Here's the big secret: there are no secrets.
Some accountants will claim that they know tax-saving secrets, but the reality is that there aren't any. Which is good because it's dangerous for business owners to be in the dark about their own taxes. So instead of talking about how to pay less taxes, I'm going to walk you through the three biggest mistakes I see all the time as a CPA at Pink Moon Financial—and how to avoid them.
You won't pay less taxes, but you'll save yourself a lot of grief.
You're paying yourself wrong
How you pay yourself depends on your business structure. The moment you decide that you want to sell anything, whether it's products or services, you become a sole proprietor. There's literally nothing you have to do—it's the default structure.
To be an LLC, however, you need to visit your Secretary of State website to find out the details on how to register. It's usually a straightforward process, but the fees vary from state to state, with some states having an annual fee of just $125 and others having filing fees of up to $800 per year. Becoming a corporation is also an option, but unless you have several owners, the costs of this business structure usually outweigh the benefits in the beginning.
The difference between an LLC and a sole proprietor is limited liability. What this means is that, if you get sued, your personal assets like your home and personal bank account are safe. If you're a sole proprietor, everything is at risk. In order to actually be protected by the limited liability, though, you must have a separate business bank account. For a sole proprietor, a business bank account is great but not required.
How does it affect taxes?
When filing taxes, there is no difference by default between the way an LLC is taxed and the way a sole proprietor is taxed. Both file a schedule C form, which integrates to your personal tax return.
Since LLCs and sole proprietors are taxed exactly the same, the way you pay yourself is also the same—with owner draws. You'll ideally want to set up a schedule and a payment amount to keep things streamlined, but essentially you can pay yourself however you want. You simply transfer money from your business account into your personal account.
It's important to understand that owner draws are not a tax deduction. This type of payment is simply a transfer of cash and is not considered a paycheck, nor are you considered an employee of your business.
LLCs do have the option to elect S-Corp status, which means that your business will be taxed differently.
S-Corp payroll requirements
If you're an LLC that has elected to be taxed as an S-Corp, the IRS explicitly states that you must receive a salary. This does not mean owner draws. It means you are an employee of your business, you receive paychecks, and—here's the kicker—you pay payroll taxes. There's no getting around this one.
This is actually something that many business owners miss. A lot of business owners elect S-Corp status and either don't know about the payroll requirement or disregard it. If this is you, you'll want to contact your CPA immediately and ask them about this because, while most IRS rules are more of a gray area, this one is very black and white.
So how do you know which business structure is right for you?
I only recommend electing S-Corp status once your profits are at least $30K-$50K—otherwise there aren't any tax benefits.
Whether to become an LLC or stay a sole proprietor is up to you. Consider the annual fee in your state as well as whether or not you're ready to open a business bank account and how important it is for you to protect your personal assets. Additionally, you'll want to consider your goals. If you're looking for grants, loans, or other funding, it's preferred for you to have the LLC structure.
Is an LLC required for every business? Nope, and as with all of your important business decisions, it will depend on your specific situation and goals.
You hire tax preparers that don't know what they're doing
There are no education or experience requirements to become a tax preparer. All anyone has to do is fill out a few forms, go through a background check, pay a fee, and boom, they will receive their PTIN. With this ID number, they're allowed to prepare tax returns. That means there are plenty of tax preparers out there who haven't taken one single tax course or who have had zero experience with taxes.
A red flag to look for is outrageous promises like guaranteeing a huge refund. No one can guarantee a refund. The tax law is the tax law, and if two different qualified tax professionals prepared your tax return, you'd end up with exactly the same amount owed.
The best way to find a qualified tax preparer is to look for credentials. A CPA, Certified Public Accountant, or an EA, Enrolled Agent, are the best credentials for a tax preparer to have. Both of these designations require passing very difficult tax-specific exams, and in some states, there are also experience requirements.
Here are some questions you can ask your tax preparer to vet them:
What industry do you serve?
Can you explain my tax return so that I understand?
What tax experience do you have?
The tax preparer is not liable for errors on your tax return
When you sign your tax return, it's similar to signing a contract—you've confirmed that all of the information on your return is accurate. Your tax preparer is not liable for your tax return, which means it's vital to find a qualified and ethical tax preparer.
Common mistakes that result in additional taxes and penalties for small business owners are failing to pay payroll taxes or receive a reasonable salary if you've elected S-Corp status and claiming deductions that are invalid. Sure, deducting every meal you ever had can reduce your tax bill, but when the IRS finds out, you'll pay those taxes back with interest that's compounded daily. Never take any deductions that aren't allowed—it won't be worth it.
Just like you wouldn't sign a contract without knowing what you're signing, you should never sign your tax return until you understand it.
You're missing tax deductions
As a small business owner, almost everything that you spend for your business is tax-deductible. Keyword: almost. To be deductible, your expenses must be ordinary and necessary. For example, shampoo is a completely ordinary and necessary expense for a hairstylist, but for a CPA like me, not so much. Deductions vary by industry, but if it's an expense for your business, it's most likely deductible. Here are some quick examples:
Entertainment expenses like sports tickets and concerts are not deductible, even if it was a company outing.
Meals are limited to 50%, and you should document the business purpose.
Gifts to employees or clients are limited to $25 per person.
Personal expenses are never tax-deductible.
How to keep track of deductions
The easiest way to keep track of your tax deductions is to use a spreadsheet. Keeping receipts is important, but you only need those in the case of an audit (which can happen years later). So yes, organize your receipts and keep them in a safe place, but as far as filing taxes are concerned, you just need to know the annual totals of your income and expenses.
Business owners often feel like they need accounting software, but the truth is that accounting software is made for accountants. Regardless of how user-friendly they may seem, without knowledge of how double-entry accounting works, they often create complications and mistakes for small business owners.
A spreadsheet is easy to set up, unlike accounting software, which usually comes with a huge learning curve. With a spreadsheet, you'll also have fewer chances for mistakes, which means your finances will be accurate and complete—so filing taxes will be a breeze.
If you're like most new business owners, bookkeeping and taxes are your least favorite tasks, so they get put on the back burner until tax season rolls around—cue the overwhelm and stress. If you want to make filing taxes easy, keeping up with your bookkeeping throughout the year is how to do it. Make sure to start small, start easy, and create a solid workflow.
Taxes can be an overwhelming topic, so naturally, you find it easier to let the expert accountant deal with it. The problem with that is it leaves you open to major vulnerabilities, and it's much easier for an unqualified or inexperienced tax preparer to take advantage of you—after all, they aren't liable.
That's why it's essential for business owners to understand the basics and to know what questions to ask. At the end of the day, the "secrets" to paying less taxes are simply to choose the business structure that's best for you, know what deductions you can take, and keep accurate records.
Disclaimer: You understand and agree that this post is intended to provide general information and education, which in some cases may be outdated, and that the information provided is not intended to be interpreted as specific business, financial, or legal advice for your business and financial situation. You agree that reading this article is not indicative of an accountant-client relationship and that any US Federal or State tax advice provided here cannot be used to try to avoid penalties, fines, or other monies due under US Federal or State tax law. You agree that the information provided here cannot be used as a defense of actions during any lawsuit and you relieve Advance Accounting, LLC from any liability. You should consult with an attorney, accountant, and/or financial advisor in your area who understands your particular business and financial situation so that you can take the right steps for you and your business.
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