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Making mistakes is a natural part of being a business owner. Unfortunately, some will cost you more than others — and it’s probably best you learn what they are upfront and avoid the hassle (and cost) of these errors. You know where I’m going with this: your taxes are one of them.
To help you make sure you’re doing what you can to stay on the IRS’s good side, here are five tax mistakes you should avoid as someone who is self-employed.
Underestimating and underreporting income
To be clear: I’m not implying that you’ll do this on purpose (bookkeeping mistakes happen!), but underreporting your income is a big no-no in the eyes of the IRS. That’s because you pay taxes on your net income (which is gross income minus expenses), so you want to make sure that you report your gross income correctly.
As a sole proprietor (or single member LLC), partnership or S Corp, you’ll need to make quarterly tax payments based on your estimated tax bill for the entire year. Of course, it’s hard to predict how your business will fare (um, hello, COVID-19), but you still need to make a good faith effort to accurately estimate your projected income for the year.
If you severely underestimate your income, you could face penalties for underpaying.
So how do you avoid this mistake? By making sure you check your numbers to make sure they’re accurate and keeping up with your bookkeeping on a regular basis.
Not separating business and personal expenses
When you’re just starting out, it’s tempting to use your personal accounts to receive money for your products and services. Even if you’re a stickler to making sure you’re reporting your business income and expenses correctly, the IRS frowns upon the commingling of funds. Think of it like oil and water: they rather be separate.
What this means is that you should separate your business and personal finances completely. Yes, it means that you will most likely need to open a separate bank account and use a business credit or debit card when you’re making business purchases.
If you happen to use your personal vehicle for business related purposes (such as driving to do onsite client work) or have a home office, then you’ll need to ensure you keep detailed records so you can justify those deductions.
Failing to pay and file taxes by the due date
If you miss tax filing deadlines, you will pay penalties — not trying to scare you, but it’s true. The exact due date for your business depends what type of entity it is.
For instance, single-member LLCs and sole proprietors will need to file taxes on April 15th. LLC partnerships and S Corps who have to file corporate tax returns have to file their taxes by March 15th.
If the tax due date falls on a weekend or a holiday, then the due date will be the next business date. In any case, make sure you prepare your paperwork and set reminders so that you can file taxes well before or at least on the day they’re due.
Keeping poor records
I get that you may be so busy running other parts of your business that your bookkeeping tasks fall behind. But, if you leave all your paperwork until the last minute, chances are you’ll feel overwhelmed or miss out on important deductions you could take.
It could even get to the point where you end up hiring someone to clean up your books, only to have them charge you more to straighten it all out.
There are many tools you can use to create a fairly automated system for regular income and expense tracking. Digital bookkeeping software pulls transactions from your bank and credit card accounts — all you have to do is double check the transactions and categorize them.
Of course, hiring help is another great option — the fees you pay are worth it, especially if the tax professional’s expertise helps you save even more money on taxes.
Taking the wrong business deductions
One of the perks about being in business is that you can deduct expenses you use towards running it. Though let’s be clear: you can’t deduct everything. If you claim something that’s not allowable in the eyes of the IRS, you could get into hot water.
Here are a number of expenses that you’re not allowed to deduct on your taxes. This list is not exhaustive, so please check with a tax professional for more information.
When you make regular trips from your home to a place of work (like an office you rent), the IRS won’t allow this as a tax write off because it’s considered commuting.
Now if you travel from your home, or office, to meet clients, run errands or make special travel arrangements for occasional business trips (like work conferences), those expenses can be deducted.
Even if you purchase clothes so you can film Youtube videos, it won’t count as a business expense. That’s because clothing that can be worn outside of work or that’s appropriate for streetwear (I’m looking at you yoga pants) is a personal expense. However, if you purchase uniforms or safety equipment like hard hats, then you can deduct those expenses.
Business Gifts Over $25
If you’re like me and give the occasional client gift, you can absolutely do so. You just can’t deduct more than $25 per gift per person. That means if you send a flower arrangement that costs $50, you can only deduct $25 of the total amount.
Fines and Penalties
Did you underpay your taxes and end up paying a fine? Unfortunately, the amount you paid can’t be deducted. If there were other penalties you paid related to your federal tax return, you can’t claim those as deductions either.
Contributing to charitable causes is great (go you!) and depending on your business entity, you can deduct them — the amount will vary and it has to be to a qualified charity. If you contribute to a political candidate or party, that sadly won’t count.
Are you part of a social club, country club or fitness facility (like a gym)? If so, you can’t take these costs and deduct them as a business expense. Yes, even if you take your clients to talk shop at your country club.
For those who belong to professional trade or business associations that are directly related to your business, that counts. For me, I am part of the American Society of Journalists and Authors. Since I’m a professional writer, I can deduct the annual membership dues as a qualified business expense.
You probably already know this but it bears repeating: you can’t deduct your tax bill on our federal tax return. There are some states that may let you deduct part of your federal business tax bill, so check to make sure. If you file a personal income tax return (like if you’re a sole proprietor), you may be able to deduct state and local sales taxes (again, double check with your local tax authority).
Sadly, taking clients to sporting events, concerts or other types of entertainment events don’t count as business expenses anymore. Although, if you or your employees have meals while on trips those are deductible, but you may be limited in how much you can deduct.
How to avoid these mistakes? Get organized!
The best way to avoid tax deduction mistakes is to keep on top of your bookkeeping so that you’re organized well before you need to file taxes. Of course, seeking the help of a tax professional is useful — trust me, when I finally hired mine, there were deductions I didn’t know existed!
As long as you regularly check your books and fix any discrepancies, your business can hum along like a well-oiled machine.