[This article has been updated to reflect the new tax law that went into effect on January 1, 2018]
Business decisions have tax consequences — whether it’s investing in new business equipment, giving your employees a raise, or making contributions to the company retirement plan. Understanding the tax implications of the actions you take — from day-to-day activities to long-range planning — can help you conserve cash flow, run your business better, and avoid problems with the IRS.
Here are a few of the most common tax issues for small businesses. Making the right decisions in these areas can help you save significant time and avoid big headaches not only during tax season but also throughout the fiscal year.
1. Choosing the Right Business Entity
When you’re just starting your business, you can select the type of business entity that best suits your needs and goals. The five main choices are sole proprietorship, partnership, limited liability company (LLC), S corporation, and C corporation. The one you select depends on various factors, including:
- The number of owners
- Concern about personal liability protection
- Payroll issues — including payroll taxes, fringe benefits, and the opportunity for deferred compensation
- Whether the business operates in more than one state
- Exit strategies
From a tax perspective, the choice of entity impacts income taxes, as well as Social Security and Medicare taxes. For example, a sole proprietor pays self-employment tax (both the employer and employee share of FICA) to cover Social Security and Medicare taxes on his or her net profit. If the owner incorporates as an LLC or a C corporation and takes a salary, only the salary is subject to FICA tax. Your choice of business entity can have significant tax consequences. Consult with an accountant or other professional tax advisor if you have questions about which type of business entity is best for your needs.
The new tax law that went into effect Jan. 1, 2018 includes several significant changes specific to corporate income tax. The corporate tax rate has been lowered to 21%, offering a significant tax cut for C corporations; also, small businesses that operate as pass-through entities (LLCs, sole proprietors, partnerships, and S corporations) will be able to take a new deduction of 20% of the owners’ business income (with some limitations — for example, professional services firms that operate as pass-through entities and have income of $157,500 if single, $315,000 or more if married filing jointly, will not be eligible for this 20% deduction).
Also, remember that you can change your business structure if necessary; owners aren’t locked into their initial choice for their business entity. For instance, if the business has been operating as an S corporation, which is limited to 100 shareholders, but the business owners decide that they now want to raise money from a large number of people through an Initial Public Offering (IPO) or equity crowdfunding, the S corporation election can be terminated, and you can choose to do business as a C corporation instead — permitting you to have more flexibility in the number of owners and the issuance of stock.
However, keep in mind that changing entities can trigger new taxes, additional paperwork, or extra regulatory reporting requirements, so it’s essential to plan ahead, know the advantages and drawbacks of each choice of business entity, and choose the business structure that best suits your business’s needs.
2. Sheltering Profits
When businesses are successful, how can owners minimize taxes and/or extract profits with little or no taxes? There are various legal strategies that can be used.
- Saving through a qualified retirement plan. Contributions to qualified retirement plans are tax deductible, so, to the extent profits are added to a plan, they are not currently taxed. Having a retirement plan helps ensure you’ll be provided with retirement income, even if the company fails along the way or does not sell at retirement for what you may have expected to receive.
- Deferring compensation. Instead of taking all of the compensation ordinarily due now, such as year-end bonuses, corporate owners can agree to defer it in a nonqualified deferred compensation plan. So long as this plan has sufficient restrictions on access to the deferred funds, owners are not taxed currently on the deferred funds; the deferred compensation becomes taxable when actually received.
- Using fringe benefits. One great tip for reducing taxable income is using your fringe benefits. Owners who would otherwise have to pay for certain expenses with their after-tax dollars can have the business do it for them. The business gets a write-off; the owners in many instances have little or no income from the company’s payment of these benefits. Examples include: education costs for work-related courses (no income); company-owned vehicle (modest income reported for an owner).
- Borrowing. An owner can borrow from the company when funds are needed to buy a home or for other personal reasons, so long as the company can afford to lend the money. The owner only receives income to the extent that the interest charged on the loan is below IRS-set rates (e.g., for a loan with a term of less than three years that is taken in Jan. 2018, the IRS rate is 1.68%).
3. Rewarding Employees
Finding and retaining valued employees isn’t easy for small businesses that have to compete with large corporations for talent. Small businesses can help their talent recruitment and management situation by rewarding employees with raises, bonuses, and fringe benefits. Cash payments, while tax-deductible for the business, are taxable to employees and subject to employment taxes. In contrast, fringe benefits may cost the business little or nothing and may be free from any employment taxes. For example, offering employee discounts, within limits, may be a low-cost way to benefit staff.
Businesses can also enable employees to pay for certain personal expenses on a pre-tax basis. This doesn’t cost the company anything other than modest administrative costs, and can save employees plenty. For example, businesses can set up flexible spending accounts for employees to pay for unreimbursed medical expenses and dependent care costs from their wages without being taxed on them.
Examples of fringe benefits:
- Education assistance
- Free parking
- Group term life insurance
- Health insurance
- Monthly transit passes for commuting
- Retirement plans
The new tax law that went into effect Jan. 1, 2018 includes several changes to the tax treatment of fringe benefits. For example, businesses and employees can no longer claim a deduction for helping pay for employee moving expenses; employers can no longer claim a deduction for onsite gyms; employers can no longer claim deductions for the costs of providing employee meals; and employers can no longer claim a deduction for providing qualified mass transit and parking benefits (although employees can still use pre-tax dollars to pay for these expenses).
The new rules are complicated; for some types of fringe benefits, even if there is no longer a tax deduction available for your company to offer certain types of benefits, it still might be possible for your employees to get a tax break by using pre-tax dollars to pay for those benefits. Talk to an employee benefits specialist or professional tax advisor to understand the implications and possible changes that may need to be made to your company’s employee benefits packages.
Effectively managing fringe benefits is an important aspect of compensating key employees.
4. Handling the Unexpected
Businesses have their ups and downs. Economic conditions may hurt sales. Catastrophes may shut you down for some time. How these events are handled can have a great impact from a tax perspective.
- Business losses. If you have a bad enough year, you often won’t owe any taxes on the current year’s income — especially if you show an operating loss for the year. What’s more, the loss may be great enough to generate a net operating loss (NOL). Previously, for tax years up to and including 2017, NOLs could be carried back for a set number of years to offset profits in those years, producing an immediate cash refund to you, and unused NOLs could be carried forward for up to 20 years, saving taxes in the future. However, under the new tax law that took effect on Jan. 1, 2018, net operating loss carrybacks have been eliminated, and carryforwards are limited to 80% of taxable income.
- Casualty losses. Hopefully, you have adequate insurance for damages to your property that result from a storm, fire, or other casualty event and to pay the bills until you resume operations. In some instances, however, insurance may fall short; the tax law allows for write-off of business losses from property damage that aren’t covered by insurance. Whereas personal casualty losses are deductible only to the extent that they exceed 10% of adjusted gross income (and, effective Jan. 1, 2018, according to the new tax law, personal casualty losses can only be deducted if the losses occur as part of an official disaster declared by the president), business casualty losses are fully deductible. On the flip side, if you have great business insurance coverage, you may have a tax gain when you experience a casualty loss. The reason: You may have fully depreciated the property, so the insurance proceeds effectively generate a tax gain. Fortunately, you can avoid tax on this gain by reinvesting the proceeds in other business property. IRS Publication 547provides more details on the rules for claiming casualty losses and dealing with other implications, such as involuntary conversions.
5. Preparing for the Future
Every business owner should have an exit strategy. This may mean selling the business at retirement, passing it on to the next generation, transferring ownership to employees, or deciding what happens when the owner dies. Depending on how you plan to pass on your business, there might be costly tax implications, including income taxes and, for transfers to family members, estate and gift taxes.
The good news: With careful planning, it’s possible to achieve your business succession and estate planning objectives while minimizing tax obligations. The bad news: You need to start planning early, think about some possibly uncomfortable and complicated questions, and get expert advice now on how to navigate your business transition challenges in the future.
Taxes should be factored into your business planning in every facet of your business operations and at every stage of your business life cycle, so you can maximize after-tax results. Always seek the counsel of a good tax advisor who can help you understand the implications of potential business decisions and plan business activities successfully.