As a small business owner, you may have been offered a way to save thousands of dollars on your tax bill. The catch? It involves leveraging a tax loophole - perfectly legal, but complex and potentially risky. Should you take the chance?
Small business tax loopholes can be enticing for business owners looking to reduce their taxable income. These ‘grey areas’ in the tax code can provide much needed tax savings and free up resources, but they come with potential downsides like IRS scrutiny, penalties, and reputational damage if they’re applied too liberally.
During today’s discussion, we explore these loopholes, their benefits, the associated risks, and whether they’re worth the gamble for your business.
What are tax loopholes?
Tax loopholes are unintended gaps or ambiguities in the tax code that allow taxpayers to reduce their taxable income, through tax deductions and business expenses, not explicitly planned by the lawmakers. But unlike common business tax deductions and credits - which are deliberate incentives - loopholes take advantage of technicalities in the law.
Often these loopholes are used to reduce business income, allowing business owners to reinvest the money into the business. At the same time, legally using these loopholes requires the expertise of a highly qualified tax professional - this may end up diminishing any savings.
Therefore, much thought and consideration should be applied to using these strategies to reduce your business’s taxable income.
Balancing the benefits of tax savings, increased cash flow, and having a competitive edge with IRS audits, the cost of professional guidance, and possible reputational damage, is key for the strategy to succeed.
6 Tax Loopholes for Small Business
1. Home office deduction
How it works
The home office tax deductible allows SBOs to deduct expenses related to the part of their home used exclusively for business. This can include utilities, rent/mortgage, property taxes, and depreciation.
Example
A sole proprietor has an extra room which is allocated solely for business purposes. The home is the SBOs principal place of business, i.e. there are no other premises they can go to conduct business.
The simplified method of calculating costs is a rate of $5 a square foot for business use of the home. The maximum size for this option is 300 square feet. The maximum deduction under this method is $1,500.
Benefit
It directly lowers taxable income by accounting for home office expenses, bringing income tax relief.
Risks and downsides
There are strict rules in place and this claim is often scrutinized by the IRS to ensure it meets the stipulations. The room or space must be used exclusively for business. This tax deduction does not apply to employees of a company. Renters can only claim home expenses for which they are directly responsible.
Worth the risk? Yes, for businesses that truly qualify and maintain clear documentation to prove home expenses. While this is a low-risk loophole, it’s essential to be meticulous in meeting IRS requirements, thereby avoiding penalties for taking business tax deductions that you’re not eligible for.
2. Depreciation deductions (Bonus & Section 179)
How it works
Businesses can deduct the cost of qualifying equipment and property either all at once (bonus depreciation) or over time (standard depreciation). Section 179 allows for the immediate deduction of assets like vehicles, machinery, and software.
Example
A small business buys a $50,000 piece of equipment for the manufacture of its products. Using Section 179, they deduct the full cost in the purchase year instead of over multiple years.
Benefit
This will boost cash flow by reducing the taxable income in the year of purchase. It also incentivizes reinvestment in the business. With bonus depreciation, a company benefits from a substantial tax break in the year the asset was acquired.
Risks and downsides
There are several annual limits placed on Section 179 deductions. For tax years beginning in 2024, the maximum section 179 expense deduction is $1,220,000.
This limit is reduced by the amount by which the cost of section 179 property placed in service during the tax year exceeds $3,050,000. Also, the maximum section 179 expense deduction for sport utility vehicles placed in service in tax years beginning in 2024 is $30,500.
These deductions must be carefully managed, as overuse in one year will leave insufficient deductions in lean years.
Worth the risk? Yes, for businesses making significant asset purchases, and looking for a way to recoup these costs from business taxes.
3. Income shifting to family members
How it works
Small business owners can hire family members to perform legitimate work and pay them a salary. This shifts income from the higher-taxed business owner to the lower-taxed family member, who might pay little or no income tax depending on their total earnings.
Example
Two business owners in a partnership decide they want to hire a 21-year-old family member, who is in college, to handle social media marketing.
The business pays them $12,000 annually, which is below the standard deduction threshold. This income is tax-free for the family member, and the company deducts the $12,000 as a legitimate business expense, lowering the tax liability.
Benefit
It shifts income to a family member in a lower tax bracket (retaining the wealth in the family, without placing a tax burden on the family member).
Risks and downsides
The work must be legitimate and valuable to the company in order to qualify for this benefit. The IRS may require proof of the actual work performed if they become suspicious of misuse. Also, the pay must align with fair market rates for the job.
Worth the risk? Yes, for businesses with legitimate work and opportunities for family members. This strategy is highly beneficial when executed fairly and legitimately, but requires documentation of hours worked and tasks completed to avoid IRS penalties.
4. Business use of vehicles
How it works
Businesses can get tax benefits from deducting vehicle-related expenses, such as fuel, maintenance, and depreciation, for vehicles used for business purposes. Under section 179, some luxury vehicles may qualify for accelerated depreciation. The cost of business insurance is also deductible for eligible assets.
Example
A florist purchases an SUV costing $60,000. They claim a portion of the cost under a section 179 deduction in the year that it was purchased. They also claim a portion of the fuel and maintenance on the vehicle under deductible business expenses.
Benefit
There are a number of ways to calculate depreciation and business expenses. Accelerated depreciation reduces the upfront tax liability.
Risks and downsides
If the vehicle is used for both personal and business activities, then only the business portion of the expenses may be deducted. The vehicle must be deemed appropriate for the type of business that it serves. E.g. buying a high-value luxury vehicle to transport dogs for your pet-grooming business would immediately be a red flag for the IRS.
Worth the risk? Yes, for businesses with a legitimate need for a vehicle to conduct company activities. For example, a sole proprietor stands to benefit greatly from this benefit because they will have a vehicle for both business and personal use while getting much needed tax relief.
5. Fringe Benefits
How it works
A fringe benefit is a form of pay for the performance of services. For example, you provide an employee with a fringe benefit when you allow the employee to use a business vehicle to commute to and from work.
Offering fringe benefits like health insurance, retirement plans, or tuition assistance can reduce taxable income for small businesses.
Example
A small perfume manufacturing business decides to pay the health insurance premiums of their employees, as a way of attracting and retaining the scarce skills of perfumers in their business.
Benefit
Fringe benefits help small businesses attract talent and compete with larger employers. For the business, it reduces taxable income. If the company can offer non-taxable fringe benefits such as employee discounts, meals, and transportation, then the company reduces its tax liability even further.
Risks and downsides
Fringe benefits require clear policies and documentation and must be applied equally and fairly to all employees. Not all fringe benefits are tax-free for employees, and this must be explained and well understood.
Worth the risk? Yes, for businesses aiming to enhance employee retention while reducing tax liability through business expenses.
6. The Augusta rule (section 280A)
How it works
The Augusta rule allows homeowners to rent their personal residence to their business for up to 14 days per year without reporting the rental income as taxable. Businesses, in turn, can deduct the rental payments as a legitimate business expense.
Example
A business owner holds quarterly board meetings or strategy sessions at home. The business rents the home for $2,000 a day for a total of 10 days, generating $20,000 in tax free rental income for the owner while deducting the same as a business expense.
Benefit
The business owner can earn an additional tax-free income and gets a deduction. There is no complex legal setup necessary - just documentation, like invoices for legitimate business expenses incurred for the running of the meetings, and meeting minutes or other documentation to prove that the meetings were legitimate.
Risks and downsides
Disproportionate rental rates and expenses will attract the scrutiny of the IRS, and a lack of appropriate documentation could lead to a disallowance of the deduction and penalties. The rule only applies to 14 days annually, capping potential benefits. SBOs should be prepared for an IRS audit, which often happens with properties that are used for both personal and business reasons.
Worth the risk? Yes, for small businesses with the property, and the ability to maintain clear documentation. The potential savings could be significant and greatly increase cash flow for the year, but overestimating rental rates could also lead to trouble, so exercise caution.
Comparative table of small business tax loopholes
Loophole | Tax Savings Potential | Ease of Application | Risks | Best for |
Home Office Deduction | Moderate | Easy | IRS audit risk, strict rules | Businesses with exclusive home offices |
Depreciation Deductions | High | Moderate | Overuse risks, limits | Businesses with major asset purchases |
Income Shifting | Moderate | Moderate | Meticulous documentation required | Family-run businesses |
Vehicle Deductions | Moderate | Easy | Personal vs. business use issues | Businesses using personal vehicles for significant business travel |
Fringe Benefits | Moderate | Moderate | Administrative burdens | Employee retention focused businesses |
August Rule | Moderate | Easy | IRS audit risk, rental rate overvaluation | Business with personal property suitable for business use |
Key Takeaways: Are Tax Loopholes Worth the Risk?
In this discussion, we’ve presented six common tax strategies that can be viewed as loopholes. There are a number of other more complex strategies such as relocation of businesses to other countries and opportunity investment funds that should be undertaken with the help of a tax professional to avoid unexpected complications.
As to whether the strategies discussed here are worth the risk, the answer depends on your business’s risk tolerance, resources, and long-term goals.
For small businesses, the stakes can be high, especially if these strategies are applied incorrectly. While the potential savings from loopholes can be substantial, they come with legal, financial, and reputational risks that could outweigh any benefits.
For this reason, it’s advisable to get expert guidance, such as the counsel offered by the senior tax associate at Hall Accounting Company. They offer personalized tax planning and preparation services for small business owners and stay up-to-date on tax law changes, proactively using tax reduction strategies, while increasing your ability to reinvest in your business.
Contact Hall Accounting Company today to take the guesswork out of your tax loopholes for your small business and focus on doing what you love.