This guest post was contributed by Michael Lewis of Money Crashers.
With the April 15 due date for tax filings looming, first-time small business owners and their advisors may be working down to the wire to complete tax returns or readying their requests for an extension of time to file. Here are some tips that will help you finalize your 2013 taxes and make next year’s tax filing less onerous.
The taxes for which you may be liable and the forms used to file them depend upon the legal status of your business. Many sole proprietors use Schedule C from Form 1040 to report profit or loss from business. Partnerships use Form 1065, and incorporated businesses use Form 1120. Be sure you have the proper form before calculating any taxes owed.
The goal of tax planning is to pay as little to Uncle Sam as is legally possible. However, business owners should keep in mind that their actions to reduce taxes also affect the book value of their assets. For example, choosing to deduct the full cost of a new machine one year might save taxes, but capitalizing the expense over a longer period would add value to your balance sheet for accounting purposes. If other business requirements dictate minimum asset values (a condition of borrowing, perhaps), your best move might be to capitalize the expense, rather than take the immediate tax savings. Before taking any action, consider what is best for your business in the long-term, not simply what reduces this year’s taxes.
Competent tax advice and accurate records are essential to operating a business of any size. As a consequence, business owners would be wise to seek out a tax consultant, business adviser, or certified public accountant before making major financial decisions. As you prepare to file your taxes, keep the following six tips in mind.
1. Keep Business and Personal Expenses Separate
Many business owners unintentionally blur the lines between their personal and business transactions, especially sole proprietors. Fortunately, the problems this causes can be avoided with a little care upfront. From the IRS’s viewpoint, a business must look and conduct itself as a “business.” Mixing personal expenses with those of your company raises the possibility that the IRS treats it as a hobby and subsequently disallows business expenses to be deducted from your income, increasing your tax liability. To avoid this, maintain separate bank accounts and credit cards in your business’s name and prepare regular accounting statements – income statement, balance sheet, cash flow statement – as evidence that it is not a hobby.
2. Get Your Records in Good Shape
Good and thorough documentation is important, even essential, to justifying many deductions from income. The most common deductions for a small business are the following:
- Entertainment —Keep a diary of all entertainment expenses, including the purpose, amount, date, and place, as well as the names and business relationships of the people entertained. Generally, only 50% of food, beverage, and entertainment expenses are deductible, subject to certain exclusions.
- Travel —To support mileage expenses on an automobile, you should keep a trip log separating personal and business use. Rather than keeping exact expenses of automobile fuel and maintenance, you can deduct a rate of $0.565 per mile traveled.
- Meals —Only those meals away from home are deductible.
- Home Office —The IRS provides a simple option for calculating the home office deduction in lieu of documenting the actual expense: the prescribed rate times the allowable square footage. This new option is available for use beginning with the 2013 tax year, and should save considerable time for filers with a home office. In either case, the room cited must be used exclusively for conducting business.
- Charitable Donations —Deductions for the contribution of assets such as used equipment or software are limited to the value of the asset on your books. If it has depreciated to zero upon your donation, you are not entitled to a deduction.
- Health Insurance —Health insurance premiums paid for employees are deductible, although the Affordable Care Act may affect the net cost of your business’s plan (see ACA credit below) and the plan’s design in future years. Beginning in 2018, insurers who offer “Cadillac” health plans will be subject to a 40% excise tax for any individual’s plan that costs more than $10,200 annually, and $27,500 for any family plan.
- Start-Up Expenses. —Under the Small Business Jobs Act, you can deduct up to $10,000 of start-up costs for investigating a potential business, or pre-organization costs incurred prior to the actual start of the business.
3. Review Accounts Receivable and Inventory Balances
Before closing your books for year end, review your accounts receivable for collectibility. Any account likely to be uncollectible should be written off since it reduces your revenue and consequently your tax liability. If you have raw, in-process, or finished inventory, review its value for marketability. Obsolete or unusable inventory should be written down to scrap value to reduce revenues and lower your tax bill.
4. Review Equipment Purchases
Under Section 179 of the tax code, you can deduct up to $500,000 per year as long as your total equipment purchases are less than $2 million. For 2013, this deduction can include up to $250,000 for qualified leasehold improvements, restaurant property, and certain retail improvements made during 2013. According to the business income limitation, you cannot claim a Section 179 deduction if it creates or increases an overall business tax loss. Be aware that using Section 179 deductions for real property may trigger high taxes on ordinary income gains when the property is sold.
Bonus depreciation of 50% for the first year is also available for some tangible personal property including software and certain leasehold costs if the expense was incurred in 2013 and the asset placed into service during the year. For cars and trucks subject to luxury auto depreciation limits (those weighing less than 6,000 pounds), those limits were raised $8,000 for 2013. In other words, a passenger car placed into service during 2013 could have first-year depreciation up to $11,160.
5. Check Potential Tax Credits
While credits and deductions both reduce your potential taxes, the former do so on a dollar-for-dollar basis while deductions reduce your taxable income so their net effect is savings equal to your tax rate. For example, suppose ABC Company has a taxable income of $100,000 with taxes due of $22,250. A tax deduction of $10,000 would reduce its taxable income to $90,000 resulting in taxes due of $18,850. The $10,000 deduction produces $3,400 in tax savings. A tax credit of $10,000 applies not to taxable income, but to the tax itself, so a credit of $10,000 would reduce taxes owed from $22,250 to $12,250. From a tax perspective, tax credits are more valuable than tax deductions.
There are a variety of tax credits for which you might be eligible, including the following:
- Research and Development Credit —This includes experimentation efforts or the development or improvement of manufacturing processes for new products. These expenses are deducted or capitalized for many businesses – rather than taken as a credit – due to the complexity of the calculations, the justification required by the IRS to prove the nature of “R&D” activities, and the limitation on the use of certain credits. Nevertheless, the benefits of this credit are such that its use should be explored before making a final decision.
- Energy Tax Credit —Credits of 10% to 30% of expenditures are available for the purchase and use of a variety of energy-efficient technologies and products including solar, fuel cells, small wind turbines, geothermal systems, micro turbines, and combined heat and power (CHP) systems. If you receive other energy incentives, be sure to confirm how the combination of credits is treated in your specific business and tax situation.
- Disabled Access Credit —If you earned less than $1 million or had fewer than 31 employees in 2013, you are entitled to a credit equal to 50% of your expenditures to provide access to persons with a disability, limited to a maximum credit of $5,000. In addition, you may also be eligible for the Architectural Barrier Removal Tax Deduction, capped at $15,000.
- Work Opportunity Tax Credit —Hiring armed services veterans may entitle you to a credit as high as $9,600 per qualified veteran depending upon the length of the veteran’s unemployment before hire, the number of hours the veteran works, the date of hire, and first-year wages. Credits for employing other persons in a “targeted group” such as people with disabilities, ex-felons, summer youths, or people receiving aid from the Supplemental Nutrition Assistance Program (food stamps) may also be available to you.
- Healthcare Tax Credits. —Under the ACA, small businesses employing 25 or fewer employees that pay average salaries of $50,000 or less and pay half of their employees’ health insurance premiums are entitled to a credit up to 35% of those premiums.
6. Prepare For the Coming Year
As you progress through your first-year tax filing, note the areas in which you lacked sufficient documentation or discovered decisions which might be modified to result in lower taxes for this year. Rather than waiting until the end of this year to prepare for the 2015 tax season, implement the necessary changes as soon as possible. For example, you should do the following:
- Confirm all employees’ withholding statuses and update their W-4 information for tax year 2014. Ensure that your 1099s are current and that they have the correct information for all vendors and contract workers – and implement a policy that no payments be made until the proper 1099s have been collected.
- Ensure that all expense statements, receipts, and invoices are properly collected and filed for easy retrieval.
- Initiate expense diaries for automobiles, travel, and entertainment where needed.
- Consult with a tax professional before incurring significant, unusual purchases in order to maximize any credits or deductions for which you might be eligible.
By mid-summer, you should have an accurate forecast of how business is going this year. If appropriate, initiate actions to reduce your 2014 taxes by timing the payment of expenses, collection of receipts, and purchase or sale of major assets, and by using other methods with the advice of your tax professional. While reducing taxes is important, it is not as important as building and growing a strong, profitable business – don’t lose a dollar in future profits to save a dime in taxes.
While the act of tax filing occurs once per year (except for quarterly filings), planning for them is a year-round exercise. Being prepared and organized can save you money and stress in the long-run. The tax code is constantly evolving to reflect political pressures and economic realities, and a wise business owner keeps abreast of the news and takes full advantage of every benefit presented.
Are you ready to file your business’s taxes?
Michael Lewis is a former business executive who writes about financial management, taxes, and economic policy.