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Avoiding the Top Small Business Tax Pitfalls

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Ensuring you don’t fall victim to these tax traps will help you avoid hefty IRS fines, whether you’re just starting out or running your business day-to-day.

Contractor Conundrums

Finding ways to cut costs without sacrificing quality is the entrepreneur's credo. But what you consider a cost-savings the IRS may deem noncompliance and issue penalties accordingly.

Misclassifying employees as contractors can cost you. At first glance, contractors are appealing. They are responsible for paying all 15.3% in FICA (Federal Insurance Contributions Act) taxes, which are simply Social Security and Medicare taxes combined. Employees only pay 5.65% in FICA taxes (7.65% in 2012 once the Social Security tax break expires) and the business owner is responsible for matching 7.65%.

One fewer employee on payroll can also mean smaller state unemployment insurance (SUI) and Federal Unemployment Tax Act (FUTA) payments.

The IRS has a long list of what constitutes a contractor. If you think you're employing contractors yet dictate when and where they do their work, provide their training and tools, and pay them according to a regular pay schedule, then you should most likely consider paying them as employees.

The 2010 federal budget planned to generate $7 billion in additional revenue over the next 10 years from stricter enforcement of proper worker classification. According to a recent New York Times article, half the states are ramping up their own classification crackdowns, hoping to cover their budget donut holes from the nation's estimated 3.4 million misclassified workers.

The solution? Classify them correctly and put them on payroll. The money you pay in FICA and unemployment taxes is usually less than what you'll pay in IRS penalties.

Adding another person to payroll may sound like a bigger burden versus simply cutting a check to a contractor, but payroll services alleviate the pain of calculating and deducting withholdings.

Some services, such as SurePayroll, also handle paying and filing all federal, state and local payroll taxes and allow you to process payroll online 24 hours a day, 7 days a week. The average customer's payroll takes 2 minutes to process.

LLC Lessons & S-Corp Snafus

Your business' IRS status dictates how you must pay certain payroll taxes. As a limited liability company (LLC), you're obligated to pay payroll taxes on your employees' incomes and manage their payroll, or you can use a payroll service. However, you cannot put yourself on the payroll if you own more than two percent of the company.

Many small business owners learn this the hard way when they don't pay FICA on net profits and IRS notices start piling up. Art Troast, a New York City-based CPA and owner of Troast consulting, noted the solution isn't always easy to swallow.

"The FICA rate is 15.3% and an effective income tax rate when you combine federal, state and local is often 25%," Troast shared. "New business owners never imagine they have to set aside 40 percent of their net profit for taxes."

Unfortunately, they do. Letting a payroll service handle the payroll tax paperwork and working with a CPA to create an estimated tax regimen is the best route for avoiding IRS or other agency penalties. This will let you know how much net profit you can invest in your business and use as your income, while ensuring those taxes get paid and filed in a timely fashion.

The other popular small business status, an S corporation, carries its own tax nuances. Whether you place yourself on payroll or use net profits for your own income is your choice. In hopes of reducing the FICA and income tax burden, some S-corp owners will place themselves on payroll and set their salaries very low. What they don't realize often hurts them: The IRS and state revenue agencies can "recategorize" the net profits owners dip into as wages.

Alter offered this: "Adding yourself to a payroll service is a quick and easy way to guarantee you're paying the right FICA amounts. But it only works if you give yourself a fair salary. The IRS is good at noticing when you don't."

Workers' Comp Complications

Workers' compensation and disability insurance are mandatory. The only businesses exempt are those where the owner is the sole employee. The minute you add that first employee, you're obligated to purchase workers' comp and disability insurance.

Yet many small business owners go without, either assuming they're exempt or hoping no one will check into it. Yet fines for workers' comp noncompliance, in particular, can be devastating, and not knowing isn't an excuse in the eyes of the government.

"Everyone with employees needs workers' compensation," Alter explained. "Luckily for small business owners, the Internet has enabled services such as ours to make it simple to add a convenient, pay-as-you-go workers' comp plan so you can avoid the fines and headaches that operating without the proper insurance policy can create."

While these three pitfalls are the most common and easy to avoid, others will surface. Trusting a payroll service to handle all of the payroll taxes and compliance lets you focus on your business. And remember: When in doubt, seek advice.

See how little full payroll tax management costs — get an instant quote.