The 5 Biggest Tax Mistakes Small Businesses Make – and How to Avoid Them
What do food poisoning and tax errors have in common? By the time you notice them, it’s too late.
Each year in anticipation of tax season, we talk about what businesses should or shouldn’t do, but usually tax advice is too little, too late. Bad habits cause more problems than single-entry and calculation errors. If you own a small or midsized business (SMB), you may have to change your tax habits.
Here, I’ll present five common tax mistakes and explain how you can easily avoid them.
1.The business can't pay off its taxes: I’ve worked with companies that fall six months (or more) behind on taxes and take yet another six months (or years) to catch up and pay off all the fines and penalties they’ve accrued. While this mistake sounds easy to avoid, often it’s not.
Think about a small restaurant in a big city. One month could be slow, but the restaurant still needs to pay salaries and rent and stock pantries. So, the restaurant meets these commitments with its operating cash flow, but doesn’t have enough funds left over to cover sales and payroll taxes. The following months are slow too; more back taxes and penalties accumulate. Catching up becomes harder and harder, even during a good month. A similar situation can occur when a small business owner designates the sales revenue from a certain delivery to cover taxes that month. If snow delays that delivery and the payment can’t come through, taxes go unpaid.
Solution: Create a separate bank account for taxes. As you generate revenue, automatically set aside what you will have to pay in taxes. Remove the money from sight so you’re not tempted to use it for other operating expenses. Funds will then be available when tax day arrives.
2.The business owes taxes in multiple states but doesn't realize it: In the old world, tax exposure was pretty simple. You have a pizza store in Manhattan, so you pay taxes in New York City and New York state. After a while, your special sauce gains prominence, and you start delivering warm pizzas across the tunnel into Hoboken, New Jersey. Did you realize that the moment your delivery truck exits the tunnel, you exposed your business to New Jersey sales tax and filing requirements?
The more your business expands – especially if you are selling through the Internet, taking phone orders, and delivering items to your customers – the more you will be exposed to different taxing localities with their different filing dates and tax rates.
Solution: My advice is to use software for sales taxes. The more you can automate the process, the less that will go wrong.
3.You choose the "Other" exemption – and get questioned: If your buyers tell you that they are exempt from taxes, you need to categorize these sales. Often, the buyer is exempt because it is a charity or government agency, and these cases are easy to track. Sometimes you are unsure, so you use the catchall: “Other reason." This used to be a safe box to check, but now state treasuries use technology to sift through tax returns and automatically flag oddities like the checked “Other” box. “Other” is a trigger for follow-up questions and requests for supporting documentation.
Solution: I recommend against using the “Other” exemption. It’s a red flag, and it will increase your chances of triggering an audit.
4.You get audited – and have nothing to show: Audits are always painful, but getting caught in an audit without meticulous records is a nightmare. SMBs are more liable to end up in this situation because they have less time and money to spend on accounting.
Solution: You need to assume the worst and meticulously document an "audit trail." Expect that one day an auditor will want to look at each sale and see how you calculated sales tax. Today, advanced tools let auditors easily sift through all of your data looking for oddities. That is what they do during the audit. For every sales tax filing, you need to collect proof that you filed the return and paid the right amount of money, and you need proof of when the return was filed and when the payment cleared. Always request a Certificate of Mailing to demonstrate that you mailed your return on time. Also, make a copy of the check and look for proof of when the payment posted from your account. Your online banking service should document the date.
Without all this documentation, you will be on the hook for back taxes, fines, and penalties. Whatever you do, help the auditors do their job. The nicer you are, the nicer they will be.
5.You don't know which taxes you're exposed to: New businesses get caught off-guard by taxes they didn’t know existed. In addition to the usual corporate, sales, and payroll taxes, jurisdictions can raise "special" taxes. For example, 39 states, as well as Chicago and Washington, DC, place special taxes on sugary drinks sold in grocery stores and/or vending machines. New York famously adds an 8-cent tax to bagels if the customer requests it “altered” (i.e., sliced or with a topping).
Solution: Because weird examples like that are common, you have to find out about them. A professional accountant is the most reliable source, but you can also consult the local Better Business Bureau or a state department of revenue website. If you browse the website’s tax forms by name, you can determine which ones are relevant to your business.
Too Many Hats?
SMB owners often try to handle accounting without professional help. Unfortunately, when one person is the CEO, COO, CFO, bookkeeper, and tax preparer of the same company, tax mistakes are more likely to happen. Even if you try to minimize accounting costs, I still recommend working with a CPA. They will save you money in the long run. Wherever possible, automate taxes with software. Good intentions don’t prevent human error – or food poisoning.
About the author:
Jonathan Barsade is the CEO of Exactor, which provides solutions to help companies with sales tax compliance.