Factoring taxes into small business decisions

Taxes infiltrate many areas of your small business and your personal finances. Some people make important financial decisions without considering taxes (and other important variables). Conversely, in an obsession to minimize or avoid taxes, other people make decisions that are counterproductive to achieving their long-term business and personal financial goals. Although taxes are an important component to factor into your major business and financial decisions, taxes shouldn’t drive or dictate the decisions you make.

The following list shows some of the ways that tax issues are involved in making sound financial decisions throughout the year.

• Type of business and benefits offered: The type of business entity you select for your business — sole proprietorship, S corporation, limited liability company (LLC), and so on — can have significant tax and other consequences. The benefits you’re able to utilize and offer to your employees, if you have them, also have tax ramifications (see Chapter 2).
• Retirement accounts: Taking advantage of retirement accounts can mean tens, perhaps even hundreds of thousands more dollars in your pocket come retirement time. Offering retirement account access to your employees can also be a valuable employee benefit for recruiting and retaining good employees if they understand what they have. Refer to Chapter 3 for more on retirement accounts.
• Spending: Throughout this book, I discuss myriad spending decisions you may face in your small business, such as buying equipment (Chapter 8), spending on employee benefits (Chapter 2), and so on. These decisions will often affect your taxes both now and in the future.
• Protecting your assets: Some of your insurance decisions also affect the taxes you pay. You’d think that after a lifetime of tax payments, your heirs would be left alone when you pass on to the great beyond — but that’s wishful thinking. Estate planning can reduce the taxes that are siphoned off from your estate. See Chapter 5 to find out more about estate planning.
• Tracking your business financials: Throughout the year, you should stay on top of your business’s income and expenses so that you can see your business’s financial health and record the numbers you need come tax time. Chapter 6 covers these important issues.

Checking out common tax mistakes

Even if some parts of the tax system are hopelessly and unreasonably complicated, there’s no reason why you can’t learn from the mistakes of others to save yourself some money, no matter the time of year. With this goal in mind, this section details common tax blunders that people make when it comes to managing their money.

Checking out corporate income tax rate reduction and simplification

At 35 percent, the United States had had one of the highest corporate income tax rates in the world before 2018. The Tax Cuts and Jobs Act slashed the corporate income tax rate to 21 percent, which represented a 40 percent reduction.

The corporate tax rules and deductions were simplified, including eliminating the corporate alternative minimum tax and closing some loopholes. The United States also moved to a territorial tax structure whereby U.S. companies would no longer pay a penalty to bring their overseas profits back home. The immediate impact of this change was to enable U.S. corporations to bring back to the United States more than $2 trillion being kept overseas to avoid excessive taxation.

The vast majority of small businesses aren’t operated as traditional so-called C-corps (more on those in a moment). Most small business owners operate as sole proprietorships (filing Schedule C), LLCs, partnerships, or S corporations. In those cases, the business owner’s profits from the business generally flow or pass through to the owner’s personal income tax return and that income is taxed at personal income tax rates (see the section “Twenty percent deduction for pass through entities” for more information).

Reducing individual income tax rates

Just as the corporate income tax rate was reduced by the Tax Cuts and Jobs Act legislation, so too were the individual income tax rates. Most of the tax bracket rates were reduced by several percentage points (see Table 1-1 later in this chapter). This, of course, is excellent news for the vast majority of U.S. small business owners who operate their businesses as pass through entities (for example, sole proprietorships, LLCs, partnerships, S-corps).

Note that at higher levels of income, the individual income tax rates begin to exceed the 21 percent corporate tax rate. Seeing this helps you to better understand the next point as to why pass-through entities are being granted a special tax deduction on their profits.

Noting 20 percent deduction for pass-through entities

In redesigning the tax code, Congress rightfully realized that the many small businesses that operate as so-called pass-through entities would be subjected to higher federal income tax rates compared with the new 21 percent corporate income tax rate. Pass-through entities are small business entities such as sole proprietorships, LLCs, partnerships, and S corporations and are so named because the profits of the business pass through to the owners and their personal income tax returns.

To address the concern that individual business owners that operated their business as a pass-through entity could end up paying a higher tax rate than the 21 percent rate levied on C-corporations, Congress provided a 20 percent deduction for those businesses. So, for example, if your sole proprietorship netted you $60,000 in 2018 as a single taxpayer, that would push you into the 22 percent federal income tax bracket. But, you get to deduct 20 percent of that $60,000 of income (or $12,000) for the pass-through deduction so you would only owe federal income tax on the remaining $48,000 ($60,000 – $12,000).

Another way to look at this is that the business would only pay taxes on 80 percent of its profits and would be in the 22 percent federal income tax bracket. This deduction effectively reduces the 22 percent tax bracket to 17.6 percent.

This is a major change that not surprisingly has made small business owners exceedingly optimistic about being able to grow their businesses. In fact, in a January, 2018 survey of small business owners conducted by the nonprofit National Federation of Independent Business just after the tax bill was passed and signed into law, a record percentage of those surveyed (covering the survey’s 45-year history) expressed optimism about it being a good time to expand their businesses.

This 20 percent pass-through deduction gets phased out for service business owners (such as lawyers, doctors, real estate agents, consultants, and so on) at single taxpayer incomes above $157,500 (up to $207,500) and for married couples filing jointly incomes more than $315,000 (up to $415,000). For other types of businesses above these income thresholds, this deduction may be limited so consult with your tax advisor.

Enjoying better equipment expensing rules

Through so-called section 179 rules, small businesses have historically been able to immediately deduct the cost of equipment, subject to annual limits, they purchase for use and place into service in their business. But the 2017 tax bill expanded these rules.

Now, more businesses can immediately deduct up to one million dollars in such equipment expense annually (up to the limit of their annual business income). And, this deduction can also now be used for purchases on used equipment. These provisions, which don’t apply to real estate businesses, remain in effect through 2022 and then gradually phase out until 2027 when the prior depreciation schedules are supposed to kick back in.

Increasing maximum depreciation deduction for automobiles

The new tax bill included a major increase in the maximum amount of auto depreciation that can be claimed. The annual amounts of auto depreciation have more than tripled. Effective with tax year 2018, the maximum amounts that can be claimed are as follows:

• Year 1: $10,000 up from the prior limit of $3,160
• Year 2: $16,000 up from the prior limit of $5,100
• Year 3: $9,600 up from the prior limit of $3,050
• Year 4 and beyond: $5,760 up from the prior limit of $1,875, until costs are fully recovered.

These annual limits will increase with inflation for cars placed into service after 2018.

Limiting interest deductions

Effective with 2018, companies with annual gross receipts of at least $25 million on average over the prior three years are limited in their deduction of interest from business debt. Net interest costs are capped at 30 percent of the business’s earnings before interest, taxes, depreciation, and amortization (EBITDA). Farmers and most real estate companies are exempt.

Then, effective in 2022, this provision actually gets more restrictive and would thus effect even more businesses. At that point, the 30 percent limit will apply to earnings before interest and taxes.

Reducing meal and entertainment deductions

The tax reform bill of 2017 eliminated the entertainment expense deduction for businesses. Under prior tax law, 50 percent of those expenses were deductible for example when a business entertained customers and even employees at sporting events, fitness clubs, and restaurants.

The new rules do include some exceptions. On-site cafeterias at a company’s offices and meals provided to employees as well as business meals associated with travel are 50 percent deductible. Meals provided to prospective customers as part of a seminar presentation are still fully deductible. Holiday parties and company picnics are also fully deductible as long as they are inclusive of everyone.

Eliminating the health insurance mandate

Since the Affordable Care Act (a.k.a. Obamacare) was passed by Congress in 2010, some Republicans in Congress vowed to repeal it. With the election of Republican Donald Trump in 2016, it seemed that the pieces were in place for Obamacare’s successful repeal. But, Republicans fell one vote short in the Senate when the late Arizona Senator John McCain gave the repeal measure his infamous thumb down vote.

So, the 2017 tax bill included a little known or discussed measure that eliminated Obamacare’s mandate effective in 2019, which required people to have or buy health insurance coverage and if they didn’t, they’d face a tax penalty. So, the penalty tax also disappears in 2019.

Revising rules for using net operating losses

Net operating losses (NOLs) can no longer be carried back for two years. However, NOLs may now be carried forward indefinitely until they are used up. Previously the carry forward limit was 20 years.

NOLs are limited each year to 80 percent of taxable income.

Defining total taxes and taxable income

The only way to determine the total amount of income taxes you pay is to get out your federal and state tax returns. On each of those returns, about one-third of the way before the end, is a line that shows the total tax. Add the totals from your federal and state tax returns, and you probably have one very large expense!

Your taxable income is different from the total amount of money you earn during the tax year from employment and investments. Taxable income is defined as the amount of income on which you actually pay income taxes. You don’t pay taxes on your total income for the following two reasons:

• Not all income is taxable. For example, you pay federal income tax on the interest that you earn on a bank savings account but not on the interest from municipal bonds (loans that you, as a bond buyer, make to state and local governments).
• You get to subtract deductions from your income. Some deductions are available just for being a living, breathing human being. And, the Tax Cuts and Jobs Act greatly increased the standard deductions. For tax year 2018, single people receive an automatic $12,000 standard deduction, heads of household qualify for $18,000, and married couples filing jointly get $24,000. (People older than 65 and those who are blind get slightly higher deductions.) Other expenses, such as mortgage interest and property taxes, are deductible to the extent that your total itemized deductions exceed the standard deductions.

Your marginal income tax rate for federal income taxes

Marginal is a word that people often use when they mean “small” or “barely acceptable.” But with taxes, marginal has a different meaning. The government charges you different income tax rates for different portions of your annual income. So your marginal tax rate is the rate that you pay on the so-called “last dollars” you earn. You generally pay less tax on your first, or lowest, dollars of earnings and more tax on your last, or highest, dollars of earnings. This system is known as a graduated income tax, a system that goes back hundreds of years to other countries.

The fact that not all income is treated equally under the current tax system isn’t evident to most people. When you work for an employer and have a reasonably constant salary during the course of a year, a stable amount of federal and state taxes is deducted from each paycheck. Therefore, you may have the false impression that all your earned income is taxed equally.

Table 1-1 gives the 2018 federal income tax rates for singles and for married people filing jointly.

Your marginal tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of taxable income. For example, according to Table 1-1, if you’re single and your taxable income during 2018 totals $50,000, you pay federal income tax at the rate of 10 percent on the first $9,525 of taxable income. You then pay 12 percent on the amount from $9,525 to $38,700 and 22 percent on income from $38,700 up to $50,000. In other words, you effectively pay a marginal federal tax rate of 22 percent on your last dollars of income — those dollars in excess of $38,700.

After you understand the powerful concept of marginal tax rates, you can see the value of the many financial strategies that affect the amount of taxes you pay. Because you pay taxes on your employment income and your investment earnings (other than retirement accounts), you need to make many of your personal financial decisions with your marginal tax rate in mind.

• For example, when you have the opportunity to earn some extra money, how much of that extra compensation you get to keep depends on your marginal tax rate. Your marginal income tax rate enables you to quickly calculate the additional taxes you’d pay on the additional income.
• Conversely, you quantify the amount of taxes that you save by reducing your taxable income, either by decreasing your income — for example, with pretax contributions to retirement accounts — or by increasing your deductions.

Actually, you can make even more of your marginal taxes. In the next section, I detail the painful realities of income taxes levied by most states that add to your federal income tax burden. If you’re a middle-to-higher income earner, pay close attention to the sidebar later in this chapter where I discuss the alternative minimum tax.

State income taxes

Your total marginal rate includes your federal and state income tax rates. As you may already be painfully aware, you don’t pay only federal income taxes. You also get hit with state income taxes — that is, unless you live in Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming. Those states have no state income taxes. As is true with federal income taxes, state income taxes have been around since the early 1900s.

You can look up your state tax rate by getting out your most recent year’s state income tax preparation booklet. Alternatively, Figure 1-1 gives you an idea of your state tax rates; it reflects state individual income taxes. Some states impose other taxes — such as local, county, or city taxes; special taxes for nonresidents; or capital gains taxes — which aren’t included in this table.

Corporate income tax rates

As I explain earlier in this chapter, the vast, vast majority of small business owners pay income taxes on their business earnings at the personal income tax rates. That’s because most small businesses are organized as sole proprietorships, which have income taxed as personal income. Also, many other small businesses that are organized as partnerships, LLCs, and S corporations pass through their income to the business owners in such a way that it, too, is taxed as personal income.

Thus, only a small percentage of small business owners have their income taxed as regular, so-called C-corporations. The Tax Cuts and Jobs Act, which took effect in 2018, compressed the previous numerous corporate income tax brackets to just one rate – 21 percent. In the next chapter, I discuss how the tax rate a business pays along with other factors play a role in determining what’s the best business entity for your business.

Employment (payroll) taxes

Business owners are responsible for the timely payment of all employee related payroll or employment taxes. Some of these are withheld from the employees’ pay while others are paid by the employer. Here are the taxes I’m talking about:

• Federal income tax withholding
• State income tax withholding
• Social Security and Medicare taxes (aka FICA) – half paid by employer, half paid by employees
• Federal unemployment tax – paid by employers
• State unemployment tax

It’s imperative that you understand and properly withhold and pay all of these taxes on a timely basis. For a list of state tax authorities, visit www.taxadmin.org/state-tax-agencies. Otherwise, you and your business could be subject to stiff penalties and interest charges. Here’s an overview of the frequency with which employment taxes are required:

• Larger employers (paid more than $50,000 in employment taxes the previous calendar quarter) must submit/deposit their employment taxes every two weeks.
• Moderate-sized employers (those that have between $2,500 and $50,000 in employment taxes) can submit their employment taxes monthly.
• Smaller employers (have less than $2,500 in employment taxes quarterly) may submit their employment taxes with their quarterly employer tax returns. Those with $1,000 or less for income tax withholding and Social Security and Medicare tax payments or federal unemployment tax payments under $500 can pay annually.

Employers must generally deposit these taxes electronically using the Electronic Federal Tax Payment System (EFTPS), which was originally launched in 1996 and doesn’t charge users. This system enables the transfer of your funds from your bank account to the U.S. Treasury.

If your annual employment taxes for your business exceed $1,000, you must file each quarter IRS Form 941, “Employer’s Quarterly Federal Tax Return.” You can instead file IRS Form 944, “Employer’s Annual Federal Income Tax Return” if your annual employment taxes are less than or equal to $1,000.

To ensure the timely credit of your taxes, plan on submitting them at least one day before they’re actually due. Alternatively, your tax advisor, payroll service, bank, or other financial institution can make the deposit on your behalf.

For more information, visit www.eftps.gov or call 800-555-4477.

Also, remember that self-employed individuals need to pay self-employment taxes, which are Social Security and Medicare taxes. See Chapter 10 for all the details.

Sales taxes

As you probably already know from your years as a consumer many towns, cities, counties, and states levy sales taxes on the purchase of particular goods and services. A related tax, known as a use tax, may be levied on the buyer of certain products from out of state.

As the seller of goods or services within a state with a sales tax, your business is obligated to collect and submit said tax to the relevant agency for sales tax collection in your state.

The Streamlined Sales Tax Governing Board was created by the National Governor’s Association (NGA) and the National Conference of State Legislatures (NCSL) in 1999 to simplify sales tax collection. By visiting their website at www.streamlinedsalestax.org/ you can find a list of Certified Service Providers that can help you collect and remit sales tax to the state(s) in which you do business. There is no cost to your business for this service, and using it eliminates any risk of your business being audited for sales tax collections.