As a small-business owner who employs 15 people, James Clift has a lot of problems to solve, and taxes might be at the root of all of them.
Taxes determine your business structure, your cash flow and your trajectory for raising capital. If you don’t manage them efficiently, they can bankrupt you in the end.
“It sneaks up on you,” says Clift, whose Vancouver, Canada-based company Durable uses artificial intelligence to create websites for small businesses, but doesn’t yet help them with their taxes.
This is how he’s seen it go for himself and the owners he helps: “You launch a business, generate revenue, and then you think, ‘Oh, I need some software to manage this.’ So you get QuickBooks and never check it, then you hire a bookkeeper.”
Clift says it’s always a scramble to get receipts and data together during tax season. And, he adds, “It’s scary, too. If you haven’t started with a good foundation, you’re sunk.”
Stan Shraybman, senior tax manager at Dimov Tax in New York, says 80% of the clients he deals with are completely lost when it comes to taxes. Part of the reason for that may be that many small-business owners try to do their bookkeeping and filing on their own, even though they aren’t experts in finance. A recent survey by Lili, a business-services company, found that 50% of business owners under 40 file their taxes on their own, and 30% of those aged 41 to 50.
For financial adviser Thomas Kopelman, it doesn’t matter how successful somebody’s business is or their age, he finds they all share a common trait: They know the absolute bare minimum about taxes.
“Most don’t even know their tax bracket,” says Kopelman, co-founder of AllStreet Wealth, based in Indianapolis. “They don’t know entity selection, they don’t know QBI. They don’t know how much they owe and when.”
When Kopelman helps small business clients, he assumes their knowledge is zero and starts from there. “Nobody has ever said, I know this, skip ahead,” he says.
Here are the three key points that small-business tax experts say people need to know to keep their businesses running and in good standing with the IRS:
1. Business structure
Entity selection sounds like a menu item at a business-parts store, but what Kopelman means by this is the way your business is registered, which has a huge impact on your taxes. Set yourself up the wrong way, and it could cost you enormously. For instance, if you’re running a tech startup and you incorporate as an S Corp instead of a C Corp, you might have trouble raising venture capital. Investors will want you to have a C Corp, Kopelman says, so that you can have more and different levels of shares available.
For others, there are advantages to being an S Corp — mostly in terms of paying yourself a salary and being able to take more deductions — rather than being an LLC, a limited partnership or simply a sole proprietor.
Kopelman recently helped a small-business owner who was in his early 20s and is on track to make a profit of more than $750,000 this year. He set up as an S Corp, but was not paying himself any salary or contributing to a retirement plan. He was doing very little record-keeping.
The first thing Kopelman did was get him to pay himself a high salary so the business would get a deduction, then he had him contribute a large chunk of that to a qualified solo retirement plan. That alone saved more than $75,000 in taxes.
“He’s really happy and excited,” says Kopelman.
2. The mysteries of QBI
The Qualified Business Income deduction, introduced in 2018 as part of the Tax Cuts and Jobs Act, might be gone before anyone really understands it. Business owners surely don’t, says Shraybman, and sometimes financial advisers and accountants don’t either.
The provision provides up to a 20% deduction on business income, but there are a variety of complicated rules that come with it. There are income phase-outs, and different professions qualify according to their own thresholds. QBI is set to sunset at the end of 2025 unless there is Congressional action to extend it.
Josselin Castillo, manager of federal-government relations for the National Federation of Small Businesses, an advocacy group, says that QBI going away is “a massive looming threat” and preserving it is her group’s number one tax priority. “If that goes away, it’ll be a massive tax hike that impacts almost all NFIB members,” she says. “It’s so absolutely critical. When we stare at the future, it’s all about QBI.”
3. Keeping track of things
When you open a restaurant or a nail salon, bookkeeping is probably not your first love. That goes even when you run a business that is geared toward helping small businesses and have a degree in accounting, like Clift.
“The constant admin work is the worst part of running a business for me,” he says. “Everything is hard, even knowing when your year-end is. I run multiple entities with different year-ends. We spend a lot of time and energy on that. It’s a complex and frustrating process.”
One of the biggest issues Shraybman sees when he’s helping small-business owners is that they don’t know when to file quarterly tax payments, and don’t know how much to pay. But that’s just one item at the top of a very long list.
“They don’t know they have to pay Social Security and Medicare taxes. They don’t know that you can have your own retirement account,” he says. They often co-mingle their personal and business funds in shared bank accounts. They round expenses instead of being exact. While Shraybman has only had one client show up with receipts in a duffel bag, most of them are not good at bookkeeping software or consistent with record-keeping.
One thing Shraybman sees all too often is business owners who purposefully skip their quarterly estimated tax payments because they think they can do better on the interest rate in the bank and they’re trying to squeeze out every last ounce of possible gain. Their rationale is something like: If you are penalized 3.5% by the IRS, but bank interest is 4.5%, they will bank a sum like $20,000 throughout the year and pay a $600 penalty. “Different strokes for different folks, I guess,” he says, “But it’s really best practice to pay the estimated tax.”