April 21, 2023

Small Business Tax Mistakes to Avoid

Man Reviewing Receipts

For small business owners, a misstep in tax planning could result in a big, unforeseen bill. Stay on top of taxes by avoiding these common mistakes.

Having a clear plan can save your small business thousands in taxes. As a certified public accountant working in the tax industry, I’ve come across tens of thousands of tax returns over my career. Over time, you start noticing patterns with the mistakes that people tend to make. I would like to share with you some common tax-related mistakes I’ve seen from small business owners, so you can try to avoid them.

1. Too complex of an entity structure.

Some small business owners try to set up overly complicated structures too soon. I have consulted with many who intend to open two or three companies immediately and start a salary for themselves. But when they're just getting started and making no profit, I always recommend that they wait six months to see how things go. My advice is, from a tax perspective, just be a sole proprietorship until you prove the ability to make a profit.

2. Too simple of an entity structure.

On the other hand, I have frequently seen a business take off while remaining a sole proprietorship. For example, a young dentist came to see me to have his tax return prepared. This was his first year in business, and he earned $85,000 net as a sole proprietor, but he did not know this was subject to self-employment tax. After I told him how much he owed, he broke down in tears. He didn't have the money; he had used it all to rehab his house. An S-corporation would have reduced his taxes, and some tax planning would have warned him about the coming bill.

3. Having no idea where you are on taxable income during the year.

After the year is over, it's pretty much too late to do any significant tax planning for your business, like purchase equipment, accelerate expenses or defer revenue. Many times, I've informed people after the year is over that their net income tripled or quadrupled over the prior year. Then what happens? An angry taxpayer, a giant tax bill and insufficient funds to pay the taxes. So, keep a profit-and-loss statement up to date, and consider communicating with your CPA quarterly to be prepared for the big tax bills.

4. Failing to contribute to a retirement plan.

Many small business owners operate for years before thinking about their own retirement. Deferring 20% of your income tax decades into the future is a pretty good bet. It's going to be a mathematical winner most of the time. Small business owners can use different retirement instruments, like SIMPLE IRAs, SEPs, solo 401(k)s or Roth accounts, and it’s relatively inexpensive and easy to get one of those plans started. I advise new business owners to set up retirement plans for themselves as well as their employees once their business has reached consistent profitability.

5. Failing to track or reimburse mileage.

Although it can be tedious, if you take the time to jot down where you go for business every day, or use a phone app to do so, you can rack up a nice tax deduction worth thousands of dollars. The IRS requires a contemporaneous record of where you go and for what purpose. If you are running an S-corporation or a limited liability company (LLC) with partners, you will want to reimburse yourself for mileage periodically, probably at the maximum mileage rate. Those reimbursements are tax deductible for your company but not taxable income to you personally.

6. Failing to understand the relationship between debt and taxes.

Buying business assets with borrowed money can create an immediate windfall for a business owner – it can even wipe out a business’ entire taxable income. However, doing so creates tax consequences down the road. At some point, the lender is going to require repayment of equipment loans, and the tax benefit can turn into a tax liability. The business has to generate a taxable profit to obtain the funds to repay the lender. At that point, the business must pay principal, interest and the income taxes on the profit. That’s why I always suggest that business owners make sure they actually need the item and have a plan for paying back the loan and the associated taxes.

While these scenarios come up often for small business owners, preparation goes a long way in preventing undesirable tax consequences. Working with an independent financial advisor and communicating regularly with your tax professional can help ensure that your business is set up for success.

For informational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information is based on third-party data and may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy or confirmed the adequacy of this article. R-23-5501.

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