Tax Deductions For Business Owners and the Self-Employed

Starting a new business on your own can be both intimidating and rewarding at the same time. Hopefully with a solid business plan and proper guidance those stepping-out on their own will be successful — and as any experienced business owner or investor knows, it’s not just what you earn, but how much you can keep after tax. To make this process a little easier, here are some basic tax considerations a new business owner should take into account.

S-CORP ELECTION

Pay yourself a “fair” salary

If you are the owner of a successful business that elects to be taxed as an S-Corp, there are significant advantages once you reach a certain threshold of income. Let’s say that your business has a net profit of $100K for the year — the IRS would allow a portion of those earnings (let’s say $40K) to be exempt from self-employment taxes (15.3% federally). Keep in mind, however, that you still have to pay income tax on the income that flows through to your personal return.

COMMERCIAL + RESIDENTIAL RENTAL PROPERTIES

Take advantage of depreciation

The idea of investing in a rental property is nothing new. Real estate has historically retained its value well over the years with the exception of a few areas in the wake of the mid-2000’s housing crisis. The tax is relatively low on your rental income — as a passive investment, the profits are not subject to self-employment taxes. Furthermore, rental property owners are allowed to deduct a non-cash expense called depreciation. Residential buildings are depreciated over 27.5 years and commercial buildings over 39 years — so the former category gets a higher deduction for the depreciation. Notwithstanding all the tax benefits of owning a rental property, it should also be mentioned that the IRS basically forces you to take the depreciation expense because if you sell your building at some point down the line, they decrease your cost basis by whatever depreciation you have claimed at that point. This concept of “depreciation recapture” can be avoided by doing what is called a 1031 exchange and can get a bit complicated.

Under Section 1031 of the code, a taxpayer can defer the realization of capital gains and associated federal income tax liability on the exchange of certain types of property. This means that you can save yourself from paying capital gains tax on your asset value gain if you buy another property. From the time you close on your sold item, you have 45 days to find an applicable property, and then another 135 days to acquire the replacement property.

TAX DEDUCTIONS ON YOUR PERSONAL RETURN

Invest in your state’s AMT-free municipal bonds

While interest rates are still quite low by historical standards, these investments may make sense for high earning individuals. The interest income (but not capital gains) you generate from the bonds are exempt from taxation. Calculate your tax equivalent yield to determine whether investing in your state’s AMT-free municipal bonds make sense.

SEP IRA

At the time of this writing, the IRS is allowing people that are self-employed to save up to $56K per year for retirement. You can then deduct your contributions from your taxable income, thereby deferring the taxation.

INVESTING FOR THE HEALTH OF IT

For those interested in becoming self-insured, the tax code offers a nice incentive. In combination with a High Deductible Health Plan (HDHP), individuals are able funds that are not taxable if the proceeds are used for qualified medical expenses. These HDHP contributions are deducted from your taxable income on your return.

For those who are self-employed, but need money to be more readily available — there’s a way. The IRS allows business owners to deduct their health insurance premiums as an adjustment to income.

KEEP UP WITH ESTIMATED TAXES

A major misstep many new business owners make when starting out is failing to plan well for their end-of-year tax bill. This is especially a problem for individuals leaving work as an employee where their income tax was withheld by their employer.

In order to avoid making this mistake a small business should pay estimated taxes to the IRS if it expects to owe taxes of $1,000 or more for the year ($500 if you operate as a corporation). Not only will paying estimated taxes help you avoid IRS penalties, they will prevent (at least some of) the sticker-shock when you file your tax return.