Reducing taxable income not only helps you retain more of your hard-earned money, but it’s also one of the best ways to find savings that can be reinvested in your business. This month, we wanted to step back to overview the most basic ways small business owners can reduce taxable income.
First, it’s critical to understand that It’s not uniquely patriotic to pay more taxes than is necessary. As U.S. President Calvin Coolidge once said, “Collecting more taxes than is absolutely necessary is legalized robbery.” The IRS considers paying no more than the correct amount of taxes, a basic taxpayer right.
Income taxes can be straightforward for those just starting out and those who are employees with few assets to protect. Once you own your own business, property, assets, and investments, however, reducing taxable income becomes an art and science. There can be dozens of ways to treat these taxable areas, and the IRS won’t lift a finger to help you identify the most cost-effective strategy.
Here are some effective strategies that are often the starting points for small businesses wanting to reduce taxable income:
Utilize Tax Deductions
One of the most straightforward ways to reduce taxes is by taking advantage of tax deductions. Common deductions for small businesses include:
- Business Expenses: Deduct ordinary and necessary expenses such as rent, utilities, office supplies, and advertising costs. Don’t overlook business-related vehicle and travel expenses, as well.
- Home Office Deduction: If you use a portion of your home exclusively for business purposes, you may be eligible for a home office deduction.
- Employee Salaries and Benefits: Wages, salaries, and benefits paid to employees are deductible business expenses. But understand fringe benefits well: This area has as many tax traps as hidden opportunities.
- Qualified Business Deduction: Many business owners can take advantage of a 20% Qualified Business Deduction (QBD), also called a Section 199A deduction.
If you’re self-employed, talk to a tax professional about structuring your role and income to make way for these and other appropriate deductions. A Net Operating Loss (NOL) can occur if your deductions outweigh your business income for the year. If this happens, you may be able to carry it over to offset taxes in future years.
Take Advantage of Section 179 and Bonus Depreciation
Section 179 expensing and bonus depreciation are two different tax deduction options, allowing you to decide whether to deduct the cost of qualifying business equipment and property in the year it’s purchased (which can significantly reduce your taxable income) or depreciate it over several years. However, check the current limits and eligibility requirements for these deductions because they’ve been changing.
Maximize Tax Credits
Tax credits can be easily overlooked, but don’t: They can directly and significantly reduce the taxes you owe. The Research and Development (R&D) tax credit is one of our favorites. You may be pleasantly surprised at what qualifies as R&D, so discuss your business activities, processes, services, and products with a tax professional knowledgeable about this specific opportunity. Read more about the R&D tax break here.
Federal, state, and local tax credits come in all shapes and sizes, depending on your location, size, industry, and how you run your business. Another example is the Work Opportunity Tax Credit (WOTC), available to businesses that hire individuals from certain target groups who face significant barriers to employment. Be sure to ask a tax professional as well as your local economic development office and other local resources about opportunities.
Defer Income and Accelerate Expenses
Timing is crucial when it comes to managing taxable income. In windfall years, you might consider delaying what income you can and accelerating expenses to reduce your taxable income for that year. Conversely, if you have losses but anticipate doing better in the coming year, there may be ways to accelerate some income and defer expenses.
Invest in Retirement Plans
Contributing to retirement plans helps you save for the future and reduces your taxable income. A few retirement account types are uniquely available to small businesses or small business owners. They include:
- Simplified Employee Pension (SEP) IRA: This plan allows you to contribute up to 25% of your net earnings from self-employment, up to a maximum amount.
- Solo 401(k): If you are self-employed with no employees, you can contribute both as an employer and an employee, allowing for higher contribution limits.
- SIMPLE IRA: This plan is ideal for small businesses with fewer than 100 employees. It allows both employer and employee contributions.
Hire Family Members
When it makes sense, hiring family members can be a great way to reduce your family’s taxable income. Wages paid to family members are deductible business expenses. Additionally, if your children are under 18, their wages are not subject to Social Security and Medicare taxes.
Keep Accurate Records
Maintaining accurate and detailed records is essential for maximizing your tax savings. Proper documentation ensures that you can substantiate your deductions and credits in case of an audit. Use accounting software to track your income and expenses (most certainly including payroll) and keep receipts and invoices organized. Interest and penalties associated with poor accounting practices can devastate a small business.
Consult with a CPA
Tax laws are complex and constantly changing. Working with a CPA who specializes in small businesses can help you navigate these complexities and identify additional opportunities to reduce your taxable income. A CPA can also provide personalized advice based on your unique business situation.
The IRS will tax you on every penny of your small business income if you let it. But there are also dozens of IRS-approved ways to keep a good portion of that income tax-free. Feel free to contact us with questions.