When I speak with prospective entrepreneurs on whether or not to take the leap of faith into starting a business, which might require digging into their personal savings to operate said business, I like to quote entrepreneur Kirk Kirkpatrick: “If at first you don’t succeed, take the tax loss.”
Deducting tax losses is just one of many benefits that the U.S. tax system offers business owners. Let’s face it, business owners are provided many more benefits, deductions, credits, and loopholes—which can significantly reduce their effective tax rate—that employees are not offered.
However, it’s important for business owners to understand the difference between legal tax avoidance and illegal tax evasion. As the former British Secretary of State Denis Healey once said, “The difference between tax avoidance and tax evasion is the thickness of a prison wall.”
Here’s how to make sure you stay on the right side of the tax law—and that wall.
Legal Tax Avoidance
The Pew Research Center reports that of most developed nations, the U.S. has one of the lowest personal tax rates around, even though its corporate tax rate is one of the highest in the world. Operating at least some form of a home-based business can open you up to more legal tax deductions and reduction vehicles than ever before—slashing your federal, state, and FICA-related tax burdens.
The goal here is to reduce your effective tax rate. Here are a few strategies.
Convert Personal Expenses to Business Expenses
Many of your personal expenses can become business expenses, which now enables them to become tax deductions. The key here is that you have to use said personal items for business. This includes:
- Your home, which becomes your home office, along with aspects associated with your home, including utility bills.
- Your external dining, travel, and entertainment. As long as you complete some aspect of commercial discussion, transaction, or associated activity in relation to the dining, travel, and entertainment spot, then you can categorize the activity under the business meals, travel, and entertainment category.
Other listings include:
- Your cellphone, which becomes your business cellphone
- Your car, which becomes your company car
- Your moving expenses
- Your higher education or professional education expenses
- Your health insurance premiums
Deduct Standard Business Expenses
These are expenses related to the business, such as marketing, inventory, supplies, materials, labor costs, interest costs, equipment, etc. You also can deduct business losses up to a certain extent if you “don’t succeed,” like Kirk Kirkpatrick mentioned.
Use SEP IRAs
Being self-employed, you are able to set up a Simplified Employee Pension Individual Retirement Account (SEP IRA) and contribute up to 25% of income or about $53,000 for 2016. The entire contribution is tax deductible.
Use Health Savings Accounts
As long as you maintain a health insurance policy with a deductible of $1,300 or higher, then you can contribute to a health savings account with 2016 limits of up to $3,350. The entire contribution is tax deductible.
Move to a State With No/Low State Income Taxes
Consider moving to a state with lower tax burdens, such as Texas, Florida, or Wyoming, which have no state income taxes. Be careful though, as while a state might have no (or low) state income tax, they might make it up through higher sales tax and/or property taxes. When considering all state taxes (income, sales, property, etc.) California and New York are some of the highest-taxed states in the country.
Use an S-LLC to Reduce FICA Taxes
An S-LLC is an LLC that’s taxed with a Subchapter S election. An LLC is a pass-through entity (no double taxation) that can be taxed in a number of ways, such as a Sole Proprietorship or Subchapter S. The reason you would select the Subchapter S is because it can help reduce the amount you would pay in FICA (Social Security and Medicare) taxes.
Taxing an LLC as a Sole Prop would mean that if your business generated $50,000 in profits, then you would have to pay FICA taxes on the entire $50,000. If you used a Subchapter S election, you would split the $50,000 with a portion considered “reasonable salary” and the other portion considered a dividend distribution, with only the salary subject to FICA taxes.
Take the FICA Tax Deduction
Speaking of the FICA tax, as a self-employed individual, you are able to deduct half of the amount you paid in FICA taxes each year.
Take Other Usual Deductions/Exemptions
You are also allowed other typical deductions, exemptions, and credits—including a deduction for what you paid in state taxes, your personal exemptions, and more.
Illegal Tax Evasion
The tax avoidance strategies outlined above do a great job of reducing your effective tax rate, so make sure that you do not gamble your freedom on using any tax evasion strategy such as:
- Under-reporting income
- Hiding income
- Falsifying records
- Flat-out not paying your taxes
- Not paying all tax amounts that are due
Selecting the Right Tax Preparer
Finally, be wary of who you allow to complete your tax return, as some tax preparers might use different forms of tax evasion on unknowing participants, or simply might not have the expertise you require.
For all of your small business tax matters, consider seeking out licensed accountants who are either certified public accountants (CPAs) or enrolled agents (EAs) who have at least 10 years of professional experience and a master’s degree in accountancy or taxation. They should also specifically market themselves as small business tax experts. Although their costs will likely be higher than other basic tax preparers, they’re likely to be more efficient and credible over a non-specialized tax preparation service.