Does it feel like every tax season is a stressful lead-up to a failing grade on an exam? So many business owners roll the dice every year and wait until April to find out what they will owe or get for a refund, having no idea in the interim what their fate will be.
The good news is that I can tell you how exactly to avoid a huge tax bill and never ride that emotional roller coaster again. To understand how to avoid owing, we first have to figure out WHY you keep owing. Below are some of the most common reasons and ways to mitigate them:
(1) You don't withhold enough
In today's age, many people have multiple W-2 jobs and what you have to understand about payroll systems is that they generally assume when you set up your withholding that you have no other income or jobs, so your withholding could be as low as 10% while your marginal income tax rate is actually 24%.
One way to make sure this is not a problem is to pull your YTD figures from your paystub and take your Federal Income Taxes Withheld and divide it by your Gross Earnings. Then do the same with State Income Taxes Withheld. If the percentage being withheld is far lower than your effective tax rate, then you may want to update your paperwork to reduce the number of exemptions you take or add a little extra withholding to each paycheck to cover the gap.
(2) You didn't pay any estimates
How many of you have felt personally victimized by the IRS as a small business owner because they didn't tell you about estimates?
The IRS wants you, as a small business owner, to mimic the behavior you once had as a W-2 employee and chip into your taxes year-round as you earn income instead of waiting until the following April. Therefore, they created this requirement to pay quarterly estimates. You typically receive a schedule of upcoming estimated tax payments with your tax return. For example, 2021's estimates come with 2020's tax return. This is another benefit of filing on time - finding out what your estimates will be before they are due.
Estimated payments for individuals are due on April 15, June 15, September 15 and January 15 each year. If you pay at least what the voucher says to pay, this helps you avoid an underpayment penalty. However, these are just estimates after all and they are based on the prior year. If you make more income during the year, you may owe a bit more than what was estimated. The best thing to do is evaluate your profits quarterly and make sure you have contributed enough toward taxes, even if that means chipping in more than the estimated payment voucher.
Feel like that is too much responsibility? Consider setting aside roughly 25% of your top line revenue into a separate bank account (perhaps a high-yield savings) and let it sit there until estimates come due. This will ensure you have enough in the bank to cover it and make sure you are not tempted to dip into that fund. This is a good habit to get into until such time that you get a better feel for how much you will make in profit and how much you will actually owe in taxes.
(3) You didn't do any tax planning
Tax planning is just a fancy word for taking control of your tax bill. The time between September and December each year is a prime season to start opening up your finances and figuring out how much you will likely owe. You don't need to leave it up to chance. I find that the clients who wind up paying the least in taxes are the ones who take advantage of their tax planning call. This allows us to run a mock tax return, figure out what might happen and get ahead of it. In the least, it helps them become aware if they will owe so they can plan to save up in the coming 3-4 months in anticipation.
But how do we actually perform tax planning to reduce taxable income?
One example is timing your income and expenses optimally. For example, if you know you will make much more revenue in 2022 than in 2021, then you may want to defer as many expenses as you can into the year with more income so it helps to offset it. Similarly, you could also defer out your invoices if you want to reduce your taxable income in the current year and shift it into the next year.
Another example is optimizing your business entity to make sure you have the right structure for your business. It may also include taking advantage of the home office or vehicle deduction and making sure all of your business expense deductions are accounted for.
We include one of these tax planning calls with all clients who book us for tax services before the end of the year. If your accountant is simply filling our the paperwork for you, then you are overpaying for something software or a storefront could do. If you need more insight and help reducing your tax bill, talk to us about tax strategy and complete this form to book a call.