3 Small Business Tax Planning Essentials

Every year, the tax code is updated to reflect changes made during the previous year. Knowing these changes enables business owners to plan and make decisions that optimize tax savings.

Judge Learned Hand once said, “In America, there are two tax systems; one for the informed and one for the uninformed. Both systems are legal.”

The best way to stay informed is to view taxes as a year-round activity and plan for it accordingly. Planning involves organized record keeping, accurate financial reports and good tax advice.

This topic will focus on the fundamentals of taxation that enable better decision-making. Our experience in working with small businesses reveals that many do not take full advantage of tax benefits, while others over-emphasize tax planning. Here we will cover the following tax planning topics: business expense deductions, asset purchase write-offs, and compensation.

There are five sets of taxes that affect business owners: income taxes, self-employment/payroll taxes, sales taxes, excise taxes and property taxes. The largest tax burden is on profits, therefore most planning focuses on keeping taxable profits as low as possible. Why should you pay more than is necessary? Judge Learned Hand puts it this way:“ There is nothing sinister about arranging one’s affairs as to keep taxes as low as possible…for nobody owes any public duty to pay more than the law demands.”

The new federal administration and many states will be putting forth opportunities to reduce taxes by hiring new people, purchasing new equipment and similar kinds of activities designed to stimulate the economy. Unfortunately, for many companies the cost of the activity and complying with the tax filings may outweigh the benefits, and others are simply not aware of these benefits.

I. Deductible Business Expenses:

The government knows that businesses have to spend money in order to make money. Therefore, there are deductible expenses that reduce taxable income. For an expense to be deductible, it must be ordinary and necessary for the business, not extravagant, and primarily for the business (not personal). Examples of deductible expenses include:

1. Direct product and service costs – For retail, manufacturing and service companies the expenses directly related to the production, acquisition and delivery of products and services are accepted as deductible. Where inventory is involved, proper inventory methods need to be used to reflect goods actually sold during the year. The various accounting methods for recording these costs and expenses offer good tax planning opportunities. Given the changing economic environment, past practices may not be favorable in the future, therefore a fresh look may be warranted.

2. Supplies – Supplies like paper clips and copy paper are deductible.

3. Entertainment and Meals – This includes food, drinks, recreation or amusement for customers, clients or employees, and business meetings during which there must be a substantial discussion of business. Generally, 50% of meals and entertainment expenses are deductible. The following are exceptions to the 50% limit rule:

• Transportation with a client or customer, employee parties, public entertainment and events for charitable organizations.
• Reimbursed expenses and accountable plans

4. Gifts – Client and customer gifts are 100% deductible up to $25 per client, per year. If the gift cost less than $4 and your business name is imprinted in it, it does not count against the $25 limit.^[1]

5. Travel – Travel expenses are deductible so long as they are business related. Types of deductible travel expenses include: transportation (taxis, limos, buses, trains and cash tips), lodging, laundry, and miscellaneous (telephone, internet access) are 100% deductible. Meals and tips to servers of meals during travel are 50% deductible.^[2] IRS classifies costs other than transportation which is deducted separately as “lodging, meals and incidentals.” The per diem (per day) or actual expense method can be used to deduct travel cost. To use the actual expense method, detail records and receipts must be kept whereas the per diem method requires just a specific IRS approved deduction amount per day.^[3]

6. Health Insurance – Premiums you pay for employees’ health insurance are 100% deductible as an ordinary business expense. Sole proprietors, partners, limited liability members and S Corporation shareholders active in a business can deduct 100% of their health insurance premiums for themselves and their families.^[4] However, owners’ premium deductions cannot exceed net profit. Owners who are eligible for coverage by a spouse’s plan cannot claim this deduction whether or not they are covered by spouse’s plan. Medical expenses not covered by insurance can be claimed as personal itemized deductions on Form 1040 to the extent they exceed 7.5% of adjusted gross income.

7. Education Expenses – Tuition, fees, and supplies are business deductions if they are related to business, trade or occupation.^[5] The education must be either to maintain or improve skills or required by law or the employer. Note that education that qualifies an employee for a new job or a different business is not deductible. For example, education expenses incurred while improving a skill set to change jobs or start a new business is not deductible.

8. Business Insurance – Business insurance such as the following are deductible: vehicle insurance, liability insurance, fire, theft, and flood insurance, malpractice or errors and omissions insurance, worker’s compensation insurance, and business interruption insurance. Only C Corporations are allowed to deduct life insurance.

9. Domestic Manufacturing – This is a tax break for manufacturers including software, film production, clothing production, agriculture and mining. Any business with more than one employee that acquires tangible personal property can get a bonus deduction on new purchases. Check with your tax advisor to see if you qualify.

10. Vehicle Expenses – Use a mileage log to keep records so that business-related mileage can be deducted. Use the standard mileage or actual expense method to calculate your deductible mileage. Commuting from home to work is not deductible mileage. Home-based office owners can deduct trips from home to business-related activities.
    If a corporation owns the vehicle, all personal use of the vehicle is taxable to the driver.^[7] If you use your car for both personal and business use, you must divide your expenses between business and personal use. A common method figuring expenses is using miles driven. Business-related usage is 100% deductible.^[8]

11. Advertising and Promotion – Marketing costs that have a clear connection to the business such as website developments, marketing consultant fees, public relations, business cards and yellow page listings are deductible. Depreciation of business assets used for entertainment can be deducted though special rules apply.

12. Accounting, legal and professional fees – Fees paid to consultants, lawyers and tax professionals are always deductible. However, in certain cases the deduction must be spread over future years.

13. Taxes – Employment taxes (Social Security and Medicare) 50% paid by the company are deductible. The other 50% withheld from employees’ wages is not deductible. Self-employment taxes (Social Security and Medicare) are 50% deductible on the individual’s Form 1040, but not as a business expense. Sales taxes are generally collected from the customer and therefore are not income or expense. Excise taxes are generally a business expense, but note they may relate to purchases that are not expensed, such as inventory. Property taxes can include both real estate and personal property taxes. These taxes are generally deductible for property owned or rented by the business. Because of the level of taxation represented by these different tax groups, there are planning opportunities for each.

The above deductible expenses are not an exhaustive list. Other deductible expenses to consider include: bad debts, cost of going into business, interest, moving expenses, charitable contributions (business owners or C Corporations), software, credit bureau fees, commissions, bank service charges, etc. Your tax planner should help take advantage of all applicable deductions.

II. Section 179: Expensing Business Assets

This is where tax planning plays an important role. Section 179 allows annual limits to write-off purchases on certain assets. Contacting your tax advisor is recommended because of the specific rules for this deduction.

Tax planning presents important opportunities to maximize the value of the business. However, we have seen a number of clients focus too much on tax planning such that they have lost the perspectives needed to manage their business. For example, tax deductions were utilized to the extent that the business lost money. As a result, the owner felt that the business was underperforming. When we pulled out the tax planning components, leaving only the essential costs for operating the business, the business was actually operating about right from an expense perspective. We recommend thinking of expenses as a) essential to the business, showing the operating results after these, and b) expenses related to the business with appropriate elements of tax planning falling into this category.

III. Employees vs. Independent Contractors:

Properly identifying your staff as employees or independent contractors is fundamental to proper tax treatment. According to the IRS, “in general, someone who performs services for you is your employee if you can control what will be done and how it will be done.”[10] The IRS reviews behavioral control, financial control, and the type of relationship when determining whether the company should be treating the staff member as an employee or an independent contractor. An additional factor is whether the individual holds himself out as engaged in a separate business. Having other clients is an example of such business activity for employees. A company is responsible to withhold payroll taxes, to pay social security and Medicare taxes, to pay Federal unemployment tax, to issue W-2’s annually, and to report wages to the IRS. Independent contractor compensation is reported through Form 1099-Misc.

Penalties for misclassification of workers can include all back payments of employment taxes plus 12% to 35% of the tax bill. If you already are in this kind of trouble, contact a tax expert for the possibility of using an IRS classification settlement program.

Articles for Further Reading:

1. Small Business & Self-Employed Tax Center: http://www.irs.gov/businesses/small/index.html
2. Top 10 Small Business Tax Deductions: http://sbinformation.about.com/od/taxes/a/Topdeduction_ga.htm
3. Be familiar with contents of Publication 15 (Circular E), Employer’s Tax Guide: http://www.irs.gov/pub/irs-pdf/p15.pdf

For more information explore our tax compliance services or book your free consultation today!

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[1] http://www.irs.gov/publications/p463/ch03.html

[2] http://www.irs.gov/publications/p463/ch01.html#d0e1112

[3] See IRS Publication 1542, per diem rates

[4] IRC Section 162 (l)

[5] IRC section 162

[6] See IRS Publication 917, “Business use of a car”

[7] Business and personal use : http://www.irs.gov/publications/p463/ch04.html

[8] “Employee or Independent Contractor?” http://www.irs.gov/govt/fslg/article/0,,id=110344,00.html