Small business owners have a lot to deal with most days. One of the last things they need is to discover they filed their taxes incorrectly, especially in the early stages of starting a business when everything can feel overwhelming. Research shows 37% of small businesses feel confused and anxious about how to file taxes. The same study showed that 25% did not know how to file their taxes at all.
The IRS also found that businesses that are not yet profitable have less incentive to engage in tax planning, which, though unwise, may explain why tax education isn’t an early priority for SMB owners. However, addressing these tax knowledge gaps is essential for building a successful, resilient business.
Ahead of US tax submission day on April 15th, this article shares some insights on small business tax preparation to help avoid tax debt, IRS penalties, and interest accrued from unpaid penalties, while making the most of deductibles.
Why Can Tax Compliance be Challenging for SMBs?
Tenacious, hard-working, and diligent entrepreneurs understand the challenge of building and scaling a business, and the priorities that must be balanced to maintain growth.
Tax season can feel like a deviation from the growth process for some. Making sure tax documents are accurate and comply with IRS requirements means paying close attention to expenditure all year round, and some can get so caught up in the day-to-day running of operations that accounting and tax can be deprioritized.
Then all of sudden it’s nearly submission day, and some SMBs can find themselves completely unprepared for the scale and complexity of small business tax filing. But it’s more than just a failure to take notice: tax compliance presents significant difficulties for lots of businesses due to numerous factors.
Costs
The Tax Foundation measures the cost of compliance for individual taxpayers filing their return nearly $74billion every year. For businesses of all sizes, the burden is more than $60billion.
Proper tax preparation also costs businesses a lot of time. The foundation also finds that U.S. taxpayers spend a total of 2 billion hours every year complying with individual income returns (including small business returns); over 1 billion hours preparing corporate income tax returns; and 1.4 billion hours filing for deductions and quarterly tax returns.
Many small business owners will see this as valuable time that could be spent on innovating products and services, improving supply chain efficiency, and breaking into new markets. This also excludes the possibility that SMB owners may make a small error and file incorrectly as a result, which leads to extra time requirements and fines.
Structure
Around two-thirds of U.S. SMB owners say they feel their tax burden is unfair, with many reasoning that larger corporations get away with paying zero in federal taxes on their profits. This is often because different business structures have different tax obligations.
The four types of business structures are:
- S partnership: AKA ‘sole proprietorship’, the company’s debts and profits are the responsibility of one person.
- Partnership: The entity is owned by more than one individual—usually either under a general partnership or a limited partnership.
- Limited Liability Company (LLC): Hybrid structure that gives owners flexibility and liability protection.
- Corporation: Business is a completely separate entity from its owners
Each business structure has its own tax advantages. For example, S partnerships are considered “pass-through entities”, and so the business itself doesn’t pay corporation tax—the taxes are passed through to the owner. It’s easy to set up and maintain, because the owner is the sole proprietor by default.
These small businesses don’t have to pay corporation tax, but this makes the business owner personally liable if anything business-related goes wrong. No corporation tax also means there are no tax benefits: owners need to pay self-employment tax on all earnings and add their business earnings to their Schedule C form (personal tax return).
Calculation errors
Being ready to prepare a small business tax return on time is just one part of the equation. Miscalculations are another common problem impacting the tax process, and are often due to human error which, unfortunately, can’t always be helped.
SMBs without an accountant are likely to be more at risk of errors. And a challenge is that owners trying to scale their SMB up may not have enough profitability to pay themselves a salary yet—let alone hire an experienced accountant to ensure their returns are without mistakes.
The importance of accuracy cannot be overstated, however. The IRS imposes penalties and fines on any company that fails to meet deadlines, or pays an incorrect amount due to any mistakes. They can also add interest onto these penalties, which often accrues from the original due date.
Common Misconceptions About Tax Submissions
1. Home office deductions are IRS red flags
While it used to be a red flag for the IRS, making a tax deductible claim from working at home costs is no longer prohibited. Small businesses just need to be sure they keep excellent records to meet IRS standards.
Tax officials used to audit all tax returns with home office deductions, but this is no longer viable for the IRS. However, it’s important to note that if you have a high deduction-to-income ratio, this may cause alarm bells to ring.
The IRS rules about home office use are:
- You must regularly use part of your home exclusively for conducting business. For example, if you use an extra room to run your business, you can take a home office deduction for running that extra room e.g., power, internet costs.
- You must show your home as your principal place of business. If you also run your business at a location outside of your home, but use your home substantially and regularly as well, you may also qualify for a home office deduction.
2. How small business tax deductions really work
Many business owners may not know what ‘tax-deductible’ means. While it does refer to what can be taken off taxable income, it is not simply subtracted per each payment. Deductibles let individuals and businesses lower their total taxable income by deducting expenses either by a flat amount, or through an itemized deduction on Schedule A of their tax returns.
In terms of what can be deducted, the U.S. Chamber of Commerce has a comprehensive guide on important tax write-offs for small businesses, including:
- Business insurance
- Interest and bank fees
- Depreciation
- Salaries and benefits
- Business meals
- Costs of Goods Sold (COGs)
- Mileage deductions
It’s important for owners to be across the tax deductibles relevant to their business, as it can save a considerable amount of money. Having an experienced accountant and/or financial adviser to support the tax journey can often ‘pay for itself’ due to this part of the process.
3. Extensions mean businesses pay six months later
A common misconception is that if you are successfully seeking an extension for filing your tax return this means you have plenty of time to do it. Businesses can request an automatic extension for free online using IRS Form 4868: this means they avoid the Failure-to-File penalty which amounts to 5% of the unpaid taxes the business owes for each month or time period the tax is late.
But, if the IRS does grant them more time to file properly, they can still be subject to the Failure-to-Pay penalty. If a business files by the end of its extension but has not paid these taxes, they will be charged 0.5% of the taxes it owes for each month they were left unpaid.
Submitting Tax as a Small Business
There’s no disputing that tax season can be a stressful time for SMBs. It’s important to closely follow IRS website guidelines, alongside some other pointers that can help businesses feel fully prepared ahead of the deadline for US tax submission on April 15th:
1. Prepare ahead of April
Many small businesses may not be doing enough to prepare ahead of tax season. Preparation can reduce the risk of missing the deadline, and can make the whole process less stressful because filing involves gathering data from multiple ledgers which takes time.
Businesses can feel more prepared by:
- Being aware of all tax due dates which may apply to the business beyond April 15th
- Printing out forms in advance
- Finding out which taxes can be filed online, and which have to be mailed to the IRS
- Keeping documentation in one place
- Maintaining a running record of all expenses: utilities, payroll, employee benefits etc.
2. Take care of payroll tax
Small businesses sometimes collect payroll taxes for employees but forget or fail or remit these funds. This is a criminal offense, and owners will face harsh penalties if it happens—they can even go to jail.
In 2022, around 30% of federal tax collected was made up of payroll taxes. It is a legal requirement that every business puts these taxes in a trust fund to then pay the IRS at the arranged periods—monthly, quarterly, or every two weeks.
Some businesses use the trust fund balance as working capital, then pay it back before tax day, but this can increase risks of not being able to pay on time. If this happens, businesses may be liable for:
- Jail time of up to five years and a $250,000 penalty
- Twice the gross gain/loss from the tax offense
- Levies on all account receivables
- Court orders to seize the business’ bank account
3. Get worker classifications right
Worker classifications are vital to ensure accurate tax reporting. Determining the difference, for example, between employees and independent contractors is important for the IRS to apply workers’ compensation. This is why they set out the rules for defining an employee.
- Behavioral control: the business has the right to control the work carried out and how, including instructions, time, and place of work.
- Financial control: The business manages payment methods, reimbursable expenses, and provides tools for the job or invests in facilities used by the worker.
The IRS also requires written contracts outlining if benefits (i.e., vacation, health insurance) are provided, the length and permanency of employment, and the nature of the task the worker performs for the employer’s business.
Fixing misclassifications
If employers misclassify a freelancer, contractor, or other worker as an employee, they can correct this mistake through the Voluntary Classification Settlement Program (VCSP). This program provides certain tax relief measures as long as specific eligibility requirements are met:
- The business must have consistently treated its workers as independent contractors before applying
- The business cannot currently be under audit by the IRS regarding employment tax issues
- The business must agree prospectively to treat the workers in question as employees in future tax years
- The employer must pay 10% of any employment tax liability that would have been due for compensation paid to those workers for the most recent year
If approved, employers don’t have to pay any penalties or interest on their employment tax liabilities for the previous years. There won’t be any need for the IRS to carry out further worker classification audits.
4. Never overstate tax deductibles
Small business tax deductions can be incredibly useful. But owners must understand what is, and isn’t, a deductible. The IRS says that a business expense, if it is deductible, must be both ordinary and necessary. This means it is common and accepted (ordinary) in the industry, and helpful and appropriate (necessary) for the business.
It’s important to differentiate expenses from COGS (like storage, raw material costs and labor) and business expenses. Organizations should never artificially enhance deductions to heighten expenses. This can result in a $5000 fine if the IRS decides you filed a ‘frivolous’ tax return, alongside back taxes, interest and other penalties like paying 20% of the disallowed amount for the incorrect claim.
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Tax season is an important time for small business owners, but entrepreneurs are faced with challenges all year round. Find out how Setscale’s purchase order financing solutions can support your financial management, boosting operational efficiency, to help you start scaling your business.
