Small Business Tax Planning

LeBron James paid 35.9% in taxes, while the owner of the Clippers, Steve Ballmer, paid 12%.

I lead with this in bold to make the point that understanding business tax concepts can save or make you a lot of money, as it has done for Steve.

In this article, we'll walk through the major points for founders to prepare for when it comes to small business taxes.

How to Plan for Small Business Taxes

When you become a solopreneur, you may brand yourself as a freelancer, creator, independent consultant, advisor - whatever you see fit. None of this matters to the IRS. What the IRS does care about is the type of federal tax classification you elect and your business’ legal entity.

Most people who decide to go solo suddenly lose the safety net of the “employee” classification, especially when it comes to legal, taxes, and finance. The tax code changes all too often and the legal space is much too complex, that attempts to become experts in these fields are futile.

‍Lesson #1: Do your homework when it comes to taxes

Know the essentials when it comes to taxes and plan ahead. Entrepreneurs should learn enough about taxes and the appropriate business legal structures to do a handful of things:

• Avoid getting into trouble with the IRS
• Administer your business on a day-to-day basis without significant outside help
• Invest appropriately to set-up the administration of your business at a reasonable cost
• Know when to consult for professional help on taxes and legal matters
• Vet external advisors in the domains of taxes and law before hiring them

If this feels daunting, then you’re not alone. This is what we felt as well. We spent countless hours in the troughs figuring this out ourselves, piecing fragments of information together. Even now, a decade into the domain of finance and business administration, a perfect answer for every situation remains elusive to us. Our answers are still dependent on various factors and situations. The difference now is that we have gained a clearer understanding of what we believe entrepreneurs starting out should consider. Below is a general outline that we’ve found helpful.

‍Lesson #2: Take an honest look at your business

This probably sounds silly, but most people actually don’t understand what their business circumstance is.

Periodically reassess. Determining your circumstances is about knowing how to run your business and realistically what your business can achieve.

Business Self-Assessment Questionnaire

Ask yourself the following questions:

• Is your gig short-term (≤1 year) or long-term (2+ year)?
• How much of a customer pipeline do you have? 3 months? 6 months? 1 year?
• Are you considering going back to Full-time Employment?
• What is your estimated annual revenue? <$50K? up to $100K? above $100K?
• What is your estimated operating expenses?
• Will you move? Different state? country?
• Will you operate in one state or multiple?
• Do you have the funds to get started?

Scenario #1: Short-term trial. Moving on in a year. Less than $50K in revenue.

Generally speaking, if you’re not sure how long you’ll remain an entrepreneur or if you’re just testing the waters, start with the simplest set-up.

• Operate as an individual / sole proprietor and file your freelancing income directly on your individual Form 1040.
• Record all relevant information related to your business including banking transactions, invoice payments, and business expense receipts. This information will be utilized to file a Schedule C along with Form 1040 come tax season.
• Set aside withholdings for taxes as you receive payment for your work.

Scenario #2: Steady business from long-term clients. Operating in one state only. More than $50K in annual profit.

You’re business is steady, and you’re making good money. You have no intention of bringing anyone on to partner, and you enjoy working solo with contractors from time to time. It may be a good idea to set-up a single member LLC for 1) asset protection, 2) tax reasons, or 3) anonymity.

From there, working with a Tax CPA to advise and strategize on tax and retirement planning can lead to extensive savings for you and your business.

‍Lesson #3: KISS - Keep It Simple Stupid

When it comes to your legal structure and tax classification, keep it simple for as long as possible. The potential savings from a more complex structure may not be worth the administrative time and cost to set up and maintain on an ongoing basis.

With a more complicated legal and tax structure such as an S-Corp, C-Corp, or LLC elected to be treated as an S-Corp or C-Corp, you’ll likely be relying on external counsel for both your tax and legal matters. These costs can add up quickly, and can be a headache to manage. Even with external help, you will still need to be at minimum conversant in these topics if not fluent to ensure the appropriate set-up. Administration then becomes an increasing part of your business.

Time spent on administration, is time not making money.

Lesson #4: Know your options

From business structure to day to day bookkeeping, the options available to business owners are just as plentiful as they are confusing. The immense flexibility and options available is intended to provide self-employed individuals the best chance for success, but most of the time, the options create confusion.

Knowing your options encompasses...

• The optimal legal business structure >> To minimize liability and maximize asset protection
• The appropriate federal tax classification and retirement planning set-up >> To minimize tax obligations and maximize savings

...without creating convoluted administrative overhead.

Types of Legal Business Structures

Understanding how your business income gets taxed, starts with understanding what business structure you have in place. Each business structure determines what options are available for tax election. At the most basic level, the options for business entity are:

• Sole Proprietorship is when an individual operates as a business without incorporating. Individuals operating as a sole proprietorship may choose to have a different name for its business commonly referred to as a DBA (ie Doing Business As).
• Limited Liability Company (LLC), per its name is a company that limits the risk exposure of the owner by separating the business as a separate legal entity from its owners. This is designed to limit the risk of any business obligation or liability from being passed through to the owner, thereby protecting the owner’s other ventures or personal assets.
• Partnership, along with Limited Partnership (LP) and Limited Liability Partnership (LLP), are common among small business owners. There can be restrictions on which professions can and/or have to be set up as partnerships as outlined by the IRS.
• Corporation needs no explanation. Corporations are the most commonly heard of entity type when people think of businesses. They are not common business structure for small business owners unless the business plans to raise significant amount of external funding through issuing equity.

Federal Tax Classification

Once you’ve determined your business structure, then you can decide how you would like your business structure to be treated for purposes of taxes.

• Pass-Through to Individual means that your business entity is disregarded for tax purposes and allowing business owners to file their business income tax on their personal income tax return. Filings due by April 15th for prior tax year.
• S-Corp, legal jargon aside, is a tax election that is a hybrid between a sole proprietorship and corporation allowing small business owners to access the tax benefits of a corporation while keeping the set-up and administration much simpler. Filings due by March 15th for prior tax year.
• C-Corp is the typical business corporation. Small business owners may elect to be taxed as a C-Corp if they so choose. We haven’t run into this often, but there may be additional tax savings by choosing to be taxed as a full C-Corp. Filings due by April 15th for prior tax year.
• Partnerships is a misnomer in a lot of ways as a federal tax classification. In effect, entities elected to be taxed as “Partnership” are actually also “Pass-through”. Each member of the partnership receives a Schedule K outlining each partners’ portion of the business to then file on their respective personal returns. Filings due by March 15th for prior tax year.

Interestingly enough, there’s no Federal Tax Classification called “Limited Liability Company”. In many ways the LLC is meant solely for legal and business reasons. The LLC can then elect its tax classification options with the IRS.

For more information, the government has excellent definitions on the different terms as well as not as good instructions on how they are taxed:

• The SBA on business structures and tax classifications
• The IRS on small businesses and self-employment

Retirement Planning

Lastly, but most often overlooked, is your business’ retirement planning set-up. One of the main reasons this step is often skipped in most initial advice on starting up is because most businesses don’t last long enough or ever make enough for founders to consider retirement planning.

18% of small businesses fail within the first year. 65% fail by their tenth year³

Effective retirement planning at the outset might actually help businesses preserve capital so that failed businesses owners can start again or plan for retirement. This relies on small business owners effectively stashing away their profits for retirement to cut down on taxes, preserving the profits. This method can also be idiotic because it stunts revenue growth and redirects capital for your business elsewhere.

Small business owners have multiple options for retirement plans just like for everything else. We list here the ones available with E*trade, Fidelity, and Charles Schwab as of the time of this writing.

• Solo 401K is similar to a regular employer’s 401K and is readily available with most large brokerage platforms. The annual contribution limit is the same as employee’s 401K limit. For 2024, it’s $23,000. Typically there are multiple 401K options available for small businesses such as the traditional, Roth, and some times a 401K account specifically structured by the brokerage firm such as Fidelity 401k.
• SEP IRA, short for Simplified Employee Pension Individual Retirement Account, is another attractive option which allows for small businesses to contribute for retirement for owners and employees. The SEP IRA limit is more complicated to calculate with a number of restrictions imposed, but contributions can be significantly higher.
• SIMPLE IRA, short for Savings Incentive Match Plans for Employees, is a set-up that allows for employer and employee contributions. This plan is targeted towards smaller businesses because of it’s simpler administration setup and costs. The biggest drawback is the lower contribution limits on an annual basis.

Consult with a tax advisor and/or a financial advisor on your personal situation to assess the best retirement option for your business. For a full list of options, refer to the IRS’s Retirement for Small Business article.

Lesson #5: Measure twice, cut once

Plan Ahead to Get Ahead

This is a common adage when it comes to building. Similarly, business owners should research and plan thoroughly before acting. As start-up veterans, we usually espouse to “Move Fast, Break Things”. However, in the domains of legal, tax, and finance, we do not play fast and loose. These domains are designed for those who spend more time thinking and less time doing. Do-overs in these domains are cumbersome, expensive, and time-consuming. Avoiding these issues at the start allows you to focus on building your business.

Recap for those who scroll and skim articles for soundbites. When it comes to setting up your business for optimal legal and tax planning, remember:

• Lesson #1: Do your homework
• Lesson #2: Take an honest look at your business
• Lesson #3: KISS
• Lesson #4: Know your options
• Lesson #5: Measure twice, cut once

Happy Hustling!

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Citations:

_{[1] https://www.sba.gov/business-guide/launch-your-business/choose-business-structure#id-review-common-business-structures}

_{[2] https://www.irs.gov/businesses/small-businesses-self-employed}

_{[3] https://www.chamberofcommerce.org/small-business-statistics/}

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