How tax planning can minimize your business' tax liability

As a small business owner, you can save significant money on your tax bill with effective tax planning. The easiest and best tax planning strategies include utilizing all available tax deductions, appropriately timing expenditures, and investing in your employees.

What is tax planning?

Tax planning is an ongoing effort and management strategy to ensure your business is minimizing its tax liability. You will need a thorough understanding of the tax deductions and tax credits available to your business. For tax planning purposes, it is important to consider all forms of tax that your business pays. This includes federal and state income tax, payroll tax, sales and use tax, and capital gains tax.

Tax planning should always be a consideration when timing large asset purchases or planning an expansion. However, it is just as valuable when making day-to-day business decisions. With effective tax planning, your business can retain more of its valuable capital for reinvesting in future business ventures or increasing the take-home pay of business owners and employees.

Ways to reduce your business' taxable income

Here are some effective tax planning strategies that will save your business' hard-earned money.

Qualified business income deduction

Many owners of small businesses qualify for the qualified business income deduction. You can deduct up to 20% of your qualified business income if your business is a pass-through entity. A pass-through entity is taxed on a personal income tax return after the profit is passed through to its members, partners, or shareholders. It includes businesses formed as a sole proprietorship, partnership, S corporation, and certain limited liability companies (LLCs). This deduction has been available since 2018.

Timing big expenditures

Most assets you purchase must be capitalized initially and deducted in part each year as the asset depreciates. Because depreciation spreads out the time it takes to deduct your expenses, it delays your tax benefit.

However, certain assets identified in Section 179 of the Internal Revenue Code (IRC) can be fully deducted in the year they're placed in service. Section 179 property includes tangible personal property such as machinery and equipment used in the trade or business, as well as qualified real property. For 2021, the maximum amount you can deduct immediately is $1,050,000.

Additionally, be sure to review your financial situation prior to year-end. If you expect a drastic change in your business' income tax bracket from one year to another, you can strategically time your income and expenses to minimize the fluctuations and maximize your tax savings in the year you expect to pay higher taxes. For example, if you use the cash method of accounting, you can prepay certain expenses for future periods to increase your current year deductions.

Set up tax-free fringe benefits

As the owner of the business, your salary or distribution of your share of the business' profits is subject to income tax. You also pay payroll taxes on your employees' wages and salaries. However, you can offer fringe benefits to yourself and your employees to reduce the impact of both these taxes. Investing in your employees also has the added benefit of increased employee morale and loyalty.

Consider setting up and funding a retirement plan for yourself and your employees. A qualified retirement plan such as a 401(k) or 403(b) allows contributions to grow tax-deferred. This means your employees don't pay taxes on contributions, but distributions are taxable when taken in the future. Employer contributions to employee retirement plans are tax-deductible as well.

Other employee benefits that can lower your taxable income include employer-sponsored health insurance, long-term care insurance, disability insurance, life insurance, and contributions to health savings accounts (HSAs).

Write off bad debts

If you use the accrual method of accounting, you should review your outstanding accounts receivable before year-end. Writing off bad debts, those belonging to customers unlikely to pay you, will increase your expenses and decrease your taxable income.

Familiarize yourself with common tax deductions

As a small business owner, it is important to thoroughly understand the tax deductions available to your business. In addition to the others mentioned already, there are many common tax deductions that can save your business money at tax time.

You can deduct expenses related to your home office, business travel, business vehicle usage, and start-up costs. If you plan to deduct any of these, keep detailed records of the expenses you incur throughout the year. Tax deductions must always be reasonable and directly business-related.

If you're overwhelmed by the breadth of tax planning strategies listed in this article, consult with a tax attorney or certified public accountant (CPA).