When’s the best time to start planning for taxes? How about now! Tax planning for small businesses is essential for long-term profitability and financial health, so use this time to create your plan for the year ahead. The right strategy can ensure that your business follows the law and minimizes tax liabilities to keep your business growing.
In this overview of tax planning for small businesses, you’ll learn some of the major variables that can impact your business taxes and time-tested advice on reducing the amount you owe while staying compliant with the Internal Revenue Service (IRS) and your state and local tax agencies.
How do taxes benefit your business?
Rather than thinking of taxes as a financial burden, think of them this way: If your business owes taxes, you’ve gone from simply having an idea, to successfully launching and growing your business. People are willing to pay for your products or services, and you may have employees, too, along with some profit. These are all great signs!
Although there’s no getting around taxes, there may be steps you can take to reduce your tax liabilities, which is the amount of your business revenue that has to go toward taxes, while still following federal and state tax laws. Filing your taxes also helps you prepare for small business loans because most lenders will require your tax returns as part of the application and approval process.
How does your legal entity impact your business taxes?
It’s important to think strategically about your business taxes and how certain decisions can impact your tax liability. Some examples may include your business’s legal entity, the retirement program you use, and the timing of large investments in equipment or property. You should also have conversations with your tax professional to minimize what you owe and maximize short- and long-term benefits to you and your business.
Let’s look at the impact of different types of business structures on your taxes:
Sole proprietorship
This is the most common business structure for small businesses, and it’s often used when first launching a business. That’s because it’s easy and inexpensive to start (typically, just a simple form filed with your local county offices).
As a sole proprietor, you and your business are considered the same from a tax and legal perspective. This means that although you’ll file special forms for your business’s revenue and expenses as part of your personal tax filing, your personal and business taxes are ultimately calculated together to arrive at your final tax liability. It also means that you‘re responsible for any debts or legal challenges the business has.
Along with income taxes, sole proprietors need self-employment taxes as part of your overall tax liability. This amount covers deductions, like Social Security and Medicare, that would come out of a paycheck if you had a job. This can be a surprise for new business owners who may only estimate to pay taxes based on income, so be sure to include this as you pay your quarterly estimated taxes, or you could end up with a large tax bill at the end of the year.
Partnership
For tax purposes, simple partnerships are similar to sole proprietorships in that your business’s income, expenses, and tax liability are a part of your personal tax returns. There are some different forms and filings required for partnerships than for sole proprietors. However, you’re still responsible for self-employment taxes on business income, as well as for personal tax liabilities.
Limited Liability Companies (LLCs) and Limited Liability Partnerships (LLPs)
LLCs and LLPs have risen in popularity in recent years. Although they’re a bit more complex and expensive to start, they may offer advantages with personal protection from some business debt and other liabilities.
LLCs can be single-owner businesses or partnerships, while LLPs will always have at least two owners. They both offer flexibility in how tax liabilities are calculated, including as sole proprietors (for single-owner LLCs), partnerships, or corporations.
S Corporations
S Corporations are a tax structure that can be selected if your business is an LLC, an LLP, or a C Corporation. Although it is somewhat more complex from operational, reporting, and tax-liability perspectives, it also offers some advantages. This includes the potential to reduce individual tax liabilities and personal legal and other financial liabilities because the entity is considered separate from the owner.
C Corporation
C Corporations are the type of business structure most often associated with large businesses, although small businesses can also choose to incorporate as C Corporations. While these structures provide some benefits to owners, they’re probably the most complex from operational, reporting, and tax-liability perspectives.
There’s also the potential to pay higher tax rates or be double-taxed, making it less advantageous. However, if your small business grows to the point where this is necessary, you likely already have a strong legal and accounting team to advise you further.
Every business structure has advantages and disadvantages for small business owners, including for tax-planning purposes. That’s why it’s important to discuss your situation with your accountant and business attorney. You should also know that your business isn’t tied to a specific structure forever. Many small businesses start as sole proprietorships or simple partnerships and evolve later to take advantage of tax benefits and other protections.
Can you receive tax deductions for your small business?
Tax deductions are specific expenses your business can subtract from revenue to reduce your taxable income and lower overall tax liability. This means that many of the costs of doing business – such as marketing, cost of goods or inventory, rent, employee pay, and much more – can be used to reduce your taxable business income.
Being aware of typical tax deductions can support your small business tax planning. As an owner, having these on your radar can help you better plan for time investments, financing, and other major financial decisions. Again, you should talk to your CPA or accountant as you plan because tax codes are constantly changing, and every small business is different. This makes it hard for financial staff or a tax preparer to keep up, despite their best efforts.
What are some tax deduction strategies for your small business?
While working with your tax professional, explore these options to see if any of these strategies are right for your business now, as well as what you can build into your longer-term tax-planning strategy:
- Deferring income: If this is realistic for your business, deferring income to the following tax year can potentially lower your tax liability. For example, if your business operates on a cash basis, you can defer receipt of invoice payments until early in the following year. While this isn’t always an option, it can be useful when your revenue, reserves, and cash flow allow for it.
- Contributing to retirement plans: Whether for yourself or your employees, contributions to qualified retirement plans may reduce your tax liability. Some retirement plans that may qualify for reductions include SEP IRAs, SIMPLE IRAs, and 401(k)s.
- Tax credits: Tax credits allow you to deduct the amount of the credit from the income tax you owe, reducing your overall tax liability. There are several tax credits available. For example, if you pay for employer-provided child care, your business may qualify for a credit.
What are some common small business tax challenges?
Along with doing the right things, an important part of tax planning for small businesses is avoiding expensive errors. Here are some common tax errors that the IRS has noted:
- Underpaying estimated taxes: Underpayment of income taxes and self-employment taxes is penalized at relatively high rates. And, because many small business owners don’t realize you need to pay self-employment taxes, you can owe a significant tax payment and penalties.
- Depositing or using employment taxes: If you have employees, an amount is deducted for Social Security and Medicare taxes every time they’re paid. As the employer, you’re supposed to hold these until they’re due—and then they’re to be paid on time and in full, no excuses. At the very least, not paying employment taxes when due can cause significant penalties.
- Filing late: Simply put, all taxes must be paid on time. It’s important to know that even if you receive an extension for your tax filings, the IRS and state agencies expect your taxes to be paid by the original filing date. Not complying with this can also give you expensive penalties.
- Not separating business and personal finances: Often (especially in the first years of business), business owners will co-mingle business and personal finances. It’s important to know that this isn’t a good practice. At best, it makes it difficult to tell personal expenses from business expenses, and at worst, if you or your business is audited, it can create significant financial challenges.
For these reasons and more, it’s essential to pay taxes on time, in full, and supported by appropriate financial records and receipts.
How to keep good tax records
Here are some record-keeping best practices to help you with your tax planning:
1. Add record-keeping systems in your daily operations
Whether this means digitizing receipts, storing records, or using software programs to organize and track your records, be sure to have a system in place and review it regularly to ensure that it moves along with your business.
For example, if you have a relatively simple, one-person business, then paper files, digitized records, and an Excel spreadsheet may work. However, as your business grows, ensure your record-management system keeps up. It’s also a good idea to create a backup system, such as a cloud-based file that stores your records for you, and to start a new and separate digital file for your personal and business records each year.
2. Regularly review your business operations for efficiencies
Most small business owners intend to keep good records, but it can be hard to keep up as your business expands and your time gets stretched even further. Implementing a routine from the start is helpful, although it can be easy to let this task slip over time.
There are software programs that can help you better manage this important task, so ask your accountant and other small business owners for recommendations.
3. Keep your records available
For small business owners, it’s a good idea to keep your business records and tax filings available for seven years. For capital investments related to your business, like home improvements that impact your home-office deduction, you should keep those receipts for as long as you own the asset. This ensures you have the information you need if you’re ever audited.
4. Stay in contact with your tax professional
If you wait until tax season to reach out to your accountant or tax professional, you may find yourself caught in their busiest time of the year – meaning longer wait times and possible delays. Staying in regular contact helps ensure your tax-saving strategies are planned and implemented throughout the year so they’re most effective.
While tax planning may sometimes feel like one more task on your long to-do list, you can benefit in the short and long run.
Pursuit can help
Once you’ve got your tax strategy in place, if you need financing to achieve your goals – such as purchasing equipment or commercial property for your business, securing working capital to help you grow, or simply getting financing to strengthen your financial foundation – Pursuit can help.
We offer more than 15 loans and a line of credit for small businesses in New York, New Jersey, Pennsylvania, Connecticut, Illinois, and Delaware. In addition, Pursuit’s Business Advisory Services offers expert consulting services in financial management, human resources, marketing, and more.
Contact us to learn more.