Running a small business is no easy feat, and one of the most complex aspects of being an entrepreneur is understanding and effectively managing your business taxes. As a Certified Public Accountant (CPA) based in California, I’ve seen firsthand how the right tax strategies can significantly reduce tax liabilities and increase savings for small businesses.
In this article, I’m going to explore some top tax deductions you can take advantage of this tax season o minimize your tax burden and put more money back into your business. Let’s dive in!
Tax Planning and Entity Selection: The Backbone of Tax Strategies
Effective tax planning is a year-round effort and not a once-a-year event. It involves proactive strategizing and regular consultation with a CPA to identify the tax benefits, credits, and deductions applicable to your business. The structure of your business (sole proprietorship, partnership, LLC, S-Corporation, or C-Corporation) – significantly influences your tax obligations and tax saving opportunities.
Some small business tax deductions or strategies emphasized in this blog are specifically designed for particular entity types. Hence, the importance of regular tax planning and astute entity selection becomes critical. This pivotal business decision not only shapes your legal and operational aspects but also defines the scope of your tax deductions.
Now, let’s explore the top tax deductions that can boost your small business savings.
Retirement Plans as Tax Saving Tools
Investing in retirement plans is a potent strategy for reducing your small business tax liability, with 3 primary options: 401(k), SEP-IRA, and Defined Benefit (also known as pension plans). We have written extensively on this topic in our blog, “Investing in Retirement Plans: A Long-term Tax Saving Strategy”, but see below for the key points on this strategy:
401(k) plans offer robust tax-saving opportunities for small businesses. Employees (including owner-employees) can contribute pre-tax income up to $22,500. These personal contributions can be matched by the company for a total limit of $66,000 for employees under 50 and a combined limit of $73,500 for business owners over 50. A safe harbor match can help maximize 401(k) contributions, and an added profit-sharing plan could accelerate reaching the $66,000 combined limit. For self-employed individuals without full-time employees, the Solo-401(k) is an excellent option, allowing contributions as both employee and employer, thus potentially maximizing retirement savings.
A SEP-IRA (Simplified Employee Pension) is another attractive retirement plan option for small businesses. In 2023, employers can contribute up to 25% of an employee’s income or $66,000, whichever is less. Unique in its flexibility, SEP-IRA contributions aren’t mandatory every year, accommodating businesses with fluctuating profits by adjusting contributions based on yearly performance. It offers tax-deductible contributions and tax-deferred growth.
Defined Benefit Plans, or pension plans, provide substantial tax deductions and can yield significantly higher contributions than 401(k)s or SEP-IRAs. They’re especially beneficial for business owners nearing retirement, or business owners with excess cashflow, with contribution limits potentially exceeding $200,000 annually. Despite requiring regular funding and administrative work, their benefits, like guaranteed retirement income and incredible tax-deductible contributions, typically outweigh the costs. Investment earnings in the plan grow tax-deferred until retirement, facilitating significant growth over time.
S-Election for Payroll Tax Savings
The Subchapter S (S Corporation) election can be an excellent strategy for small businesses to save on payroll taxes. By electing to be an S Corporation, a small business can distribute profits to its shareholders as dividends, which are not subject to self-employment taxes, rather than wages, which are. With self-employment tax at 15.3% in 2023, these tax savings add up quickly. However, this should be under the guidance of your CPA, as the IRS requires shareholders who work for the company to be paid “reasonable compensation” before profits are distributed as dividends. Taking an unreasonably low wage to maximize this benefit might find you in hot water with the IRS, and paying penalties and interest you could otherwise avoid. Reasonable compensation concepts are on the subjective end of the tax code, so a qualified and experienced CPA should be consulted when taking advantage of this.
Pass-Through Entity Tax (PTET) Election
The California Pass-Through Entity Tax (PTET) election is another crucial tax-saving measure. The 2017 Tax Cuts and Jobs Act capped state and local tax (SALT) deductions at $10,000 on personal returns. So if you are paying more than $10,000 in your combined state income tax and property tax (for example), every dollar over $10,000 is not deductible. However, new in 2021, PTET allows California businesses to circumvent this limitation by allowing businesses to pay the state tax at the entity level, which is then fully deductible at the federal level. The resulting benefit is a reduction in the federal tax liability.
Only certain entity types are allowed this benefit, and the deadlines to participate in this benefit are strict. Schedule a consultation with us to help you navigate this, and you can also find a bit more information in our blog, “PTET Credit”.
Section 199A: Qualified Business Income (QBI) Deduction
Section 199A, also known as the Qualified Business Income (QBI) deduction, can provide a significant tax cut for small business owners. Essentially, it allows eligible taxpayers to deduct up to 20% of their qualified business income from a partnership, S corporation, or sole proprietorship. The rules for this tax strategy are complex, with income limitations on certain taxpayers and none for others. There are also a lot of tax planning opportunities with this tax strategy, where actively planning your company’s salaries or fixed asset depreciation with QBI in mind could optimize the benefit. This can result in substantial tax savings, so don’t overlook it when preparing your taxes!
Depreciation is a tax deduction that allows businesses to recover the cost of certain property over the property’s lifespan. The Tax Cuts and Jobs Act ramped up the benefits of “bonus depreciation,” allowing businesses to write off up to 80% of the cost of qualifying property in the year it’s put into service, rather than having to depreciate it over several years. Unless Congress acts to preserve this, the bonus depreciation tax strategy will shrink over the coming years from 80% in 2023, down to 40% by 2025.
The inclusion of this bonus depreciation provision is a powerful incentive for businesses to invest in new, eligible property, such as machinery, equipment, and certain software. Businesses should, however, be strategic about these investments, aligning them with their operational and financial goals. Consultation with a tax advisor is crucial to fully leverage the benefits of bonus depreciation, and to prepare for the upcoming changes in the law.
Even with this being phased out (for now), bonus depreciation provides immediate tax relief that can give your business a significant financial boost.
Section 179 Deduction
Similar to bonus depreciation, section 179 is another beneficial tax deduction that allows businesses to deduct the full purchase price of qualifying equipment or software purchased or leased during the tax year. The deduction is capped at $1 million, with a phase-out threshold starting at $2.5 million. This means you can potentially write off a substantial amount in a single year, providing immediate tax relief.
In essence, Section 179 is designed to incentivize businesses to invest in themselves by accelerating the rate of their tax deductions. Rather than gradually deducting the cost of equipment or software over several years through depreciation, businesses can immediately recoup the cost in the year of purchase. The deduction applies to a broad range of assets, including office equipment, vehicles, and computer software. It is especially beneficial for small and medium-sized businesses, helping them improve their operations and efficiency while minimizing the financial burden of tax liabilities. However, businesses should carefully consider their purchasing decisions and consult with a tax professional to fully understand the implications and restrictions of this tax law.
Employing Your Children
Here’s a strategy you may not have thought of: Employing your children. By shifting some of your high-tax income to your child’s lower tax bracket, you can achieve significant tax savings. When you compensate your child for legitimate work done in your business—such as administrative tasks—you can count there wages as a deductible business expense, thus reducing your overall taxable income.
Furthermore, if your child’s earnings are within the standard deduction threshold, they may not be liable for ANY income tax on those earnings. This arrangement not only leads to potential tax advantages, but it can also provide an opportunity to teach your children about work ethics, responsibility, and the basics of finance. However, it’s essential to ensure that the compensation is fair for the work performed and to maintain appropriate documentation for tax purposes. Always consult a tax professional to ensure compliance with all IRS rules and regulations.
Home Office Deduction
The home office deduction presents a key opportunity for substantial tax savings for those operating their businesses from home. If a distinct area of your home is devoted solely for business use, you may qualify for this deduction. As a business owner you have two calculation options: the simplified method, which uses a standard deduction per square foot of the home office, and the regular method, based on the actual business expenses tied to your home office, such as a fraction of mortgage, utilities, insurance, property tax, or home repairs.
While the simplified method offers convenience and ease of calculation, the regular method often yields higher tax savings as it accounts for actual costs incurred. Though it requires more meticulous record-keeping and calculation, it may significantly lower small business tax liability for many home-based businesses. Therefore, though the simplified method may seem tempting for its ease, it’s worth considering the regular method for its potential for larger deductions. Consulting with a tax professional can help you navigate the choice, ensuring the maximum benefit and compliance with IRS guidelines.
Automobile Purchase and Depreciation
When you use a car for business purposes, such as gas, repairs, and insurance, these are deductible business expenses. Moreover, you can also take a depreciation deduction. The Section 179 deduction allows you to write off up to $25,000 for certain business vehicles, and the bonus depreciation can provide additional write-offs. Make sure to consider the 6000GVWR rule, which allows for more significant deductions for vehicles with a gross vehicle weight rating (GVWR) over 6,000 pounds. Any time you are considering purchasing a new vehicle, don’t be shy about talking to your CPA about how it will be used in the business and what tax savings opportunities are there for you.
There are many other small business tax deductions that you can take advantage of, such as:
- Health Insurance: If you are self-employed and pay for your own health insurance, you can deduct all of your health, dental, and long-term care insurance premiums.
- Education: Business-related educational expenses can also be deducted. This can include courses, workshops, books, and professional publications.
- Advertising and Marketing: Any costs related to promoting your business can be fully deducted.
- Business Travel Expenses: If you travel for business, expenses like transportation, meals, lodging, and incidentals can be deducted.
- Legal and professional fees: some legal and professional fees are also available for tax deductions for small business.
Remember, the key to successful tax planning is keeping thorough records and working with a knowledgeable CPA. These strategies can help you navigate the complex tax landscape and identify all the tax-saving opportunities available to your small business.
Every business is unique, so what works for one might not work for another. It’s always a good idea to consult with a CPA to find out how these tax deductions can work for your small business.
Taxes shouldn’t be an afterthought; strategic tax planning can provide your business with the financial flexibility it needs to grow and thrive. By understanding these deductions, you can take control of your business’s financial future and boost your savings. Remember, every dollar saved in taxes is another dollar you can reinvest in your business!