Taxes are one of the biggest costs associated with running a small business. And if you aren’t careful, you could wind up with a large bill at year-end.
Fortunately, there are many ways to legally reduce your tax liability. These include accelerating cash collection, delaying equipment purchases and taking advantage of business credits.
1. Taxes on Investments
Whether you operate as a C corporation or an S corp, your choice of accounting method determines how the IRS taxes the income your business generates. You also need to choose between using cash or accrual.
Your accountant can help you understand the tax consequences of each of your options, so you’ll make the best decision for your business. In addition to your income tax rate, you’ll pay payroll taxes (Social Security and Medicare) on all of the earnings you receive, as well as property taxes on any real estate your company owns.
You’ll be subject to capital gains taxes on the profit you make from selling business investments. You’ll also pay sales taxes on many of the goods and services you use to run your business.
2. Taxes on Dividends
In some cases, it might be beneficial for a small business owner to receive dividends instead of paying themselves a salary. This allows them to avoid paying CPP and Employment Insurance for themselves as well as save on corporation taxes.
However, it’s important to understand the tax implications of this decision. Nonqualified dividends are taxed at your regular income tax rate, not capital gains tax rates. The IRS will send a Form 1099-DIV for any distribution you receive.
As a small business owner, it’s important to pay attention to state and local sales taxes. Failing to register, collect and remit these taxes can lead to fines and penalties. Also, be sure to keep your personal and business expenses separate. Mixing personal and business costs can trigger an audit by the IRS.
3. Taxes on Interest
As a business owner, you’ll pay taxes on your net income, which is figured by adding all your business expenses (the IRS has a comprehensive list) and subtracting your business income. Keeping accurate records of these expenses is critical for tax deductions, and it helps to use all-inclusive accounting and tax prep software that can calculate your federal income taxes each quarter.
Another way to save on taxes is through tax credits, which offer dollar-for-dollar reductions in your final tax liability. But don’t try to dip into money that’s earmarked for payroll taxes, because doing so could result in a stiff penalty from the IRS. That’s one of the reasons it’s important for small business owners to keep excruciatingly accurate records. Also, don’t commingle personal expenses with business ones, Blake says.
4. Taxes on Pass-through Income
Many small businesses receive income from “pass-through” business entities, which pass profits directly to owners without the entity paying taxes. A 2017 tax law allows qualified pass-through business income to be deducted for individuals at rates lower than those for labor income.
Qualified business income (QBI) is defined as the net profit of your business minus some regular deductions. The deduction is available to the owners of sole proprietorships, partnerships, S corporations and some LLCs.
Pass-through income includes self-employment tax, which pays for social security and Medicare contributions. It also includes federal income tax at individual rates, which range from 10% to 37% in 2022. High-income taxpayers may also face the additional 3.8% Medicare surtax.
5. Taxes on Business Property
If you operate a business that counts property among its assets, you may be responsible for local and state property taxes. You’ll also likely be responsible for sales tax obligations if your company sells products that are subject to these taxes.
Small businesses can qualify for a variety of tax deductions, including mortgage interest on an office building, financing charges built into a lease contract and fees associated with extended payment terms on customer invoices. You can find a full list of possible deductions in IRS Publication 535, Business Expenses.
Aside from choosing a proper business structure and tracking tax deductions, there are other important things you can do to reduce your company’s tax liability. From avoiding commingling personal and business expenses to taking advantage of depreciation opportunities, these strategies can help you manage your tax burden more effectively.