Specialists are fond of saying that tax planning should be done throughout the year, not just as April 15 hurtles toward us. Although some small businesses might rely on an outside tax preparer or accountant to guide them, business owners still need to stay informed about changes to the tax code to claim all the deductions they are entitled to, and to make prudent decisions regarding their business overall, such as hiring a new employee or buying a major piece of equipment. Some small business owners may unwittingly shortchange themselves when it comes to "obvious" tax deductions, like home office expenses, because they don't fully understand the requirements or are fearful of an audit. We consulted with a variety of tax specialists to find out about some write-offs that small businesses overlook or don't maximize.
Hire family members
"A home office deduction can be pretty valuable," says Damon Yudichak of Yudichak CPA PC, a Wake Forest, North Carolina-based full service tax and accounting firm. "In the past, there's been a lot of fear that the IRS would audit small business owners because they had a home office, but it's a legitimate tax deduction."
To be eligible for the deduction, a home office needs to meet certain requirements. For example, it must be the primary location where you conduct business and the space must be used exclusively for business purposes—eight to 10 hours a week at a minimum, Yudichak says. Small business owners who qualify can deduct a portion of their regular household expenses, such as mortgage interest, property taxes, homeowners insurance, and utility bills.
According to Yudichak, the IRS allows two ways for calculating how much of those monthly expenses you're entitled to deduct. One method is to figure out what percentage of the total square footage of the house is taken up by the office and use that percentage as a basis to deduct expenses accordingly. The second method is "where you take your square footage and multiply it [by an amount set by the IRS]. In 2013, it was $5 a square foot," he explains. "Make sure you take pictures and document everything," such as accurate copies of your monthly bills and other deductible expenses.
Another overlooked tax write-off is to employ members of your family in your business, particularly children. Yudichak says that you can hire your children over the age of 7 and pay no federal income tax on the first $6,200 of their earnings for 2014. State income tax varies, but small business owners can still come out ahead. In Yudichak's home state of North Carolina, the first $3,000 of wages is not taxed. Children that work for a sole proprietorship or a partnership are also exempt from paying Social Security, Medicare, or federal employment tax.
Since each business entity—a sole proprietorship, partnership, C corporation, or S corporation—has its own advantages and limitations, choosing the right set-up is essential for tax planning and should be made in consultation with a tax advisor. Yudichak begins by interviewing the small business owner "to know what their goal is and the type of business it is. Those are the big things that I look at. Otherwise they could choose the wrong business entity and pay unnecessary taxes."
Talk early and often
Sometimes a small business misses a tax write-off simply because they fail to maintain frequent contact with their tax advisor.
"There are a lot of little items—$100 here, $200 there—that add up to thousands that people don't realize they can deduct," says Jerry Michalowski of Gerald H. Michalowski, CPA, a Torrington, Connecticut-based firm providing accounting, tax, and payroll services. "They don't communicate with their tax people enough to tell us what they're doing so we can make suggestions." For example, when Michalowski had his own home office and his hot water heater had to be replaced, he was able to deduct 40 percent of the unit's cost—a sizable write-off that some home-based business owners might have overlooked on their own.
Small businesses should consult with their tax experts whenever they're thinking about making a major financial decision. For example, one of his clients hired a veteran and then asked Michalowski if there were any tax breaks. There were—but because the small business had to file for them before the veteran was hired, they lost out on a $3,000 credit.
Michalowski cautions that "there are a lot of areas of gray" in the tax code that are open to different interpretations. Small business owners should work with a tax preparer that is informed and forthright about these issues and then decide between the two of you about the best way to go forward.
Set up a SEP
Even otherwise astute small business owners may not be familiar with certain types of common or ordinary business deductions. "I've had people who tell me that they want to do a section 179 and other people who have not heard about it," says Brian Walsh of Brian Walsh EA, a Ramsey, New Jersey-based tax, payroll, and accounting service, with over 50 small business and self-employed clients.
In the case of section 179, it allows a business to deduct the full expense of a capital item—such as the purchase of a small truck by a construction firm—in one year, instead of writing it off over time, provided that the business made a profit that year.
Another strategy for small businesses that wish to lower their profits and cut their tax bill is to open up a Simplified Employee Pension Plan (SEP). Small business owners can put up to 25 percent of their compensation in the account, up to a certain limit that changes every year—but they are also required to make contributions to the SEP accounts of their employees as well. "They don't necessarily have to make the maximum contribution to the employees' accounts, but the contribution still ends up being a deduction for the small business," Walsh says.
Small businesses that haven't set up a SEP account for 2014 can still put one in place for last year, Walsh says, by filing "an extension for the tax return and then setting the plan up during the extension time period to make a contribution. I think it makes the small business owner look like a hero in terms of making a contribution to the employees and basically saying to them that their services are valued.”
Disclaimer: Since the details of your situation are unique, you should always seek the services of a qualified financial planner and tax advisor.