Small business owners should plan their taxes as their income grows to avoid being surprised by large tax liabilities. Tax planning is crucial for a successful business, and there are various strategies available for minimizing tax bills, especially for businesses with larger incomes. Some strategies include optimizing home office deductions, maximizing retirement contributions, and reducing debt.
Make the most of your home office deductions
Home office deductions are one of the most commonly missed expenses that can save you lots of money on your tax return. This is partially because there are some common misconceptions around what qualifies as a “home office.” The IRS allows both homeowners and renters to claim a home office deduction; so even if your space is leased, you may claim it on your tax return. It’s also available for all types of homes, from a houseboat to a studio apartment (but not a hotel or an Airbnb that you’re staying in on vacation). To claim a home office deduction, your space must meet these two requirements:
- Regular and exclusive use: The space you consider your office must be used exclusively for business purposes. For instance, if you use a guest bedroom as both your office and a place for your in-laws to stay, that room is ineligible for this deduction.
- Principal place of business: Your home office must be your primary place of business. That means you don’t have another office elsewhere. Your home office must be used “exclusively and regularly for administrative or management activities.” Management activities refer to things like billing customers, making sales calls, bookkeeping and setting up appointments.
Check with your accountant to make sure you can take advantage of a home office deduction. It can save you a lot of money on your tax return!
[Read more: Running a Home-Based Business? Important Tax Information You Need to Know]
Defer income to reduce your taxable income
Remember, your income tax is charged based on the amount of income you made during the previous calendar year. In this case, a successful sales strategy is a double-edged sword: the higher your income, the higher your taxes. If you’re hoping to lower your tax burden in April, defer some income until the next calendar year.
There are two ways to defer income depending on which accounting method your business uses:
- Cash-basis accounting: Delay sending invoices, or extend the due date on the invoice until the new year. Your income tax rate is based on when you actually receive payment, not when you’ve sent out the invoice.
- Accrual-basis accounting: If your business doesn’t charge until after you’ve fulfilled the delivery of goods and services, delay until next year. Strict guidelines apply when a business is recording deferred income under accrual accounting, though, so it’s wise to check with your financial advisor to make sure you’re doing it correctly.
Adding to a retirement plan is not only an investment in your future, but it’s also good for your tax rate.
[Read more: Accounting Guide: Cash Basis vs. Accrual Basis]
Be proactive about procurement and depreciation
Equipment is one of the biggest expenses in a small business budget. Writing off new purchases and offloading old equipment can significantly help your tax burden. If you need to purchase a car, laptop or other equipment, make that purchase before the end of the year. The earlier date of purchase can be declared as a higher expense, or even a full purchase price, since the item will have had less time to depreciate. Likewise, you may be able to take advantage of business credits for things like solar panels, energy-saving upgrades or other sustainable investments. Check the IRS list of business tax credits to see if there’s anything your business needs that you can claim.
In addition to moving up expensive purchases, now is the time to review depreciation rules. Follow these steps to maximize your expenses and reduce your tax rate in April:
- First, declare the entire expense in 2022.
- Use a shorter depreciation timeline.
- Use an accelerated depreciation method.
- “Decrease the residual value to allow a greater annual depreciation expense.”
Read more about how to apply depreciation in IRS Publication 946.
Maximize contributions to your retirement plan
Adding to a retirement plan is not only an investment in your future, but it’s also good for your tax rate. Contributions to a 401(k) are made with before-tax income, meaning your monthly salary decreases each pay period, leading to a lower tax rate.
Individuals are eligible to contribute up to $22,500 to a 401(k) in 2023. If your account is set up as an IRA, you may contribute up to $6,500 in 2023. Business owners can also set up 401(k)s for their employees. Small businesses can claim the cost of setting up and administering each 401(k) plan, up to $500 a year for each of the first three years that the plan exists. Plus, it’s a great benefit to offer your employees.
Pay down your debt
Lots of small business owners take on debt to finance their growth. A loan won’t be taxed in the same way as business income, but you may be taxed on interest payments. Speak to a CPA or accountant who can tell you whether or not you can make your loan as tax-efficient as possible.
At the same time, make sure you write off any uncollectible debts you may have accumulated through the year. Uncollectible or bad debts are those which are owed to your business by a customer that you (the business owner) or a creditor has not been able to collect. The IRS permits you to write off bad debts before the year. Run your accounts receivable aging report to see who hasn’t paid. If the results show a customer who is no longer active, then you may be able to strike this person’s balance from your total sales figure. This reduces your income, lowering your income tax. The caveat here is that unfortunately if you do write off a bad debt and the person pays you later, you must reverse the write-off.
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