Can a Small Business Get a Tax Refund?
The benefit of getting a tax refund is pretty clear for most business owners — it means money that can be tucked into savings or reinvested in your company.
But there are a couple of things small business owners should understand before counting the greenbacks. First, most small businesses pay income taxes at the individual rate — in other words, your business income (or loss) may be included on your personal tax return. In fiscal year 2017, the IRS processed 150.7 million individual tax returns and issued nearly 122 million refunds amounting to almost $383 billion. The average refund, as of April 6, 2018, was $2,811.
Second, while a small business owner can receive a tax refund on their personal taxes and it may be nice to receive that cash, a tax refund isn’t necessarily good, at least in the eyes of your accountant or financial adviser. “From my perspective, a tax refund isn’t a good thing for anyone,” said Peter Palion, a CFP at Master Plan Advisory Inc in New York. “While it may feel good psychologically, a refund is basically getting back taxes overpaid — so your own money without any interest.”
In this guide, we’ll explain a few tax basics for small businesses and what impact the Tax Cuts and Jobs Act might have on your business.
What is the small business tax rate?
The way you structure your business may affect your overall tax outcome, said Nathan Rigney, lead tax research analyst with the Tax Institute at H&R Block, though he noted that other factors affect what you’ll pay in taxes as well.
What’s your entity type?
When you established your business, you picked a business entity: sole proprietorship, partnership, limited liability company (LLC), C corporation, S corporation are common choices, to name a few. Sole proprietorships, partnerships, LLCs and S corporations are known as “pass-through” entities because their taxes pass through their owners on their personal tax returns. Under the Tax Cuts and Jobs Act, passed in December 2017, they are able to deduct 20% of their income from federal income taxes. Under the previous tax code, owners were taxed on the entirety of their income. C-corps, on the other hand, are recognized as a separate taxpaying entity. We’ll take a look at each type below in more detail:
- Sole proprietorship: This is the easiest and least expensive way to structure a business. Sole proprietorships are not taxed separately. Most sole proprietors report their income with a Form 1040 and Schedule C.
- Partnership: This is the simplest structure when two or more people are involved in a business. Each partner contributes money, property, labor or specific skills and expects to share in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gains, losses and such from its operations. But instead of paying income tax, it “passes through” any profits or losses to its partners. Each partner includes their share of the partnership’s income or loss on their individual tax return. The partnership files a copy of the Schedule K-1 (Form 1065) with the IRS to report your share of the partnership’s income, deductions, credits, etc.
- Limited Liability Corporation (LLC): An LLC provides personal assets such as your vehicle, home and banking accounts a level of protection in the event of a lawsuit against your business, though certain types of businesses — banks and insurance companies, for example — can’t be LLCs. For tax purposes, an LLC is considered a sole proprietorship (one member) or partnership (multiple owners), though LLCs could elect to file taxes as C-corp, which we’ll describe later.
- S Corporation: Corporations are created when shareholders incorporate a business. Though an S-corp is a legal entity separate from its owners, profits are passed along to shareholders who must pay personal income tax on that profit. Unlike a C-corp, which we describe below, the number of shareholders for an S-corp is limited to 100.
- Corporation: Also called a C-corp, this is the most expensive business structure to form. Corporations offer the strongest protection to its owners from personal liability and require more extensive record keeping, operational processes and reporting. The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends (aka double taxation).
A C-corp is taxed separately from its owners. If a C-corp pays more estimated tax during the year than is due on the final return, it can get a tax refund.
Which business entity provides the best tax advantages for you?
As you can see, sole proprietors, partners and S-corp shareholders include their share of taxable business income, expenses and credits on their individual income tax returns. Since individual income tax rates range from 10% to 37%, your marginal tax rate will vary, Rigney said.
Even though C-corps are not pass-through entities, they benefited from the Tax Cuts and Jobs Acts, too. They are subject to a flat entity level tax rate of 21%, down from 35% in 2017, but the shareholder must also pay tax at the individual level if and when they receive dividends from the corporation, Rigney said.
“Notice that for business owners in the top marginal tax bracket, it may be worth considering restructuring as a C-corp to take advantage of the lower combined rates. Of course, there are many considerations other than tax that must be considered before changing business entity type,” Rigney said.
It’s also important to remember that the “pass-through” deduction is set to expire in 2025. Go here to learn more about how tax cuts may affect your small business.
What other taxes does a business pay?
Federal income taxes aren’t the only taxes a small business will pay. Small businesses will also pay state income taxes (for states that have a state income tax), employment taxes and excise taxes if you operate a business that could have an environmental impact. You would also have to pay property taxes if your business owns land or buildings. Check out this small business tax preparation checklist for more.
Reducing your taxable income
Now that you understand how the types of business entities affect the way small business owners pay income taxes, Palion suggests that small business owners focus less on trying to get a refund and more on reducing their tax liability.
“In general, a small business can reduce its tax liability by claiming allowable deductions against business income,” he said.
Examples of business deductions include:
- Office rent or a deduction for using part of the business owner’s home as an office
- Office expenses such as telephone, Internet, stationery and office supplies
- Equipment leases/ purchases/ depreciation
- Car and truck expenses such as lease payments or depreciation if owned plus gas, tolls, insurance, maintenance and parking
- Business travel including taxis, airfare and lodging
- Advertising and promotion
- Personnel costs, including salaries, bonuses, commissions, health insurance and contributions to retirement plans
Of the above, perhaps most advantageous to a small business – especially sole proprietors or a family enterprise – is the ability to deduct retirement plan contributions, Palion said.
“Unlike all other deductions, the money contributed to the business owner’s retirement account is still his or hers,” he said.
Other ways to reduce your taxable income
There are a number of ways small business owners can reduce taxable income. Captive insurance with deductible premiums, the purchase of capital equipment, oil and gas investments are some of the ways Matthew Chancey, a Tampa, Fla. CFP at ClaraPhi Advisory Network, suggested.
Tax-advantaged savings accounts such as a Health Savings Account (HSA) and Simplified Employee Pension -Individual Retirement Account (SEP-IRA) are among the most popular ways for a small business owner to reduce taxable liability in the current year.
Mike D’Avolio, senior tax law expert at Intuit ProConnect Group, said that a small business can reduce its tax liability in the current year by deferring income and accelerating tax deductions and tax credits.
Contributing to their retirement plan is one of the most attractive deductions for small business owners because of government provides generous incentives, D’Avolio said, explaining that there are a “variety of retirement plans available to small businesses that allow the employer and employee a tax-favored way to save for retirement.”
“Contributions made by the owner for himself or herself and for employees can be deducted. Furthermore, the earnings on the contributions grow tax-free until the money is distributed from the plan,” he said. “The small business owner is also allowed a tax credit equal to 50% of the first $1,000 incurred in starting up a plan.”
Looking for business funding? Learn more about small business loans here.
Can a small business get a tax refund? The bottom line
Evaluating how your business entity impacts your taxes and reducing your taxable income can be advantageous for you as a small business owner but in looking at the big picture, don’t forget the details. Small business owners will need to pay estimated quarterly taxes — failure to do so could result in a fine.
Receiving a tax refund at the end of the year may seem like a bonus, but it could be an indication that you overpaid those estimated taxes. “If a small business owner receives a refund, it means he or she overpaid estimated taxes which can hurt their cash flow,” D’Avolio said. “It’s wise to run estimates of income, deductions and credits throughout the year to properly calculate estimate taxes.”
He suggested building in a small cushion since there’s a penalty associated with underpaying these estimates and working with a tax professional who can help you through this process if you don’t have time or the expertise.