Preparing for 2021 – Tax Planning Strategies for Small Business Owners
If you are a small business owner, every penny of your income counts. This means that you not only want to optimize your revenue, but also minimize your expenses and your tax liability. Unfortunately, far too many entrepreneurs are not well-versed on the tricks and tools available to them and end up paying far more than they need to. You don’t need an accounting degree to take advantage of tax-cutting tips. Here are a few of our favorites.
THINK ABOUT CHANGING TO A DIFFERENT TYPE OF TAX STRUCTURE
When you started your business, one of the first decisions you needed to make was whether you wanted to operate as a sole proprietor, partnership, LLC, S corporation or C corporation. But as more time goes by, the initial reasons for structuring your business the way that you did may no longer be applicable, or in your best interest from a tax perspective. There is no requirement that you stick with the business structure you initially chose.
Ever since the Tax Cuts and Jobs Act of 2017 (TCJA) changed the highest corporate income tax rate from 35% to 21%, sole proprietorships, LLCs, partnerships and S corporations can realize significant tax savings by electing to be taxed as a C corporation. This simple change can make sense if the owner of these pass-through businesses is taxed at a high tax bracket. If so, all you need to do is fill out and file Form 8832. Before doing so, make sure that the tax savings you can realize are a reasonable tradeoff for the other reasons that you may have originally selected the structure you are currently in.
PASS THROUGH BUSINESSES CAN GET A 20% TAX BREAK
One of the most impactful changes that the TCJA made for pass-through businesses whose income is passed through for taxation as their owners’ personal income is a valuable tax break known as the qualified business income (QBI) deduction. For those that are eligible, this deduction is worth a maximum 20% tax break on the income they receive from the business – but determining whether or not you are eligible can be a challenge.
There are several restrictions on taking advantage of the deduction, particularly with reference to specified service trade or businesses (SSTBs) whose owners either earn too much income or rely specifically on their employees’ or owners’ reputation or skill. Though architecture and engineering firms escape this limitation, other business models – including medical practices, law firms, professional athletes and performing artists, financial advisors, investment managers, consulting firms and accountants – fall into the category that lose out on the deduction if their income is too high. In 2019 single business owners of SSTBs began phasing out at $160,700 and are excluded once their income exceeds $210,700, while those who are married filing a joint return phase out at $321,400 and are excluded at $421,400. To calculate the deduction, use Part II of Form 8995-A.
Businesses that are not SSTBs are eligible to take the deduction even when they pass the upper limits of the thresholds, but only for either half of the business owners’ share of the W-2 wages paid by the business or a quarter of those wages plus 2.5% of their share of qualified property.
These limitations and specifications for what type of business is and is not eligible are head-spinning, and though it is tempting to simply take the deduction, it’s a good idea to confirm whether you qualify and how to claim it with our office before moving forward.
KNOW HOW YOU’RE GOING TO PAY YOUR TAXES
It is incredibly rewarding to live the dream of owning your own small business, but the hard work required to generate revenue makes paying taxes extra painful. This is especially true because of the “pay as you go” tax system that the United States uses, which asks business owners to make quarterly estimated payments. While employees pay their taxes ahead via payroll deductions withheld by their employers, there is no such automatic system set up for small business owners, and that leaves many with the temptation of delaying making payments in order to maintain liquidity.
Unfortunately, failing to pay taxes quarterly can put you in the uncomfortable position of still having to pay at one point, with the additional burden of penalties and interest as a result of your delay. Though setting aside the money to pay taxes requires discipline, doing so will save you from the penalties charged by the IRS, which are calculated based on the amount you should have paid each quarter multiplied by both your shortfall and the effective interest rate during the specific quarter (established as 3 percent over the federal short-term rate – C corporations pay a different rate). Even if you don’t calculate your quarterly estimated rates correctly, the safe harbor rule allows small businesses to pay the lower amount of either 90% of the tax due on your current year return or 100% of the tax shown on your last filed tax return. For those whose AGI was over $150,000 in the previous tax year, the safe harbor percentage is 110% of the previous year’s taxes.
While it is always a good idea to increase the amount you send in if you are having a higher-income year, by doing a simple calculation of your safe harbor number and dividing it by four, you have a reasonable quarterly payment that you can safely send in on the due dates (April 15th, June 15th, September 15th and January 15th of the following year). By setting aside the appropriate percentage that you will owe from each payment you receive, you can easily set aside the money you will need to pay and entirely avoid concerns about penalties or interest. Payment is most easily submitted using the online link for IRS Direct Pay, though many people opt for sending in the paper vouchers for IRS Form 1040-ES, along with a check. There is also an EFTPS system available for C Corporations’ use.
CHOOSE YOUR ACCOUNTING METHOD CAREFULLY
Each small business owner calculates their income and revenue differently, with many using a method of accounting that is based on when money is received rather than when an order is placed and counts expenses when they are paid rather than the item or service ordered. This is known as the cash method of accounting.
Whatever method of accounting you use, smart business owners can strategically adjust their approach, reporting their annual income based on cash receipts in order to reduce their end-of-year revenues, especially if there is reason to believe that next year’s income will be lower or, for some other reason, they anticipate being in a lower tax bracket.
An example of how this approach would be helpful can be seen in the case of a business that expects to add new employees in the new year. Between that expense and other improvements planned, it makes sense to anticipate that net income will be down and the tax bracket for the business will be lower, so any work done or orders placed towards the end of the current tax year should be accounted for when payments arrive so that the income can be taxed at a lower rate. The contrast to this is if you are anticipating your business revenue increasing and being forced into a higher tax bracket in the new year: in that case it makes sense to try to collect monies for work done in the current year early, so that you can take advantage of your current, lower tax rate. The same can be done for business expenses such as office supplies and equipment, which can be deferred and accelerated in the same way so that you can take advantage of tax deductions in the way that is most advantageous.
ESTABLISH AND MAKE DEPOSITS INTO A 401K OR SEP
One of the smartest ways to lower your taxable income is to contribute to a retirement account. Not only does doing so lower your business’ tax liability, but also ensures a more secure future. As a small business owner, either a 401(K) plan or a Simplified Employee Pension (SEP) plan will do the trick while benefiting both you and those who work for you in the future.
While a 401(k) that is established prior to year-end will let you deduct any contributions you make (with contributions limited to the lower of $57,000 or the employee’s total compensation), business owners who fail to set up this type of plan by December 31st can still turn to the SEP as an alternative. Though SEP contributions are restricted to 25% of the business owner’s net profit less the SEP contribution itself (technically 20%), a SEP can be established, and contributions made up until the extended due date of your return. If you obtain an extension for filing your tax return, you have until the end of that extension period to deposit the contribution, regardless of when you actually file the return.
IF YOU TOOK OUT A PPP LOAN, PLAN ON IT BEING FORGIVEN
Many small businesses took advantage of the PPP loans that were offered by the government in the face of the COVID-19 crisis. While these loans were attractive because they are forgivable and gave businesses a chance to survive the dire circumstances, in April of 2020 the IRS issued Notice 2020-32, which indicated that despite the fact that the forgivable loans can be excluded from gross income, the expenses associated with the moneys received cannot be deducted. This effectively erases the tax benefit initially offered because losing the employee and expense deduction increases the business’ income and profitability.
There is some chance that this issue will be resolved by Congress, as it clearly contradicts the original intent of the tax benefit that accompanied the PPP funds, but that action has not yet been taken. It’s a good idea to talk to our office about this as soon as possible, as having to pay taxes on expenses incurred may be particularly challenging in the face of the difficulties the pandemic has imposed. Being financially prepared to pay more taxes than you originally intended may be a bitter pill to swallow but will still be better than having to pay penalties and interest if you fail to pay what the government says that you owe.
Though all of these strategies can be helpful, they may not all be appropriate for your situation. Keep them in mind as you go into the end of the year and be prepared to ask questions to determine which apply to you when you speak with our office. Contact us to discuss tax planning for your business today