[This article has been updated to reflect the new tax law that went into effect on January 1, 2018]
Taxes for small businesses can be confusing and, as a small business owner, you likely have several questions: How much do I pay? Why do I have to pay this amount? How can I reduce taxable income?
Finding ways to lower your taxable income legitimately and avoiding pitfalls are important activities that can have great returns: lower taxes for your small business.
Unfortunately, many small business owners overpay on their taxes by missing out on certain deductions or managing their businesses and retirement savings in a way that is not efficient for tax purposes. Considering the U.S. tax code is roughly 70,000 pages long, it’s understandable why small business owners and even accountants have trouble navigating it. There are many complexities to deal with when trying to minimize your tax bill, but, with the right strategies, you can save money on taxes while making your life easier throughout the year, as well as during tax season.
Here are 10 ways to save money on your small business taxes:
1. Keep an eye on adjusted gross income.
Many tax breaks, limitations, and additional taxes tee off of adjusted gross income (AGI) or modified adjusted gross income (MAGI), 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 your AGI does not exceed $200,000 if you’re single or $250,000 if you’re married filing jointly. (Despite other tax cuts that were part of the Tax Cuts and Jobs Act of 2017, this tax, which was intended to help pay for Obamacare, is still in effect.)
2. Use accountable plans.
If you reimburse employees for travel, entertainment, tools, or other costs, consider doing 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, potentially saving the company employment taxes and lowering taxable income overall.
Also, if your company does not already offer an accountable plan for employee reimbursement, your employees will likely soon be asking you for one — because, under the new tax law, employees cannot deduct miscellaneous unreimbursed employee expenses. Giving your employees an accountable plan for reimbursements can help your employees save money on taxes, as well as helping the business — it’s a win-win.
3. Make smart tax elections.
There are several ways to reduce your taxable income by being strategic about your business expenditures. For example, you are allowed to deduct the cost of acquiring machinery and equipment in full, up front, up to a set dollar amount — $500,000 in 2017, and increasing to $1 million in 2018 as part of the new tax law.
However, if your business is just starting up or is not yet profitable, you can ask your accountant about depreciation for these items — it might be better for your overall tax situation if you can spread out the value of the purchases across your future tax years instead of deducting the full purchase price all at once. This can help produce deductions for future years when these assets 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 to ask your accountant about:
- Deducting vehicle expenses based on actual costs or the IRS mileage allowance(currently 53.5 cents per mile)
- 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.
In addition to claiming disaster losses, you can also consider deducting the business insurance expenses that you pay every year. IRS form 1040 can help you determine your business insurance deduction. The following is a list of different business insurance coverages that you can deduct:
- Liability insurance
- Workers’ compensation insurance
- Commercial auto insurance
- Business interruption service insurance
Because unscrupulous people sometimes form small businesses as a fraudulent means to cheat on taxes, the IRS has begun to more heavily scrutinize small business filings to make sure the companies are legitimate businesses, and not just tax shelters. Small businesses that are registered as the following should consider seeking professional assistance in learning what insurance premiums can be deducted as legitimate business expenses:
- Single person LLCs
- Sole proprietorships
- Separate entities
4. Don’t overlook carryovers.
Certain deductions and credits have limitations that can prevent you from using them fully in the current year, but could permit a carryover to future years. Keep track of carryovers so that you won’t forget to use them in future years (this is done automatically by most 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 (limited to 80% of taxable income)
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 possibly benefit from your business’s success without triggering tax. Consider talking to your accountant about:
- 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 loan interest is below IRS-set rates (also known as Applicable Federal Rates), the business may have to report interest from this arrangement, but with interest rates low, this isn’t too costly these days.
6. Consider the benefits of abandoning property rather than selling it.
If property has no value to the business, talk to your accountant about the benefits of abandoning it rather than selling it for a nominal amount. This could allow 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, which is another way to reduce your taxable income. Tax-exempt benefits you can consider offering your employees include:
- Health benefits
- Long-term care insurance
- Group term life insurance
- Disability insurance
- Educational assistance
- Dependent care assistance
- Transportation benefits
- Meals provided for employee convenience
More details on the tax benefits of fringe benefits plans are available in IRS Publication 15-B (2017), Employer’s Tax Guide to Fringe Benefits.
8. Shelter profits in retirement plans.
It’s actually quite easy to set up a simple retirement plan for your employees, such as a 401(k) or a similar tax-deferred retirement plan where employees can make tax-deductible contributions to save for their future. With a tax-deferred retirement plan like a 401(k) or traditional IRA, the employee doesn’t pay taxes currently on contributions to retirement plans. Instead, the retirement savings funds grow on a tax-deferred basis; distributions are taxable when taken in the future (when the employee 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 while giving them choice and flexibility in planning for retirement, instead of a defined benefit pension plan where more of the burdens are on the employer.
Also, setting up a retirement plan is not just good for employees — it’s good for your company. That’s because employer contributions to an employee retirement plan are tax deductible and you might qualify for a tax credit for setting up your employee retirement plan.
9. Do year-end planning.
While tax planning is a year-round activity, you can achieve dramatic savings by taking 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 lowers your business’s tax liability for the current year, since you can move those profits into the next tax year and defer tax on the cash you would be collecting for one year. Of course, tax planning should be sensitive to business realities; don’t defer income in this manner if you are having a cash flow shortfall or have concerns about the ability of a customer to pay. Be sure to speak with your accountant about this.
There are several other strategies that can help you lower your taxable income just before the end of the year. One strategy is to purchase fixed assets and claim a portion of depreciation immediately. It is also important to revalue your assets that are listed on your books. This can help lower your net profit, as you increase depreciation claimed on the asset. If an asset has no use or is of no more value, ask your accountant if you should delete it.
If you have an account receivable with a customer who is unlikely to pay, then you might be able to write this off as an uncollectible debt, also known as a Bad Debt Deduction. It will be considered a loss and will allow you to lower your profits and taxes; however, to qualify for this deduction, you must have previously included the bad debt in your business income, and you must have intended the transaction to be a loan, such as a loan to clients and suppliers, credit sales to customers, or business loan guarantees.
Lastly, when it comes the end-of-year planning, it’s best to have your taxes filed and submitted on time. There are separate penalties that apply for late filing and for late payment, so you should file on time even if you’ll need more time to pay.
Many small businesses and small business owners will likely be paying lower tax rates in 2018 — so that means you should work hard to minimize your 2017 income by making additional 2017 contributions to tax-deductible plans like your traditional IRA, SEP-IRA, 401(k), and Health Savings Account (you can make prior-year tax-deductible contributions to all of these plans until the 2017 tax filing deadline of April 17, 2018).
Even if “last year” is over, you can still make some tax moves within the first quarter of the new year to help save money on “last year’s” taxes — and that is especially important at the start of 2018, when so many big changes are underway in the tax law that could potentially help you save money on taxes.
10. Change your business structure.
If you’re doing business as a sole proprietorship or partnership, it may be time to pick a new business structure. Many small business owners choose to do business as an LLC (Limited Liability Company), a “pass-through entity” that offers significant flexibility for the tax treatment of your business income.
For example, an LLC can elect to be taxed as an S corporation. In this way, the business owner pays themselves a reasonable salary (which is subject to FICA taxes just like any employee’s salary), but then the rest of the LLC’s income passes through as a “distribution” of business income that is not subject to FICA taxes. Operating as an LLC and filing taxes as an S corporation can help you save significant money at tax time, because it helps you avoid owing self-employment tax on a large portion of your income.
If no such election is made — and the LLC does not pay taxes as an S corporation — then the LLC owner has to pay self-employment tax (the equivalent of the employer’s and employee’s share of FICA) on all the business’s 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. This can add up to thousands of dollars in tax savings.
Another advantage to structuring your business (if you haven’t already) as an LLC or other pass-through entity is this — beginning with the 2018 tax year, owners of LLCs and other pass-through entities will be able to deduct 20% of their business income on their individual tax returns.
There will be some limitations and exceptions to this pass-through deduction — for example, the deduction is phased out for owners of service businesses with taxable income of $315,000 or more for married filing jointly/$157,500 for single filers.
There are some additional complexities to the pass-through deduction depending on what type of business you operate — for example, the maximum deduction depends on your company’s total wages and capital investment — so be sure to talk with your accountant about what the new tax law means for you.
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 new ways to lower taxes for your small business. This is especially important as you enter 2018. With all of the new rules for personal and business tax deductions, the moves you make now can potentially save you significant amounts of money this year and into the future.