- A tax liability is the tax debt you owe the federal, state or local government.
- Understanding what deductions you can make, what equipment to purchase and how to invest in operations can help reduce your tax liability.
- Tax credits can reduce your tax
- This article is for small business owners looking to better manage their taxes.
For most people, taxes are due April 15, but businesses must prepare (and pay) taxes year-round. The decisions you make throughout the year impact your business's tax liability. If this is your first year filing a business tax return, you might be nervous about how much you owe the government.
What is tax liability?
Your tax liability is the total amount of taxes you owe to the U.S. Internal Revenue Service (IRS), state or local government. A tax liability includes your income tax, employment tax, capital gains tax and past taxes that haven’t been paid yet. Ultimately, anything you are required to pay taxes on is a tax liability.
How can I reduce my taxable income?
From business expenses to careful investments, there are a variety of strategies that smart business owners can use to reduce the portion of their business income that can be taxed.
1. Know which deductions you can legally make.
"Many small business owners are unaware of deductions and are missing out on money that can be saved every year," said Gary Milkwick, chief product officer of 1-800Accountant.
Milkwick named some of the most common business expenses owners can deduct from their taxes:
- Expenses and mileage for personal vehicles that are used for business
- Cell phone bills, if the phones are primarily used for business
- Costs of operating a business from home, such as a portion of your mortgage, rent or utilities
- 50% of meal and entertainment expenses with existing or potential partners, employees, contractors and clients
- Costs to purchase business equipment, such as computers, printers, monitors and phones
- Setting up and contributing to retirement plans
2. Make smart purchases and investments.
If you're going to invest in new equipment or services for your business, the timing of those purchases can affect your tax liability this year or next year, said Milkwick. Starting in January, plan out what you're willing to invest in before the end of the year.
"If it's November, and you're planning on purchasing equipment within the next several months for a business expansion, for example, it may make sense to accelerate the purchase … before the end of the year to get the tax deduction in the current year," Milkwick told Business News Daily. "[The] same goes for services. If it's toward the end of the year, and you're planning on a large marketing campaign over the next several months, it may make sense to prepay for some of the costs to take the deduction in the current year."
Happen to have spare cash to make bigger investments? Be sure to consider tax-friendly opportunities. For example, you can write off a significant portion of initial investments in areas like real estate and oil and gas, said Casey Minshew, CEO of EnergyFunders.
"Oil and gas investments that pass through 'intangible drilling costs' help reduce an investor's taxable income, as they can take these costs as active deductions against their earned income," Minshew said. "This can generate up to a first-year return of 30% based on tax benefits alone, even before a drop of oil has been produced."
Business owners often mistakenly think that all cash inflows are taxable income and all cash outflows are deductions, Milkwick said. In reality, the nature of cash inflow or outflow determines whether it can be taxed or deducted.
For example, he said, income from the sale of the business's goods or services is taxable. However, some common cash increases that aren't taxable to the company include bank loans, lines of credit and loans from the owner to the business.
"These [loans] are also not deductible to the owner until the business spends the money," Milkwick added.
If you're not sure whether you can or should use any tax deduction strategies, consult with your tax attorney or certified public accountant (CPA).
3. Invest in your employees.
Finally, one of the best ways to reduce your taxable income is to reinvest earned money back into your business, specifically your employees. This will reduce your tax burden while simultaneously giving your team better chances of success.
Generally speaking, the salaries, wages, bonuses and other compensation you pay your employees in a given year are tax deductible so long as they fit the following criteria:
- The compensation is both ordinary and necessary.
- They are a reasonable amount.
- They paid for services that were actually provided.
- They were paid for or incurred in the current year.
Investing in your business by hiring skilled employees can lower your tax burden, but employee retirement contributions are also tax deductible for employers. According to the IRS, employers may deduct 401(k) contributions as long as they don’t exceed the limitations described in section 404 of the Internal Revenue Code.
Offering your employees matching, profit-sharing or safe harbor contributions is a great way to boost their morale, attract the top talent and grow your business as research shows happy employees are more productive workers.
Key takeaway: Reduce your taxable income by understanding deductions and credits, make tax-friendly investments, and invest in your employees.
Avoid an audit.
While it makes financial sense to explore all your options for reducing your tax bill, you need to be careful. If your deductions look suspicious to the IRS, the agency might audit your business.
The IRS has switched its focus from large corporations to smaller business entities like sole proprietors, LLCs, partnerships and S corporations, said Jessie Seaman, former senior managing attorney at Tax Defense Network. In other words, Seaman said, your business could be under even greater scrutiny than your big competitors are.
Seaman noted that the IRS commonly looks for certain types of business tax deductions – such as those for home offices; meals, travel, and entertainment; vehicle use; and real estate losses – to make sure taxpayers are adhering to limits and regulations.
Similarly, Steven Aldrich, former chief product officer of GoDaddy and the former CEO of online accounting system Outright, reminded business owners to keep personal and business expenses separate. (The IRS looks for personal expenses reported as business expenses, he said.) And always report full, gross income before any fees, such as those for credit card processing, are taken out, he added.
If you receive an audit notice, read Business News Daily's guide to handling an audit properly. Then consult your tax professional for the next steps.
Key takeaway: Reduce your odds of being audited by avoiding comingling personal and business expenses or taking egregious deductions.
How can I reduce my tax exposure?
One of the best ways to decrease your tax exposure is to pay attention to tax credits as well as tax deductions.
Unlike tax deductions, which reduce your taxable income, tax credits are deducted from your tax burden. Rather than decreasing the income you owe taxes on, tax credits grant a dollar amount reduction in the tax that you owe. There are many federal tax credits available for businesses, such as the general business credit, investment credit, credit for employer-provided childcare and facilities, the Indian employment credit and more.
In some cases, you may find that your business is eligible for more tax credits than you can legally take that year. In these cases, you can do one of two things:
- Apply the tax credit to previous years when you did not exceed your credit limit to receive a retroactive refund.
- Carry the balance forward and apply them to the next tax year.
Many states offer tax credits to encourage economic growth and business investment. These vary from state to state, and many are offered for businesses that increase employment, use local resources, or operate in underdeveloped cities and regions. Your state's treasury department or chamber of commerce will have comprehensive information on the state and local tax credits that are available.
Many businesses record their deductions carefully but forget to explore all the tax credits that might be available to them. To ensure that you reduce your business's tax exposure as fully as possible, work with your accountant to make sure you are taking every applicable tax credit that can benefit your business.
Key takeaway: Securing tax credits can reduce your overall tax liability. Consider the general business credit and investment credit to start.
What is the tax treatment of charitable contributions?
Individuals who make qualified charitable contributions may deduct those contributions up to 60% of their adjusted gross income, as long as they itemize the deductions on their income taxes. Taxpayers who take the standard deduction may not deduct charitable contributions.
Corporations can deduct certain charitable contributions, though they may not deduct more than 10% of their pretax income in any given year. Excess contributions may be carried forward for up to five years. How your contributions are treated may also depend on the type of contribution you made, such as cash, property or shares of stock.
Certain charitable contributions also count as business expenses. If your business received any benefit in exchange for the donation, such as ad space or event sponsorship, the donation can be considered a business expense.
Key takeaway: Charitable contributions can be deducted, although corporations cannot deduct more than 10% of their pretax income in the same year. Some charitable contributions are also business expenses.
What makes a business tax-exempt?
Tax-exempt organizations do not have to pay federal income taxes, though may still be required to pay state and local income tax. To be eligible for tax-exempt status, the owners and founders of a business must not receive profits from it.
A variety of organizations can be tax-exempt, but they generally fall into one of nine categories:
- Religion (such as churches or synagogues)
- Arts or culture (such as art museums)
- Education (such as universities or parent-teacher associations)
- Public social benefit (such as the Gates Foundation or United Way)
- Health (such as nonprofit hospitals or cancer societies)
- Human services (such as homeless shelters or the Girl Scouts)
- Environment (such as human societies or environmental foundations)
- International or foreign affairs (such as the International Committee of the Red Cross)
- Membership organizations (such as veterans' organizations or labor unions)
- Not give net income to an owner, founder, or any other individual.
- Have a religious, scientific, educational or other charitable purpose.
- Not be involved in political campaigns or attempt to influence government legislation.
- Not violate public policy or be involved in illegal activity.
If you are a 501(c)(3), in addition to being tax-exempt yourself, donations that individuals make to your organization are tax-deductible. There are a variety of other tax-exempt entities, such as a 501(c)(4) status for social welfare organizations. The IRS provides information on who can claim tax-exempt status and which forms you will need to use to file the return.
Key takeaway: Tax exempt businesses are identified by law and registered with the IRS. Tax exempt businesses are generally non-profit 501(c)(3) organizations.
How do I calculate my business taxes?
If you are not a tax-exempt organization, the business taxes that you owe depend on the type of business that you have. A limited liability corporation, for example, will have a different tax structure than a sole proprietor.
The main federal taxes that business owners must calculate are
- Income taxes: Every business, except partnerships, will need to file an income tax return every year. (Partnerships file an information return.) How your income tax is calculated depends on the structure of your business. Partnerships, sole proprietorships, corporations and S-corps are the most common types of business structures.
- Estimated taxes: Income tax is pay as you go throughout the year. Employees have taxes withheld from their paychecks, but businesses and the self-employed must file estimated taxes throughout the year, based on the income you have earned up to that point in the year. Federally, four income tax payments are due on April 15, June 15, September 15 and January 15 for the previous tax year. Estimated tax is calculated using Form 1040-ES or Form 1120-W for corporations.
- Self-employment tax: Employees generally have Social Security and Medicare taxes withheld from their paychecks. If you are a self-employed business owner, however, you must calculate and pay your own Medicare tax and Social Security tax through self-employment taxes. Some groups are exempted from self-employment taxes, but, generally, if you earn more than $400 from self-employment, you must pay self-employment taxes, which you can calculate using Schedule SE on Form 1040.
- Employment tax: If your business has employees, you have to file a portion of their Social Security and Medicare taxes, along with income tax withholding and the federal unemployment tax. These are calculated and paid through employment tax.
- Excise tax: Not all businesses need to calculate or pay excise taxes. You must pay excise taxes if you manufacture or sell certain products, use specific kinds of equipment or facilities, or receive payments for specific services. Businesses that must pay excise taxes range from indoor tanning providers to aircraft management services. Before calculating business taxes, find out if you are required to pay excise taxes and which forms you will need to file.
Depending on the assets that your business owns, you may need to pay additional taxes, such as property tax. Most businesses must also pay state and local taxes. Though these taxes are often much lower than federal taxes, they can be more complicated to calculate and can carry large penalties for mistakes. Check all your forms carefully before submitting your taxes to avoid fines.
Calculating your business tax does not depend on a single number. Due to deductions, credits, and changes in the tax code, the actual rate that you pay will likely change every year.
To ensure that you are calculating your business taxes correctly, work with a tax preparation specialist or certified accountant throughout the year. A tax pro can advise you on strategic decision-making that will reduce your tax liability and ensure that you receive every deduction, credit or tax exemption possible.
Key takeaway: To calculate your taxes, tally your total from income tax, self-employment tax, excise taxes and more. Consult with a certified public accountant to ensure your tax bill is correctly tabulated.
Sean Peek also contributed to the reporting in this article. Some source interviews were conducted for a previous version of this article.