Once your small business starts earning a profit, you have to decide if you should distribute those profits to yourself (and any other owners) or reinvest them back into the business.
While it can be tempting to pocket your company’s profits, funneling at least some of that money back into the business is worth considering.
For one, reinvesting can help improve the company or expand operations, leading to even higher profits down the line. For another, reinvested money is generally considered a business expense, which means you likely won’t have to pay income taxes on it.
Read on for a closer look at why you may want to reinvest a percentage of your profits back into your business, how this can impact your business taxes, and ways you might use profits to help expedite business growth.
What Constitutes a Business Profit?
Profit is the money a business pulls in after accounting for all expenses. Any profits earned funnel back to business owners, who can choose to either keep it as earnings, distribute it to shareholders as dividends, or reinvest it back into the business.
Whether you own a small dog grooming business or a multinational corporation, the main goal of any business is to earn money. Thus, a business’s performance is based on profitability. For accounting purposes, companies will often report gross profit, operating profit, and net profit (the “bottom line”).
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What Are Businesses Taxed On?
Any profits that aren’t reinvested in a business are typically taxed as income. How that tax is paid depends on the structure of the business.
Most small businesses are pass-through entities, which means that the gains or losses are passed through to the owners on their personal income tax returns. Corporations, on the other hand, pay a flat tax on business profits.
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Types of Business Taxes
When we refer to “taxes” for a business, we’re actually using an umbrella term for many different types of taxes a business may have to pay. Let’s take a closer look.
Income Taxes
Income taxes are based on the net income of your business for the tax year. Net income is the same thing as profit (income minus expenses). If you share a business with others, the net income is divided among the owners based on your business agreement. Most small businesses pay both federal and state income taxes.
Estimated Taxes
Employees have taxes withheld from their paychecks, but as the owner of your business, no one is withholding taxes from the money you take out of the business.
Instead, you need to file estimated taxes throughout the year based on the income you have earned up to that point in the year. Typically, federal and state estimated tax payments are due on April 15, June 15, September 15, and January 15 for the previous tax year.
Self-Employment Tax
Employees generally have Social Security and Medicare taxes withheld from their paychecks. If you are a self-employed business owner, however, you must calculate and pay your own Medicare and Social Security tax through self-employment taxes.
Excise and Sales Taxes
Depending on which state you operate in and what type of goods or service you sell, you may need to set up a system to collect sales tax from your customers and report and pay that tax to your state.
You may also need to pay federal and local excise taxes. An excise tax is a legislated tax on specific goods or services, such as fuel, tobacco, and alcohol.
Payroll Taxes
If you have employees, you must withhold payroll taxes from their paychecks and pay applicable federal, state, and local taxes. The taxes usually withheld from employee paychecks include FICA (Medicare and Social Security taxes) and federal, state, and local income taxes. Employers and employees each pay half of the FICA tax.
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How to Reduce Taxable Income
As a business owner, there are many strategies you can use to reduce the portion of your business income (or profits) that can be taxed. Here are some you may want to consider.
Reinvesting Business Profits Into the Business
Reinvesting means retaining net profits (the income left over after all operating costs and overhead are paid) and investing them in activities or expenses that can help increase the value of the business. As a business expense, reinvested income generally isn’t taxable.
You may, however, want to reinvest only a portion of your profits and look for other ways to infuse capital into the business, such as applying for a small business loan. Interest paid on business loans is typically tax deductible as a business expense.
Finding Deductions
There are numerous business tax deductions you may qualify for and, when you add them all up, they can amount to a significant reduction in your taxable business income. Here are some of the most common small business deductions:
• Inventory
• Business property rent
• Utilities
• Company vehicle expenses
• Insurance
• Rent and depreciation on equipment and machinery
• Office supplies
• Furniture
• Advertising and marketing
• Business entertainment
• Travel expenses
• Interest paid on all types of small business loans
Tax Audits
As a small business owner, it makes financial sense to explore all your options for reducing your tax bill. However, when it comes to deductions, you need to be careful. It’s particularly important, for example, to keep your business and personal expenses separate. If your deductions look suspicious to the IRS, the agency could potentially audit your business.
Investing in Employees
One great way to reduce your company’s taxable income is to invest in your employees. Generally speaking, any wages, bonuses, or other compensation you pay your workers in a given year are tax deductible as a business expense. That includes any fringe benefits you offer — such as gifts, health plans, and employee discounts — as well.
Rewarding your workforce can do more than lower your tax liability, however. It can also help boost their morale, increase productivity, attract the top talent, and grow your business.
Choosing Purchases and Investments Wisely
While it’s clearly important to invest in your business, the question remains: Where should you focus your funds? Here are a few purchases and investments you may want to consider.
• Equipment: It can be smart to reinvest profits into new machinery and equipment as your current assets age and become expensive to maintain. Upgrading equipment can increase efficiency and help you stay on the cutting edge of your industry.
• Software: Investing in software, such as payroll and accounting software, can help streamline tedious tasks and free you up to focus on more important matters, such as growing your business.
• Inventory: In some cases, using business profits to buy more inventory can be a smart business move. If you often sell out of popular products, for example, beefing up inventory can help you capture sales you’ve been missing out on.
• More marketing: You might consider hiring a marketing professional or agency to help create buzz about your business, improve search rankings, and expand your customer base.
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Tax Planning Strategies
One of the best ways to make your business tax efficient is to pay attention to tax credits and not just deductions.
Tax credits are particularly valuable because, unlike deductions, which reduce your taxable income, credits reduce your tax bill on a dollar-for-dollar basis. For example, if your small business owes $25,000 in taxes, a $5,000 tax credit means you can subtract $5,000 from your tax bill and only owe $20,000.
There are a number of tax credits your business might qualify for, including:
• Credit for Small-Business Health Insurance Premiums
• Employer Credit for Paid Family and Medical Leave
• Work Opportunity Credit
• Credit for Increasing Research Activities
• Disabled Access Credit
• Credit for Employer-Provided Childcare Facilities and Services
• New markets credit
The Takeaway
It takes hard work to establish and grow your business. Once you’re able to cover all your expenses, pay yourself a salary, and still have money left on the table, it may be time to consider putting that extra money into your business.
Reinvestment means pouring a percentage of your company’s profits back into your business. It can be a great way to increase the value of your company and to help your company grow. What’s more, reinvesting can reduce your business tax liability at the end of the year, for the ultimate win-win.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How much is a small business able to make before paying taxes?
A small business generally must pay taxes on any profit it earns, but the specific amount before paying taxes depends on deductions, credits, and the business structure. For self-employed individuals, income over $400 is subject to self-employment tax, while other tax obligations vary by income and state laws.
What does the 20% business tax deduction do?
The 20% business tax deduction, part of the Qualified Business Income (QBI) deduction, allows eligible small businesses to deduct up to 20% of their qualified business income from their taxable income. This reduces their overall tax liability, promoting business growth and investment.
What is a business write-off?
A business write-off is a tax deduction that allows businesses to subtract certain eligible expenses from their taxable income. Common write-offs include operating costs, rent, supplies, meals, startup expenses, employee salaries, and more. These deductions reduce the overall tax liability by lowering the business’s reported income.
Can you invest business profits to avoid taxes?
Yes, you can reinvest business profits into the company to reduce taxable income, but you cannot avoid taxes as a small business owner. While reinvesting can lower taxes, it doesn’t fully eliminate tax obligations, as profits are still subject to applicable tax laws and limits.
Photo credit: iStock/Andrii Yalanskyi
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