A sound tax strategy is a vital component of any successful small business. Developing one for your business will require you to make numerous important decisions on how your taxes are reported.
Taxpayers and their tax professionals work hard to develop strategies to minimize the tax obligation while staying in compliance with all applicable laws and regulations. To help you navigate these decisions and better guide you as you work with your business’s tax professional, we’ve compiled some common questions entrepreneurs ask when working on their tax strategy.
While Pursuit offers the following tips, we highly recommend that small business owners work with a tax and accounting professional to develop a tax strategy and to answer tax questions. By working with a tax professional, especially one that understands your industry, you’ll be able to present an accurate and reliable picture of your business financials through your tax returns.
Q: I pay both payroll taxes and taxes withheld from my employees. These are both deductible expenses, right?
A: Payroll taxes are reflected as a business expense on your income statement and your tax returns, but remember that there are two parts to this type of tax. Federal payroll taxes amount to 15.3% of gross wages. As an employer, you pay half of that amount and it is deductible. The other half is the amount you withhold from your employee’s check and pay on their behalf, and this is not deductible. Additionally, there are income taxes that you withhold from your employees’ checks, which are also not deductible.
Consider this simplified example:
An employee gets paid $1,000 in a pay period. The total payroll tax due for this employee’s pay period is $153. Half of that, $76.50, comes out of the employee’s check. You pay this amount on behalf of the employee and it is not deductible. The other half is an additional, actual expense for your business that you can deduct. You are then required to withhold approximately 25% of the check, $250, for income taxes on behalf of the employee, and this amount is not deductible.
After all has been accounted for, you get to write off the $1,000 in wages plus the $76.50 you paid as the employer’s portion of payroll taxes. The employee gets a check for $673.50, which accounts for their total pay ($1,000) less $76.50 (their payroll taxes) and less $250 (their income taxes). The difference between the $673.50 and their gross wage is the amount of taxes you’re withholding from them.
Think of the taxes that you’re paying on behalf of your employees as money that has already been spent on wages (that you can deduct) and then the taxes are just a piece you’re temporarily holding onto to give to the tax agencies.
Q: What about sales taxes? Are they deductible?
A: Sales taxes are deductible, but only if your pricing is tax-inclusive. This means that you’re quoting prices to your customers that include taxes. These taxes are then included in your revenue and you should include them as an expense when reporting taxes. If your pricing is tax-exclusive, this means you quote prices without tax and then add taxes on at checkout. In this case, the taxes are not included in your revenue and shouldn’t be included in expenses when reporting taxes.
Q: Should I switch my reporting from cash to accrual, or vice versa, to reduce my tax bill?
A: Simply put, cash basis reporting means you count sales and expenses whenever cash moves in and out of your bank account. Accrual basis reporting means you count sales when they are made (regardless of when you get paid) and expenses when they are incurred (regardless of when you actually pay them).
It is certainly worth a discussion with your accounting professional to determine the best way to report your revenue and expenses. If your company has a long lag time between when it pays for the costs of its goods and services and when it gets paid for those goods and services, then it might be time to switch to accrual basis reporting. Accrual basis reporting would more evenly align your revenues and expenses in the same period of time. In cash basis reporting, a company with the same timing gaps would have one reporting period with all revenues and few expenses (and a hefty tax bill), and another reporting period with all expenses and little revenue (and lower taxes, but an inaccurate picture of their operation).
Switching to accrual basis reporting for this tax year might not lower your taxes, but it will help keep your tax bills consistent moving forward. It is not recommended that you switch from accrual to cash basis just to avoid a large tax bill. Doing so will simply delay those profits to be taxed next year.
Q: I rely on the earnings of my company in order to pay personal expenses. Can I write off personal expenses that I charge to the business?
A: No. Per the Internal Revenue Service (IRS), any personal expenses that you charge to your business should not be counted as business expenses. The proper way to pay personal expenses from your business is to take a distribution as the business owner, and reflect that distribution as personal income on your own tax return.
It can be hard to tell whether some expenses are business or personal, like meals or travel, but others are more obviously personal expenses, like personal care or home services. Moving forward, keep your business and personal expenses separate, and avoid reaching for your business card at checkout when the cost is strictly personal.
Q: All of the money I spent starting my company can be counted as expenses on my taxes, right?
A: The purchase of furniture, fixtures, machinery, and equipment to start your business are considered to be purchases of fixed assets. These should be reflected on your company’s balance sheet, and not reflected as an expense on your business income statement. Your business gets to write off some of the value of these assets, which is called depreciation, and it will be reflected on your income statement in future years via a deduction for depreciation.
The IRS does allow you to expense up to $5,000 of your startup costs, including the purchase of assets, if your total startup costs are less than $50,000. However, if you choose to count the purchase of these assets as an expense, then you’ll give up the option of getting a depreciation write-off. Anything above $5,000 is expected to be treated just like the purchase of fixed assets: you count them towards your balance sheet and then get to expense their amortization, which is when a portion of these costs are counted as an expense over the long term.
Q: I’ve heard that a business is allowed to depreciate its assets in any way they choose. Is that true?
A: American tax code does provide very flexible rules for how businesses can depreciate their assets; however, there are certain restrictions.
The tax code specifically indicates the useful life, or maximum amount of time in which an asset can be depreciated, for every asset class. Apart from adhering to that defined timeline, as a business owner you have some flexibility. You can choose to depreciate your assets straight-line, meaning in equal amounts over that useful life, or take what’s known as accelerated depreciation.
Accelerated depreciation is when an asset incurs a larger amount of depreciation soon after it is acquired, and a lesser amount throughout the rest of its useful life. Businesses do this for a myriad of reasons, such as having a larger tax write-off when the asset is newer.
A common error that businesses make when using accelerated depreciation is incorrectly calculating each year’s write off. Many accounting software platforms don’t have the capability to automatically calculate accelerated depreciation, and business owners end up doing it themselves. A good rule of thumb is to make sure you track depreciation to date and never depreciate an asset more than the value for which you acquired it.
Q: Is the best strategy for a small business to reduce its tax liability when filing its annual taxes?
While you can reduce your tax liability by underreporting your revenue and/or over reporting your expenses that type conduct is criminal. Additionally, your access to capital from investors (equity capital) or lenders (leveraged capital) will be severely impaired as most evaluate the financial performance of the business by reviewing its tax returns.
All lenders and investors will ask to see your business tax returns before making a decision to provide funding to your business. If your business shows little or no profit on your tax returns, it will make it difficult or impossible to get approved for a loan, to attract other investors or even to sell your business for what it’s really worth.
We recommend that you take a long-term view of your business when forming a tax reporting strategy. Avoid criminal liability and maximize your value by reporting all income and expenses. Remember, income for tax purposes is reduced by deductions for business expenses, which may result in no tax liability at all.
When you first start your business, you should consult an accounting and tax professional for advice on the tax reporting method (cash or accrual), permissible business expenses, management of withholding for employees and payment of sales, withholding and income taxes. Once you are up and running, get advice from your accounting and tax professional periodically throughout the year to make sure you’re recording information the right way and gain an understanding of the process.
If you need help finding an accounting and tax professional, contact Pursuit’s Business Advisory Services team.