Here are a few ideas for small business owners to reduce their tax liabilities.

Maintain Complete Records

Given the economic downturn, business owners will seek every deduction, tax credit and income reduction they can legally take on their tax returns. Therefore, it will be important for businesses to have complete records of all their business expenses, revenues, deductions, credits and other claims, just in case there is an IRS audit. In addition, complete and accurate records will make preparing the tax return much easier.

Business owners must ensure that all receipts, credit card statements, bank statements, cancelled checks and other related documents are kept with accounting records that accurately record every transaction. In particular, “listed assets,” items that can be employed for both business and personal uses (i.e. cell phones, cars, computers, stereos and televisions), have special record-keeping requirements. These records are mainly to document the legitimate business usage for these dual-use assets, such as a mileage record for a car.

File 1099 Forms

Employers must send 1099 forms to any independent contractor to whom they paid $600 or more during the tax year. If filing these forms creates an undue burden on the firm’s accountant(s), they can use tax preparation software, online tax preparation services, their CPAs or professional tax preparers to complete and distribute the 1099 forms.

Depreciate Every Asset

To shelter the most income legally possible, identify, tag and depreciate every asset possible, from light fixtures to laptops to company-owned vehicles. Every asset type has its own depreciation rate, so the depreciation must be properly calculated.

Note: Under Section 179 of the Tax Code, up to $100,000 of certain assets can be depreciated in their first year of usage, instead of depreciating them over a longer time frame. However, Section 179 depreciation cannot exceed the firm’s taxable income, so firms’ must weight all their options.

Capital Expenditure Deduction

The recent economic stimulus package allows businesses to deduct up to 100% of their capital expenditures to a maximum of $250,000 (the previous limit was $125,000). Therefore, it might make sense for firms to make capital purchases in the current tax year that had originally been planned for a later time frame.

Write-Off Inventory

Depending on a firm’s accounting treatments, damaged and obsolete products should be revalued to determine if any portion or even the full value of the items can be written off. Any reduction in the value of the inventory can be taken as deductions to the firm’s gross income, providing tax benefit that does require actual cash expenditure.

Pay Dividends Now

Firms anticipating higher Dividend Tax Rates in the future could pay dividends this year at the current 15% rate. There are certain distinctions between the handling of dividend payments depending on whether the firm is a “C” or “Subchapter S” Corporation, so a business owner’s CPA, professional tax preparer or business advisor should be consulted before deciding on dividend pay-outs.

Avoid Paying In-State Sales Taxes on Out-Of-State Sales

Provided a firms sells products only, without after-sales service or support, they do not have to pay in-state sales taxes on their out-of-state sales under Public Law 86-272. However, this exception is not valid in all states, so business owners must consult with their CPAs, professional tax preparers or business advisors to determine if they can avoid paying the in-state sales taxes on their out-of-state sales.

Defer Receipts & Accelerate Expenses

Any receipts received in January next year instead of December this year reduces a firm’s current tax bill and defers the taxes owed on them until April of the next year. Provided the firm’s cash flow can handle it, accelerate payment of any future expenses to this year, particularly if the product or service is needed for the first quarter of the next year. Expenses that can be paid in advance or accelerated include office supplies, cell phone services, rents, insurance premiums, utility bills, subscriptions, maintenance contracts, travel bookings, and equipment purchases and repairs.

By deferring income and making advance payments, this year’s income will be reduced, thus reducing the current tax liability and deferring the liability to the following tax year. Any strategy to defer receipts or accelerate costs will depend on the firm’s profitability for the tax year, the legal structure (i.e. sole proprietorships, partnerships, LLCs, S-Corporations and C-Corporations), and other considerations.

Business Loans

Principal and interest paid on business-related loans are classified as business expenses, therefore these payments reduce a firm’s taxable income. Accurate records must be maintained to justify the expense, including the total amount of the loan, plus the amortization of principal and interest. Furthermore, the assets or expenditures the loan financed must be necessary to operating the business.

Charitable Deductions

Charitable deductions can be made in cash or in kind, such as donating used office equipment, thus reducing the firm’s tax liability. Note: A fully depreciated asset provides no deduction.

Donations are only deductible if made to qualified charities, so the firm must check that the charity is qualified under IRS rules (See IRS Publication 78 for a list of qualified organizations or search online at the IRS home page). Also, any donation of $250 or more require proper receipts and an acknowledgement from the recipient charity.

The value of time or services spent volunteering cannot be deducted nor can any part of a donation that benefits the donating entity. Only the amount of the donation that exceeds the value of any gift or service received in return can be deducted.

Tax Credits

Tax credits directly offset a firm’s tax liability, while excess credits can be carried forward for several years. A partial list of possible tax credits include: Employer Social Security Credit; Disabled Access Credit; Investment Credit; Work Opportunity Credit; Research Credit; and Alcohols Fuel Credit. There are other tax credits available for low-income housing and “green” projects, such as using renewable energy (See “Green Incentives” below).

Establish a Non-qualified Retirement Plan

Unlike a 401(k) plans or some IRAs, Non-Qualified Retirement Plans allow unlimited contributions and are very simple to administer. In addition, Non-Qualified Plans can be established for selected employees and do not have to be for all employees. As such, they can be an effective retention tool for highly valued employees and can also be performance based.

Create a Simplified Employee Pension IRA

A Simplified Employee Pension (SEP) IRA receive beneficial tax treatment for employers and employees.

For employers, SEP contributions are not subject to federal income tax withholding, Social Security, Medicare or federal unemployment taxes. Though similar to a 401(k) Plan, businesses can claim a credit for a portion of the costs to establish their SEP.

For employees, SEP contributions are deducted from pre-tax earnings, lowering their taxable income and so, their tax liability. SEP contributions are limited to 25% of an employee’s compensation up to a maximum of $46,000.

Set-Up an Employee Stock Ownership Plan (ESOP)

An Employee Stock Ownership Plan (ESOP) provide small business owners a way to have employees share the risks and rewards of ownership, while selling some of their shares. ESOPs function similarly to 401(k) Plans with a stock investment option, except that the shares purchased are in the member’s employer. An added benefit is that both the interest and principal of loans used to buy shares for the ESOP are tax deductible, and ESOPs do not pay federal income tax.

Also, if the firm is a “C-Corporation” and 30% or more of the stock is sold to the ESOP, the capital gains taxes can be reduced or even eliminated. To do so, the proceeds of the stock sale must be reinvested in stocks, bonds or other securities issued by US companies, but government bonds and mutual funds do not qualify for the special tax treatment. Note: Owners of S-Corporation stock that is sold to an ESOP is not eligible for the ESOP rollover tax benefit.

Further, if a C-corporation pays cash dividends to ESOP participants and the participants reinvests the dividends to acquire additional shares for their account, the corporation can take a tax deduction for the value of the dividends paid. A tax deduction can also be taken on dividends paid on ESOP leveraged stock provided the dividends paid the interest or principal on the ESOP loan used to buy the stock. Dividends used to repay loan interest or principal do not counted against the 25% contribution limit for leveraged ESOPs. There are certain tax benefits for S-Corporations establishing ESOPs.

Employees do not pay income tax on the stock in the ESOP until they take distributions, though there are penalties for distributions taken before the employee reaches 59.5 years of age. However, the employee can roll over the full value of the ESOP account into an IRA or other qualified retirement plan tax free.

Green Incentives

In the current environment, both state and federal governments are offering a wide range of tax incentives to small businesses for “green” (i.e. environmentally-friendly) activities and investments. These include utilizing renewable energy sources (i.e. solar, wind, hydro, others) and purchasing energy efficient appliances and equipment. Some states allow the “green” tax credits to offset both business and personal tax liabilities. Additional information is available from the “Database for State Incentives for Renewables and Efficiency.”

Use Independent Contractors

Firms are not required to withhold federal or state income taxes, pay the employer’s share of Social Security and Medicare taxes or provide unemployment benefits to independent contractors. However, the relationship between the firm and contractor must not be construed as an employee-employer relationship or there will be back taxes and penalties assessed by the IRS.

Hiring Business Owner’s Relatives

When a business owner hires their children, they may not have to withhold income or Social Security taxes. In addition, children on the firm’s payroll presumably pay a lower tax rate than the earnings of the business owner, thus sheltering some of the family’s overall earnings. Further, the children can contribute to a Roth IRA, reducing their tax liabilities on investment earnings, while saving for retirement. Note: Naturally, the owner’s child must be of legal working age, receive a reasonable wage and perform work tasks that benefit the company or the exemptions will be disallowed. If a business owner hires their spouse or parents, they do not have to pay federal unemployment taxes on their wages.

Avoid Double Taxation on a Residence

Intra-state commuters, such as those working in New York, but living in New Jersey or Connecticut, could be taxed by both states, if they own a residence in both. There are several ways to avoid this double taxation:

- Prove that less than 183 days per year was spent at the New York residence

- Rent, rather than own, the New York residence

- Rent our the New York residence for at least 1 month per year to avoid being classified as a “statutory” New York resident

Similar double taxation jeopardy could confront those living in Rhode Island or new Hampshire, but working in Massachusetts, as well as with other intra-state commuting situations. Business owners should consult with their CPAs, professional tax preparers or business advisors to determine if their intra-state commute could subject them to double taxation.

Business Abandonment

In extreme circumstances, a business owner might be better off abandoning their business, rather than simply liquidating it. To obtain the maximum tax benefit, the business must generate an “ordinary” loss, not a “capital” loss. Ordinary losses are not limited and can offset any other type of personal income. In contrast, capital losses can only be applied against certain income types, to specific limits, then carried forward to future years.

These methods for minimizing a small business’ tax liabilities require professional assessment to ensure compliance with IRS regulations. Therefore, business owners should consult with their CPAs, professional tax preparers or business advisors to determine which of these methods will work for their enterprise.

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