One of the most common pain points for business owners is taxes. Naturally, the idea of write-offs becomes a business owner’s best friend. The more you can write off, the less you have to pay in taxes. Unfortunately, many business owners leave thousands of dollars on the table by trying to do it themselves. When you start to look at tax planning as an investment and not a cost, there are ways you can dramatically improve your financial health.
Why Business Owners Want to Write Off Everything
Simply put, the reason why business owners want to write everything off is because they want to lower their taxes. Writing a large check each quarter to pay taxes can motivate many people to explore other options. Finding ways to reduce that amount each quarter would mean more cash to reinvest into the business or take home to the family.
As a result, there are three important numbers we need to target: Total Income, Taxable Income, and your actual Total Tax.
- Total income: The sum of all your income, including profits, wages, rental income, investment income, and anything else.
- Taxable Income: Total income minus allowable deductions (and adjustments like self-employed health insurance premiums or student loan interest).
- Total Tax: The amount calculated based on taxable income, after applying tax rates and accounting for any tax credits.
After you know your total income, we need to distinguish between the different types of write-offs: tax deductions and tax credits. They are not the same thing and it’s important to understand the difference.
For example, let’s say a $100,000 taxable income at a 25% tax rate would hypothetically result in $25,000 in taxes.
- Adding a $10,000 tax deduction would reduce the taxable income down to $90,000, and a 25% tax rate would mean $22,500 is owed in taxes, saving you $2,500.
- Adding a $10,000 tax credit would directly reduce the tax owed from $25,000 to $15,000, without affecting taxable income.
Tax credits reduce your total tax dollar for dollar. Tax deductions only reduce your taxable income before the tax calculation is applied. As a result, tax credits will always be preferred to deductions, but both types of write-offs can dramatically increase your cash flow and reduce your taxes. In our example, every dollar in deductions is saving 25 cents in taxes. The higher your tax rate is, the more each write-off can benefit your tax situation.
Common Deductions and How to Utilize Them
For pass-through entities like a partnership or S-Corp, business deductions flow through to the owner’s individual tax return. This means that both personal and business deductions are available to reduce your taxable income and in turn your total taxes.
Perhaps the easiest deduction is for operating expenses, and hopefully, most business owners should already be utilizing it. Most day-to-day expenses to run the business qualify as operating expenses. This could include rent, utilities, supplies, professional fees, salaries, insurance, marketing, and many others. This happened to me the other day, but if you hear a friend say they “run all of my expenses through the business”, this is what they mean. As long as these expenses are common and necessary within your industry, they are generally deductible.
Beyond basic operating expenses, there are more advanced deductions and credits available. Working with the right financial team can help you find and maximize your write-offs. The concept of depreciation is one of the first “advanced” tactics that I look at for business owners with real estate or other assets. If you took an accounting class in college, you may remember that depreciation is the process of writing off investments in physical assets like real estate, vehicles, or machinery. Generally, you can deduct a portion of the investment each year over the life of the asset, until you have fully deducted the original cost.
When done correctly, you can also elect not to incrementally deduct the investment and instead accelerate the deductions to earlier years. For example, Bonus Depreciation and Section 179 deductions could allow larger deductions in the year of the purchase. Take advantage of these deductions whenever you can. Due to sunsetting provisions from the Tax Cuts and Jobs Act, bonus depreciation in the year of purchase already decreased from 100% down to 80% last year. Tax laws are constantly changing so make sure you speak with a tax professional to understand what affects you.
Work With the Right Team to Maximize Your Write-Offs
Chances are you are missing out on some deductions and credits simply because you are unaware that they exist. The tax code can be confusing, and many times what may seem like obvious tax savings are often missed. That is why it is important to have a CPA and a financial advisor on your financial team. The role of a CPA is to help you pay taxes and keep you compliant with the IRS. They thrive in applying each specific part of your business to the tax code. Unfortunately, many times an accountant is not able to see the entire financial picture. People assume their CPA will find every tax savings possible, even though they may not have the time or understanding of your situation to do so.
This is where your financial advisor should come in. If your advisor does not ask for your tax return each year, that should raise questions. The role of a financial advisor is to incorporate every aspect of your financial life and communicate with you and your financial team. For example, your accountant should execute the depreciation strategy on your tax returns, and your advisor should make sure that strategy keeps you on track to reduce your lifetime tax bill. You need experts to help execute your financial plan as well as step back and look at the big picture with you.
Depending on the state of your business and personal finances, you may be leaving thousands of dollars on the table, if not more. Hiring the cheapest tax preparer and advisor (or not hiring either), could mean learning too late about write-offs applicable to you. I had a client a few years ago whose accountant missed one of her quarterly tax payments. She would have paid an extra $5,000 in taxes if I did not see her tax return before it was filed. Not everyone needs a premium accountant or advisor, but would you pay a few thousand dollars to get back tens or hundreds of thousands? Simple business math would say so, and that is possible when you see accountants and advisors as investments. The value of high-quality advice from accountants and advisors can help tremendously.
Take the Time to Understand Your Taxes
At the end of the day, it is important to understand what your tax situation looks like. It’s easy to want to write off everything possible and never pay taxes, but taxes are a normal part of our economic system and are not going away. There are many deductions and credits to implement to help reduce your taxable income and your taxes, and chances are good that you are missing some currently. Focus on where you want to go in your financial life and work with experts to help you get there.
TC Falkner 