Everyone’s excited to get a tax refund after filing their returns during the April tax season. But what about small businesses? Do refunds apply to them? We will discuss how tax refunds work for small businesses, how the IRS generates refunds, and why a refund for any taxpayer may not be the best tax planning strategy.
Small Business Taxation
Any discussion of small business taxation (and its effect on a potential refund) begins with a business’s choice of operating form and taxation method. Before discussing small business refunds, we must understand taxation.
All businesses must report their profit or loss on a tax return. Any business structured to pay taxes on its profit can potentially get a refund. The only type of business falling into this category is a regular or C corporation that files a Form 1120.
Very few small businesses take this form, so that process is beyond the scope of this article.
Can a Small Business Get a Tax Refund?
Most small businesses are sole proprietorships or pass-through entities (partnerships and S Corporations). There is also the Limited Liability Company (LLC), which can choose how its method of taxation (usually as a partnership but also as a sole proprietorship in the case of an LLC owned by an individual).
While these entities all report their profit or loss on their specific tax returns, the IRS taxes that profit and loss at the individual level on Form 1040. The IRS does not require these entities to pay income taxes, so they cannot generate a refund. Any potential refund is, therefore, generated at the individual level.
How the IRS Generates Refunds
The IRS generates refunds when the amount a taxpayer withholds for taxes and the estimated tax payments they have made for the year is more than the amount of tax they owe for that year. Employees working for a company have taxes withheld on their earnings.
In most cases, it is simply a matter of comparing the withheld amount with the tax owed and either getting a refund or owing more tax at the end of the year.
A taxpayer who owns a sole proprietorship, a single-member LLC, a partner in a partnership, or a shareholder in an S Corporation pays taxes on their share of the business’s profit.
Typically, the owner does not get paid a salary for which taxes are withheld (although this can be the case in an S Corporation), so they must pay taxes another way. Since the IRS works on the pay-as-you-go method, you must pay estimated yearly taxes.
What Are Estimated Taxes?
For each tax year, a small business owner must make estimated tax payments quarterly – on April 15th, June 15th, and September 15th of the current year and January 15th of the following year.
The IRS compares the total of these tax payments, in addition to any withholding due to a spouse’s wages, to the amount of taxes owed, and if more, they generate a refund.
What Happens If I Don’t Make Estimated Tax Payments?
If you don’t make estimated tax payments, a large amount of taxes and possibly penalties will be due on April 15th (without any refund).
Remember that in all of the above instances (except for shareholders of an S Corporation), the owner is subject to regular income tax and self-employment tax, approximately 15% of the business’s profit over and above the regular income tax.
The owner must know the business’s income as of the quarterly dates (at a minimum) and estimate the year-end profit so they can calculate an estimated tax payment for income and self-employment taxes. This is how they can generate a potential refund.
Is Getting a Refund Good Tax Planning?
No, getting a refund is not good tax planning. We just expect a tax refund because of conditioning.
The IRS has set up the pay-as-you-go system to generate cash flow to operate the government. Of course, they always want as much as they can legally collect in tax payments. Because they withhold taxes, it is not always clear how much people are paying until it’s too late.
Additionally, every year, advertisements tell taxpayers to get their refunds by tax preparation companies. While getting a refund check may seem great, do you want to use the IRS as a savings account?
What Is Proper Tax Planning?
Proper tax planning involves estimating the amount owed on April 15th from all sources, including a small business, and then ensuring either a taxpayer’s withholding, estimated tax payments, or both are just enough to cover the taxes owed and avoid potential penalties.
Theoretically, the refund should be zero, giving the taxpayer use of that money throughout the year. Even the minuscule interest from a savings account is better than no interest from the IRS. Just remember the refund is your money. Think about how and when you want to use it and plan accordingly.
The worst tax planning of all is loans offered against a refund. The interest rates on such loans are significant and can greatly reduce the tax savings a taxpayer is entitled to.
Plan for and Legally Minimize Small Business Taxes
While a small business’s activities contribute to the overall refund or additional taxes experienced, you must consider many factors. You should never enter a business transaction or operation solely for tax reasons. You must account for all aspects, and if there is a tax benefit, then so much the better.
Savvy small business owners work with a competent professional, such as a Certified Public Accountant or Enrolled Agent, to plan for their business’s success and resulting tax consequences.
A professional can work with the business owner to maximize profits, plan for, and legally minimize taxes. Considering the taxpayer’s financial matters, they can help properly manage the cash flow by using the money throughout the year rather than waiting for a refund to the business’s advantage.