Top 3 Tax Mistakes for Small Business Owners
When you start your business, the last thing that is typically on your mind are the tax mistakes you could make. For most your skill, product, and business always come first – and that’s not a bad thing! However, that can lead to some small details – like taxes and the tax mistakes small businesses make fall to the wayside. While this may sound like a problem, I think it’s good for you to be laser focused on the things that make your business tick rather than little details when you start.
However, once your business starts to grow these little details can come back to haunt you.
Today, we’re going to talk about the Top 3 Tax Mistakes that I see Small Business Owners Make, the problems they cause, and how you can make them go away!
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The goal for this blog is to provide an easy to navigate path for you to fix some small business tax mistakes. Some of these details are difficult, while others are easy and only take a little bit of time to correct.
The Top 3 Tax Mistakes Small Business Make that I see are the following:
1. Not separating business & personal accounts
2. Messing up the home office deduction
3. Overspending simply to get a write-off
Small Business Tax Mistake #1: Keeping it Personal
A common way a business gets started is on the side. Picking up a few additional dollars or having a good idea can quickly turn into a full-fledged business before you know it. The first Small Business Tax Mistake is that your business and personal expenses can become commingled – with it becoming borderline impossible to tell what is a personal or business expense.
Why is this important?
Failing to separate your finances properly can result in either overstating or understating your taxes. While opposites, neither is an ideal way to start on your financial journey!
There are two main ways this Small Business Tax Mistake happens:
- You begin using your personal account for business purposes with your income and expenses all commingled in one account. This can lead to overstating your income because you may miss some business expenses in your accounting!
- You setup your business account but then fund personal expenses out of your business. If you fail to record them properly, this can have the opposite effect and lead to you taking deductions for personal expenses which aren’t allowable! This can lead to you understating your income with the possibility that you can be penalized if you are audited!
Neither of these outcomes are ideal. Luckily, they can be solved without any complex or difficult solutions.
Here’s how I would go about avoiding this Small Business Tax Mistake as a new business:
- Setup a separate business account/credit card
- Tie all business income & expenses exclusively to these accounts
- Do not spend personal expenses from your business accounts
- Utilize a bookkeeping software like QuickBooks to help track your expenses
By following those steps, you can save yourself quite the headache down the road. If you’re already living in a world where you've mixed your business and personal expenses, don’t worry too much!
Step 1 to solving this problem would be to start fresh moving forward with all of your accounts and expenses being properly tracked. Then, you can go back and verify all of your historical data to clean up the old tax issues. If that doesn’t sound like something you’d like to do, a bookkeeper can help you clean up your books and set you on your path forward – typically for a one time or monthly recurring fee.
While you would think this is a basic things to setup, it is by far the most common small business tax mistake that I see.
Small Business Tax Mistake #2: Messing Up Your Home Office Deduction
The second Small Business Tax Mistake that I see is the home office tax deduction. When tax time comes around, small business owners around the country are always searching for that magic deduction that can help them save money. Invariably, they ask themselves – how much of my house can I deduct? And that leads to Small Business Tax Mistake #2 – overstating your Home Office Tax Deduction.
Unfortunately, overstating the home office deduction is an all-too-common tax mistake for small business owners and one that can have sizable repercussions. The IRS states that, “taxpayers generally must exclusively and regularly use part of their home or a separate structure on their property as their primary place of business.”
Exclusive and regular use of the part of your home for a home office is a very clear, strict standard. Claiming areas that are shared with family use is an easy way to get yourself into trouble with this Small Business Tax Mistake. This is also an area that is commonly abused and as a result the IRS is aware of these issues. If you’re not regularly and exclusively using that space for business, do yourself a favor and save yourself the time and hassle of getting yourself into trouble with the IRS.
Another common way to overstate your deduction is to try and claim home improvements as business expenses. As you can imagine, these are typically non-business related so they are typically unallowable.
The second way that the home office deduction can turn into a Small Business Tax Mistake is through depreciation.
As every rental investor knows, depreciation is a tax expense that allows you take an expense for “wear and tear” on a property without having to spend money. However, this is only allowed in the context of business use and cannot be done with personal houses and property.
However, once you qualify for the home office deduction that percentage of the house is used in a business and can qualify for depreciation. While this does create a current year tax deduction it can have unintended consequences down the road.
That unintended Small Business Tax Mistake is how it affects Section 121 which allows you to exclude the gain on $250,000/$500,000 of gains if you are single or married filing joint. If you take depreciation against your home under your business, that depreciation is then recaptured at the time of sale. At that time, that amount is subject to 25% tax rates.
Depending on your financial circumstances, this could be a good or bad idea. However, you need to be aware of it before depreciating the house!
Small Business Tax Mistake #3: “It’s a Write-off”
The last Small Business Tax Mistake that I see is more behavioral than technical. By that I mean that this is something where business owners aren’t necessarily wrong. They understand the tax code perfectly; however, they are driven to make certain decisions based purely on taxes.
The final small business tax mistake that I see is buying something that you really don’t need purely to save money on taxes by classifying it as a business expense.
The reason that I think this can be a mistake is boiled down to one question –
Why are you trying to save money on taxes?
Is it to pay less in taxes or is it to put more money in your pocket and keep more or what you make?
I hope your answer is the second one – keep more of what you make. You would think this would be self-explanatory, but many times people miss out on putting more money in their pocket purely to pay less in taxes.
Have you ever said to yourself “Sure I can do that, it’s a write-off anyway” for something you really didn’t need?
This can be something as simple as TV, and oftentimes can be something as large as a car. You go hunting for those year-end deductions to save a few bucks and those expensive items start looking really reasonable.
Long-term these decisions can add up to make a substantial difference in your overall financial health.
Here’s an example that shows what would happen if someone had 3 options:
- Buying a truck
- Paying the taxes and investing the remainder
- Investing in a 401(k)
As you can see, investing your money even after you pay taxes is significantly better than buying depreciating assets with pre-tax money in this example.
This isn’t to say that you shouldn’t buy equipment, supplies, and vehicles that you need for work. Business must come first. However, if you don’t need them you should evaluate if it is the best long-term decision.
This Small Business Tax Mistake may seem like the most innocent of the 3, but it can add up to substantial amounts over time.
Summary
The Top 3 Tax Mistakes Small Business Owners make that I see most frequently all come from the fact that no one wants to make taxes part of their daily life. Business should and will always come first. However, these decisions can add up to substantial amounts over your lifetime and will continue to grow as your business grows larger.
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