Tax strategies are one of the most overlooked ways in which small businesses could be saving money. Below are three key recommendations with example scenarios that illustrate how small businesses can save hundreds of thousands of dollars with the right tax planning.
The CARES Act in 2020
Use the Removal of the Excess Business Loss Limitation
The Tax Cuts and Jobs Act of 2017 (TCJA) limited the allowable losses that could be deducted for noncorporate taxpayers to $250,000 for individuals and $500,000 for married filing joint taxpayers. This put a limitation on a business owner’s ability to use net business losses to offset “non-business” income. Net business losses occur when your business income is lower than your business expenses. Non-business income is passive or investment income from capital gains, trust distributions, dividends, interest, some rental income, or your W-2/employee income.
The CARES Act retroactively removes the business loss limitation by providing taxpayers affected by the limitation provision with refunds for 2018 and 2019, and removes excess business loss limits in 2020, when many businesses are expected to have higher losses than in previous years.
The effect of this tax change could potentially be enormous for an individual and very costly if overlooked. A good tax adviser can help ensure that obscure and relatively new tax benefits like this are effectively taken advantage of.
Below shows an example of the impact of this tax law change for an individual with $3 million of losses from his or her LLC as well as $3 million of short-term capital gains income in 2020.
|2020 Taxes With Excess Business Loss Limitation||2020 Taxes Removing Excess Business Loss Limitation|
|Losses from LLC ownership||$3,000,000||$3,000,000|
|Loss limitation (Single filer)||$250,000||N/A|
|Short-term capital gains||$3,000,000||$3,000,000|
|Taxable gains after applicable business loss deductions||$2,750,000||$0|
|Short-term capital gains tax|
|Net after-tax cash flow|
= LLC losses + capital gains – taxes
Payroll Tax Credit vs. PPP Loan
If your business has been affected by a shutdown order or have experienced a 50% reduction in gross receipts, you may qualify for a refundable payroll tax credit of 50%. The credit is applied to the first $10,000 of each employee’s compensation, including health benefits, from March 13, 2020 through Dec. 31, 2020.
If you’ve received a PPP loan, then you are not eligible for the payroll tax credit and vice versa, so do the math to see what’s more worthwhile. If your total payroll tax credit would be more than your total forgivable PPP loan amount, it would be better to go with the outright credit.
Other provisions under the federal CARES Act that you may want to look into include whether you qualify for PPP loan forgiveness and the Social Security tax deferral. However, under the recently passed Paycheck Protection (PPP) Flexibility Act, you are now eligible for the payroll tax deferral included in the CARES Act if you have an existing PPP loan. In addition, make sure to check whether your state, county, and/or city may have tax credits or other assistance for local small businesses this year.
OnDeck is here to support small businesses – check out our COVID-19 Resource Hub for more helpful information for small businesses impacted by COVID-19
Set Up Your Small Business as a Separate, Pass-Through Entity
Choosing a business structure for any new business entities or changing the structure of an existing business can be a key tax decision. Creating a legal entity is important in protecting your personal assets from the liabilities of your business operations. However, forming your business as a corporation instead of a pass-through entity has major disadvantageous tax consequences due to double taxation for C-corps.
Below is an example for the distributed earnings of a corporation vs. an LLC owner:
|Business Set Up as a C- Corporation||Business Set Up as an LLC|
|Corporate tax (20%)||$400,000||N/A|
|Corporate net income (Assumes all distributed to owner)||$1,600,000||N/A|
|Ordinary income tax (35%)||$560,000||$700,000|
|Net after-tax cash flow||$1,040,000||$1,300,000|
This isn’t to say that no small business should ever be set up as a C-Corp. C-Corp profits are taxed at the corporate income tax rate. In some cases, depending on where your business is incorporated and your personal tax situation, the corporate income tax rate may cost less than if the business was set up as an LLC.
Set Up and Contribute to a Retirement Account
Depending on your company’s size and employees’ needs, you can choose from these retirement plan options:
- 401(k): A common employer-sponsored retirement plan that both employers and employees can contribute to.
- Solo 401(k): A 401(k) plan for a business owner with no employees.
- SEP IRA: An individual retirement account that is primarily used for employer contributions.
Outside of the tax incentives, there are certainly multiple other benefits to utilizing an employer-sponsored retirement account, including the recruitment and retention of employees and your personal financial security.
However, the tax benefit can be substantial. Any of the tax-advantaged retirement accounts can help reduce the following:
- Personal taxable income: Contributions to a traditional 401(k) plan can be deducted from your taxable income and could put you in a lower tax bracket. This applies to all employees of the company, including the business owner.
- Payroll taxes for the business: A matching contribution to a 401(k) does not require the payment of payroll taxes, making this a cost-efficient way to compensate employees when compared to a raise or a salary increase.
- Annual corporate tax bill: All employer contributions and some of the fees to the institutions for the management of the retirement plan are tax deductible for the business.
You may also qualify for a tax credit of up to $1,500 by using the IRS’s Credit for Small Employer Pension Plan Startup Costs.
Learn more about retirement planning for small businesses: 5 Most Important Things Small Business Owners Should Know About Retirement Planning
These tax strategies and others can be complex to monitor, especially while managing all of the other logistics of running a business. Tax law changes continuously, and there are many regulations that apply selectively, to certain scenarios and types of businesses, particularly with government relief programs in 2020. A tax adviser can help you navigate key business decisions that can have an impact on your tax bill, and flag any updates that are most relevant to your business.
Learn more about tax strategies for small business owners at Harness Wealth, which combines innovative technology and human expertise to help clients effectively unlock financial opportunity.
*This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for health, tax, legal or accounting advice. You should consult your own health professionals or tax, legal and accounting advisors before implementing any business changes.