Misunderstood Tax Deductions for Your Business
You work hard to generate a profit, and there are a number of business deductions that can reduce your tax liability. Filling out your tax return is time consuming, and recent tax law changes have made the process more difficult.
To understand the deductions your business can take, you need to consider your business structure.
Understanding Your Business Structure
There are a number of ways to structure your business, and the structure impacts how your profits are taxed. Broadly speaking, a business can have a C corporation structure, or a pass-through entity structure.
Taxation of C Corporations (C Corp)
Both the C Corp and the individual taxpayer (shareholder) are taxed on company profits. Here’s an example:
- Company taxes: the C Corp earns $100,000 in 2020. The corporation files a C Corp tax return and pays taxes on company profit
- Dividend: The C Corp pays a $40,000 dividend (share of earnings) to Julie, a shareholder.
- Personal taxes: Julie pays taxes on the $40,000 dividend on her personal tax return.
If you operate a C Corp, you need to be aware of the double taxation of business profits. Pass-through entities, on the other hand, have one level of taxation on profits.
Operating a Pass-through Entity:
As the name implies, pass-through entities pass the company profits and losses directly to the owners. Sole proprietorships, partnerships, S Corporations, and some other businesses are pass-through entities. Here’s a partnership example:
- Openfield Partners generates a $50,000 profit in 2020.
- The partnership files a tax return that documents the profit, the partners, and each partner’s ownership interest. However, no taxes are assessed on the partnership tax return.
- Sally, a partner, is entitled to 20% of the 2020 profit. She is issued a K-1 form and receives $10,000. The $10,000 is added to other income on her personal tax return, and she sends the K-1 form with her tax return.
Most businesses operate as pass-through entities. If you understand how to file business taxes, you can post the proper tax deductions.
Posting Car and Truck Expenses
The IRS instructions allow you to deduct the actual expense of operating a vehicle, or take a standard mileage rate. Actual expenses include repair and maintenance costs incurred during the year.
Keep in mind, however, that tracking actual expenses can be time consuming, and you may fall behind on your recordkeeping. If you can stay on top of your actual expenses, you can compare the total to the standard mileage deduction and take the larger deduction.
Accounting For Depreciation Expense
Physical assets, including machinery, equipment, furniture, computer hardware and software are depreciated. Depreciation expense is posted as an asset and is used to produce revenue over time.
It’s important to remember that the tax deduction for depreciation may be different than the depreciation expense in your financial statements. Work with an accountant on this issue. If you simply take the depreciation expense from your income statement, you may be using the wrong amount for tax purposes.
Including Repair and Maintenance Costs
Don’t let the costs incurred to repair and maintain assets slip through the cracks. Many business owners focus on the dollars needed to purchase assets, and forget about repair and maintenance expenses.
Keep your vehicle repair and maintenance expenses separate- see the car and truck expense discussion above.
Counting Retirement Plan Contributions
A Simplified Employee Pension (SEP) plan is for self-employed people, and an Individual Retirement Account (IRA) is available to both employees and self-employed workers.
Business owners may be able to deduct contributions made to retirement plans, and you need to understand the difference between two retirement plan categories. Talk with your financial advisor and an accountant regarding this deduction.
Paying Self-employment Taxes
This may be the biggest source of confusion for sole proprietors. Keep these points in mind:
- Employees pay their share of FICA Tax (Social Security and Medicare taxes) through payroll withholdings, and the dollar amount of the withholdings are reported on the W-2 form.
- The employer pays a portion of the FICA tax also, and the employer deducts the taxes paid as a business expense.
- For 2020, the employer and the worker each pay a 7.65% tax, and high-income earners may pay an additional Medicare tax.
- If you’re self-employed, you pay both the employer and employee portion, and then deduct the employer portion on Form 1040. Use Schedule SE to compute the amount of the tax deduction.
It’s critically important that self-employed workers complete Schedule SE and pay self-employment taxes. If you don’t, you may be subject to large penalties and interest on the amount that you owe.
Tax Impact of a Business Sale
If you decide to sell your business, your tax liability is based on the sales proceeds you receive, and the cost basis of your business. Cost basis is the money an owner has invested in the business. Here are the components of cost basis:
- Original capital contributed to the business by the owner
- Add: Any additional capital contributions since business inception
- Less: Capital withdrawals
- Equals: Cost basis
Dividends (taking a share of earnings) does not affect cost basis. Withdrawals are dollars taken out of the business that are not earnings.
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