What business owners wish they knew sooner: 7 common tax mistakes
Making mistakes in filing your tax return or when paying the IRS is stressful to say the least. In 2021, the IRS assessed $37.3 billion in civil penalties. Even worse, making too many mistakes can lead to an IRS audit.
Even when business owners don’t face penalties in a tax year, they rarely feel like they made the most out of deductions, tax credits, and deferments.
We get it.
Taxes are confusing, especially if you’re a new business owner.
That’s why we wrote this blog on seven small business tax mistakes that you’ll wish you had known sooner. Want to potentially avoid an IRS audit? Want to legally lower your tax obligation and save your business money? Want to feel more confident in your tax strategy? Then keep reading.
#1 - Underreporting income
You may feel tempted to underreport your income to the IRS. After all, it’s your money, right? You could theoretically not report that income if you receive cash or cryptocurrency payments.
Paying taxes is a social obligation. Aside from how you feel about underreporting income, the IRS has many ways of finding out. They also have methods to determine if your underreporting was intentional.
Let’s say you made a few honest mistakes. Will the IRS still penalize you? The unfortunate answer is, “most likely, yes.” Let’s discuss what happens if you underreport your income and the IRS finds out.
What happens if you underreport income?
The IRS will send you a CP2000 if they find you have underreported income. How can the IRS even find out? Well, other third-party organizations like banks, mortgage companies, and other businesses you transact with do. They will report money they paid you or other transactions. They also receive copies of income-reporting statements (such as forms 1099, W-2, K-1, etc.) sent to you.
Suppose you have a reasonable cause for underreporting your income, like a small unintentional error. Suppose you made an underpayment on estimated taxes. The IRS might waive the penalty due to a mistake made in good faith. In this case, the IRS can still penalize you for 20% of the underpaid amount. You can file an amended tax return if you make a mistake on your tax return.
In the case of intentional underreporting, the IRS could fine you up to 75% of the underreported amount. IRS's examiners may also refer the case to the Internal Revenue Service Criminal Investigation Division. This office may pursue criminal prosecution.
Why Are Penalties So High?
Yes, the IRS penalty fees are excessive. The last thing any small business wants is to be hit with an unexpected tax bill hurting their cash flow even more. The IRS’s theory is that excessive penalties discourage business owners from making careless mistakes and withholding taxes.
#2 - Making too many deductions
Recent tax bills have changed how you can take deductions from business-related activities. The more deductions you claim on your return, the more likely the IRS will double-check your return and audit you. The IRS states that deductible food expenses must be “ordinary and necessary” for running your business.
Business owners that run a small business that isn’t their primary source of income get tripped up by deductions. If you claim a loss on your tax return several years in a row, the IRS may declare your venture a hobby instead of a business, disallowing deductions.
Taking too many deductions ending in round numbers can be a red flag. Most of the time, receipts and expenses don’t end in round numbers. The IRS will expect that most of your deductions are not all round numbers.
#3 - Mixing personal and business finances
We’ve already shared this in a few blog posts because it’s so important. One of the first things you should do when starting a business is to create business bank accounts. Use your business account only for business expenses and income. Get a credit card attached to your company for expenses if you can.
Want to make it easier to distinguish business and personal expenses? Then separate personal and business finances. This will give you or your tax accountant a big leg-up when budgeting and filing your return. The easier it is to wade through your finances, the easier it is to get everything right on your return.
#4 - Not doing any tax planning
As a business owner, you likely deal with taxes a few times a year. You have a lot of things you'd instead prioritize daily. For example, seeing clients or managing employees over your taxes.
It’s crucial that you segment a portion of time at least monthly to plan taxes. Too many business owners treat tax preparation like record keeping. They just fill in income and expense columns and hope that’s enough. Tax planning, especially with the help of a professional, can help you avoid an unreasonable tax bill.
Here are three tax planning strategies for small businesses:
- Write Off Bad Debts: Bad debt is money owed to your business that becomes null and void due to non-payment. Loans to clients, credit sales, or business loans are bad debts. You can deduct bad debts, in whole or in part, from your taxable gross income.
- Establish Fringe Benefit Plans: As you increase your employees' salaries, so will your employment tax obligations. Not all fringe benefits are tax-exempt. A few non-taxable fringe benefits include on-premise meals, disability insurance, and health insurance.
- Hire Your Spouse Or Kids: There is no age limit for hiring your child as long as they do legitimate work. Your child can earn up to $12,950 and owe nothing in taxes on that income. Hiring your spouse can increase tax savings too. Instead of paying them a salary (which increases payroll and employment taxes), you can pay them non-taxable fringe benefits.
#5 - Skipping deductions
Hopefully, we didn’t scare you away from tracking and making deductions on your upcoming return. The government wants to give businesses every chance to thrive. Self-reported deductions are one way the promote business ownership. Once again, IRS publication 535 shares more details on business tax deductions.
Business owners are allowed to deduct insurance premiums if they’re necessary for the business. Here are a few common examples of insurance policies that you can write off:
- The business owner’s out-of-pocket health insurance
- General liability insurance
- Workers compensation insurance
- Business income insurance
- Malpractice insurance
- Auto insurance
- Property insurance
Business startup costs are considered capital expenses instead of operating expenses. Business formation costs up to $5,000 are tax deductible in the first year. Over several years, your business can further deduct startup costs through amortization. IRS Publication 535 has more information on capital expenses and amortization.
According to the IRS, For any contribution of $250 or more (including donations of cash or property), you must obtain and keep a written acknowledgment from the organization. This indicates the amount of the cash and a description of any property other than cash contributed. After following this process, your business can write off the charitable contribution.
#6 - Skipping estimated taxes
Many business owners who sign up for the ComplYant are surprised to learn about a concept called estimated taxes. Estimated taxes even catch business owners who know they’ll owe them by surprise.
Estimated Taxes are a type of tax that individuals and business owners pay on taxable income not withheld via a W2. Who has to pay estimated taxes? Individuals, solopreneurs, entrepreneurs, partners, or shareholders who believe they will owe over $1000 in taxes.
#7 - Spending money just to avoid taxes
At the end of the year, business owners across the country look at their bank accounts and all think the same thing. “I am going to owe a ton of money in taxes.” After doing the math, they decide spending the money inside the business is a great way to lower their tax obligations.
This may make sense initially, especially since paying taxes is quite painful. However, if your business is just spending money to spend it, you’re wasting money on things that could benefit your business far more.
If your business is low on critical supplies or needs to invest to continue operations, then by all means, make that purchase before December 31st to lower your taxes the following year.
If that’s the case, consider using that extra cash for savings. Savvy business owners will save money for events like another Covid situation, unplanned debts, liabilities, or payroll expenses if their business loses profitability.
Avoid costly mistakes with ComplYant
Sometimes, it can feel like the IRS intentionally trumps you into making mistakes on your taxes. Although their mission is to maximize tax revenue for the federal government, it is not done through malicious means. The truth is that an infinite number of business types and tax situations create a never ending need for new IRS tax codes.
That leaves you, a business owner, short on time and knowledge of taxes feeling like you’re constantly playing catchup. If you learned a lot from this article, you could take advantage of even more tax-saving tips and strategies using a tool like ComplYant.