Finance

Essential Small Business Tax Tips: Avoid Mistakes and Save Thousands

Dan Nicholson

Most small business owners are doing tax preparation completely wrong, costing them unnecessary money and stress. In this article, I'll show you the right way to do it so that you can keep more money in your pocket and have less tax stress. Tax preparation shouldn't be a surprise at all. It should be a check mark, just crossing it off the list. Spoiler alert: your tax preparation starts about a year sooner than what you're doing right now.

Understanding Tax Deadlines and Planning Ahead

Tax deadlines are well known: March 15 and April 15. If you file an extension, the dates are September 15 and October 15. These dates are consistent year after year unless there's an extraordinary event like the COVID-19 pandemic, and even so, any emergency changes should be communicated well in advance. Knowing these fixed dates allows you to plan ahead and avoid unnecessary surprises.

Avoiding surprises means understanding that tax preparation is not the same as tax planning. 

The Difference Between Tax Preparation and Tax Planning

Tax preparation is simply reporting to the IRS what you did for the year, reconciling, and calculating the taxes you owe compared to what you've already paid. If there's a difference, you either get a refund or owe more. It’s a reporting event.

Tax planning, on the other hand, is strategic. It's about finding ways to pay the least amount of tax legally required based on your goals. Proper tax planning starts during the tax year. Once the tax year ends, most tax planning opportunities vanish. There's a common myth that your CPA or tax preparer can significantly reduce your tax liability during tax preparation. In reality, they’re just reporting on what’s already happened. Tax planning involves strategically finding opportunities and executing them to achieve your financial goals faster.

As part of your planning, you need to know your effective tax rate. Project your income based on wages and business profits, then use online tax calculators to estimate your total tax and marginal bracket. Take that rate, multiply it by your profit each month, and set that money aside in a separate account. When tax planning reduces your tax bracket, the money in your savings account becomes a windfall, which you can repurpose towards your goals. This proactive approach contrasts sharply with the common practice of hoping for a refund or scrambling to pay an unexpected tax bill.

The Importance of Understanding Your Business and Tax Details

You're not a tax expert, but you know your business better than anyone. Details matter, especially on your tax return, because how transactions get reported impacts their deductibility. For example, a band manager’s expenses for attending concerts can be categorized as research and development, which is 100% deductible, rather than entertainment, which is 0% deductible. Properly categorizing expenses not only increases deductibility but also reduces risk by avoiding abuse areas scrutinized by the IRS.

Your tax preparer, who only sees the information on a P&L, lacks the context of your business operations. For example, there's a six-digit code that describes your business, which can impact your eligibility for certain deductions, like the 20% pass-through deduction. Choosing the wrong code can lead to unnecessary scrutiny and disallowed deductions. This code also affects lending decisions, as lenders assess risk profiles based on it.

Common Mistakes and How to Avoid Them

Navigating the complexities of tax preparation can be challenging for small business owners, and even minor errors can lead to significant financial consequences. By understanding and addressing some of the most common mistakes, you can optimize your tax strategy, minimize liabilities, and maximize savings. Here are three frequent errors and how you can avoid them to ensure a smoother, more cost-effective tax preparation process.

Misclassification of Business Entities: One common mistake is taxing a business as a sole proprietorship instead of an S corporation. Sole proprietorships are subject to federal income tax and self-employment tax, which is 15.3% on the first $180,000 of income. Converting to an S corporation can significantly reduce this tax burden by requiring a reasonable salary subject to self-employment tax while exempting remaining profits.

Incorrect Reporting of Short-Term Rentals: Another frequent error is improper reporting of short-term rentals. The IRS clarified that rentals where the average stay is seven days or less should be reported on Schedule C, not Schedule E. This distinction can mean the difference between taking substantial losses and saving thousands in taxes. For instance, misreporting can prevent a $200,000 loss from being claimed, costing $80,000 in tax savings.

Missing the De Minimis Safe Harbor Election: The de minimis safe harbor election allows businesses to expense certain items directly rather than depreciating them, limiting IRS scrutiny. This election must be recorded on a timely filed return and cannot be added later through amendment. Missing this election is a common mistake, resulting in missed opportunities to limit risk and gain tax deductions.

Conclusion

To avoid these costly mistakes, you need to shift from reactive tax preparation to proactive tax planning. This involves understanding your business details, properly categorizing expenses, choosing the right business entity, and staying informed about IRS rules. By integrating these strategies into a broader financial perspective, you can reduce your tax liability and redirect savings toward your financial goals, ensuring a more secure and prosperous future.

Remember, the biggest risk is not living the life you want. Make sure your tax strategies are working for you, not against you.

Sources

Investopedia

NerdWallet

IRS

Forbes

Legal Zoom

NoLo

Dan Nicholson is the author of “Rigging the Game: How to Achieve Financial Certainty, Navigate Risk and Make Money on Your Own Terms,” deemed a best-seller by USA Today and The Wall Street Journal. In addition to founding the award-winning accounting and financial consulting firm Nth Degree CPAs, Dan has created and run multiple small businesses, including Certainty U and the Certified Certainty Advisor program.

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