5 Unique & Real Ways to Reduce Small Business Taxes
You can SERIOUSLY lower your taxes if you're a small business.
Most accountants are terrible teachers and they're not engaged with their clients each year to actually help them create a tax reduction plan, implement the plan and maximize it as the business fluctuates throughout the year.
Your business deserves tax reduction planning
We help small businesses lower their taxes including income tax, Social Security tax and Medicare taxes.
I want to show you five specific things that your Accountant should be bringing to the table as ideas to lower taxes.
Not all of these strategies are for every business, but if you get somebody engaging with your financials every month and aggressively working to implement the most beneficial strategies, you'll be able to lower your taxes by tens of thousands a year.
You could easily lower your self-employment taxes from $20,000 a year to $10,000 a year.
I dislike when benefits are overstated and hyped up in an unrealistic manner, and I assure you that I am not overpromising here.
If you do not work with a tax planner, you are overpaying in taxes.
Not only do we do small business tax returns, bookkeeping, payroll and serve as your CFO, but we provide aggressive tax reduction planning throughout the year so that you can ensure that you're never over paying in taxes.
Without further ado, here are five things that you could use as a small business owner to lower your taxes.
1 - Maximize your S Corporation
One of the most powerful tools available to a small business is to implement an S Corp. strategy.
I'll keep this brief, but let me just share with you that an S-Corporation will dramatically reduce your Social Security and Medicare taxes that you owe as a self-employed individual.
Out of the gate, businesses are set up as Sole Proprietorships.
If you file a 2553S Corp. election, you can take your LLC or small business and elect for it to be taxed as an S-Corporation.
Let's do a quick overview of the difference between an LLC, Sole Proprietorship and S-Corporation.
Sole Proprietorship versus S-Corporation taxation
Sole proprietorship equals 100% of income subject to self-employment tax.
All of your net profits in a business are first subject to self-employment taxes.
What are self-employment taxes? Self-employment taxes are the combination of Social Security and Medicare taxes.
Unlike when you were a W-2 employee, you will be on the hook for paying both the employer and employee side of your self-employment taxes.
Employees are on the hook for 50% and the employer pays the other 50%.
So, when you were an employee at a W-2 job, you were paying 7.65% and the employer was paying 7.65%.
Now that you are self-employed and the business owner, you will be on the hook for the entire 15.3% self-employment tax.
Social Security and Medicare taxes for small businesses
The Social Security tax is 12.4% and it is subject on all income up to the Social Security limit, every year.
All income that is higher than the Social Security limit is no longer subject to the 12.4% Social Security taxes.
Every year, the amount of income subject to Social Security taxes increases because the government has mismanaged the fund and it is slowly coming under higher and higher pressure for Social Security benefits as the baby boomer generation continues to draw, while contributions and funding do not increase at the same pace.
The first $147,000 of your income is subject to the 12.4% Social Security taxes.
Medicare tax is 2.8%.
Unlike Social Security taxes, Medicare taxes do not have a limit; you will owe 2.8% on all of your income, no matter how high it goes.
In fact, at around $200,000 in income for single filers, you will start to pay an additional tax rate on top of the 2.8%.
Long story short, it was part of the Affordable Care Act and you can drive up your overall tax burden significantly if you are a higher income earner.
S corporation taxation versus LLC
S-Corporation is split into two types of income.
Your corporation will pay you a salary and then you will take distributions as an owner.
The salary you take from your S-Corporation will be subject to self-employment taxes, while your owners distribution or dividend is not subject to the self-employment taxes.
The goal then, would be to take as low of a salary as possible, but a salary that is legal and does not disobey the governments reasonable salary laws.
Long story short, since we would all like to take zero salary, the IRS has determined that we must take what's called a reasonable salary according to our participation in the business.
Depending on what you do and what the real cost of replacing you would be, you will determine a salary that is reasonable for your position.
Work with a wise accountant to maximize the S Corp.
The most important thing is to work with a wise tax and accounting expert that knows how to provide insight and guidance around your reasonable salary calculations throughout the year, so that you do not illegally take too low of a salary or mess up your tax payments & compliance.
S corporations require more compliance
Your S-Corporation can provide dramatic tax reduction, but it also has additional cost of compliance.
What is required to maintain and set up an S corporation versus a Sole Proprietorship?
In an S-Corporation, you will need to have a more expensive tax return completed at the end of the year which is called an 1120 S. You will need to run your own payroll for your reasonable salary, and you need to convert to the S-Corporation while setting up documents as a corporation as well.
Here at Whyte CPA, we are able to help you set up and then maximize your S-Corporation.
How much might I save in taxes with an S corporation strategy?
The amount of salary that you have to pay yourself will differ compared to other small businesses, so these are simply for illustration purposes only.
- Sole proprietorship $120,000 = 18,360 in SE Taxes
- S-Corp with $60k Salary & 60k Distribution = $9,180 in SE taxes
You could save nearly $10,000 a year with this example.
When should you become an S-Corporation?
The most important thing is to only become an S-Corporation if you plan on growing your business, and the overall tax savings outweighs most of the cost of compliance.
It's probably not a good idea to become an S-Corporation only for tax savings, because it's also helpful for asset protection and a number of other LLC benefits.
An S-Corporation is one way to help save in taxes and can actually fund retirement plans and hiring an accountant, so that your business can scale and grow.
Remember, successful business owners have an accounting team on their side helping them lower their taxes, avoid wasting time outside of their strengths, avoid immature bookkeeping mistakes, ensure that you avoid surprises by helping pay in taxes, run the payroll for you, and ensure that year-end taxes and reporting is closed out perfectly.
We love helping business owners lower their taxes, make great decisions throughout the year and establish pristine financials, so that they can scale their operations.
2 - Small Business Retirement Plans
The second major way that you can reduce your taxes is by utilizing small business retirement plans and use hyper tax efficient employer contributions to 401(k)s, SEP IRA, or simple IRAs.
Employees versus no employees
One major thing to note here is that retirement plans have conditions if you have employees.
Whatever retirement plan you are going to provide to yourself, you cannot discriminate against your employees and you must offer them a similar type of plan, at least to your full time employees.
Employer contributions explained
The IRS wants to help people save for retirement, so it has provided tax benefits to people in order to participate in retirement savings, but it has also provided businesses great incentive to provide compensation in the form of retirement plan contributions.
Employer and employee contributions explained for 401(k)
Remember when you used to work at a corporation that had a 401(k)?
One of the most common types of plans is called a safe harbor, where an employer would provide matching contributions up to a certain percentage of income.
The employee would contribute up to 4% of their income, and the employer would make a matching contribution, essentially doubling their investment.
The money that the employee puts in is called the employee contribution.
The money that the company puts in is called an employer contribution.
Employer contributions are NOT subject to 12.4% Social Security OR the 2.8% Medicare taxes. The employer contribution is a straight line deduction in the business as well.
In other words, the contribution the employer makes to a qualified plan, or the “Match” or the profit share plan, will immediately avoid a 15.3% SE tax for many people (not if you’re already above the thresholds, etc).
So, you could make 15.3% on your investment right away!
What are small business retirement plans?
- 401(k) plan
- Individual or solo 401(k) plan
- Simple IRA
- SEP IRA
- Deferred compensation plan
This is where it's really important for you to pay attention because if you have employees, this is about to change dramatically.
If you have employees, you must offer them the same set up.
Profit share percentages for the Employer Contribution
In many of these plans, the business will pick a percentage of salary to contribute as an employer contribution into the retirement plan.
This will either be a profit share percentage or a safe harbor system.
Each retirement plan has its own rules, but generally speaking, you will be picking a percentage of salary, often not to exceed 25%, and you will make that contribution to all statutory employees.
If your employees are not full-time, if they are all subcontractors, you probably will not have to consider them a statutory employee.
If you have employees, you should view retirement plan contributions as one of the most tax efficient ways to compensate your employees.
Essentially, you avoid a 15.3% friction between you and your employee when you use a contribution.
If you have no employees, this gets awesome!
Many people do not have any employees. I want to talk a little bit about how they can really maximize a small business retirement plan.
One of the best small business retirement plans is called the solo 401(k) or an individual 401(k).
We are aware of a product from Vanguard that is incredibly inexpensive and allows access to passively traded index funds that have very low fees to them.
Quick breakdown of the solo 401(k):
- Employer contribution = up to 25% of S Corp. salary or Schedule C income
- Employee Contribution = up to 100% of your income, not to exceed the contribution limits of $20,500 (with additional $6,500 catchup for folks 50 and older)
The employee contribution can be a deferred contribution, where the contribution will be deductible now and then taxed as income when withdrawn, or it can be a Roth Contribution.
Deductible vs. Roth Contributions for Small Businesses
Deductible - you deduct the contribution, paying only Social Security Taxes, and no income taxes. Then, when you withdraw the taxes in the future (penalty free after 59.5 years old) it will be seen as income and will be subject to taxes.
Roth - You’ll pay both income tax and self employment taxes on all of it, then it grows tax free, and it is NOT subject to tax when it is withdrawn in the future.
Employee Contribution = $20,500 in 2022 with $6,500 catch up (additional) for 50 years and older.
S-Corp vs. Schedule C (Sole Proprietorship) Contribution Rules
S-Corp Salaries determine the employer contribution. Sole Proprietorship full Schedule C income determines employer contribution rules.
S-Corps are good for lowering the 15.3% self employment tax, but they also limit the amount of income you can contribute to a retirement plan.
Generally speaking, an S-Corp’s 15.3% tax savings for the distribution far outweighs the contribution avoidance, so you’ll want to do both usually.
EXAMPLE (for illustration purposes only)
$120,000 in Schedule C
Up to a $30,000 Employer Contribution = avoids $4,590 in SE Taxes
Take a $60,000 reasonable Salary in S-Corp = Saves $9,180 in SE Taxes
The S-Corp would then be able to do up to a 25% employer contribution into a SEP IRA or Solo 401k.
$60k x 25% = $15,000 Contribution = avoids another $2,295 in SE Taxes.
Long story short, an S-Corp, with a SEP IRA or Solo 401k, is a super great way to reduce taxes.
$120,000 = total savings of $11,475 in SE Taxes.
Essentially, you can use your tax savings from the S-Corp to fund a small business retirement plan contribution and enjoy massive tax savings every year.
S-Corps Need Retirement Savings Because SS Benefits are Lower
Another important thing to remember is that an S-Corporation will have a lower Social Security benefits compared to a regular Schedule C business.
When you have a lower salary subject to self-employment taxes, that means you have less salary subject to Social Security taxes, which means that your Social Security benefit is predicated on a lower salary.
S-Corporations can lower your Social Security benefits, but it's also important to remember that there is a diminishing return on higher income within the social security benefit.
Long story short, it's good to take a bunch of the savings you get from your S-Corporation and put it into a retirement plan, so that you're not stuck when you get older.
For more information regarding contributions, retirement plans and withholding check out this article from the IRS.
3 - Hire Your Kids to Lower Taxes
Did you know that you can hire your minor kids in your small business, pay them for real and actual work and enjoy a massive tax reduction?
I'm going to show you something pretty cool that a lot of people don't think about. It's all predicated on the idea that your family owned small business can legitimately hire your minor children and pay them for work and there are a couple of special tax advantages for disregarded entities.
What is a disregarded entity?
A disregarded entity is a business entity that:
- has a single owner
- is not organized as a corporation
- has not elected to be taxed as a separate entity for federal tax purposes
The owner of a disregarded entity reports the income of the disregarded entity on the owner's return.
S-Corps and Disregarded entities, can both hire their kids for real work and pay them appropriate wages.
The minor child will then pay taxes like any other individual, and enjoy a massive standard deduction.
The standard deduction means that the first $12,550 is income tax free.
Now, in an S-Corp, those wages would be subject to FICA and medicare. They will pay 7.65% in social security and medicare taxes, and then your business will pay the second half.
Children working in an S-Corp will pay the 15.3% SE Tax (split between employer & employee) but they will get a standard deduction and pay 0% income tax on the first $12,550 and then only 10% on the next $10,275.
S-Corp Child Pay
7.65% FICA + Medicare
7.65% FICA + Medicare by business
First $12,550 = 0% Tax
Next $10,275 = 10% tax
Disregarded Entity Child Pay
NO Employment Tax!
First $12,550 = 0% Tax
Next $10,275 = 10% tax
For disregarded entities and children working within the business, their wages are not subject to Social Security or Medicare tax.
If you stayed a Sole Proprietorship and did not convert to an S-Corp, you would be able to pay your minor kids and save a ton in taxes.
If you convert to an S-Corporation, you won't get the benefits of paying no employment taxes, but they will enjoy a very low income tax situation because of the standard deduction and the low income tax rates on the first $10,000 or even $40,000 of income.
If you are in a high income tax bracket, hiring your children and letting them participate in the business in a real and legit manner and keeping excellent records, can be a fantastic way to shift income away from your high tax bracket and over into a much lower tax bracket.
4 - Home Office, Equipment & Improvements:
Section 179, Depreciation & Cost Segregations
If you work with your tax advisor to make wise decisions around new equipment, improvements and other investments into your business, you might be able to dramatically reduce your taxation by utilizing bonus depreciation, Section 179, depreciation and other tax benefits.
Long story short, you should be looking into what type of equipment and improvements to buildings or facilities would dramatically improve your capabilities and work to time these investments properly, according to the fluctuations of the income in your business.
I won't bore you with this, but I'll just tell you - work with us and we'll make sure that you're being smart with your new purchases and take advantage of big tax deductions!
Home Office Deductions
Whatever portion of your home that is used for business, can generate a huge deduction for home office.
You can calculate in a couple of different ways what percentage of your home is being used for business purposes and then use that proportion to identify home-office deductions and write-offs.
The principal portion of your mortgage is never deductible.
While the principal portion of your mortgage is never deductible or utilized in a home office deduction, the interest, utilities, improvements and a number of other things will be included in the home office deduction.
As people continue to work from home more often, that means that small businesses are often able to utilize larger portions of their homes as home offices.
That means many of the improvements and utilities, along with mortgage interest, can be deductible in a pro rata manner.
Your home office could be a massive deduction for your business.
5 - Real Estate Investments
Buy and hold real estate is one of the most tax efficient investments you can own.
In summary, you will get a couple of layers of tax benefits from owning either a residential or commercial building as an investment property.
Buy-and-hold rental income is considered passive income, and is not subject to self-employment taxes.
Income from rental investment properties is not subject to Social Security or Medicare taxes.
Besides enjoying the benefits of avoiding self-employment taxes, income from Investment Properties also get:
- Bonus Depreciation
- Cost Segregations
You will take the value of your residential property or commercial property, and divide by either 39.5 or 27.5 years, to give you your depreciation schedule for your rental property.
Your depreciation amount is not subject to tax, and essentially lowers the taxable income from the business.
In other words, you can dramatically reduce the amount of income subject to tax with depreciation.
Cost Segregations & Bonus Deprecation
Besides that, you will probably be able to utilize a cost segregation study to fast forward even more depreciation.
Besides all the tax advantages, buy-and-hold real estate also benefits its investor because you only need to come up with a portion of the capital in order to buy the income producing asset.
You will only need between a 10 and 25% down payment with a bank in order to purchase your property and then it will enjoy massive tax benefits.
S-Corps can rent from LLCs which hold rental property
Shift income from your S-Corporation by renting a property you own that is held in another shell company or LLC.
You cannot write off any down payment used in acquiring a property, but you can create a legitimate agreement between your S-Corporation and another business that holds a property that you would actually rent from.
In other words, you buy property in an LLC and then you rent it to your S corporation.
This shifts income from an active activity, which is subject to self-employment taxes and shifts it over to another business where it is not subject to self-employment taxes. The end result is that you will have a more tax advantaged business operation and a great investment.
It's also worth noting that being diversified in asset classes, tax qualifications and business activities is a good idea.
Your wealth should not be entirely tied to your business, securities investments, real estate or cash.
It's usually a good idea to be diversified in a number of excellent investments and real estate can be a fantastic way to hedge against other types of problems.
Long story short, if you utilize an S-Corporation, small business retirement plans, hiring your kids, utilize depreciation or bonus depreciation in Section 179 and then look into buy-and-hold real estate, you can dramatically reduce your taxes.
Here at Whyte CPA, we can guide you through the process every year and every week!