Small Business Tax Deductions: What You Need to Know
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Out of the several thousand small business owners I’ve had the opportunity to get to know over the years, no more than a few have taken advantage of every tax break available to them.
Nearly all of them worked with a CPA or other tax professional, nearly all of them hate paying taxes, and nearly all of them are intelligent people… and yet nearly every one of them paid more in taxes than they were legally required to – if only they took advantage of sound tax planning. In other words, after spending time with them I discovered they had spent years tipping the IRS.
This is entirely unnecessary and in my opinion a bit wasteful. Not that we don’t receive benefits for paying tax dollars (roads, schools, defense, etc), but from an individual’s perspective paying taxes feels an awful lot like paying a fee. Something that we should avoid doing any more of than necessary.
As a small business owner, you are eligible for many tax deductions that non business owners don’t have available to them. And by taking advantage of these deductions, you can reduce your tax liability and keep more of your hard-earned profits. The following are a few general tips and guidelines to help you pay the minimum amount of tax you are actually required to pay.
1. Keep Good Records
I simply cannot over stress how important this is. Without clear records not much else really matters, because without them you can’t prove that you qualify for the tax strategies you’re trying to take advantage of. Even if you actually do qualify for a deduction or credit, if you get audited you have to be able to prove it – or you owe the tax dollars anyway – plus interest and penalties. That’s a bad situation, so keep track of your money.
Technology is pretty amazing these days and bookkeeping services aren’t very expensive. As a general rule it’s better to have someone else be in charge of tracking this stuff than you the owner, because your time should be spent elsewhere – but please have the awareness to be able to check over it and make sure it’s correct!
2. Understand Deductible Business Expenses
Not all expenses are tax-deductible, and it’s important to understand which expenses are to make the most of them. In general, expenses that are considered “ordinary and necessary” for your business are deductible, while personal expenses, or expenses only indirectly related to your business are not. Some of the more common (and commonly missed) deductible expenses are:
- Using your home:
If you work from home, you may be eligible to deduct a portion of your home expenses, such as rent, mortgage, property taxes and utilities.
Businesses can “rent” their primary residence to their business up to 14 days each year, under what’s known as the Augusta Rule, and not report it as income.
Depreciation is the gradual loss of value of an asset over time, and it can actually be deducted from your income over time. Pretty much every business asset like equipment, machinery, vehicles, etc. have a “useful life” and in some instances you can make the decision to either depreciate the item over it’s useful life -or- bump the depreciation up to the current year (giving you the full tax deduction right now).
One extremely common miss is the opportunity to apply this principle to real estate via what’s known as “cost segregation.” These tax savings can often be enormous and well worth the effort. However, anytime you’re dealing with adjustments to depreciation schedules it’s especially important to consult with a tax professional.
- Advertising and marketing:
In general you can deduct the full cost of all marketing. For growing businesses, this can add up to a pretty big total for a full year. This is one people will often throw money at right before the end of the year to prepay advertising for part of the coming year.
- Interest on business debt:
Any interest you pay on business debt is deductible. There are some potential snags in this strategy, but I’ve seen some self employed or small business owners transfer personal debts into the business’ name in order to gain this deduction.
3. Tax Deductible Account Contributions
Retirement Accounts: Contributions to a retirement plan, such as a 401(k), SIMPLE or SEP IRA are also tax-deductible. Read this white paper On Retirement Accounts for Small Business Owners which I wrote for more info on what might be a good fit for your situation, but the main strategy with these accounts is “tax timing.” If your current taxable income places you, for example, in the 32% tax bracket, contributing $1,000 to a tax-deductible retirement account would save you $320 in federal income tax. You’ll have to pay tax on this money when you pull it out, but if you are in a lower tax bracket at that time, for example the 12% bracket, you’d save 20% of your money. I can’t go so far as to say this is a 20% rate of return, because we simply don’t know what taxes will be in the future, but if it works out like the example above it certainly feels like a 20% rate of return.
Health Savings Accounts: in order to contribute to a Health Savings Account (HSA) you must have an eligible health insurance plan, but if you can HSAs are one of the most tax advantaged places to put money. Unlike retirement accounts which are basically playing around with the timing of when you’ll pay income tax, if done correctly HSA contributions avoid tax altogether.
You get a tax deduction for the money you put in, and if used for health related expenses (pretty much anything you’d think that would mean) you don’t pay tax when you pull it out. Plus, you can actually invest your HSA dollars and the growth is also tax free if used for health related expenses. You can’t beat 0% tax.
4. Consult with a Tax Professional
This sounds a bit self-serving, but it’s great advice for most business owners. Navigating the tax code ban be complicated, and most business owners don’t have the time to make sure they’re taking advantage of all the deductions or credits they’re eligible for. Ideally you have someone helping you with tax strategy – either a CFP or CPA – AND someone helping you actually file your taxes correctly – either a CPA or EA.
If you don’t have relationships with these people, find them.
Small business tax strategies are amazing because of all the ways to move the needle on improving your financial life, they don’t take the same type of effort saving money does. Often they’re just about moving things around on paper. The result of this can help you save thousands of dollars on your taxes and hopefully find something better to do with that money.
If you have specific questions about your financial situation or are interested in finding out if we’re a good fit to help you with your money, click the link below to discover your next steps.
By: David Talley, CFP®