By John McCarthy, JD, CPA, CFA, Assistant Vice President and Trust Officer at Byline Bank
As a small business owner, you understand the importance of monitoring your taxes. Not only is it important to stay on top of filing deadlines for different types of taxes and regulations imposed by local and federal governments, but also understanding how to maximize deductions and credits can help reduce tax liabilities.
That’s why this blog post will provide seven tips that may help reduce or eliminate certain taxes. With the right information and knowledge in hand, understanding the complexities of various tax issues can become much easier. So, let’s dive into seven essential tax tips tailored specifically toward helping small businesses succeed!
Tip #1: Take advantage of tax-loss harvesting
Investing in stocks can lead to gains over time. However, there are strategies you can use to further maximize your potential return. One of these strategies involves holding onto your winners while selectively selling off poorly performing stocks, a process known as tax-loss harvesting. Through this process, you can accumulate unrealized gains while also recognizing losses for tax purposes.
Alternatively, you can also purchase a tax-loss harvesting vehicle. This investment product tracks the performance of an index while selectively selling off stocks to recognize losses. The vehicle then purchases similar securities, and after 30 days, previously sold stocks may even be repurchased, allowing you to continue building your portfolio while also minimizing your tax liability. Many asset managers—including Byline—offer tax-loss harvesting vehicles.
Because personal losses can offset gains from pass-through entities, tax-loss harvesting allows you to utilize tax losses developed from your personal return against gains from your small business. After any gains are offset, you can only take a net capital loss of up to $3,000 per year on your personal return to offset ordinary income. Unused losses, however, can be carried forward indefinitely to offset future gains.
Whether you’re planning for your retirement or your family’s future, Byline Bank’s Wealth Management team is ready to provide customized solutions for your financial needs. Get in touch.
Tip #2: Offer employees a retirement plan
Offering a retirement account to your employees can be a particularly effective strategy for minimizing a company’s tax payments. Businesses that set up a 401(k) for their employees are permitted to set aside a significant amount of income into those accounts: a total of up to $66,000 ($73,500 including catch-up contributions) per year including both employee and employer contributions. Employee contributions are permitted up to $22,500 per employee, and up to $30,000 for employees who are 50 years of age and older. Although Social Security, Medicare, and federal unemployment taxes must be paid on this income, it is not subject to federal and state taxes until a distribution is taken from the 401(k). Employees may also elect to make Roth (after-tax) contributions to the plan providing tax diversification.
Some highly profitable companies may want to also consider a cash balance plan. This is a defined benefit plan that sets forth a benefit for an employee at retirement in terms of a stated account balance. Furthermore, a cash balance plan can be used in addition to a 401(k) plan.
Another option if you and/or your spouse are the only employees of your business: You may want to set up a one-participant 401(k) plan. Under this plan you can make elective deferrals of up to $22,500 ($30,000 for those age 50 and over). You can also make employer contributions of up to 25% of your compensation/self-employment income, for a total of up to $66,000 ($73,500 including catch-up contributions) per year.
Tip #3: Maintain a health insurance program
Health insurance plans can offer businesses many tax benefits. For instance, if you are a small business employer (that is, with fewer than 25 full-time employees) and you set up a health insurance plan for your employees and pay at least half of their premiums, you may be eligible to receive a credit of up to 50% of premiums paid for up to two years. Additionally, businesses or the employee can contribute $3,850 per employee (or $7,750 for an employee’s family) in pre-tax dollars to a health savings account (HSA) if the employee is covered under a high-deductible health plan (HDHP). An employee’s unused balance in an HSA will carryover from one year to the next.
Alternatively, for employees not covered under an HDHP, a business can set them up with a flexible spending account (FSA) and contribute up to $3,050. When made by an employer, both FSA and HSA contributions are exempt from employment taxes. Furthermore, both FSA and HSA distributions are tax-free as long as they are used for qualifying medical expenses.
Tip #4: Don’t miss out on depreciation opportunities
When it comes to maximizing deductions, so-called Section 179 depreciation and bonus depreciation can be valuable tools in a business’s tax management arsenal. Typically, a business purchases an asset (such as equipment) and depreciates its value over time in subsequent tax years. Section 179 of the US Internal Revenue Code, however, allows businesses to immediately deduct 100% (up to $1,160,000) of capital expenditures (phased out dollar for dollar when such expenditures exceed $2.8 million). One wrinkle to this method of depreciation is that deductions that can be made on a vehicle are limited to $19,200.
Another wrinkle to Section 179 depreciation is that it cannot be used to create a net loss for your business. However, bonus depreciation can. Like Section 179 depreciation, bonus depreciation allows businesses to immediately deduct a large percentage of an asset’s value instead of depreciating that value over the asset’s lifetime. In previous years, businesses were allowed a 100% bonus depreciation on assets, but this is currently being phased out, and in 2023, the maximum depreciation rate has been set at 80%. Therefore, you can depreciate 80% of all modified accelerated cost recovery system (MACRS) assets with a recovery period of 20 years or less in the year the asset is placed in service. This includes most tangible assets placed in service (things like office furniture and computer equipment), but it does not include land or office buildings.
Tip #5: Take credit for material participation
All of the aforementioned depreciation can result in business losses that ultimately reduce your personal tax burden. This is because, as a small business owner, you can typically claim business losses on your personal tax return, provided that you “materially participated” in the business that generated the loss; otherwise, these losses are disallowed in the current year and must be carried forward. Material participation can be met by meeting one of a number of criteria set forth by the Internal Revenue Service, but it generally requires that you be actively engaged in the management of the activity.
Regarding special rules for real estate losses: For such losses to offset your personal income, you must be a “real estate professional” and materially participate in real estate activity. To qualify as a real estate professional, you must spend more than 50% of your time performing services related to real estate and the total amount of time you spend on real estate activities for the year must exceed 750 hours.
Even if you do not qualify as a real estate professional, if you “actively participate” in real estate activity, by performing activities such as approving new tenants, deciding on rental terms, and approving capital expenditures, you can deduct up to $25,000 of losses from this real estate activity. This deduction amount begins to phase out when your annual income exceeds $100,000.
Tip #6: Deduct qualified business income
Another deduction to be mindful of as a business owner relates to qualified business income (QBI). According to the IRS, QBI “is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.”
Under Section 199A of the US Internal Revenue Code, businesses can deduct 20% of their QBI (as well as dividends from real estate investment trusts and income from publicly traded partnerships) from their Schedule C or flow-through entity. Something to note, however: If your business is considered a specified service trade or business, which includes most service businesses, then the deduction begins to phase out when your personal income exceeds $182,100 (or $364,200 if a business owner is married and filing their personal tax return jointly).
Tip #7: Consider classification as an S corporation
When it comes to optimizing your personal tax payments, small business owners can benefit greatly from classifying their firm as an S corporation. This is because, if your small business is currently taxed as a partnership or a sole proprietorship, then you are paying self-employment tax on almost all of your ordinary business income. In other words, you will have to pay an additional 15.3% tax on this income due to Social Security and Medicare taxes.
When you as a small business owner classify your firm as an S corporation, however, you can choose to pay yourself a “reasonable compensation,” which is subject to employment taxes, but all the income you derive from your business above that amount is free from employment taxes. A “reasonable compensation” is what you would have to pay to an outside service provider for similar services. This amount will typically be lower than the total amount of your business’s profit, and as a result, you will be able to save on employment taxes.
Unlocking Your Business’s Financial Potential
While managing your company’s tax strategy can seem daunting, it doesn’t have to be. Every business has the potential to maximize their bottom line and cut costs with a few savvy tax tips. From tax-loss harvesting and offering health insurance, to taking advantage of depreciation opportunities and considering the formation of an S corporation, there are multiple tools that every small business owner can use to reduce their taxes.
As an entrepreneur, you know that taking risks is part of the job. But when it comes to maximizing your personal wealth, smart, informed decisions can help you stay one step ahead financially.
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This article was written by John McCarthy, Assistant Vice President and Trust Officer II at Byline Bank.
The above material has been provided for informational purposes only, and should not be relied on for tax, legal, or accounting advice. You should consult with your own tax, legal, and accounting advisors in addressing any of the above information.
