Figuring out your taxes as a small business owner can feel like a guessing game. Not only do you need to plan around your future uncertain income — you also need to keep track of changing federal laws.
As you get ready for another year, these strategies can help you determine your small business tax rate.
What Is the Federal Small Business Tax Rate?
Your tax rate depends on the structure of your business.
For C corporations, the current tax rate is 21%. With other business entities, such as sole proprietorships, partnerships and S corporations, the income passes directly to owners, so you owe your personal income tax rate on your share of the profits. If your business is an LLC, your tax rate depends on whether you’ve elected to operate as a C corp, a partnership, an S corp or a sole proprietorship.
The IRS publishes small business tax rate adjustments every year. But be careful about using the current published rates to estimate what you’ll owe.
“We have a new administration that said they’ll raise tax rates for the rich, which can include business owners,” said Steven Weil, president of RMS Accounting in Fort Lauderdale, Florida. “We know the rates for 2020, but for 2021, you basically need a crystal ball. As you plan, it depends if you think the rates are going to change or not for your business.”
Estimating Your Tax Rate
One of the tax challenges that small business owners face is that they don’t know what their revenue will look like in a given year, and revenue helps determine tax rate.
“When you set out in January, you just don’t know what’s going to happen,” said Jessica Dennehy, co-owner of MadMen Barbershops just outside of New York City and a small business coach. “We have projections, but they’re just guesstimates. One year, our revenue went up by way more than we expected and pushed us to a higher bracket. The next, it wasn’t as high.”
Despite this tax rate uncertainty, the IRS still expects you to send in taxes throughout the year.
If you run a C corp or an S corp, it’s usually a little easier. You can set up a formal payroll to pay yourself a salary, and your payroll provider takes the estimated taxes out of your paycheck. With the other business structures, income passes directly to you before it’s taxed. You need to figure out your estimated taxes and pay them quarterly.
To avoid IRS penalties on your 2021 taxes, your estimated payments must be at least 90% of your 2021 year-end tax bill or 100% of your 2020 tax bill. Estimating your 2021 payments on your 2020 taxes could help you avoid penalties, but you could owe more when you file your 2021 tax return if your revenue or tax rate goes up.
Staying Ahead of Your Taxes
Dennehy uses a simple system to stay in the black.
“I look at the last year to see what I would have had to put away to not owe a lump sum out of my savings,” she said. “Then I add a little more. Let’s say that amount came out to $1,000 of taxes per month. I might put aside $1,500 just to be safe.”
With this approach, Dennehy has a buffer in case her taxes end up higher. If they’re lower, she can pocket the savings.
She also updates her business financial statements once a quarter to catch potential changes ahead of time — say, if her revenue jumped significantly year over year, and she needs to save more for taxes.
And though you need to keep your tax bill in the back of your mind, Weil believes your primary focus should be on your business’s overall health. After all, if you don’t pay your rent, vendors or employees, your business shuts down. If you fall behind on your taxes, you can set up an installment plan with the IRS or take out a small business loan to cover the tax debt.
“A lot of business owners are saying, ‘I’m not worried about paying taxes right now; I’m worried about paying the rent,'” he says. “It makes sense to prioritize.”
Credits and Deductions
The tax credits and deductions you take also determine your tax rate and how much you need to pay during the year. If you have a lot more expenses and deductions than usual — maybe you made a large investment in new equipment — this could reduce your small business tax rate in 2021.
The average business owner often overlooks this part of the calculation, Weil argues.
“People overpay their taxes during the year because they underestimate their expenses,” he said. “They overpay by about 15% to 20%.”
When you overpay, you have to wait until after you file to get the money back as a refund — and that’s time that your business doesn’t have access to that cash.
Still, Dennehy doesn’t see this as a bad thing.
“In the back of my mind, I know I’m going to have a certain amount of deductions based on my travel, inventory and other expenses,” she said. “I try not to save based on that, though, because I don’t want to undershoot and get stuck owing money at filing.”
It’s up to you which strategy you prefer. If you estimate your payments based on your potential tax breaks, you’ll pay less during the year, but you’ll have a higher chance of owing money when you file. If you don’t factor your breaks in, you might overpay during the year, but you’ll have a better chance of getting a refund.
Where an Accountant Can Help
Dennehy stays in touch with her accountant throughout the year to figure out how her tax rate changes.
“I give them my quarterly Excel spreadsheets to see if I’m on track or if something has really changed,” she said. “Even though I try running the numbers myself, my tax pro has a more trained eye for the details.”
Business owners who regularly communicate with a professional are usually in a stronger position, Weil says. For example, an accountant could help fine-tune your cash flow analysis.
“Even someone who only uses a bookkeeper will have more accurate records and do better come tax season,” he said.
Still, he adds, the real value of working with an accountant is that they can help you find extra tax benefits throughout the year — especially when the rules keep changing.
“We had one business owner recently come in and save $5,000 by amending a previous return,” Weil said. “They could have saved even more had they made different decisions. But by the time they sat with us, it was too late.”
Weil recommends meeting with your accountant two to three times a year to strategize and stay current with the federal small business tax rate.
Tax rate planning might not be the most exciting small business activity, but it can prevent many financial headaches. By following this advice, you can get your records ready for another year — and maybe trim down your tax bill.
