Small business taxes 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?
Understanding how to reduce taxable income legitimately and avoid pitfalls is important and can have great returns.
Understanding How to Save Tax in 2020
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 during tax season.
Here are 10 tips to reduce taxable income for small businesses.
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). For example, you’ll avoid the 0.9% additional Medicare tax on earned income if your AGI does not exceed $200,000 (single) or $250,000 (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. Reimburse Using an Accountable
If you reimburse employees for travel, entertainment, tools, or other costs, consider doing so using a plan that meets IRS requirements. This 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. 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 for how to reduce 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, upfront, up to a set dollar amount. In 2018 that expensing cap increased to $1 million per 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 58 cents per mile)
- Deducting vehicle expenses based on actual costs or the IRS mileage allowance. Beginning in January 2019, it became 58 cents per mile.
- Deducting home office expenses based on actual costs or the IRS simplified rate. The current standard deduction is $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.
Another method for how to save tax is that 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:
- General Liability Insurance
- Workers’ Compensation Insurance
- Commercial Auto Insurance
- Business Interruption 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 and carryovers are a way to reduce taxable income. 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
Salary, bonuses, and distributions of your share of business profits are taxable. However, there are ways in which you can possibly benefit from your business’s success without triggering the tax. Consider talking to your accountant about:
- Tax-free fringe benefits, including medical coverage, health savings accounts, 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.
Learn more about the types of income that are tax-free.
6. Consider Abandoning vs Selling Property
If the 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.
7. Use Fringe Employee Benefits Plans
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. Tax-exempt benefits you can consider offering your employees include:
- Employer-sponsored health insurance
- 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 (2019), Employer’s Tax Guide to Fringe Benefits.
8. Shelter Profits in Retirement Plans
It’s actually quite easy to set up a simple small business retirement plan for your employees. An employer-sponsored 401(k) or a similar tax-deferred retirement plan will allow employees to 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. This means 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. Many small businesses prefer this over 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 action at the end of the year. There are several strategies that can help you lower your taxable income just before the end of the year.
- Delay billing for unpaid work until payment is received. If your business uses cash basis accounting, you can delay billing for work done at the end of the year until payment is received in the following year. This lowers your tax liability in the current year. Just don’t defer income if you are having a cash shortfall or have concerns about the customer’s ability to pay.
- Purchase fixed assets and claim immediate depreciation. You can lower taxable income in the current year by claiming a portion of depreciation on recently purchased fixed assets. It is also important to revalue your assets that are listed in your books. This can help lower your net profit as you increase claimed depreciation. If an asset has no use or value, ask your accountant if you could delete it.
- Write off bad debt. 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. This is 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. You must also have intended the transaction to be a loan, such as a loan to clients and suppliers, credit sales to customers, or business-loan guarantees.
- File and submit your taxes on time. When it comes to 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.
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. This is especially important at the start of 2020 when so many big changes are underway in the tax law that could potentially help you save money on taxes. You can make prior-year tax-deductible contributions to all of these plans until the 2019 tax filing deadline of April 15, 2020.
10. Restructure Your Business
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). Why? Because it’s considered 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. The business owner pays themselves a reasonable salary (which is subject to FICA taxes just like any employee’s salary). 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. It would help 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 on all the business’s net earnings. This is the equivalent of the employer’s and employee’s share of FICA. For example, say the LLC has profits of $250,000 and it would be reasonable to pay the owner a salary of $100,000. 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.
As of the 2018 tax year, one other advantage to structuring your business as a pass-through entity began. Owners of LLCs and other pass-through entities are now 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 a 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.
Final Thoughts on How to Reduce Taxable Income
When it comes to how to save tax, 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 2020. The moves you make now can potentially save you significant amounts of money this year and into the future.