4 Common Tax Planning Mistakes for Small Business Owners & Strategies to Potentially Avoid Them
By Trent Derrick, CMT®
There’s a common saying from Robert Kiyosaki: “It’s not how much money you make, but how much money you keep.” As a small business owner, I’m sure you can relate. It can be devastating and discouraging to work all year just to turn around and hand over your hard-earned money to the government. But that’s what happens year after year when 46% of Americans overpay in their income taxes. (1)
If you’re a small business owner, don’t wait until tax season to start thinking about ways to minimize your tax burden. Here are 3 common tax planning mistakes I see and how you can potentially avoid them.
Choosing the Wrong Business Structure
As a small business owner, choosing the right business structure is one of the most important decisions you will make. I often work with clients who have chosen a business structure based on what they want their business to be rather than what it currently is. It’s great to aim for the stars, but you have to be realistic about your current needs so you don’t end up costing yourself unnecessary filing fees and taxes.
For instance, choosing a C corp business structure is great for large, well-established companies. But it comes with the risk of double taxation that should definitely be avoided if you are just starting out and focused on growth. Conversely, choosing a passthrough entity that classifies your earnings as self-employment income is probably not the best choice if you’re earning enough to push you into higher tax brackets. At that point, it might make more sense to incorporate and take the flat corporate tax rate of 21% rather than pay based on your marginal tax bracket which maxes out at 37%!
To potentially avoid this, check out my other article on choosing the correct business structure for your needs here.
Not Keeping Track of Expenses
One of the perks of owning a business is the ability to deduct your expenses against income. But in order to deduct, you must have proof of purchase. Fortunately, technology has made it easier than ever to track and organize spending (e.g., QuickBooks, Quicken, Mint, FreshBooks).
There are dozens of expenses you can deduct as a small business owner. (2) Here are a few of the most common deductions:
- Start-up costs
- Online services and subscriptions
- Travel expenses
- Continuing education
- Software, hardware, and other equipment
- Health insurance premiums and medical care expenses
- Home office and supplies
- Retirement contributions
So if you’re still dumping out shoeboxes of receipts for your tax preparer to dig through, it’s time to get organized. You’re costing yourself a lot of money. Not only are you more likely to miss out on deductions, but you’ll be charged a hefty hourly fee for your CPA to sort through the mess.
Putting Off Retirement Planning
As a small business owner, it’s easy to fall into the trap of being so busy running the business that you forget about yourself—specifically your retirement! While this can be detrimental to your long-term financial security, it’s also a mistake when it comes to tax planning. Contributing to a qualified retirement plan is one of the best ways to reduce your taxable income as a small business owner.
There are several options when it comes to tax-efficient retirement planning, including:
- Traditional IRA: This type of tax-advantaged retirement account allows you to contribute a maximum of $6,000 per year ($7,000 if over the age of 50). (3) Contributions are tax deductible, meaning they will reduce your current year tax liability.
- Roth IRA: Similar to a traditional IRA, a Roth IRA has a maximum contribution amount of $6,000 per year ($7,000 if over the age of 50), (4) but contributions are not tax-deductible. You will not receive a current-year tax benefit, but your contributions and earnings will be tax-free when withdrawn in retirement. This type of account is especially useful if you think you will be in a higher tax bracket in retirement than you are right now.
- SEP IRA: A Simplified Employee Pension (SEP) IRA functions similarly to a traditional IRA, except as the owner, you set up and contribute to accounts for both yourself and your employees. In 2022, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $61,000, (5) and your contributions are tax-deductible up to 25% of all participants’ compensation, or up to 25% of net earnings if you’re self-employed. (6)
- Solo 401(k): Also known as an individual 401(k), a solo 401(k) is designed for businesses with only one employee, the business owner. Solo 401(k) plans have two types of contribution limits. First is the profit-sharing limit for employer contributions, which is the lesser of 25% of business revenue or $61,000. (7) The next limit is the annual employee elective deferral limit, which is $20,500 for individuals under age 50, and $27,000 for those age 50 and older. (8) The combined limit for both employer and employee contributions is $61,000 (or $67,500 if older than 50), but because there are two types of contributions permitted, most self-employed individuals will be able to contribute more and receive a larger tax break than if they used a SEP IRA.
The sooner you incorporate retirement planning into your small business, the more time you will have to take advantage of tax-deferred growth.
Not Maximizing Deductions
There are several reasons why small business owners don’t necessarily take all the deductions they deserve. Whether you didn’t know about it, or didn’t understand how it applied to your specific situation, tax deductions can be confusing to navigate for many.
Here are some examples.
Many business owners who work from home are nervous to take the home-office deduction. They believe doing so will lead to extra scrutiny of their tax returns. The problem is, this deduction can be significant. And if you’re sure you qualify, there’s no reason not to take it. (9)
Carryover deductions are another commonly missed deduction. These include capital losses, net operating losses, and charitable donations (among others). If you don’t have an organized system in place (or change tax preparers each year), these are easy to lose track of.
Lastly, we have the “it’s too much work” deductions. This would include things like auto expense deductions (requiring you to track mileage). It seems like a lot of work, but it can be worth it. Think about it. If you run a small business, a big chunk of your drive time is likely business related. It can be burdensome to track miles, but if you make it a habit, the time you spend tracking will likely pale in comparison to the taxes you’ll save.
Are You Making Some of These Mistakes?
If you’re a small business owner making some of these tax planning mistakes, know that it’s not too late to get organized and make the most of proactive tax strategies. Get started today so you don’t pay more than you have to. To learn more about your tax planning options, book a consultation with me here or email me at firstname.lastname@example.org.
Trent Derrick is a financial advisor and Chief Market Technician at Legacy Wealth Management. Trent is passionate about the value small businesses bring to their communities and specializes in serving small business owners by providing seamless financial advisory services tailored to their financial needs, including tax planning, cash flow management, retirement planning, and bookkeeping. Trent has a bachelor’s degree from the College of Charleston and studied economics at the University of South Carolina, Columbia. He is a Chartered Market Technician® (CMT®) professional. Trent serves as a guest lecturer for the College of Charleston’s MBA program and acts as chairman of the Market Technician Association’s Charleston chapter. When he’s not working, Trent, a proud Eagle Scout, enjoys volunteering with the Charleston Animal Shelter’s outreach program. Trent and his wife love to cook international cuisines and host dinner parties with their friends. To learn more about Trent, connect with him on LinkedIn.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.