Tax season is in full swing. And in celebration of today's tax deadline (March 15, 2017, is the deadline for filing 2016 S-Corp and partnership tax returns, or extensions, 2017 S-Corp elections, and 2017 Section 475 elections), here are my tax strategies for entrepreneurs.
1. Hire a Tax Professional
Who are tax professionals? There is the classic Certified Public Accountant, AKA the CPA and an Enrolled Agent, AKA the EA. Here's the difference between them.
You should work with a tax professional because the tax code is very long and complicated and it changes each year. The 2016 tax code clocked in at 74,608 pages. Sure, not all the pages are actually tax code. But for comparison, the entire Harry Potter series (US Version) clocks in at 4,100 pages long. The tax code is 18 times the entire Harry Potter series. Should you really be fucking with that? No, you should be focusing on your business.
Beyond understanding the tax code, your tax professional will help you with lots of other questions you might have. Here are some: How can you set up a clear separation between your business and personal expenses? How will you keep track of your business expenses? Should you set up a formal business entity?
Get a tax professional. They'll help you protect yourself, keep everything organized and not lose your chill during tax season as you try to get everything in order.
2. Separate Your Business and Personal Accounts
Once you have your business account set up, make sure you're putting all your business income into the account and paying for your business expenses out of the business account. It sounds so simple, because it is. But it's not easy. Even though you'e probably read about me telling you to do this, there are some of you who still haven't done it. And I'm not trying to throw shade for the sake of throwing shade, I'm just demonstrating that it's a common issue people can easily solve, but for reasons like inertia, they sit on it.
I'm going to be real with you guys for a second and I'm sure some of you will appreciate this. But when I first started working for myself, I totally fucked this up for a couple of months when I was freelancing. I didn't set up a separate account and it was a total pain in the ass when it was tax time.
So, just make the time. Prioritize going to the bank. Even as a sole proprietor, set up separate accounts for your business.
Once you get the business set up properly, run your business like a business. Pay for your personal expenses from your personal account and business expenses from your business account. Your tax professional can help you understand what expenses you can deduct and how much you can deduct. Here are some common business expenses that you can deduct: start up costs, a portion of your business meals, marketing and advertising. The home office deduction is a common and prickly equation that you'll definitely need help navigating.
After your accounts are set up and you get an understanding of what expenses get paid from where, the next thing to focus on is understanding how much money you need from your business every month to pay yourself. How awesome would it be if your business funded your personal life and your personal goals? Pretty damn awesome, that's how awesome. You'll need to spend significant time and energy figuring out how to make this possible. Another reason why hiring a tax professional will help you keep focused on that.
3. Pay Quarterly Taxes
Estimated quarterly tax payments are exactly what they sound like. They are tax payments that you make each quarter. The amount of each payment is an estimation based on your earnings from the prior year.
Typically, your accountant will prepare file your taxes each year. And they'll often recommend that for the next year, you pay quarterly estimated tax payments. And they'll give you vouchers that you need to send to the tax authorities with the amount you need to pay and when they're due. Make sure you put these on your calendar!
Let's stop and understand an important legality surrounding taxes. Technically, you're supposed to pay taxes as you earn income. So, if you have a paycheck (either from an employer or through your own company) and you're set up to be paid as a W2-employee, you're paying taxes from each paycheck you earn.
Unless you're set up on a payroll service (like Gusto), you're responsible for paying your own taxes for the income you pay yourself.
So the reason you may want to pay quarterly taxes is twofold. The first is because you're technically supposed to pay taxes as you earn income. The second is so that you don't get a big, fat tax bill due come April 15. Quarterly tax payments makes your tax bill manageable. Maybe quarterly tax payments might even help you sleep more soundly each night. Am I reaching there?
4. Have a Separate Tax Savings Account
Tip 3 was awesome, but how can you make sure you have the money to pay your quarterly tax payments on time? The easiest thing to do is to set up a tax savings account. What's a tax savings account? It's a normal savings account. But the money you are putting into it is specifically for income taxes.
Especially if you don't pay yourself through payroll, this will help you. Every time you pay yourself, you put a portion of your income into your tax savings account. A good rule of thumb is 20% - 30%. But make sure to check with your tax professional on a percentage amount. Voila!
5. Understand Your Retirement Plan Options
The retirement plan has been a beloved tool for tax planning. The reason is twofold. First, you're saving for your old self. And two, you'll get some sort of tax benefit. The tax benefit can come now or later. You can put in pre-tax dollars and reduce your income tax bill or you can put in post-tax dollars and when you get your retirement payments, they'll be tax free. So taxes are always there, but with some retirement plans you have the flexibility of when you pay taxes.
A common retirement account you've probably heard of is an individual retirement account, AKA an IRA. There are two types of IRAs: the traditional and Roth. Traditional IRAs allow you to put in pre-tax dollars for a tax savings now. And a Roth allows you to put in money you've already paid taxes on and avoid taxation later.
The reason you'd choose a Roth is because you assume you'll be in a lower tax bracket now and higher tax bracket later. And you assume you'll save on taxes now by paying them at a lower tax bracket. This is awesome, but we don't really know what tax bracket you'll be in the future and how the tax code will change.
Almost anyone can open up an individual retirement account. If you're an employee participating in a 401(k) plan, depending on how much you've contributed, you can also have an IRA. If you're a freelancer, you can also open up an IRA. For 2016 and 2017, the maximum amount you can contribute to an IRA is $5,500. This number usually gets bumped up by $500 every 2 years.
Entrepreneurs have an other option available to them: the SEP IRA. There is a higher contribution limit. So if your business does well and you need to fund retirement and want to reduce your taxes the SEP is awesome for that. The big drawback with a SEP is if you have employees. By law you're obligated to contribute to their accounts if you're contributing to yours.
If that's too much of a burden, a Simple IRA is a good option. The contribution limits aren't as high. But it's a good tool for business owners who have employees and want to allow their employers to have access to a retirement.
There are some other options too like a Solo(K) or a 401(k) plan. Talk to your tax professional about what accounts you are able to open up and how much you can contribute. The amount you contribute will be a function of what is legally allowable and what you can afford to put away.
6. Consider Setting Up a Formal Entity
If you've been a freelancer/running a sole proprietorship for a bit and your business is starting to grow, you may want to consider setting up a formal entity, like an s-corp or LLC.
There are tax advantages and liability protection that come with setting up a formal entity. And when you're more established and ready to do that, it often times makes sense.
Setting up an s-corp can help you avoid additional layers of taxes, the main one being the dreaded self-employment tax. You can also set up strategies to pay yourself and reduce your overall tax bill. Yet another reason why working with a tax professional is worth the investment.