Year-End Tax Planning Strategies for Small Business Owners
Each year, small business owners overpay their taxes because they miss out on certain deductions and tax-planning strategies that can reduce their taxable income. Often, it’s because they just don’t understand the tax saving strategies available to them. But you don’t need to make tax planning your full-time job to save money at tax time — to help you out, we’re sharing a few tax planning strategies you might consider.
- Consider a tax status change
- Take advantage of the 20% pass-through tax deduction
- Create a plan for paying taxes
- Defer income — or accelerate income
- Accelerate expenses — or wait
- Consider employee bonuses
- Set up — or contribute to — a retirement account
1. Consider a tax status change
As a small business owner, you have several options when it comes to structuring your business. You can operate as a sole proprietor, partnership, LLC, S corporation or C corporation. Each business structure has different pros and cons and changes the way that your business is taxed.
If you outgrow one type of business structure, you can usually change it to one that’s a better fit. For example, LLCs can elect to have their business treated like a C corporation by the IRS by filing Form 8832.
Making such an election used to be rare, as the top corporate tax rate was 35%, but the Tax Cuts and Jobs Act of 2017 (TCJA) dropped the top corporate income tax rate from 35% to 21%.
Pass-through businesses, such as sole proprietorships, partnerships, LLCs and S corporations, don’t pay a corporate income tax; instead, the net income from the company “passes through” to the owner’s individual tax return, where the highest tax bracket is 37%. For LLC members in the top tax bracket, a tax status change can have significant tax savings.
Of course, tax savings aren’t the only factor that goes into selecting a structure for your small business. Before changing your tax status, consult with a tax pro who can help you crunch the numbers and run a cost-benefit analysis.
2. Take advantage of the 20% pass-through tax deduction
C corporations aren’t the only businesses that benefited from recent tax reform. The TCJA also granted a potentially valuable tax break to pass-through businesses, including sole proprietors, partnerships, LLCs, and S corporations.
The qualified business income (QBI) deduction provides pass-through business owners a deduction worth up to 20% of their share of the business’ income. But it does come with a lot of rules and limitations.
Owners of specified service trades or businesses (SSTBs) lose out on the deduction if their income is too high. SSTBs generally include any service-based business, other than engineering and architecture firms, where the business depends on the reputation or skill of its employees or owners. That includes law firms, medical practices, consulting firms, professional athletes, performing artists, accountants, financial advisers, investment managers and more.
If your business is an SSTB, your QBI deduction starts to phase out once your total taxable income exceeds a certain amount. For the 2019 tax year, those thresholds are $160,700 if single or $321,400 if married filing a joint return. You’ll need to use Part II of Form 8995-A to calculate your deduction. Once your income is over $210,700 for single filers ($421,400 for married filing jointly), you can’t take the deduction at all.
If your business is not an SSTB, but your total taxable income is above those upper limits, you can claim the deduction, but it’s limited to:
- 50% of your share of W-2 wages paid by the business, or
- 25% of those wages, plus 2.5% of your share of qualified property
Confused? You’re not alone. The QBI deduction can provide a generous deduction for some pass-through business owners, but figuring out who can claim it and then calculating the deduction is no easy task. Talk to your accountant if you think you might qualify.
3. Create a plan for paying taxes
Paying taxes is arguably one of the least enticing aspects of small business ownership. For that reason, some small business owners put it off. They skip making their required quarterly estimated payments, figuring they’ll catch up at tax time — but that can be a costly mistake.
In the U.S., we have a “pay as you go” tax system, meaning you’re required to pay federal tax on your income as you earn it. For employees, that means having taxes withheld from their paychecks. As a small business owner, you need to make estimated quarterly payments. If you don’t make estimated payments or pay too little throughout the year, the IRS will charge penalties and interest.
The IRS calculates those penalties by figuring out how much you should have paid each quarter, then multiplying the difference between what you paid and what you should have paid by the effective interest rate for the period. The effective interest rate is set quarterly at the federal short-term rate plus 3%; for the first quarter of 2020, it stands at 5%. This would apply to individuals, sole proprietorships, and S corporations; only C corporations would pay a different rate.
Estimating how much you’ll owe can be a challenge. But fortunately, the IRS provides a safe harbor rule. Under the safe harbor rule, you can generally avoid underpayment penalties and interest by paying 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 (or 110% if your AGI is over $150,000)
Calculate your safe harbor amount using the percentages above, divide it into four equal payments, and send those payments to the IRS on April 15, June 15, Sept. 15, and Jan. 15 of the following year. You can make your payment online using IRS Direct Pay or mail a check with the vouchers included in IRS Form 1040-ES.C Corporations are required to make estimated payments via the EFTPS system.
Be sure to set aside money each month for those estimated payments. But remember, the safe harbor doesn’t mean you’re fully paid up for the year. It just ensures you won’t be penalized. If your income is significantly higher this year than it was on last year’s tax return, you’ll want to set aside a little extra.
4. Defer income — or accelerate income
Many small businesses use the cash method of accounting on their books and tax return. Under the cash method, a company recognizes income when it’s received and expenses when they are paid — in other words, when cash actually changes hands.
That creates some interesting tax planning strategies. If you expect to be in a lower tax bracket next year, you might want to defer income to next year, when you’ll pay taxes at a lower rate.
For instance, say you did some work for a client in December of this year, but you haven’t sent the client an invoice yet. You plan on hiring a new employee and reinvesting a bunch of profits back into your business next year, so you expect your net income will be lower, and you’ll be in a lower tax bracket. If you waited until January of next year to invoice your client for the work you did in December, you could defer income to the next year and lower your tax bill.
On the other hand, it might make more sense to accelerate income to this year. Say business is booming, and you’re about to land a new contract that will significantly increase your income next year, pushing you into a higher tax bracket. You might want to invoice and try to collect payment from your customer this year so that more income will be taxed at your current tax rate.
5. Accelerate expenses — or wait
Deferring and accelerating also work for business expenses.
Say you’re in a higher tax bracket now, but expect to be in a lower tax bracket next year. If you were planning on purchasing office supplies and equipment next year, you might want to accelerate those deductions, and take them this year to reduce your taxable income for the current year.
On the flip side, if you expect to be in a higher tax bracket next year, you might put off paying some bills and purchasing equipment and supplies until the next year, when you’ll need all of the tax deductions you can get.
6. Consider employee bonuses
Bonuses can provide an incentive for workers with the added benefit of being a tax deduction for businesses, but the IRS has a few rules around what does and doesn’t qualify as deductible.
If your business uses the accrual basis of accounting, you recognize income when it’s earned and record expenses when they are incurred, regardless of when the cash actually changes hands.
To deduct accrued bonuses, the IRS requires you to finalize the amount of bonuses by the end of the year, and pay the accrued bonuses within two and a half months from the end of the year.
Secondly, regardless of whether your business uses the cash or accrual method, bonuses can only be deducted if they are paid to employees. Bonuses paid to sole proprietors, LLC members, and partners aren’t deductible, because the owners of these types of businesses are considered self-employed.
Also, keep in mind that you need to withhold taxes on bonuses. The IRS typically required employers to withhold federal income tax on bonuses at a flat 25% supplementary rate, rather than the employee’s standard withholding rate.
7. Set up — or contribute to — a retirement account
Setting up or contributing to a retirement account can reduce your taxable income. Business owners have several options for retirement savings, both for themselves and for employees.
- If you set up a 401(k) plan before the end of the tax year, you can deduct any contributions made to the plan when you file your tax return. The plan document dictates how much an employer can contribute. For 2020, total employee and employer contributions to a 401(k) plan are limited to the lesser of an employee’s compensation or $57,000.
- If you missed the cutoff to set up a 401(k) plan last year, you might still be able to set up a simplified employee pension plan, also known as a SEP. You have until the due date of your return (including extensions), to set up a SEP. The employer contribution to a SEP is limited to 25% of the employee’s compensation.
Every business’s tax situation is unique, so it’s important to discuss these strategies with your tax professional before making any significant moves, but the above strategies should help you prepare for your meeting and understand more about the ways that your small business can minimize taxes.