Thinking of starting your own small business? Already an owner? It’s time to understand how tax deduction can make you keep more of your hard-earned money!
No matter how you hustle, understanding the legal impact of your business entity and getting a good CPA will save you on taxes.
We’ll first go over the legal entities you can form, then we’ll discuss how that might impact your tax deduction.
Tax Deduction Biases Today
Today, corporate America pays fewer taxes than ever before even as they make higher profits than ever.
Corporate taxes as a share of profits are at their lowest levels in decades.
With the passage of the corporate tax cut act in 2017 under President Trump, the legal corporate tax rate is at its lowest level of 21%, and the actual tax rate fell well below 10% due to tax loopholes.
But if you’re a small business owner, this doesn’t apply to you at all.
Today individuals and small businesses pay 80% of the government’s entire tax base! Big corporations only pay 20% even though they account for nearly 50% of the business income.
As a small business or a salaried worker, you’re paying more taxes to the government than the large companies. So it’s time for you to think about how to save yourself some taxes through deduction.
Small Business Entity Types
There are four ways to form your small business, each has a different impact on tax deductions.
- Sole Proprietorship
Sole Proprietorship: Self Employment Income is Personal Income
There are several forms of organization for a business; the most common for small business is the sole proprietorship.
In a sole proprietorship, there is no separation of the business from the owner. You are the business and the business is you.
The majority of business owners choose sole propriership because it’s dead simple.
To create a sole proprietorship, there is no need to hire a lawyer, there’s no need for corporate paperwork and fees, and you can be in operation tomorrow, theoretically.
How do you become a sole proprietorship? Just head over to your city hall and file some paperwork to register your sole proprietorship.
You’ll need a proof of address, an identification card, and it costs $35. In return, you’ll get a piece of paper with an EIN number that you’ll later to file for your taxes.
The sole proprietorship is simply a continuation of that risk-taking spirit that inspires so many of us to take the leap into business ownership!
Why a Sole Proprietorship?
Sole Proprietorship is easy. The ability to combine your business and personal income is one of the key advantages to operating in a sole proprietorship.
You report the income of the business on a special section of your personal tax return called Schedule C, “Profit or Loss from Business”. And this makes your business income part of your personal tax reporting.
Although the business information is a separate schedule, all the profit or loss flows through to the individuals 1040 or 1040A. If you make $1000 in W2 salary, $500 in business revenue and spend $200 in business cost, your personal income will be $1000+$500-$200 = $1,300.
Your income and the business’s income are one and the same. And they’ll be taxed the same.
You’ll get a tax benefit if the business shows a loss because this loss directly decreases your income, and thus your tax.
The other advantage would be the freedom to make any decisions the owner deems necessary, without any further input.
What are some of the disadvantages? The biggest would be the fact that the owner is the business, and as such is solely responsible for debts, damages, liability, and operation. This is called unlimited liability.
Other disadvantages are the owner’s difficulty in raising capital. You can’t give shares out to investors like you could with a corporation.
And another disadvantage is the continuation of the business. If the current owner dies, then the existing sole proprietorship ends; there’s no inheritance because you are the business.
If you are opening a small side business such as writing a blog or if you just want to test the waters, I’d suggest starting with a sole proprietorship. You don’t know if you’ll succeed yet or jump from one business to another.
Once you start making consistent money and want to build a business for the long term, it is time to change into an LLC or an S-Corp.
Create SEP to Deduct Tax and Retire Early
One of the great incentives to a sole proprietorship is the ability to establish tax-exempt retirements accounts, the most common is the SEP: Self Employed Pension plan.
Retirement accounts like SEP allow the small business owner to put away a large sum of tax-free money, even more than the limits of 401K.
SEPs can get set up to contribute up to 25% of salary with a maximum contribution of $56,000 in 2020. Comparatively, the maximum contribution of a 401K is only $19,000.
That’s right, you can save on taxes as a small business 3. times what you can save working for someone else!
If you’re self-employed, SEP is one of the biggest opportunities to deduct taxes from your income, just like you would with a 401K or IRA.
The great news is that SEP works for not only Sole Proprietorship, but also LLPs and S Corps. Though most of the SEPs are done by just 1-person small businesses formed under SPs (sole proprietorships).
Take advantage of this favorite tax deduction today!
Limited Liability Companies (LLCs) are Not Any More Tax-Deductible
If you’ve got a partner for your business, then, of course, you can’t be a sole proprietorship.
So the next logical choice is to form an LLC – a limited liability company.
While a sole proprietorship is simple and cheap, an LLC is considerably more complicated, usually requiring the use of a lawyer or at least the help of an online filing company like LegalZoom.
The benefit of an LLC is that it is flexible in taxation, and some argue, has more liability protections for the owners.
To operate an LLC, you have to register an LLC and pay a fee, usually $500 and up. You have to also pay an annual fee to maintain the LLC as long as your LLC is active.
But here’s the catch: an LLC can be taxed as a sole proprietorship, a partnership, or corporations
By default, LLCs with more than one member are treated as partnerships and taxed under Subchapter K of the Internal Revenue Code. However, an LLC can elect to be treated as an association taxable as a corporation by filing Form 8832, Entity Classification Election.
The majority of LLCs elect to be taxed as partnerships where each partner is allocated a certain income from the. business, and that. income is taxed the same as your personal income.
Is a Limited Liability Companies (LLCs) Better?
LLC claims to protect you from lawsuits – but my experience has been that it really doesn’t when you have a real lawsuit. So if lawsuits are what you’re worried about, you might as well form a sole proprietorship.
LLCs are better than sole proprietorship if you have multiple partners in the business, and if you want to preserve the business beyond you.
LLC is also a lot more hassle though. Compared to a sole proprietorship, LLC licenses take more time and money to create and maintain. You must also spend more time to carefully split your business and personal expenses or else you might lose your LLC title.
And yet, most LLCs get no more tax deduction compared to a sole proprietorship because all income is treated as personal income.
So LLC has all the inconvenience of a corporation without the true legal protection and tax benefits of a corporation. Only do it if you have to.
S Corporations: Tax Deduction Through Dividends
One of the most widely used, second only to the sole proprietorship, is the S corporation; what is the S corporation and how does it work?
The advantages of operating a business as an S Corporation are:
- Your liability is limited
- It is a perpetual legal entity
- The S corporation can raise money by selling shares of stock to corporate investors.
- Owners can receive dividends from the S corp, which is taxed at a much lower rate than personal income!
- S Corp incomes are still pass-through, which means the corporation itself does not get taxed, but the owners of the corporation are (either via income or. dividends)
What does all this really mean? You are only liable to the extent of your investment in the corporation. If you’ve only invested $100,000 in a business, you are only liable for the value of the investment of $100,000.
The fact that a corporation is a legal entity and is perpetual means that even if one officer, board director, or shareholder should die, the business continues, often quite successfully.
Qualification for an S Corporation
There are however certain qualification requirements for an S Corporation; they are as follows:
- The corporation is a domestic corporation
- Must not be a member of an affiliated group of corporations
- Have only one class of stock, although not all shareholders need to have the same voting rights, and no shareholder of the corporation may be a nonresident alien.
The only requirement that is today posing a problem is the requirement that all shareholders be citizens or residents of the United States, not nonresident aliens.
Yes, a foreigner that is a US resident can own an S-Corp. As per the IRS, a US resident alien is an individual that is not a US citizen or US national and who meets either “the green card test” or “the substantial presence test” for the calendar year.
A European investor living in Europe cannot own an S-Corp in the United States.
Special Tax Advantages of an S Corp
S Corp can pay its owners a salary, but the owners can also receive dividends from additional profits the company may earn. This is the key benefit of an S Corp and the biggest tax deduction.
Shareholders of S. corp receive two types of income from their S corporations: wages and profit distribution.
While wage is taxed at ordinary income (as high as 39% for the highest tier), profit distribution is taxed like dividends (0%, usually 15%, max 20%)
So once you start making serious dollars that will get you to quit your full-time job and maybe hire a few others, it’s time to start considering an S-Corp.
You might save more on taxes with S Corp by channeling your earnings into profit distribution where they’ll be taxed at a significantly lower rate than regular wages and salaries.
But S Corps have more strict guidelines. For starters, you have to be a U.S. citizen or resident. You cannot have more than 100 shareholders.
It also costs more to form an S Corp and the vast majority of S Corps incorporate in Delaware.
But once your earnings get high enough, savings from this tax deduction becomes quite significant such that the hassle is small compared to the tax deduction savings.
The C corporations are really the starting point for the use of a corporation as a form of business.
The C Corporation existed much earlier than the S Corp and is the chosen mode of organization and operation for all large businesses in America today.
The advantages of operating a business as a C Corporation are:
- Your liability is limited
- It is a perpetual legal entity
- The C Corporation can raise money by selling shares of stock to corporate investors.
The ability to raise money is perhaps one of the best advantages.
Many times, a business will need to increase cash flow, or fund the purchase of new equipment; if you can sell shares in the business, you have a built-in way to fund those needs.
S Corp vs. C Corp Comparison
What’s the biggest difference between a C corp and all others above? C corps are separate from you and taxed separately.
The great disadvantage of a C Corp is the “double taxation” of profits. Profits of the corporation pay corporate income taxes (21% since Trump’s 2017 tax cut), but then any payments (dividends OR salary) to owners and shareholders also need to pay taxes, again.
In this regard, S Corps are pass-through entities like sole proprietorships and LLCs. S Corps do not pay corporate income tax, but C Corps do pay corporate income tax. S Corps pass-through income to the owners. C Corps and its owners are separate entities.
This is just a casualty of the situation: if you wish to have the business entity treated as a separate legal entity, it must also be treated as a separate taxable entity.
Actual Taxes Paid by C Corps
But as you already know, corporations in the U.S. actually pay less than 10% of the corporation income tax due to tax loopholes.
In fact, C corps nowadays pay 21% on income tax thanks to the 2017 tax cut, which is way lower than the personal income tax rates.
But that doesn’t mean C corp is always the right choice for your business. C corp is complex to start, maintain, and there are many rules you have to follow.
Sure, there are many tax deduction strategies for C corps, but most require complex accounting and international lawyers. It’s probably not worth getting a C corp if you operate a small business.
But if you are making in the tens of millions in profit or more, this becomes an option on the table. In particular, C corp is ideal for:
- Those that need funding and investors and will likely have hundreds of shareholders if not more: venture-funded startups, for example.
- Companies that one day hope to go public.
- Large private companies making hundreds of millions of dollars and have the funds and means to hire people to stash money into foreign countries as a way to lower corporate taxes.
Non-Profits: Tax Eliminations
Many of the Unites States’ non-profit and charitable organizations are exempt from property taxes, income taxes, and many other forms of personal property taxes.
So really – the biggest tax-deductible play is to form a nonprofit because you don’t have to pay any taxes.
The downside is that you can’t distribute nonprofit profits to shareholders. That doesn’t mean, however, that you can’t pay yourself a huge salary to operate a nonprofit.
The original intent of the government allowing a nonprofit is for entities to do good without the worry of raising money to pay for tax expenditures.
But as time has passed, many of the non-profit agencies have grown into political, economic and social giants there has been an ever-increasing demand for accountability.
Many of these non-profits are property-owning, big businesses.
From the religious groups to the universities and research centers around America, they generate massive amounts of revenue, but because of their non-profit status, they are exempt from paying any tax.
If you are thinking about starting a business, don’t automatically discount establishing a nonprofit. This might be the right place and the most tax-deductible option.
Self-Employment Taxes: the Opposite of Tax Deduction
If you work for an employer, part of your paycheck pays for social security and medicare.
Self-employment tax is the self-employed individual’s contribution to social security and Medicare taxes. Small business owners are required by law to pay their fair share of the self-employment tax.
Who must pay self-employment tax and why? If you’re self-employed and earn more than $400 through a sole proprietorship, LLC, or S-Corp, you pay self-employment tax.
And if you operate more than one business, your net earnings from self-employment are the combined net earnings from all your businesses.
The only difference between the employee and the self-employed is the employer pays half of the employee’s social security and Medicare taxes. The self-employed, however, is responsible for the entire amount.
This means opening a business implies that you will be paying more taxes than if you worked for someone else. It’s the opposite of tax deduction, it’s an additional tax burden you have to watch out for!
Pay Self-Employment Taxes at the Year-End
When must you pay self-employment taxes?
Generally, you pay them at the end of the year, when you file your personal tax return.
Why is it this way? Because many self-employed business owners don’t file the net profit or net loss figures on their self-employment earnings until the year’s end. If there is a net loss, the self-employed individual receives a credit for self-employment tax due at one-half of the amount due.
To learn more about individual liabilities, exemptions, and alternative tax methods, please visit the online site for IRS Forms and Publications at www.IRS.gov. Topic 554, Publication 517 and 533 will provide more detailed and situation-specific information.
Schedule C Returns: Where You Maximize Tax Deductions
Sole proprietorships use Schedule C returns to report their earnings and expenses to the IRS.
The most important piece of information is your business income for the year.
For income, sales receipts may be all that is necessary; for others, invoices and service receipts may be okay. Either way, the ability to provide your income will be the first item of business.
Using Expenses to Reduce Taxes
Next, you’ll need to provide costs. Costs are critical because they are the key to a massive tax deduction. The more costs you can attribute to your business, the lower your profit and tax you need to pay.
If you run a successful business, chances are you’ll benefit from hiring an account to find you more costs to add to your Schedule C as a way to reduce your taxes.
And since every business is different, there is no magic formula. Below are examples of expenses you can submit and are tax-deductible:
- Cost of goods sold
- Advertising expenses
- Labor expenses
- Insurance expenses
- Office expenses
- Licensing expenses, and
- Legal and professional services expenses.
Another form often associated with Schedule C is the Expenses for Business Use of Your Home, or Form 8829. This deduction is a secret tax deduction many folks don’t know. But it can only happen if there is a net profit.
Tax Deduction on Business Expenses
Submitting your business to reduce taxes is so important. Many businesses only succeed for the first few years because of the tax deduction on business expenses.
Let’s take a look at some of those expenses by category, and the necessary record-keeping that must be done.
The major categories of expense are:
Tax Deduction from Utilities
Unless you have an online business, the most often incurred utility expenses would include water, electricity, waste removal, telephone, and internet and cable expense.
It would be impossible to operate a successful business without access to the above-listed utilities.
These costs on a monthly basis will normally run into several hundred dollars, if not into the thousands of dollars; the ability to deduct these expenses on the income tax return is a way to recoup some of the expenses and avoid high tax liability.
Deduct Insurance Expenses from Taxes
Insurance expense can be a tremendously expensive business expense, but a necessary one.
No lending institution will lend money for a business without general liability insurance, renter’s insurance, or Worker’s Comp insurance.
For large businesses, banks also require carrying insurance, an assurance that in the event a disaster, the business will not be a complete loss.
Insurance is often related to revenue: more revenue, higher insurance. So if you make more money, make sure you count your insurance as part of the expenses, otherwise, you’ll be overpaying in taxes.
Interest Expense Qualify for Tax Deduction
If you have a loan against your business you’re going to pay interest expense.
If you operate your business and purchase products’ own credit from a vendor and you don’t pay the bill you will pay interest there, also.
As with the homeowner’s mortgage interest, business credit interest is completely tax-deductible to the business!
Labor (W2 and 1099) Expenses are Super Tax-Deductible
Labor expenses are often the most money-consuming expense a business will ever incur when you account for the wages paid, the taxes paid, and a liability associated with the need to meet payroll expenses on time.
A business cannot stay open and operate without the necessary labor; the necessary labor will not stay and work without necessary pay.
So make sure you count every dime you’ve paid, both W2 and contractors via 1099, both full-time and part-time or one-time. This often has the largest tax deduction for any business.
Depreciation as a Hidden Tax Deduction
Depreciation is not a direct expense for the business, but it’s an expense that benefits the business owner greatly during tax season.
Any equipment fixtures or other capital investment have what’s known as a “useful life”.
The length of the useful life of the equipment determines the amount to depreciate each year. And this amount is tax-deductible
There are two different methods for depreciation, there’s the straight-line method and there’s the modified accelerated cost recovery system that used by most accountants for business owners to their benefit.
Anything from furniture, cell phones, computers, to houses and machines can be depreciated and become tax-deductible.
Most small business real estate developers earn massive tax deductions through depreciation and interest payments of their properties.
Tax deductions from depreciation, though not a “real expense”, can significantly reduce your tax burdens if you work in a capital intensive industry, from real estate, manufacturing to transportation.
Tax Deduction on Cost of Goods Sold
Cost of goods sold refers to the materials needed to produce whatever it is you’re selling.
If you’re in the service industry, your cost of goods sold is relatively small, since providing a service doesn’t require you to purchase additional materials to produce the service.
But if you’re actually making a product, you must purchase materials to manufacture a product in some way.
IRS has an entire section devoted to the cost of goods sold and determining that exact value regardless of the business entity you are filing under.
If your business maintains an inventory, it too will play a part in determining your cost of goods value; even contract labor will play a role in determining your cost of goods sold.
When you finish collecting this information, it’s merely a process of adding and subtracting in order to determine exactly what figure is to be used for your cost of goods sold. The higher your cost of goods sold, the lower your profit, and the less you have to pay in taxes.
Between business expenses and the cost of goods sold – you are looking at the majority of your tax deductions for your small business.
Whatever business you form, and however you perform, make sure you get a good CPA that understands how to save you on taxes.
Conclusion Tax Deduction Guide for Small Business
Starting a business can be terrifying. But it can also be the most empowering and self-validating experience to build something from nothing.
It’s not hard to start a business, and never get intimated by the legal or tax aspect. Just head over to your city hall and get a sole proprietorship and file everything under your name to start.
As you make real money, consider other business entities to reduce your taxes. Make sure you hire a competent account to maximize your tax deductions through business expenses and cost of goods sold.
What has your journey been on the business building road? Do you have any questions? Comment below and let’s chat!
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