Chapter 1
IN THIS CHAPTER
Appreciating the value of year-round tax planning
Noting the various taxes you and your business pay
Even though I write about personal finances, including tax issues, I don’t particularly enjoy dealing with taxes. I would rather cut my lawn, take care of my neighbor’s dog, or even visit my dentist (for a routine cleaning). At least in all these cases, I know my time commitment is reasonably limited, and when I’m done, I’m satisfied that the job has been done well, and I can move on to something else.
Filling out state and federal tax forms is often complicated and confusing. Because I write about taxes, I feel that it’s essential for me to complete my own forms and returns, which forces me to wallow in the details as much as possible so that I can more fully appreciate the challenges taxpayers face. (By contrast, prior surveys have found that the representatives in Congress who sit on committees that draft the nation’s tax laws generally use paid tax preparers themselves.) A report from the National Taxpayer Advocate cited “the complexity of the tax code as the No. 1 most serious problem facing taxpayers.”
Though some of this book deals with the drudgery of completing required tax forms, much of it deals with the more interesting — and dare I say, fun — part of taxes, which is planning ahead and strategizing so as to reduce and minimize your taxes. You see, if you simply view your role with taxes and your small business as jumping through the many hoops that federal, state, and local authorities require, you’re missing out on something really big — saving and keeping more of your hard-earned money.
This chapter introduces the basics of small business taxes. Here, I discuss the value of tax planning all year long, and I define some important tax-related terms regarding the taxes you pay or may come across.
Taxes are a large, vital piece of your small-business and personal-financial puzzle. You’re required by law to complete your tax forms each year and pay the taxes you owe. You do this because you have deadlines and don’t want contact initiated by local or state authorities or the IRS, to result in fines, penalties or worse, jail time!
Nothing really forces you to plan ahead regarding your tax situation and small business. That’s why the vast majority of small business owners don’t take steps year-round to plan and reduce their taxes. However, tax planning all year is valuable because it enables you to stay on top of your tax and business financial situation and minimize the taxes you legally owe. In this section, I explain typical ways in which taxes enter small business decisions and some common tax mistakes folks make in this realm.
The following list shows some of the ways that tax issues are involved in making sound financial decisions throughout the year.
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.
Too many people seek out information and hire help after making a decision, even though seeking preventive help ahead of time generally is wiser and more financially beneficial.
If you’re self-employed (or earn significant taxable income from investments outside retirement accounts), you need to make estimated quarterly tax payments. You also need to withhold taxes for your employees and send those taxes along to the appropriate tax agencies. Some small business owners don’t have a human resources department to withhold taxes and dig themselves into a perpetual tax hole by failing to submit estimated quarterly tax payments.
To make quarterly tax payments, complete IRS Form 1040-ES, “Estimated Tax for Individuals.” This form (discussed in Chapter 10) and its accompanying instructions (and payment coupons) explain how to calculate quarterly tax payments. For more information on the requirement for employee tax withholding, see Chapter 6.
All the tax deductions and tax deferrals that come with accounts such as 401(k)s, SEP-IRA plans, and individual retirement accounts (IRAs) were put in the tax code to encourage you to save for retirement. That’s something that you as a small business owner should be doing for yourself as well as encouraging your employees to do.
Most excuses for missing out on these accounts just don’t make good financial sense. Some folks underfund retirement accounts because they spend too much and because retirement seems so far away. Others mistakenly believe that retirement account money is totally inaccessible until they’re old enough to qualify for senior discounts. (See Chapter 3 to find out all about your small business retirement account options.)
In the long run, owning a home should cost you less than renting. And because mortgage interest (on up to $750,000 of mortgage debt) and property taxes (up to $10,000 when combined with your state income tax payments) are deductible, the government, in effect, subsidizes the cost of homeownership.
If you have a home office, you may be able to take additional expenses on your tax return. If you need a retail or commercial space for your small business, you should compare leasing to buying and be sure to factor in the tax benefits of owning. See Chapter 4 for more about real estate and taxes.
Or suppose that you operate on a cash accounting basis and think that you’ll be in a lower tax bracket next year. Perhaps business has slowed of late or you plan to take time off to be with a newborn or take an extended trip. You can send out some invoices later in the year so that your customers won’t pay you until January, which falls in the next tax year.
As a small business owner, ask yourself how much you’re worth running your business versus how much you’re worth as a bookkeeper. Then ask yourself which task you enjoy more and consider hiring a bookkeeper.
Note that using a tax advisor is most beneficial when you face new tax questions or problems. If your tax situation remains complicated or if you know that you’d do a worse job on your own, by all means keep using a tax preparer. If your situation is unchanging or isn’t that complicated, consider hiring and paying someone to figure out your taxes one time. After that, go ahead and try completing your own tax returns.
Corporate tax reform in the United States was long, long overdue. For too many years, corporations in the United States faced a much higher corporate income tax rate than did companies based in most overseas economies. As a result, increasing numbers of U.S. companies had chosen to expand more overseas rather than in the United States and to be headquartered outside of the United States, which wasn’t good for the long-term health of U.S. economy and labor market.
Congress passed the Tax Cuts and Jobs Act in late 2017, which took effect with tax year 2018. It was the most significant tax reform package passed since the Tax Reform Act of 1986. What follows are the highlights of the most significant provisions that affect (and mostly benefit) small business.
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).
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).
TABLE 1-1 2018 Federal Income Tax Brackets and Rates
Federal Income Tax Rate |
Individuals Taxable Income |
Married Filing Jointly Taxable Income |
10% |
$0 to $9,525 |
$0 to $19,050 |
12% |
$9,525 to $38,700 |
$19,050 to $77,400 |
22% |
38,700 to $82,500 |
$77,400 to $165,000 |
24% |
$82,500 to $157,500 |
$165,000 to $315,000 |
32% |
$157,500 to $200,000 |
$315,000 to $400,000 |
35% |
$200,000 to $500,000 |
$400,000 to $600,000 |
37% |
More than $500,000 |
More than $600,000 |
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.
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.
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.
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:
These annual limits will increase with inflation for cars placed into service after 2018.
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.
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.
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.
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.
When it comes to federal income taxes, many people remember only whether they received a refund or owed money. But you should care how much you pay in taxes and the total and marginal taxes that you pay so you can make decisions that lessen your tax load. Although some people feel happy when they get refunds, you shouldn’t. A refund simply signifies that you overpaid your taxes during the previous year. When you file your income tax return, you settle up with tax authorities regarding the amount of taxes you paid during the past year versus the total tax that you’re actually required to pay, based on your income and deductions.
In this section, I define important tax terms such as total taxes, taxable income, marginal tax rates, and corporate tax rates, and I also discuss the federal and state income tax systems.
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:
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.
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.
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.
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.
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.
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:
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:
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.
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.