Effective Tax Planning for Business Owners

Trevor Kern |

Owning your own business has many benefits. You can set your own hours, choose your income, take vacation time when needed and you will certainly get along well with your boss! However, being a business owner also comes with some challenges, one of which is tax planning.

When you work for someone else, many tax considerations are handled by your employer. In this instance, income, social security, and Medicare taxes are withheld from your paycheck. As a business owner, the responsibility of determining the amount of taxes you owe falls on you and the type of business entity you operate will determine what taxes you will need to pay. As such, you may want to take steps to ensure that you complete all tax requirements effectively and beneficially for your business and for you.

Types of Business Taxes

When you started your business, you had to decide on what type of business entity to establish. The form of business you chose dictates what type of taxes you must pay and how you will need to pay them. There are generally four types of business taxes: Income, Self-Employment, Employment, and Excise tax.

Income Tax

Typically, all businesses must file an income tax return, with the exception of partnerships. Income tax is paid during the year as you earn or receive income. This tax is usually paid through tax withholding, however if you do not withhold income taxes or you have not withheld enough, you could end up with a large tax bill at the end of the year. You may also be required to pay quarterly estimated taxes the following year. Usually, it is a good practice to review this each year.

Self-Employment Tax

The federal government uses self-employment tax to fund social security and Medicare benefits. If you work for yourself, you are required to pay this tax if you have more than a minimal amount of income.

Generally, you'll have to make quarterly estimated tax payments to cover your federal income tax and self-employment tax liability, which can cause a cash flow crunch. You will probably have to make estimated state tax payments as well. If you do not make estimated tax payments, you may be subject to penalties, interest, and a bigger tax bill at the end of the year.

Employment Tax

When you have employees, you as the employer will have additional tax responsibilities. You are required to withhold federal and state income taxes, except for in states that have do not have a personal income tax, from their wages. You will also be responsible for withholding social security and Medicare (FICA) taxes and paying a matching amount, typically about 50 percent. Usually, payment of these taxes is a deductible business expense. Finally, you are required to report and pay Federal Unemployment (FUTA) tax, which is solely covered by the employer.

Excise Tax

Based on the type of business you operate or the products you make, you may be required to pay excise tax. This tax applies to companies that manufacture or sell particular types of products, operate specific kinds of businesses, use various kinds of equipment, facilities, or products, or receive payment for certain services. It is critical to determine if this tax applies to your business.

Understand and Use Tax Deductions

Unfortunately, there is no way of getting around paying taxes, however it may be valuable to determine what tax deductions you can utilize.

1. Employ Family Members

Depending on the type of business you operate, you may be able to save on taxes by hiring a family member. By doing so, you transfer business income to your relative and your business can take a deduction for a reasonable level of compensation paid. Ultimately, this reduces the amount of taxable business income that flows to you.

For example, wages paid to children under age 18 are not subject to employment taxes and a spouse may not be subject to federal unemployment tax. You should be careful because the IRS can question compensation paid to a family member if the amount does not seem reasonable considering the services performed. In addition, when hiring a family member who is a minor, be sure that your business complies with child labor laws.

2. Establish a Retirement Plan

Because you are self-employed, you must take care of your own retirement needs. You can do this by establishing an employer-sponsored retirement plan, which can provide you with a number of tax and non-tax benefits. With such a plan, your business may be allowed an immediate federal income tax deduction for funding the plan. As an employee of the business, you can also generally place pretax dollars into a retirement account to grow tax-deferred until withdrawal. There are several types of retirement plans, so be sure to explore all of your options and consider the complexity of each.

3. Take Advantage of Business Deductions

Since deductions lower your taxable income, be sure your business is taking advantage of any business deductions to which it is entitled. You may be able to deduct a variety of business expenses, including rent or home office expenses, as well as the cost of office equipment, furniture, supplies, and utilities. To be deductible, business expenses must be both ordinary (common and accepted in your trade or business) and necessary (appropriate and helpful for your trade or business). If your expenses are incurred partly for business purposes and partly for personal purposes, you can deduct only the business-related portion.

Tips To Lower Your Taxable Income

Consider the following items as possible deductions for your business.

  1. Deduct the business expenses associated with your motor vehicle, using either the standard mileage allowance or your actual business-related vehicle expenses to calculate your deduction.
  2. Depreciate business equipment, furnishings, and vehicles.
  3. Deduct the appropriate portion of business meals, travel, and entertainment expenses.
  4. Take the self-employed health insurance deduction, if you qualify.
  5. Deduct some or all of the cost of long-term care insurance for you and your spouse.
  6. Consider setting up a health savings account (HSA), a tax-exempt trust, or custodial account established in conjunction with a high-deductible health plan to set aside tax-free funds for health care expenses.
  7. Write off some start-up costs.

Being self-employed comes with many challenges and complexities. This is why it is important to find a tax plan that best suits your business, while using all opportunities to conserve your capital. Understanding which taxes you have to pay and which deductions you can apply could save you a lot of money.

Trevor Kern, Advisory Services offered by Zeller Kern Wealth Advisors, a Sacramento Wealth Management firms and a Registered Investment Adviser.

Zeller Kern Wealth Advisors does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.