A Tax-Preparation Checklist for the Self-Employed
Here are seven boxes to check.
Tax season can be a stressful time for most people, and for entrepreneurs, it can be twice the pressure of having to manage both personal and business taxes.
Making things worse is that the coronavirus pandemic has created major last-minute changes to the tax policies. However, there is a way for the self-employed--whether you are a sole proprietor or running a business with other employees--to maximize tax savings while minimizing stress. These seven strategies will help keep you on the ball for this tax season and in preparing for the future.
Although the IRS extended the U.S. tax deadline for federal taxes, if you make quarterly tax payments, your deadline to pay is still April 15 and the next one will still be July 15. Despite current events, the government wants to get back on a normal schedule. So, it is expecting estimated tax payments on time. You can check your state tax deadlines here.
The IRS requires you to make payments of 90% of your current year’s liability or 100% of the prior year’s tax liability. If you’ve just struck out on your own, in your first year of business you’re generally not required to make estimated tax payments because you don’t have an estimate of what your earnings will be.
One way to make staying ahead of the IRS payments easier is to set up a business savings account for your tax savings (I recommend different accounts for different aspects of your cash flow). Allocate 30% of all money earned to this account. This should be enough to have you in good shape for your taxes during the year.
Business owners can save for retirement by funding a Simplified Employee Pension Plan, a traditional Individual Retirement Account, or a Roth IRA. Unlike 401(k)s, these retirement accounts don’t need to be funded by Dec. 31 of the tax year. Any contributions for the previous tax year are due no later than the tax deadline. The federal U.S. tax deadline was April 15 but was recently extended by the IRS until May 17. This gives business owners much more time to review their financials and see exactly how much they can contribute.
For instance, with a SEP IRA you can contribute up to 25% of net income or $58,000 (whichever is less). So, a business owner would need a net income of $232,000 to max out the SEP IRA for 2021. With that said, we don’t want to start letting the tail wag the dog, which simply means that we don’t want to spend or invest money that we need for the normal operations of our business. Please be mindful of this before maxing out any retirement accounts.
Contributions to a SEP and traditional IRA lower your taxable income, whereas contributions to a Roth IRA are not tax-deductible because they are aftertax contributions. However, you can withdraw the money in a Roth IRA tax-free in retirement. Therefore, a Roth IRA will save you on taxes later.
If you employee other self-employed contractors, don’t forget to send them 1099 forms. A 1099 is an official record of the income you paid them for the previous tax year. In general, business owners must issue a 1099 form to anyone they’ve paid at least $600 in rent, services, or other income related to business expenses. The penalties for not filling out the form varies from $50 to $550 per return.
Last year, many small businesses took advantage of programs offered by the federal government to help boost the economy and support business owners impacted by COVID-19. Therefore, if you applied and received a Paycheck Protection Program loan, make sure your expenses were recorded properly.
PPP loans can be forgiven and become grants. Early this year, the Small Business Administration agreed to allow business owners to deduct expenses paid for with PPP funding. However, because this decision was made so late, many business owners may forget to add these expenses to their profit and loss statements, which could cause them to have a higher taxable income.
This very scenario came up with one of my clients. Last year, his original CPA incorrectly told him that he couldn’t deduct the $75,000 in PPP money that he used for payroll expenses. This means that his profit and loss statement was increased by $75,000. This was in the 35% tax bracket, so this mistake would have cost him $26,250 in federal taxes and excess self-employment taxes.
Also, remember to complete a PPP loan forgiveness application as soon as possible. If business owners do not complete the forgiveness application, this grant will turn into a loan. As a result, you will have to add it to your 2020 balance sheet. Fortunately for you, the SBA recently introduced a simplified forgiveness application that will allow one-click forgiveness for loans under $50,000.
And for beyond this tax season…
It’s important for you to know where your money is going. Recap last year’s fixed and variable business expenses and ask yourself two very important questions. First, “Do I still need this expense?” If the answer is yes, ask the next question, “Can I get this at a cheaper cost?” You’ll be surprised with how much money can be saved with this simple exercise.
I did this for my business this past January. I had subscriptions I barely used, multiple software that provided the same services, and contractors that I was able to negotiate a better price with. After all was said and done, I was able to cut over $2,000 in monthly expenses, which translates to over $24,000 in yearly income.
The best tax planning is not done during crunch time. All too often, by the time you’re filing your taxes, it’s too late to reverse mistakes.
Midyear reviews give you time to pivot how you are spending money and help you identify more deductions you can take and save. For instance, I had a young couple come to me last summer who owned a very successful digital marketing business. They were on course to earn over $400,000 in net income for the year. The problem was that they were still operating as an LLC, which caused them to pay more self-employment tax than needed, so we converted the LLC to an S-Corporation. This saved them just under $15,000 in self-employment taxes alone. A good strategy is to meet with your CPA midyear and again during the last quarter of the year.
The views expressed in this article do not necessarily reflect the views of Morningstar.