6 Tax Questions Every Entrepreneur Should Ask Themselves

My brother William introduced me to this important quote: "If people aren't thinking about what you're talking about, then talk about what they're thinking about!"

Business owners (at least in the US) are thinking about taxes, so today that's what I'm writing about.

To begin, let's review this "New Simplified Tax Form" I scraped from cybersalt.org :

Maybe you're thinking, Yep, that's exactly how it feels. I just wish the forms were that simple since that's what I end up paying anyway!

I get it. For most people, taxes and tax discussions are about as enjoyable as cooked spinach, calculus and family strife.

Despite the negative feelings, tax time doesn't have to be that bad. If you get the right puzzle pieces in place, tax time can be more like Friday night pizza and less like cooked spinach.

Here are six strategic questions to guide you and your company in the right direction.

1. Do we have the right tax CPA?

I've seen the following story played out many times:

John and Mary know a friendly CPA who does their personal taxes. John and Mary start a business. Since the company is small, their CPA does the taxes for the new business.

The business expands into a $2M, $5M, and then $10M company. The company becomes an S Corp. The original tax CPA is still handling the company's tax work. Unfortunately, he is in over his head and no one really knows it.

I'd say 50-80% of companies in the $5M-$10M range have outgrown their tax CPA. Sometimes they've simply outgrown a specific partner at their CPA firm, but most often they've outgrown the entire firm.

Does that mean you should immediately fire your tax CPA and rush over to big hitters like PwC , Baker Tilly or BDO ? Not at all. If you were a large-mouth bass in the fish bowl at your old CPA firm, now you'd be a minnow in the ocean.

Instead find a quality, mid-sized CPA firm with a good reputation. They don't have to be local, but that is a bonus. Schedule short strategy meetings with a couple firms this summer and see how it goes.

2. Do we have the right tax entity type?

Me: Do you know the tax entity type of your business?

Business Owner: We're an LLC.

Me: No, you're not. The IRS doesn't even recognize LLCs as tax entities.

This common conversation highlights the painful fact many entrepreneurs barely understand how their company is structured for tax purposes.

In the US, virtually all for-profit companies fall into one of four tax entity types:

1. Sole proprietorship
2. Partnership
3. S Corporation
4. C Corporation

If your company is structured as an LLC for legal purposes, it still must be taxed as one of the four types above.

You should loosely understand these options and which is best for your company. Getting that understanding might require going back to Point 1. If you want to teach yourself, here's a deep dive I wrote on the topic.

In short though, I'd say the majority of mid-sized private companies are taxed as S Corporations. Partnerships can be valid as well, particularly in certain income ranges and certain blends of active/passive owners. C Corporations can also be valid, particularly for growth-minded startups or companies with foreign investors.

I will make one practical side point: If your business has achieved any scale and is still structured as a sole proprietorship, I recommend moving it to the formal entity status that comes with the other three options.

There are two reasons for this recommendation:

1. The tax info for a sole proprietorship is filed on the owner's personal tax return. If some outside party (such as a bank) needs to see your company's tax filings, you either need to give them your whole personal tax return or pick out disparate pages to send. The other entities have stand-alone tax returns.
2. The formal structure of a partnership or corporation generally has a positive impact on bookkeeping and financial clarity. It's a little easier to keep business and personal operations separate.

I speak from experience. A couple years ago I switched my own firm from a sole proprietorship to an S Corporation. I wish I'd done it years ago for the reasons mentioned above.

That's a small example of why entity type matters. Before making a switch though, make sure you understand the ramifications and definitely consult your tax CPA!

3. Do we have the right fiscal year end?

This is an obscure point, but a valid one in some cases. Again, this question may take you back to Point 1. It also takes you back to Point 2, since entity type can impact fiscal year end options.

Let's say your company has a distinct business cycle that starts fresh each spring and winds down in the winter. In your mind March 31st feels like your true year end.

If that date feels like your year end, then consider making it your year end. Doing this could substantially improve financial clarity and improve tax planning opportunities. A fiscal year end is also attractive to tax CPA firms because it represents off-season work.

Stick to fiscal years that land on a quarter end though. If you don't, it's a pain to tie out payroll tax reports and handle other administrative items.

4. Is our company's accounting up-to-date enough to make tax strategy decisions?

Many newborn companies (and even teenage companies) run with messy books. It's not uncommon for companies to be so far behind in accounting that no one has a good grasp on profits.

That is an enormous problem for at least three reasons:

1. Management. To effectively run a business, you really should know where you're at within 5-25 days after the end of each month. Delays beyond that can have a devastating impact on your ability to run the company.
2. Tax strategy and planning. Without up-to-date numbers there really is no viable way to do effective tax planning, particularly at year end.
3. Strategic partners. Bankers, attorneys and tax CPAs do not like working with companies with poor accounting. You cut your own throat when you need help from these people but your accounting is not up-to-date.

This point is one of the most important on the list, and also one of the hardest for small and mid-sized companies to achieve.

5. Are we maximizing current tax strategies?

This post is not a discourse on tax strategy, but let me suggest a few low-hanging fruit ideas:

1. Employee Retention Tax Credit. The rules for this are complex, but if your company qualifies, the tax credit can be enormous. In the past few months we've helped several of our companies calculate credits that ranged from the low $100,000s to over $1,000,000.
2. Cash basis vs accrual basis. In general if your receivables are substantially more than your payables, there can be a significant one-time "pop" in tax savings by electing cash basis for tax purposes. The opposite is also true, but less common.
3. Guaranteed payments vs draws. Partners in a partnership receive "guaranteed payments" instead of wages. If these payments can be reclassified as owner draws, they are generally eligible for the Qualified Business Income Deduction which is generally 20%. In essence, if you convert $100,000 of guaranteed payments to draws, there is potential of receiving a 20% ($20,000) tax deduction.
4. Research and development tax credit. This credit is even more complex than the ERTC in Point 1, but can be highly lucrative as well. If you do any kind of design or experimentation with new products, software, or business lines, you should ask about this credit. This point goes back to the first question about finding the right tax CPA. Most small tax firms do not or cannot maximize this credit accurately.
5. Employee benefits. Let's say you are trying to decide between offering your 20 employees a bonus of $3,000 each or contributing $3,000 to each employee's Health Savings Account (HSA). All things being equal, the HSA contribution will save your company over $4,000 of Social Security tax that would be owed if the $60,000 (20 employees x $3,000 each) had been paid out in bonuses. The employees also collectively save over $4,000 in Social Security tax and they avoid federal income tax as well. That might amount to another $15,000 in collective tax savings for the employees. In this simple example, $23,000 in total taxes would collectively be saved by funding HSAs rather than paying bonuses. Other benefits such as retirement plan contributions tend to be highly tax-efficient as well.

There would be many more suggestions; this is just a quick list to stimulate your thinking.

6. Have we seriously considered paying more tax than we need to?

Wait, what? That's right - one of the most powerful tax planning opportunities is making sure you pay at least a small amount of tax each year.

For example, in 2021 the maximum federal tax rate for a married couple earning $81,050 or less was only 12%. Also, at those income levels, the couple easily qualifies for lucrative child tax credits if they have dependents.

Too many entrepreneurs wipe out their company's tax profits with accelerated depreciation and waste those low tax brackets and tax credits. In future years, the pendulum swings back and they have large tax profits that are taxed at higher rates.

Most (profitable) business owners with dependents should target at least $80,000 to $100,000 of taxable income if possible. For high profit businesses, the ideal target could be closer to $300,000 in taxable income (again, for a married couple with dependents).

Dipping below these minimums in a year with high depreciation can set you up to pay future tax at much higher rates. Make sure you're paying enough tax now!

Conclusion

One last point: Don't let taxes (or the minimization of taxes!) drive your business or your life. Instead, make decisions based on the economic sense of the decisions themselves. It may be hard to believe, but life goes on even if you pay a few too many dollars in taxes.

Sure, you should try to work with a good tax CPA and make tax-efficient decisions, but in the end it isn't worth the stress to fret over every penny of tax. Remember, the goal is to make taxes seem like Friday night pizza, not cooked spinach!

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