Tax season is here again, adding to the workload and anxiety of America's small business owners, more than half of whom are 50 or older, according to data from the U.S. Financial Surveys and Census.
For small business owners — and self-employed workers — who are profitable, finding appropriate deductions for 2023 while also looking for ideas that might mitigate future income tax bills can be a bit overwhelming.
If, while calculating your earnings, you realize that you've actually done well (or more than well) while simultaneously concluding that you'll get a higher tax bill than you were prepared for, don't panic. First, congratulate yourself for running a successful business (which is no easy feat).
Second, take a breath and think about the following strategies and tips. Some may offer relief on your 2023 tax bill while others can help you in the future as you continue to grow your business.
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Quarterly and penalties
In general, if you expect to owe more than $1,000 when you file your 2023 return, you will be required to pay estimated taxes on a quarterly basis starting this year. If you don't or pay too little, you may also be subject to an underpayment penalty.
To minimize penalties, you should pay at least 90% of what you expect to owe, says Lee Reams Sr., co-founder of the tax consulting website TaxBuzz.
Fortunately, the IRS considers taxpayers to have paid within a reasonable period of time as long as they do so by April 15 of the current year for the prior year's returns (and therefore, by April 15, 2024, for the 2023 tax year). This means that if you have the money, pay your estimated taxes now.
Reams explained that another way to avoid punishment is to apply for first-time commutation, which allows people who have been committed in the previous three years to have their sentence pardoned.
As a self-employed person or business owner, you may feel as if you pay more in taxes than if you were a traditional W-2 employee. Maybe you are too. This is because of a little thing called self-employment taxes.
Self-employment tax
Self-employment tax is a combination of Social Security and Medicare payments paid by both the employee and the employer (technically, you're both), says Jane Dietelberg, director of tax planning at Northern Trust Wealth Management. When you work for someone else, they pay half of that tax and you pay the other half.
For the year 2024, the total percentage is 15.3%.
If you're like me, you've probably wondered if there's any way to reduce your self-employment tax bill. There probably is: You could Choose to change your business structure or the way your business is taxed, although this will not be possible in the previous year and is not necessarily recommended for every person and every business.
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Small business structures and tax rules
Most people who start a business do so as sole proprietors and report their business income and expenses on their personal tax returns on Form 1040. They will pay full self-employment tax, as well as any regular income tax they may owe.
If you own a business entity with your sister, for example, you can minimize your self-employment tax by choosing to be an S corporation, Dietlberg explained. These corporations pass along the company's income, losses, deductions and credits to its shareholders, who report it all on their personal tax returns.
Unlike most partnership income, S corporation income is not self-employment income and is not subject to self-employment tax, according to the IRS. S corporations were created so that owners of small and incorporated businesses would not be double taxed by paying corporate and individual income tax. There are many rules for S corporations, including the types and numbers of shareholders allowed.
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Incorporation options take work
Another option, becoming a limited liability company (LLC), provides businesses with partnership flexibility while protecting shareholders' personal assets from being seized to settle the LLC's debts or legal liabilities. At most, LLC shareholders can only lose the amount they invest in the company.
LLCs can be taxed as partnerships if there are two owners or as a “disregarded entity” if it is a single-member LLC. Such companies get liability protection but don't file a separate business tax return, said Robert Morris, a partner at the law firm Pullman & Comley.
Regardless of the number of people in any LLC, it must include the descriptor “LLC” on any letterhead or business card. (If you are an S corporation, you must use “Inc.”)
“You can't be casual about it, announce to the world that you're using a corporation or LLC,” Morris explained.
The tax savings could be significant
As an LLC, you can also choose Subchapter S as your tax status, which means you want to be taxed as an S corporation.
This tax breakdown could potentially save you thousands of dollars, said Homan Radfar, CEO of Collective, a financial platform for full-time freelancers. This is because S corporations split profits between salaries and business profits, the latter of which are not subject to self-employment tax.
“Once a company is making more than $60,000 a year, that can add up to a lot of money,” he said.
Before deciding to change your business structure, consult a tax professional or accountant to make sure you understand the paperwork and documentation you will be required to provide. Most importantly, you must pay yourself a reasonable salary report on both the IRS's W-2 form and on its K-1 form, which allocates profits and losses to each employer.
It breaks down like this: Let's say you made $50,000 as an LLC. All of this is subject to the self-employment tax. If you are an S corporation and pay yourself a salary of $10,000, only your salary will be subject to income tax and FICA deductions. (As an employee and employer, you will pay the full amount at 15.3%).
“The difference is that the remaining $40,000 will be S corporation income that flows through to you but is not subject to self-employment tax,” Morris explained.
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Always be careful
Don't get too excited, though. He went on to explain that “the IRS takes the appropriate position that you have to decide how much of the $50,000 would be considered reasonable compensation to the owner.
So, if the entity is earning $50,000 and the owner is doing all the work, the IRS might say $10,000 is an unreasonably low salary, recognizing that you're only paying yourself too little to avoid paying self-employment tax — which of course could To be honest.
“You have to do it in advance. If you're going to get paid, you have to do it by December 31,” Morris said.
In addition to payroll forms, S corporations must have complete financial statements, including profit and loss statements and documented assets, liabilities, and stock.
For some, all this extra paperwork may not be worth the potential savings. Incorporating yourself may have other consequences at the state level. States can require unemployment insurance contributions or franchise tax payments for the right to do business within their jurisdiction. Forming an S corporation also means you'll have to file a separate business tax return (Form 1120-S), Reams said.
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Tips to reduce taxes
“A retirement plan is the best tax shelter ever,” Morris said, as long as you don't need to access that money until you reach retirement.
You can contribute to the previous year's retirement plan until April 15 of the current year. Self-employed retirement plans like SEP-IRAs or Solo 401(k)s allow contribution maximums that are more than double that of traditional employee plans: 25% of your income up to a maximum of $69,000 in 2024, Radfar said.
“If your company's cash flow is able to be maintained, this is one of the best ways for solopreneurs to reduce their tax bill and fund their future,” he said.
If your business is an S corporation, the most you can contribute to an IRA or other deferred retirement savings plan is based on your personal income as reported on your IRS Form W-2 and not on your business earnings, Ditelberg said.
This distinction may not matter if you also have a corporate job with a retirement plan; You may just want a lower self-employment tax.
“On the other hand, if your business is your main business and you want to be able to save more for retirement, you may prefer an LLC,” she continued. Because although you will owe self-employment tax on all LLC profits, all company profits will be counted when determining how much you can contribute to your retirement plan.
Deductions and expenses
Aside from retirement plans, Reams also suggested choosing to take the entire deduction for any equipment purchased in one year rather than spreading it out over a few years if you need to lower your tax bill.
“One of the most common deductions that freelancers take is the home office deduction, but it is often misused,” Radfar said.
The rules state that you must use part of your home regularly and exclusively for the business to qualify. This means that if you have anything personal in your office, “like an exercise bike or a daybed for guests, you can't use the entire square footage,” he explained.
Once you calculate the percentage of your home devoted to your business, you can also deduct that percentage for expenses including mortgage interest, property tax, insurance, depreciation, utilities, repairs, and phone and Internet costs. Like all business expenses, be sure to keep detailed records.
And don't forget charitable contributions, even if you choose to be taxed as an S corporation, Radfar said. He explained that when you file an S corporation tax return, qualified charitable contributions appear separately on a line of the owner's K-1 tax form, meaning the charitable contribution flows through to Schedule A, where itemized deductions are reported.
Vanessa Nerudi is a freelance journalist covering health, TV/film culture, outdoor adventure, travel and cycling for Hearst, HuffPost, PopSci, Vulture, BBC Travel, Threads and more. She is also a pattern maker and seamstress for film and television, but prefers to ride her bike most of the time.
This article is reprinted with permission from NextAvenue.org©2024 Twin Cities Public Television, Inc. all rights are save.
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