Congress waited until the early hours of January 1, 2013 to pass the American Taxpayer Relief Act of 2012, which the president signed the next day. Although this was not the first piece of legislation approved at the last minute, it underscores how daunting it can be for small businesses to do any kind of tax planning while they wait to find out what laws and provisions will be enacted. Still, by looking carefully at their returns, entrepreneurs can use their tax situation to help manage their finances and make sound business decisions in the year ahead. We checked with three experts to get their perspective on how small business owners can gain tax advantages.
Pick the right structure
One of the first things a small business can do to manage their tax bill is to examine their business structure to see if it gives them the best tax advantages. "The first tip I would give to almost anybody who has income besides W-2 wages is to form a corporation or a limited liability company (or an LLC)," says Aaron Young, CEO of Laughlin Associates, a Nevada-based company that specializes in helping entrepreneurs find the right business structure. "Right away, you're going to see your taxes go down for the investment of a few hundred dollars."
For example, a sole proprietorship is subject to self-employment tax, but a corporation or an LLC is exempt. An S corporation allows you to take part of your salary in dividends, which further reduces the tax bite. "Small business owners, including very small operators, don't realize that they can benefit from this just like a big company," Young says.
Corporations exist to reduce the risk to business owners and to get every advantage that the government allows, Young says. For example, while a home-based sole proprietor would not be able to write off a home gym, a corporation could turn their spare bedroom into an exercise facility and deduct 100 percent of the cost as part of a wellness plan.
Still, Young warns that sole proprietors should think carefully before incorporating because each business structure has its own legal and tax consequences. For example, depending on who will own the company and whether it will seek outside financing will help determine the best way to incorporate. "It's not good for a husband and wife to own a limited liability company because the government looks at them as one person," Young says. "If you're going to bring in outside equity, then you're going to want to be a C corporation. They have lower tax rates than individual tax rates."
Another factor to consider when incorporating is different attributes of each business structure. For example, shareholders of an S corporation are taxed at their individual income tax rate. In contrast, profits from a C corporation are taxed twice—at the corporate level and then again at the individual level when the profits are distributed as dividends.
Document and deduct
Studies from different sources, including the General Accounting Office, show that many small businesses overpay their taxes. It is clear that many entrepreneurs are not aware of all the deductions that they are legally entitled to.
"I have found that there are two reasons people miss deductions. One is that they don't know what they don't know," says Sandy Botkin, CEO of the Tax Reduction Institute and author of Lower Your Taxes Big Time. "For example, if you talk business with a client in person and then go out to the theater with them, you can deduct 50 percent of the cost of the tickets. You can write off any meals that you have with that client."
The second reason that small business owners miss out on deductions is because they do not properly document their expenses. For example, to document a local business appointment by car, you should record the mileage, the date and explanation of the trip, and the beginning and ending addresses. "If you don't have something triggering you to write down the types of things you need for a deduction, you're not going to do it," Botkin says. He recommends getting software that does the work for you. There are different expense tracker apps on the market—including Botkin's own application Taxbot—that supply everything you need for documentation.
Overnight business trips have their own requirements, but small business owners can still reap a handsome amount of deductions. "For every day you're doing business, you can deduct your road expenses, including 50 percent of your food and 100 percent of your lodging. You can even deduct 100 percent of the dry cleaning bill for the clothes you wore while away,” Botkin says.
In looking for an accountant, Botkin recommends choosing a CPA, tax attorney, former IRS attorney or Enrolled Agent who is "honest but aggressive. Someone who tells you to take every deduction you may be legitimately entitled to with the right documentation and who specializes in your industry."
Review with a pro
Small business owners should set aside time with their accountant to do some serious tax planning, but not at the height of tax season.
"I always suggest to people that they get together with their tax professional in, say, midsummer once tax season is over and the accountant is rested to go forward with some tax planning," says Bonnie Lee, an Enrolled Agent and founder of California-based Taxpertise. "They can pull up a comparative profit and loss statement from the prior year to see if your net profit or sales have increased or decreased and then you can go from there."
Tax issues are rarely a favorite topic among small business owners and the details can seem overwhelming at times. But the evidence is clear that taking the time to review your taxes with a qualified professional could put your business on firmer financial footing.
Disclaimer: Since the details of your situation are unique, you should always seek the services of a qualified professional for advice specific to your business.