You don’t have to pay more than the tax law requires. But, as Albert Einstein said, “the hardest thing to understand in the world is the income tax.” Finding ways to minimize your small business taxes legitimately and avoiding pitfalls are important activities that can have great returns: lower taxes. Here are some good ways to do this.
1. Keep an eye on AGI.
Many tax breaks, limitations, and additional taxes tee off on adjusted gross income or modified adjusted gross income, which for most filers is the same as AGI. For example, you’ll avoid the 0.9% additional Medicare tax on earned income from a salary or self-employment if AGI does not exceed $200,000 if you’re single or $250,000 if you file a joint return with a spouse.
2. Use accountable plans.
If you reimburse employees for travel, entertainment, tools, or other costs, do so using a plan that meets IRS requirements, which is called an accountable plan. With this plan, the business deducts the expenses but does not report the reimbursements as income to employees, saving the company employment taxes.
3. Make smart tax elections.
Even though the year has ended, you can still favorably impact taxes by making tax elections for optimum results. For example, you are allowed to deduct the cost of acquiring machinery and equipment in full up to a set dollar amount ($500,000 in 2013; $25,000 in 2014 unless Congress increases this limit). However, if you’re just starting up or are not profitable, you can simply use depreciation for these items. This produces deductions for future years when they may be more valuable to you. For example, if you are in the 15% tax bracket now but expect to be in the 35% bracket in the future due to increased profitability, a $10,000 deduction would have you currently saving only $1,500 in taxes; depreciation over five or seven years (depending on the type of item) would produce total savings in the 35% bracket of $3,500, or $2,000 more. Other options:
- Deducting vehicle expenses based on actual costs or the IRS mileage allowance (56.6 cents per mile in 2013; 56 cents per mile in 2014)
- Deducting home office expenses based on actual costs or the IRS simplified rate ($5 per square foot up to 300 square feet of space)
- Claiming disaster losses on prior-year returns rather than on the return for the year in which the disaster occurs
4. Don’t overlook carryovers.
Certain deductions and credits have limitations that prevent you from using them fully in the current year, but permit a carryover to future years. Keep track of carryovers so you won’t forget to use them in future years (this is done automatically by tax preparation programs and should be done by tax professionals you may use). Examples:
- Capital losses
- Charitable contribution deductions
- General business credits
- Home office deduction
- Net operating losses
5. Use tax-free ways to extract income from your business.
While salary, bonuses, and distributions of your share of business profits are taxable, there are ways in which you can benefit from your business’ success without triggering tax. Consider:
- Tax-free fringe benefits, including medical coverage and retirement plans.
- Loans by the business to you on a no- or low-interest basis. If the interest is below IRS-set rates, the business may have to report interest from this arrangement, but with interest rates low, this isn’t too costly these days.
6. Abandon property rather than selling it.
If property has no value to the business, you may want to abandon it rather than selling it for a nominal amount. This allows the business to take an ordinary loss on the property, which is fully deductible, rather than treating the loss as a capital loss, which is subject to limitations. Depending on the property, it may be classified as Section 1231 property, a loss on which may be ordinary or capital, depending on other Section 1231 transactions for the year and prior Section 1231 losses.
7. Use fringe benefit plans for employees.
Additional wages trigger employment tax costs for the business, but if the business pays for certain fringe benefits for employees, these taxes can be avoided. Find a complete list of fringe benefits that are exempt from FICA taxes in IRS Publication 15-B.
8. Shelter profits in retirement plans.
It’s actually quite easy to set up a simple retirement plan for your employees. You don’t pay taxes currently on contributions to retirement plans. The funds grow on a tax-deferred basis; distributions are taxable when taken in the future (when you may be in a lower tax bracket).
There are several retirement plan choices. The one to use depends on your situation. Remember that if you have employees, the business must cover them on a nondiscriminatory basis (owners and management cannot be favored). But a plan such as a 401(k) shifts most or all of the cost of savings to employees.
9. Do year-end planning.
While tax planning is a year-round activity, you can achieve dramatic savings by actions at the end of the year. For example, if your business is on the cash basis for accounting purposes, you can delay billing for work done late in the year so that payment will be received in the following year. This effectively defers tax for one year. Of course, tax planning should be sensitive to business realities; don’t defer income in this manner if you have concerns about the ability of a customer to pay.
10. Change your business structure.
Whether you’re a sole proprietorship, limited liability company (LLC), or use some other business structure, it may be time to pick a new business structure. For example, an LLC can elect to be taxed as an S corporation. In this way only salary paid to the LLC owner is subject to FICA taxes. If no such election is made, the LLC owner pays self-employment tax (the equivalent of the employer’s and employee’s share of FICA) on all of the business’ net earnings. For example, say the LLC has profits of $250,000 and it would be reasonable to pay the owner a salary of $100,000 if an election to be taxed as an S corporation is made. Without an election the owner pays self-employment tax on $250,000; with the election, the business and the owner each pay FICA only on $100,000.
You can reduce the amount of taxes you pay if you take advantage of breaks and opportunities that are out there. It’s up to you (and your tax advisor) to discover them!