6 Last Minute Tax Strategies Small Business Owners Can Use Before April 15
If you’re a small business owner, April 15th has a wholly different connotation than it does for most of America. While most working Americans, who are standard W2 employees, are excitedly anticipating the receipt of a big refund check, small business owners dread the annual scramble to gather their K1s, compile deductions, pay their CPA, all to be told that they need to write a big check to the IRS on April 15th.
In sum, April 15th is one of the worst days of the year to be a small business owner. And while this article can’t eliminate all that stress, using the 6 strategies outlined here can at least make the check you owe the tax man a little smaller and the day a little easier. In this article we highlight six last minute tax deductions, credits and planning steps you can take to minimize your 2016 tax bill, even if you didn’t do a thing to prepare earlier this year.
1. 529 College Savings Plans
If you have kids and you’re a small business owner, the number “529” should be a part of your financial vocabulary. In case it isn’t, here’s a quick refresher: A 529 plan is a type of tax-advantaged investment that is designed to encourage savings for future college education expenses.
In plain English, you can contribute up to $14,000 if filing single (or $70,000 over five years) or $28,000 if filing married jointly (or $140,000 over a five-year period) into a 529 plan. If your state has a state income tax, you can likely deduct all or part of your contribution on your state income taxes. And on the federal income tax side, the big benefit of a 529 plan is that while you don’t get an income tax deduction in the year of the contribution, the investment grows tax free, and as long as it’s used for higher education, there is never any income tax on the growth of the money.
Check your state’s 529 deduction rules, but given that you can do a massive lump sum contribution of up to $140,000 without incurring federal gift taxes, and potentially get a state income tax deduction up to your full contribution, this can be a powerful last minute tool to significantly reduce your 2016 tax bill.
Over 30 states offer a state tax deduction or credit for 529 contributions. The majority of these require that the contribution be made before December 31, however, if you live in Arizona, Kansas, Missouri, Montana or Pennsylvania you can claim a state income tax deduction for contributions to any state’s 529 plan for any contributions made before April 15th.
2. IRA Contributions
Perhaps the biggest tax perk to being a small business owner is the ability to contribute to an IRA or Individual Retirement Account. And, if you earned less than $117,000 (single) or $184,000 (married filing jointly) then you can and should max out your IRA deduction by contributing $5,500 prior to April 15th. With the applicable tax deductions, it’s literally the smartest financial decision you can make every year.
Just to review, the big benefit of an IRA is that it’s tax deductible in the year of the deduction (traditional IRA), or alternatively you can pay tax in the current year and have the money get withdrawn tax free (Roth IRA). No matter which type of IRA you decide makes more sense for you, this is about the easiest and most no-brainer thing a small business owner can do in order to lower their tax bill and better prepare for their retirement.
Technically, you need to make your contribution by April 17th, 2017, but it needs to be postmarked by April 15th, so let’s just call it April 15th. But contributing to an IRA can all be accomplished on the same day, so you’ve still got time.
3. Backdoor Roth IRAs
While an IRA might be the best perk available to small business owners, it isn’t available to everyone. Unfortunately, if as a married couple, your taxable income exceeds $194,000 per year, you’re no longer eligible for the tax benefits that make contributing to an IRA worthwhile. But, all is not lost, as there exists a legal loophole called the “Backdoor Roth IRA”.
To put it simply, if you earn too much money, you no longer qualify for the tax deduction on an IRA contribution by investing into an IRA directly. If, however, you contribute to a Roth IRA by converting it from a traditional IRA there is no income cap, so you still get the income tax benefit.
Practically speaking, a Backdoor Roth IRA just means that you make a nondeductible contribution into a Traditional IRA before April 15th, and almost immediately convert the contribution into a Roth IRA. Your investment account manager will handle all of this for you, typically for free. And because the Roth IRA was funded via a Traditional IRA instead of directly, the federal income tax deduction cap doesn’t apply, and thus you get the tax benefits of a Roth IRA contribution.
Beware, however, if you have existing Traditional IRA, SEP or SIMPLE IRA, you won’t be able to take full advantage of this loophole without first either converting those pre-existing IRAs, or more practically, moving those funds into a Self Employed 401(k) Plan (which your investment account manager can walk you through, again, typically for free).
The benefits of a Backdoor Roth IRA are equivalent to a Roth IRA. Essentially you pay tax on the $5,500 in income this year (so no 2016 tax savings), but the money grows and gets withdrawn tax free in the future, which is a potentially massive savings. And given that your income level precludes you from participating in so many other tax-advantaged vehicles, a Backdoor Roth IRA is particularly worthwhile for high income small business owners.
To complete a Backdoor Roth IRA You need to make a contribution into a Traditional IRA by April 15th. This can be accomplished in a single day, so you have time. If, however, you have pre-existing Traditional, SEP or SIMPLE IRAs and need to first convert them into a Self Employed 401(k) first, that can take a little bit longer, so you’re pushing your luck for 2016 tax savings.
4. Itemized Deductions
According to the most recent IRS data (2013 tax year) only 30.1% of US households chose to itemize their tax deductions. Just to recap, the federal government offers you the ability to deduct a number of expenses against your income before calculating your income tax. But to do that, you need to keep track and document those deductible expenses and list them all on your tax return. Or, alternatively, you can forego tracking expenses and just take the standard deduction ($6,300 single, $12,600 married filing jointly, $9,300 head of household – 2016).
The decision of whether to itemize your deductions or take the standard deduction comes down to how many individual deductions you have. For a quick check, if you’re not a homeowner (and therefore don’t pay mortgage interest or property taxes), you don’t make very significant annual charitable contributions, you don’t contribute to a 401(k) or IRA, or have significant medical expenses, education expenses, or student loans, then the analysis is simple, don’t bother tracking deductions and take the standard deduction.
If, however, some of the above does apply to you, make sure that you compile a FULL list of all deductible expenses and send them to your CPA. Some of the big individual deduction categories include:
- Cash and Non-Cash Charitable Donations (think Goodwill),
- Mortgage and student loan interest payments,
- Medical and dental expenses,
- State sales taxes (e.g. if you purchased a new car, boat, or other big ticket item),
- State income taxes
- Home office deduction
- Education and training expenses for your job
- Childcare expenses
- Health Savings Account (HSA) contributions
- Tax preparation costs
Tax deductions are so common that people often forget that they are in fact a tax benefit. But they are potentially the biggest one. When you claim a tax deduction it reduces the amount of your taxable income. For example, if you made $100,000 in income, but had $20,000 in tax deductions, you’d only be taxed as though you made $80,000. For itemizing tax deductions to be worthwhile for you, your family’s total taxable deductions would need to exceed the standard deduction ($6,300 single, $12,600 married filing jointly, $9,300 head of household – 2016).
This is obvious, but the deadline to claim taxable deductions is on your federal tax filing date. So, without an extension that means you have up until April 15th 2017 to compile all of your 2016 deductions. If you file an extension you have until October 17th, 2017.
5. Tax Credits
Tax deductions are great. Tax credits are literally 3-4x better. So even if you’re not going to invest the time to itemize your tax deductions, you owe it to your wallet to check if you qualify for any income tax credits.
Unfortunately, there aren’t a lot of tax credits available, and most of those that do exist don’t typically apply to small business owners as they’re targeted to low income individuals and the elderly. But given their significance it’s worth the time to check. Some of the big common tax credits include:
- Earned Income Tax Credit (EITC) – For low income working families.
- Child Tax Credit – For parents of kids under 17. Up to $1,000 per child.
- Child and Dependent Credit – For parents of kids under 13. Up to $6,000.
- American Opportunity Tax Credit – For students or parents paying college tuition. Up to $2,500.
- Lifetime Learning Credit – For students or parents paying college tuition. Up to $2,000.
- Saver’s Credit – For low income workers that contribute to their retirement. Up to $1,000 ($2,000 for couples)
- Foreign Tax Credit – For Americans living, working or with investments abroad.
- Elderly or Disabled Tax Credits – For low income seniors or disabled individuals.
- Adoption Tax Credit – To offset adoption expenses. Up to $13,460.
- Residential Energy Efficient Tax Credit – Offsets 30% of property expenses used for qualifying energy efficiency upgrades.
- Plug-In Electric Motor Vehicle Tax Credit – For new vehicles purchased in 2016. Up to $7,500.
- Prior Year Minimum Tax Credit – For AMT payments in the prior year, if AMT is not applied in the current year.
Tax credits sound sort of like tax deductions, but comparing the two is like comparing apples and oranges. A tax deduction just lets you use the deduction to lower your taxable income (so in effect a $1,000 tax deduction gets you between $250 and $350 off of your tax bill). By contrast, a tax credit is a dollar for dollar reduction of your income tax liability. Thus, a $1,000 tax credit saves you a full $1,000 on your bill for 2016 taxes.
Qualifying tax credits must be claimed on your 2016 tax return. That means your deadline is April 15th 2017, or if you’ve filed an extension then you have until October 17th 2017.
6. Timely 2016 Estimated Tax Payments
Most small business owners file a tax extension (Form 4868 – Automatic Extension of Time to File Form 1040) almost every year as a matter of course. In many cases, that’s because without all of the K1s you need to file your personal return, filing your personal taxes by April 15th is literally impossible for most small business owners.
Unfortunately, many people wrongly assume that filing an extension extends your obligation to pay 2016 taxes to the IRS as well. It doesn’t. Even if you file an extension you need to make an estimated tax payment for your full 2016 tax obligation by April 15th.
The IRS charges interest and penalties. And that interest starts accruing immediately after April 15th. So while it may not feel like you’re saving money when writing a big tax check, it’ll feel a whole lot worse in a few months when you’re writing the same check plus interest and penalties.
Your check needs to be postmarked by April 15th, 2017.