small Businesses Lower Their Tax Bill?
Every business leader wants to be that person who saves big on business taxes and therefore doesn’t dread tax season every year. You can be that person by following a fairly short list of basic guidelines designed to make tax season go as smoothly as possible.
Following these guidelines will prove that contrary to popular belief, there is no single “secret” to simplifying and capitalizing on business taxes. You just have to be extra aware of the fundamentals virtually every business leader has already heard at some point.
Here are a few tips for lowering your tax bill and making tax season less stressful:
1. Stay Organized and Up to Date
Rule number one for business taxes is staying organized and up-to-date. All relevant documents, like receipts and statements, should be preserved and recorded. Most business leaders tend to update their books monthly but it’s easy to forget about expenses or deposits in a few weeks’ time. If this sounds like you, you might want to update your books weekly, which will improve your memory so that you can eventually switch to monthly. In addition to keeping all important information in one place, accurate bookkeeping is crucial for claiming business expenses and being prepared in the event of an audit. If you plan on hiring a bookkeeper, make sure he or she is using cloud applications that allow you to access this data at any time as well.
Many mobile apps and software tools make it much easier to prepare for tax season.
Shoeboxed, for example, is a free app that stores your receipts, bills, and other financial documents. All you need to do is snap a photo, upload the document to the app, and it automatically extracts the important information, such as vendor, date, total, and payment type. In an instant, that information gets added to your fully searchable digital database of transactions.
2. Find a Good Accountant
The business leaders who save the most money during tax season have at least one thing in common. They all have knowledgeable and dedicated accountants at their disposal. Thanks to their accountants, these business leaders factored business taxes into nearly all major spending decisions. They knew what they could and could not deduct, and were up to date on the latest tax laws. Most business leaders are far too busy to do this themselves.
You could theoretically wrack your brain writing out a list of possible deductions. But your accountant will likely be able to produce a list that’s double the size in a quarter of the time. So, the next time you see an article give advice like “know what to deduct” or “make deductions work for you,” remember that these are just different ways to say “get a good accountant.”
3. Separate Personal and Business Finances
Business leaders are most susceptible to being charged with a false claim when they fail to separate business and personal expenses. You can avoid this scenario entirely by having a separate bank account and credit card for your business. This will allow you to clearly define which expenses and payments were personal or business-related. That’s one of the key differences between filing taxes as a business leader and an individual: having to show proof for deductions.
If you use a personal account to pay for a business expense, the IRS could technically classify this expense as a “hobby.” Without separate accounts, it could be difficult to convince the government that your deductions are indeed legitimate.
Even if you don’t face legal trouble, mixing business and personal expenses will make tax season much more frustrating (and expensive) than it should be. When you maintain accurate records of expenditures and income, it’s easy to put together the necessary statements and follow your business’s progress.
During their early days, countless small businesses make the mistake of mixing personal and business finances. In some cases, this is because some banks only let you open business checking accounts if you fulfill certain requirements. You might have to deposit a minimum amount into the account each month or maintain a minimum daily balance in order to avoid fees. Younger businesses might not be sure they can fulfill these requirements and don’t want to take on the stress of opening an account at a second bank. The solution is to simply open a second personal bank account. This will essentially act as your business checking account and allow you to separate your finances.
4. Know How Much To Pay Each Quarter
A critical advantage of staying organized and having a good accountant is knowing how much to pay the IRS each quarter. Your accountant will tell you how much of your income you should set aside every month for taxes, along with when to make quarterly payments. Assuming you know how much to save could be a mistake, since it could be anywhere from 25% to 35% of your gross income. Some businesses run the risk of having to pay penalties if they don’t pay quarterly estimates. Receipts from quarterly payments are also yet another important document to save with your records. You might need them to prove that you filed quarterly payments when it’s time to file your taxes.
5. Note Any Life Changes from the Past Year
A lot can happen in a year. Did you sell or buy a home? Change your marital status? Move to another state? Did your son or daughter start college? Certain changes to your personal life can affect your taxes. For example, there may be tax incentives for first-time home buyers as well as owners of investment properties such as commercial buildings. And if you listed your home for sale, be sure to ask your accountant about taxes on capital gains.
If your last name has changed due to marital status, you’ll need to apply for a new Social Security card. There will be a delay in processing if your social and your name don’t match on your tax form.
If you have a kid who just went off to college, you may be able to deduct a portion of their tuition. According to the IRS, you can claim the tuition and fees deduction if:
- You pay qualified education expenses of higher education.
- You pay the education expenses for an eligible student.
- The eligible student is you, your spouse, or a dependent for whom you can claim an exemption on your tax return.
6. Issue 1099s to Independent Contractors
If you’ve paid an independent contractor more than $600 per year, you need to send them a 1099-Misc form before tax season.
7. Leverage the Small Business Jobs Act of 2010
Though it was designed to increase accessibility to tax credits, the Small Business Jobs Act also provides $12 billion in tax relief for small businesses. Certain self-employed individuals can deduct the cost of health insurance for themselves and their family members. The use of mobile phones for business purposes can also be deducted without extra documentation.
8. Donate Unused or Unsold Business Inventory
Don’t waste money storing or trashing unsold inventory. Charitable donations have recently become one of the most advantageous deductions for small businesses. Thus, many businesses are finding new ways to capitalize on this deduction. However, it’s important to note that donations greater than $500 have more rigorous reporting rules.
9. Donate Appreciable Stocks Instead of Money
This is a very smart way to maximize your donations deduction. You can deduct the worth of the stock at tax time, not the worth at the time of purchase. So if the stock appreciates, you get a bigger piece of the pie on that deduction.
Do you contribute to charitable organizations throughout the year? If so, IDonatedIt is an app to help track and value your non-cash charitable donations. These are tax-deductible expenses that can reduce your taxable income and lower your tax bill. To document your donations quickly and easily, just open IDonatedIt and input the donation date, the charity name, and the fair-market value of the item. You can also attach photos of donated items and email the detailed donation report to yourself or your accountant.
10. Capitalize on Home Office Deduction
If you have an actual home office, you can capitalize on a considerable deduction. Your accountant will likely calculate this deduction by dividing the size of your home office by the square footage of your entire home. This percentage will allow you to deduct a portion of your home-related business expenses (mortgage interest, insurance, utilities, repairs, etc.).
If you use only part of your kitchen or living room to conduct business, your accountant will find a more IRS-friendly amount to deduct.
11. Claim the Mileage Deduction Instead of Auto Expenses
Are gas prices on the higher or lower side? In the case of the former, you might consider claiming the mileage deduction instead of the deduction for auto expenses. Numerous mobile apps make it much easier to track your mileage.
12. Don’t Save Everything For One Day
Many business leaders like to take care of their tax returns in a single day. They believe that devoting an entire day to this tedious process will make it less stressful. But then they realize that before going over deductions and filling out paperwork, they must first sift through piles and piles of documents and receipts. That might take a while. So, rather than saving both processes for a single day, split it into two. Take one day to gather all the materials for deductions you need and another to complete the actual tax return. Just like any other business endeavor, the more time you spend preparing for a task, the easier that task will be.
13. Use a Reliable Accounting Software
With so many accounting software tools available, it can be difficult to find the right one for your business. Odds are, this decision will come down to the size of your business and your business’s revenue system.
Here’s what to look for in a reliable accounting tool:
- Customization possibilities – The software should allow users to customize invoice templates, create personalized receipts or add customized reports.
- Easy to use – You don’t need to be a rocket scientist in order to use accounting software, so make sure it has a user-friendly interface that’s easy to understand.
- Industry-preferred – Different industries prioritize different features, which is why there are so many types of software on the market. Before choosing a system, find out which one is most popular with your closest competitors.
- Backup functionality – This feature is crucial in a world where more and more small companies are hit by cybercriminal attacks;
- Secure to use online – If your software allows access from any location, check the type of servers and connection they use. The developer should use an encrypted connection, to prevent any data loss when you’re connecting from a remote location, and the servers should be fast, secure, and updated regularly.
- Customer Support – Make sure you can reach the developer anytime you have a question, or something doesn’t go according to plan. Software tools can have hidden bugs or faulty updates, so you should always have access to reliable support.
- Scalability – If you plan on growing your business, make sure the software can support a more complex financial system.
14. Don’t Take a Large Salary
One reason many new business owners don’t pay themselves at all is that from a tax standpoint, the advantages clearly outweigh the disadvantages. To determine if you fall into this group, consider your business entity and whether it’s best to calculate your salary via the owner’s draw method or the salary method. Depending on these two factors, there could be more tax benefits to reinvesting most of your profits into your business rather than taking a full salary.
The Owner’s Draw Method
The owner’s draw method takes your salary as a percentage of the company’s profits, but only the profits and not revenue. Business owners who use this method are not legally obligated to withhold for Medicare, Social Security, or federal and state income taxes when they take their paychecks. Come tax season, however, you’ll still have to report that income and pay the equivalent taxes on it. You must therefore keep accurate records of your own income and consistently put money away for your upcoming tax payment.
The Salary Method
The salary method pays you at a fixed interval like the rest of the workforce (usually bi-weekly). Thus, your paycheck is either a flat amount or determined by how many hours you worked in that interval.
According to the legal obligations from the previous section, officers of C-corporations (CEO, COO, etc.) and owners of S-corporations must be compensated through the salary method. These obligations also state that their paychecks must include deductions for Social Security, Medicare, and federal and state income taxes.
Of course, it’s your accountant’s job to know which tax regulations have the biggest impact on your company. Reinvesting most of your profits could minimize your tax burden, not to mention increase your eligibility for the most desirable business loans. Traditional institutions like banks are historically biased towards applicants with “skin the game.” In their eyes, people who invest in their own businesses are less likely to let those businesses fail.
Your accountant could also present strategies in which the bulk of your salary comes from capitalizing on certain deductions and tax breaks. Ultimately, the two of you will decide whether taking a smaller salary offers more pros than cons for your business.
15. Use Cash Basis Accounting
The majority of US small businesses use cash basis accounting when keeping financial records and filing tax returns. With cash basis accounting, income is recorded when it’s officially in your bank account.
For example, let’s say you completed a project for a client on June 15. Afterwards, you sent that client an invoice with a due date of July 3. Even though you did the work and billed the client in June, you won’t record the income until you actually receive it in July. The income will therefore appear on your financial statement for July, not June.
Cash basis accounting also records expenses once they are paid, as opposed to when you receive the bill or when the payment is due. Let’s say you forgot to pay a recurring bill that was due by the end of August. At the end of September, you’ll probably receive a statement asking for August’s bill as well as September’s. So, even though the bill was due in August, cash basis accounting says the expense should show up on your financial statement for September.
With accrual basis accounting, income is recorded when it’s earned, not received. And by “earned,” we mean a sale or deal taking place. Let’s say you are tasked with a project in June but don’t get paid until July. The income would still show up on June’s financial statements. It was during this month that the initial sale took place, even though you did not receive any income up front.
How Does Accrual Basis Accounting Raise Your Tax Bill?
Accrual basis accounting records expenses when they’re incurred, as opposed to when you actually pay them. So, even if you forget to pay a recurring bill that’s due in August, the bill would still show up on your financial statements for that month.
Since accrual basis accounting records income when it’s earned, you may also end up paying taxes for money that has yet to reach your bank account. Businesses that use accrual basis accounting tend to pay higher taxes in general.
We previously noted that accrual basis accounting can lead to paying higher taxes. Well, that’s the last thing a new entrepreneur wants to do, especially if revenue hasn’t taken off just yet. Luckily, cash basis accounting shows you exactly how much cash you have in your bank account at any time.
Let’s say you performed a service before the deadline for filing tax returns, but the client paid you after the deadline. With cash basis accounting, you wouldn’t have to report the sale for the previous year’s taxes because the income didn’t hit your bank account. Instead, you’d report the revenue and pay taxes on it for the new year.
Which Businesses Must Use Accrual Accounting?
Despite the popularity of cash basis accounting, it would still make more sense for certain businesses to use accrual basis accounting. Here’s a few of those scenarios:
- Your average gross revenue over a three year period exceeds $25 million
Any business that averages more than $25 million in gross receipts must use accrual basis accounting when filing tax returns. Up until 2019, the threshold for using accrual basis accounting was $5 million. That ended with the passage of the Tax Cuts and Jobs Act.
- You sell inventory
Another provision of the Tax Cuts and Jobs Act affects businesses that sell inventory. Prior to the law, any business that sold inventory had to use accrual basis accounting. Today, businesses that have earned up to $25 million in revenue over the past three tax years can either categorize their inventory as “non-incidental materials” or use the same accounting method from their previous financial statements.
- Your state’s sales tax laws require it
Certain states require businesses to use accrual basis accounting when filing sales tax returns. Businesses located in these states must therefore take extra measures to ensure timely payments after sending invoices. Failing to do so could essentially result in paying sales taxes on money they haven’t received. Examples of such measures include an automated invoicing system or accounts receivable/invoice factoring.
16. Use a Business Loan at the End of the Year
Taking out a small business loan towards the end of the year is another popular strategy for reducing taxable income. For example, a retailer or wholesaler might use a loan to capitalize on year-end inventory sales or clearance events. Paying a portion of the price upfront might result in even greater savings.
However, you can only use this strategy by working with a business lender that can approve your desired amount as soon as the sale begins. Thus, you should start researching potential lenders well before the winter to find one that fulfills these two qualities.
17. Small Business Loan Interest Rate Deductions
If you took out a business loan this year, the interest from each monthly payment may be tax deductible. This is because the interest rate you pay is considered to be an actual business expense. However, it’s important to note that this tax deduction only becomes available when you start spending the business loan on business-related expenses. In other words, you can’t claim the deduction if you keep the money in a bank account and don’t it, even if you’re paying interest.
Business Taxes: It’s All About the Right Resources
Business taxes don’t have to be complicated. In fact, you could say that the only hard part is gathering the various resources you need to get your books in order and capitalize on the most advantageous deductions. To clarify, you must take the time to find a good accountant and the right accounting software for your business. Once these steps are out of the way, you won’t have to worry about missing out on opportunities to lower your tax bill.