There’s more to taking care of business taxes than gathering records and filing a return after the end of the year. By the time tax season rolls around, it’s too late to plan many of the best strategies to improve your tax situation. Instead of tallying up the damages when you prepare your tax return, consider planning, organizing and making payments on your tax liability throughout the year. This can help reduce the amount you owe.
Your federal tax liability is the total amount of tax you owe to the IRS, state or local government for the year. A tax liability includes your income tax ― including tax on capital gains ― self-employment tax and any other federal taxes.
A tax liability is not the same as the amount you owe when you file your return. For example, if you paid $5,000 in estimated taxes to the IRS for the year and your tax due for the year when you file is $6,000, you owe the IRS $1,000 ($6,000 – $1,000). Your tax liability, or the amount you pay the IRS for the year, is still $6,000, regardless of how much you pay when you file or even if you get a refund.
Tax debt from previous years includes any unpaid tax liability from each year, plus penalties and interest that have accrued since those taxes should have been paid.
You can have a tax liability even when you receive a tax refund. Your tax liability is the amount of tax due on your tax return before any payments you made or had withheld.
The most straightforward way to reduce your tax liability is to reduce your amount of income subject to tax. From timing business expenses to making careful investments, business owners can use a variety of strategies to lower their liability.
“Many small business owners are unaware of deductions and are missing out on money that can be saved every year,” said Gary Milkwick, chief financial officer of 1-800Accountant.
Milkwick cited the following common business deductions as opportunities to reduce your liability:
During the COVID-19 pandemic, business owners could deduct 100 percent of qualifying meals and entertainment expenses. For 2023, that provision expired and now you can only deduct 50 percent of your expenses for meals and entertainment.
If you plan 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 your investments for the year and time purchases wisely.
“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.
He continued, “[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.”
On the other hand, if you have lower income this year and expect to have more taxable income the following year, consider postponing major expenditures until at least January 1. The idea is to match deductible expenses to higher income years so you can offset taxable income most effectively.
Do you happen to have spare cash to make bigger investments? 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, managing director of Choose Veritas, Inc.
“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 percent based on tax benefits alone, even before a drop of oil has been produced.”
Business owners often mistakenly think 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, income from the sale of a business’ 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.
Another common mistake made by small business owners or their bookkeepers is to assume all deposits are income, including refunds and even transfers from one account to another. Look carefully at deposits in your bank account to make sure no nontaxable deposits and transfers are counted as income.
One of the best ways to reduce your taxable income is to reinvest earned money back into your business, specifically your employees. This reduces your tax burden while simultaneously helping your team succeed.
Salaries, wages, bonuses and other compensation you pay employees in a given year are generally tax deductible if they fit the following criteria:
Contributions by employers to employee retirement accounts are also tax-deductible. 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. Plus, on top of the benefit of reducing your tax liability, offering employees matching, profit-sharing or safe harbor contributions is a great way to boost morale, attract and keep top talent and grow your business.
If your spouse, children or other family members work in your business, consider paying them as employees. One reason to pay a spouse a salary is so that they contribute to Social Security in their own name.
Paying children to work for you can lower your overall tax burden because your kids are likely in lower tax brackets than you are. In addition, you are not required to pay Social Security or federal unemployment tax (FUTA) on your children’s salaries.
Reduce your taxable income by understanding deductions and credits, making tax-friendly investments, investing in your employees and formally hiring family members.
While it makes financial sense to explore all your options for reducing your tax bill, be careful. If deductions look suspicious to the IRS, the agency might conduct a tax audit of your business.
The IRS has switched its focus from large corporations to smaller business entities like sole proprietors, limited liability companies (LLCs), partnerships and S corporations (S-corps), said Jessie Seaman, vice president of tax at Liberty Tax. In other words, your business could be under even greater scrutiny than big competitors are. [Related article: What Should I Know About an LLC?]
Seaman noted that the IRS especially scrutinizes certain types of business tax deductions, such as those for home offices; meals, travel and entertainment; vehicle use; and real estate losses.
One of the most important things you can do to reduce your business tax liability and prevent audits at the same time is to keep good records. Keep separate records for your company to avoid commingling business and personal transactions. Most business deductions are lost or contested in an audit not because taxpayers didn’t know they were deductible but because of sloppy or nonexistent recordkeeping. Take advantage of expense tracking apps, high-quality accounting software and tax solutions to keep your records up to date at all times. As your business grows, consider paying accounting and tax professionals to help minimize your tax burden.
If you receive an audit notice, read Business News Daily’s guide to handling an audit properly.
One of the best ways to decrease your tax liability is with tax credits.
Unlike tax deductions, which reduce taxable income, tax credits reduce the tax you owe dollar for dollar. Many federal tax credits are available for businesses, such as the general business credit, investment credit, credit for employer-provided child care and facilities and the Indian employment credit.
Your business may be eligible for more tax credits than you can take in a year. If that happens, you may be able to do one of two things:
Many states also offer tax credits to encourage economic growth and business investment. These vary from state to state and many are awarded to businesses that increase employment, use local resources or operate in underdeveloped cities and regions. Your state’s treasury department or chamber of commerce should have comprehensive information on available state and local tax credits.
Tax credits reduce your overall tax liability. Consider the general business credit and investment credit to start.
Individuals can deduct qualified charitable contributions if they itemize deductions. However, you receive more tax benefits if your charitable contribution qualifies as a business deduction. Contribution deductions taken by your business can reduce your taxes further by lowering your adjusted gross income and your income subject to self-employment tax.
Not all donations are deductible business expenses, however. You can deduct certain charitable contributions as business expenses if your business received any benefit in exchange for the donation, such as ad space or event sponsorship.
If you run an organization with a purpose other than producing income, you may save on taxes by applying for tax-exempt status — that’s because tax-exempt organizations don’t pay federal income taxes. To be eligible for tax-exempt status, the owners and founders of a business must not receive profits from it, although they may receive expense reimbursements. If you receive a salary from your nonprofit organization, you are treated as an employee. The organization pays payroll taxes and withholds taxes, and you report your salary as an employee on your individual tax return.
Organizations that can be tax-exempt generally fall into one of nine categories:
To receive tax-exempt status, your business must register with the IRS. The most common form of a tax-exempt organization is 501(c)(3) status. To be eligible, your organization must:
If your business is tax-exempt, donations made to your organization are tax-deductible. Be aware that nonprofit organizations may still owe state and local income tax.
Tax-exempt businesses, generally nonprofit 501(c)(3) organizations, are identified by law and registered with the IRS.
If your business is not a tax-exempt organization, the way you pay business taxes depends on your business organization type. An LLC, for example, will have a different tax structure than a sole proprietor.
The main federal taxes that business owners must calculate and pay are as follows.
You may need to pay additional state and local taxes, including state income tax, property tax and local transit levies. Although these taxes are often much lower than federal taxes, they can be complicated to calculate and may carry large penalties for mistakes, so you’ll want to check all forms carefully before submitting.
Federal income taxes, including self-employment tax, are paid as you go throughout the year. Unlike employees, who have taxes withheld from their paychecks, businesses and the self-employed must file estimated taxes every quarter based on the income earned up to that point in the year. Federally, 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.
To get the best result when it comes to reducing your tax liability, work proactively with a tax preparation specialist or certified accountant throughout the year. A tax pro can advise you on strategic decision-making to lower your tax liability and ensure you receive every deduction, credit or tax exemption possible. While managing the business of your business may be one of the least appealing parts of being a business owner. Tax planning is crucial to ensure your company remains financially sound and in line with the law.
Sally Herigstad and Sean Peek contributed to this article. Source interviews were conducted for a previous version of this article.