Maximizing tax deductions for small business owners
One of the most important things for small business owners to do is maximize tax deductions that are available to them. I list three ways to do so, which include keeping detailed records, contributing to a retirement plan, and understanding what expenses are deductible. I also provide reasons why it is so important for small business owners to take advantage of these available tax deductions.
Since my small business owner clients have many responsibilities with running their businesses and do not have much available time to focus on finances, I provide tax advice and help them navigate the complexities of tax laws and regulations to make sure they are maximizing available tax deductions specific to the circumstances of their businesses. These tax deductions reduce tax liability, which helps the overall financial health of their businesses.
Keeping detailed records
Throughout the year, small business owners should maintain organized records (e.g., receipts, invoices, bank statements) of all business-related expenses. By taking the time to document these expenses accurately, small business owners give themselves the opportunity to take advantage of deductible items when it is time to file their tax return. For small business owners, there are software options available that provide this type of recordkeeping service. Also, there are bookkeeper companies that can provide this service as well. The IRS has noted the importance of recordkeeping for small business owners.
Contributing to a retirement plan
Retirement plan options (e.g., SEP-IRA, Solo 401k, SIMPLE IRA) available to small business owners are designed to help provide long-term financial security, but they also have tax advantages (i.e., tax-deferred savings) meaning that they can deduct contributions made to these plans, which reduces taxable income. I illustrate below with a hypothetical example.
Carla is a sole proprietor who has done fitness coaching for nine years. Over the past few years, she has earned significantly more income than when she first started her business. Carla decides to hire a financial planner, Sue, who believes she should start saving more for her retirement while also reducing her taxable income (via deducting contributions) during these high-income years. For these reasons, Sue recommends that Carla opens and starts contributing to a solo 401(k). Carla follows this advice and begins to contribute the maximum amount every year going forward.
Understanding what expenses are deductible
There are tax laws and regulations related to deductible expenses that small business owners should be aware of. Note that the IRS considers an expense to be tax-deductible if it is “ordinary and necessary,” which means the deductibility of an expense can depend on a small business owner’s specific industry and profession. In other words, an expense that is “ordinary and necessary” for one small business owner might not be “ordinary and necessary” for another. This list is not exhaustive, but some common tax-deductible expenses for small business owners include:
Rent
Utilities
Office supplies
Software subscriptions
Education
Salaries
Travel expenses
Meals
Vehicle expenses
Fees paid for professional services
Advertising and marketing expenses
Importance of maximizing tax deductions
For any business, cash flow is what keeps operations going. Maximizing tax deductions reduces a small business owner’s taxable income, which directly has a positive impact on cash flow. As a result, a small business owner will have more cash flow, which can be used for items that are more effective. These items can include reinvesting in the growth of their business, expand operations (taking advantage of a growth opportunity), bolstering emergency cash reserves (to get through economic downturns if necessary), and saving for personal financial goals (e.g., retirement, college savings for children). I illustrate with the following hypothetical example.
John has owned a technology consulting business for eight years and currently has one employee. Over the past few years, his business has grown exponentially and knows that his tax liability will continue to increase as well due to his higher income. John decides to work closely with his tax professional to make sure he is taking advantage of any available tax deductions for his business each year, which has helped him reduce his overall tax liability. With more free cash flow available, he now has started to reinvest more into further growing his consulting business and investing even more in his son’s college savings account because his son will be attending college in less than five years from now.
There are times when small business owners are at a disadvantage when competing against larger businesses who have more resources so every advantage that a small business owner can get does matter. Reducing overall tax burden by maximizing tax deductions frees up cash flow to remain competitive (e.g., by investing in marketing, retaining productive employees with competitive salaries).
The success of small business owners can be an engine for U.S. economic growth, which means that when businesses take advantage of tax deductions, it allows them to reinvest cash flow into initiatives that create more jobs, careers, and other opportunities.