224 | Tax Planning Opportunities for Business Owners

Hilary Hendershott: Welcome to Love Your Money with me, Hilary Hendershott. Today, I will be talking all about the world of business taxes to equip you as a business owner with the knowledge and strategies you need to thrive. In this episode, we’re going to explore an essential aspect of running a successful business, and that’s taxes. It’s timely because most of us are thinking about our tax returns this month, February 2024. And while the idea of paying taxes isn’t necessarily exciting, it’s important to remember that paying taxes means your business is profitable. It is a sign of success and growth. Despite what you read on the internet about how some business owners claim they avoid all taxes, it is not true. Paying taxes also presents an opportunity to optimize your financial situation.

In today’s discussion, I will share valuable insights and actionable information that’s going to empower you, as the business owner, to navigate the very complicated landscape of taxation effectively. Whether your business is a sole proprietorship, a partnership, an LLC, or a corporation, understanding your tax planning, tax obligations, and how to make informed decisions will have a significant impact on both your confidence and peace of mind and your bottom line. But here’s the thing, the world of taxes can be very complex, sometimes overwhelming, especially for those not well versed in tax law and financial planning, and that’s why your team is so important.

The power of a good CPA, which is a certified public accountant or EA, which is an enrolled agent, and a knowledgeable financial advisor should not be overlooked. Your team really can be the linchpin of your financial success, guiding you through the maze of tax regulations, helping you identify deductions and credits, and a proactive tax strategy tailored to you and your business’s unique abilities and needs. So, if you’re a business owner looking to optimize your tax situation, reduce your liability, and ensure that your hard-earned profits are put to best use, you’ve come to the right place.

Before you sit back, relax, and let’s dive into the world of tax advice for business owners, take one minute and click share on this episode in your podcast player. Send this episode to a friend who has been complaining about taxes. They really need to hear it. I am a certified financial planner. The acronym is CFP. That means I do have extensive education and experience on the topic of taxation, but I’m not a CPA. I don’t prepare taxes. I do have decades of experience helping clients with their tax planning and working hand-in-hand with their CPAs. And of course, I’m in the trenches with you. I myself file business taxes for my business. But this episode is not tax advice and shouldn’t be interpreted as personalized tax advice. Instead, I will be offering insights and general education and information that you can use in your head, in your practices, and in your conversations with your tax professional as you think about your taxes for 2023 and beyond.

Okay. So, let’s talk about what’s great about paying taxes. And I know what you’re thinking. “Hillary, taxes? Great. You really have to be kidding me.” Ah, I get it. Hear me out. Paying taxes, believe it or not, really is a good sign of good health in your business. It’s a clear indicator that your business is profitable and that really is something to celebrate. Because when your business is thriving, paying taxes means your hard work is bearing fruit, your strategies are working, your services and products are in demand. The goal is not to pay zero taxes, despite what you read on the internet or hear from your other business owner friends. That is almost always either unprofitable or illegal. And let’s not forget, as a business owner, if you’re paying taxes, it also means that you are getting paid. And that is the big win.

So, I’m not saying we should all just happily write a blank check to the IRS. No, no, no. We have to do smart tax planning, including looking for legitimate ways to minimize your tax burden. That’s a crucial part of financial management. After all, it’s your right to use every legal avenue to reduce what you owe. But, and this is a big but and this is a lesson I see, unfortunately, some people not learn until it’s too late, please, please, please do not let the tax tail wag the dog. What do I mean by that? Well, simply put, making business decisions solely to avoid taxes can lead you down a path that’s probably not in the best interest of you or your business. For example, lowering your taxable income can limit the amount you’re able to pay yourself. It also lowers the amount you can contribute to retirement accounts. It also lowers the amount you’ll eventually collect from Social Security, and absolutely lowers the potential sale value of your business.

Remember, your ultimate goal in your financial life is to grow your net worth and achieve financial freedom. So, don’t step over dollars to pick up pennies. Don’t let tax avoidance strategies overshadow your primary goals, which in your business are growth and stability and profitability. You want to earn high profits, extract those profits from your business in the form of payroll or profit draws or owner income to grow your net worth, which leads to financial freedom. Okay. So, don’t get distracted with thinking that you need to paint zero tax. Remember, your tax preparation and filing responsibilities live in three very different spheres or phases. Your goal should probably be to stay in phase one. If you learn nothing else from this episode, please learn about these three phases and how to best stay in phase one.

Phase one is you prepare in partnership with your tax and financial professionals and submit your tax return to the IRS and the appropriate state authorities. This is where you have the control. You report your income, claim your business costs and deductions, and ultimately you tell the IRS what you owe. Then you pay that amount. Sounds straightforward right? But if the IRS doesn’t like the way your tax return looks, if the numbers don’t tell a cohesive story, you might have to go to phase two.

Phase two kicks in if your tax return raises any red flags for the IRS, leading to an audit possibly years later. Suddenly, you’re not just dealing with numbers on a paper, and you are no longer trusted to be the one telling your own tax story. You’re defending your analysis to people who know far more than you about the tax code and get paid to collect additional tax dollars from you. I almost never hear about people getting audited and not ending up owing money. After all, the auditors have to pay their own salaries, right? And the pain of being audited isn’t just about trying to prove you’re right. It’s also about the time, stress, and sometimes significant amounts of money that it takes to defend your original filing. I mean, think about it. Hiring tax professionals and also probably lawyers to sit in that audit or exam room with you and the IRS agent is a major financial headache.

And then there’s phase three. If it turns out that your tax return was more wishful thinking than accurate reporting, you will end up with a substantial bill. We’re talking penalties, back taxes, interest, the works, and you’re probably flagged for future audits to boot. So, you see, while it might be tempting to stuff your tax return with aggressive and even questionable claims, it might even look great on paper. And I definitely know people brag about it on social media. It’s a very risky game. Remember, the IRS has quite the bite. They’re not just some toothless authority. No, no, no. And I’ve seen this happen. They can reach into your bank account, levy your assets, and turn your financial world upside down, and all without what we typically consider to be due process. The takeaway here is simple but powerful. Short-term gains can lead to long-term pains when it comes to excessive and creative tax minimization. Another word for that is tax evasion. It’s not just about what you pay or don’t pay now, it’s about the long-term implications of your choices.

Okay. So, hopefully, you got that lesson hard learned. Let’s start at the beginning of how you structure your business and how does that impact how you’ll pay taxes. Firstly, your business structure is the legal framework you choose for your business. It dictates your liability as well as your management and compliance obligations. You should determine your business structure in a conversation with your tax professional. Common structures include sole proprietorships, limited liability companies. The acronym for that is LLCs and corporations. Each of those has its unique characteristics.

For instance, a sole proprietorship is the simplest form where there’s no legal distinction between the owner and the business. On the other hand, a corporation is a separate legal entity offering liability protection but also requiring more complex compliance and governance. I myself run a business that’s a corporation that’s legally considered to be an LLC. So, tax, I’m a corp. Legal, I’m an LLC. Don’t run out and do that because it’s how I run my business. It’s just how I run my business. Your business or legal structure influences your tax filing status but they’re not always the same. For example, a sole proprietorship and a single-member LLC both report their business income and expenses on a Schedule C and file on a personal tax return. These are known as pass-through entities. So, fundamentally, you still file your taxes as an individual, and all of your personal income and business income is taxed at your personal income tax rates.

Now, contrast that with an LLC, which can alternatively choose to be taxed as a corporation, which means your business income is no longer always taxed to you as an individual. Okay. So, you have corporate taxes or individual taxes. Now, the worst-case scenario, consider a corporate tax return. For example, if you’re the owner or shareholder in a standard C corporation, you could face double taxation, meaning you’re taxed on the same income twice. First, the corporation pays income taxes on its profits, which are, of course, revenue minus expenses. And then from that income, either dividends or income are paid to the shareholder, you, and this income is included on your personal tax return. So, that same dollar could be taxed twice, first to the business and then to you. But if you elect to be taxed as an S-Corp, the business income passes through to the shareholders’ personal tax returns, avoiding double taxation.

What do you want to learn from this? All you want to know is to be aware that it’s possible to be taxed twice, and you want to make sure, in partnership with your tax preparer, that that doesn’t happen. So, when choosing your business structure, you and your tax professional will and should think beyond the immediate legal and tax implications. You need to consider how it determines how much you might owe in taxes, and how your business structure will grow with the business that you want and expect to run. In summary, personal income tax applies to all individuals. If you take money out of your business, you’ll pay personal income tax. And if your business files as a C Corp, you’ll pay corporate income taxes too. Understanding these taxes is crucial because they form a significant part of your financial landscape.

Okay. We’ve covered income taxes that you’ll pay as a business owner. Let’s also mention a few additional taxes that business owners pay. We all pay payroll taxes. So, besides federal, state, and local income taxes, there are also Social Security and Medicare. If you’re paying yourself and/or your employees on payroll, you will see taxes withheld for those taxes on your pay stubs. So, the payroll provider doesn’t allow you to spend all your income and then not be able to pay Uncle Sam at the end of the year. No, they’re just going to take it right out of your paycheck, and then they’re going to send it to the government. And you, if appropriate, get to make the case that you over-withheld or that they owe you that money back but most of the time, they keep it. So, yes, earning money is expensive.

As a business owner, you may also have to pay sales taxes. Sales tax applies to the sale of goods and services. And of course, those rules and rates vary by state. Each type of tax obviously has its nuances, and so you have to really stay informed if you’re subject to one of these lesser-known sort of nuanced taxes.

So, now that your business is structured ideally and you have a knowledge of the different types of taxes you pay, let’s talk about deductions. So, why do we do that? Well, of course maximizing legit deductions reduces your taxable income thereby lowering your tax bill. Here’s how to understand this. If you need to buy something that costs $100 and you have to pay income tax on that money, and you’re in a 20% tax bracket before you buy it, that thing that costs $100, you have to actually earn $120 to buy it because you have to send $20 to the federal government. However, if it’s tax-deductible, it comes off your taxable income and implicitly, it only costs you that $100. So, you get to pay what that thing costs and you don’t have to pay Uncle Sam for permission to buy it. So, that’s what a business deduction does. Let’s talk about some of the common deductions that business owners often take.

Health care expenses. If you’re self-employed, you can deduct premiums for medical and dental for yourself, your spouse, and dependents. This is a really valuable deduction because I don’t know if you’ve noticed, but healthcare costs are significant in the US.

The home office deduction. If you use a portion of your home, if you work from home regularly and exclusively for business, you can deduct a portion of your home-related expenses, such as, if applicable to you, rent or mortgage interest, insurance, utilities, repairs, and depreciation. It really is a great way to allocate household expenses to your business, but make sure you follow the IRS rules. I have heard this one is a huge red flag for the IRS, if you try to deduct too much.

Travel expenses. When you travel for business, expenses like airfare, hotels, car rentals, and even dry cleaning can be deductible. Just ensure that the travel is necessary for your business and keep good records. So, in the old days, we used to keep paper receipts and you would write the name of the client you were meeting with or the team member you were meeting with or having dinner with on the receipt, and we did it like that. These days, almost everyone is paperless. So, I use a combination of obviously my credit card transaction log and my electronic calendar. So, if I have dinner with you, you better bet your name is on my calendar. And that’s how I’m going to know and remember who I was with. I also have a CRM where I keep notes on most of my client conversations.

Meals and entertainment. Okay. This is the most misunderstood category. Business meals with clients or employees are deductible, but typically only 50% of the costs will be deductible. So, what I do, I put the whole thing on my company card. My bookkeeper takes half that expense and moves it over to nondeductible. Again, same as above, keep clear records of the business purpose of the meetings. Remember, you probably can’t deduct tickets to the Super Bowl. Especially for tax year 2023, entertainment is no longer deductible, but that could change in the future. But for now, no mas.

Vehicle use. If you use your vehicle for business and this one is important because transportation is a very big expense for most people, maybe you travel to your client offices, you can deduct car expenses. Now, you have two options. Track all your actual expenses like gas, maintenance, and insurance, which is honestly a huge pain in the butt or use the standard mileage rate set by the IRS. So, you just put your number of miles driven times the standard mileage rate. That’s the deduction you get. Also, make sure you ask your tax preparer about using the Section 179 deduction. This allows you to potentially deduct 100% of a vehicle’s cost, including gas and maintenance. Again, check with your tax preparer.

One of the most important practices that enables me and you to keep deductible expenses separate from nondeductible or personal expenses is how you manage your expenses all year round. If you are only thinking about taxes in February, March, and April, you are making a huge mistake and probably costing yourself lots of money. I personally manage my expenses this way all year round. I recommend it to all of my business owner clients. Very simple. I use one card for business and one card for personal. Literally, if you meet me and I have my cell phone with me, it has a wallet on the back. In that wallet, one personal card, one business card, and my driver’s license. That’s what I travel with. So, I use one. I put the business card down if it’s a business expense. I put the personal card down if it’s a personal expense. That way, it’s 100% clear at the end of the year and to my bookkeeper which expenses I believe are business expenses. If I make a mistake, we make a corrective journal entry and it’s no big deal.

It’s not about finding loopholes because for the most part, those don’t exist. A better way to think about it is that you are smartly navigating the rules that are in place to pay the least amount of tax that’s legally required. And now you know why savvy business owners use separate bank accounts and credit cards for business cash flow, why we use accounting software like QuickBooks, and why it’s so important to hire an experienced bookkeeper to keep the books in order. Bad bookkeeping almost always equals inaccurate returns.

Okay. Let’s talk about tax credits. Tax credits are really valuable for business owners because they are a dollar-for-dollar reduction in tax liability. So, using my previous example of something that costs you $100, you have to earn $120 to buy it if it’s a personal expense and you only have to earn $100 to buy it. So, you essentially get a 20% discount versus the tax credit, which if you get a $100 tax credit, that’s literally putting $100 of tax obligation back in your pocket so they’re more valuable and of course, they’re more rare. Since tax credits are tailored to specific entity types and business segments, I don’t have time to describe them all but your CPA, your tax preparer should be knowledgeable about the tax credits that are specific to your industry or that you could be eligible for.

Here are some of the ones I think are the most interesting. The research and development tax credit is for businesses that engage in qualifying research and development activities. Sounds like a big bucket. This can include developing new products or improving existing ones. Again, that sounds like a pretty good, pretty liberal definition, so ask about that one. The small business health care tax credit for businesses that pay their employees under $56,000. The energy-efficient commercial buildings deduction. This is a section 179D deduction. This applies to businesses that install energy-efficient systems in their buildings, including improvements in lighting, heating, cooling, and water heating. Also, consider the employer credit for paid family and medical leave. The Alternative Fuel tax credit, the credit for employer-provided childcare facilities, and the tax credit for establishing a 401(k) plan.

Speaking of a 401(k) or retirement plan, this is my favorite tax benefit to talk about. Retirement account contributions are not only tax-deductible, they create wealth for you and your employees. My clients and me and the people who work for me are actively contributing to either solo 401(k)s, group 401(k)s, Simple IRAs. There’s also the SEP IRA. Depending on the business structure and number of employees, you have to know which one of these you qualify for. Maximum contributions depend on the type of account you’re eligible for. This is where a savvy financial advisor like myself and my team will be an invaluable resource for you. For example, my first four or five years in business, I believe I had four or five different account types, and you literally have to open new accounts. And I opened those accounts because I happen to have that knowledge of which account type I qualify for. I did that for myself, but we also do that for our clients.

Consider, for example, a business owner who files as a sole proprietor and is in the 32% tax bracket. If she maximizes the 2024 contribution into her solo 401(k), which is $23,000, she will save $7,360 in federal taxes this year. So, that’s $7,360 towards her future financial freedom that she would otherwise have to pay to the IRS. So, you’re literally taking money out of Uncle Sam’s pocket and putting it back in your own. And that is why I love what I do. As we wrap up today’s episode, I hope the insights I’ve shared have helped you better understand the realities of tax prep, filing, and paying. Remember, understanding and strategically managing your taxes isn’t just about following the complex rules of the tax code, it’s about empowering your business and yourself towards greater financial success and stability.

Okay. I’ve got something exciting lined up for you in our next episode of Love Your Money. We’ll be sitting down with an experienced CPA. His name is Tim Thompson. He really has a wealth of knowledge from working with business owners across the country. He and I work for several clients together. That’s how I know him, and I find his insights to be incredibly valuable. So, don’t miss out. Tune in to the next episode for an enlightening conversation that could change the way you think about your business finances. Until then, keep your eyes on the prize. Remember to approach your business decisions with wisdom and foresight. Thank you for joining me today. Please forward this episode to a business owner friend who needs to hear it. Really, taxes are so misunderstood. So, forward this episode, just take a second and do that. And I look forward to having you back for another weekly episode of Love Your Money. Let’s continue this journey towards financial freedom together.