tax filing mistakes by small business

Common Tax Mistakes to Avoid as a Small Business Owner

For small business owners, filing taxes can feel like navigating a minefield, with even higher stakes due to the increased risks and potential penalties. Even the smallest tax mistakes can lead to costly penalties, audits, or worse, legal challenges. Navigating tax season effectively without making any tax mistakes requires awareness of the common errors businesses make and how to avoid them. In this article, we explore tax mistakes that small businesses often make, backed by up-to-date research and expert advice to help you stay on track.

1. Inaccurate Income Reporting

One of the most frequent tax mistakes small businesses make is the misreporting of income. This could range from failing to report all revenue streams to incorrectly categorizing income types, such as mixing personal income with business revenue. Any mistake in income reporting can trigger audits or result in severe penalties.

Why it matters:

In the 2020-2021 Tax Gap Report, the IRS projected the total annual tax gap at $688 billion, with underreporting of  income being a major contributor. For small businesses, this often happens when income from cash transactions or side services is not properly reported. For example, a small business owner might fail to report revenue earned from side jobs or freelance work, which isn’t captured by information returns like 1099s. Since the IRS already receives income-related documents like W-2s and 1099s from other parties, any discrepancies between the business’s reported income and the IRS records can lead to audits or penalties.

Prevention Strategies:

  • Careful Record Keeping: Keep meticulous records of all income, even if it’s from side gigs or occasional projects. If it’s revenue, it needs to be tracked.
  • Cross-check Information Returns: Ensure that all W-2s, 1099s, and K-1s received from clients or employers match the income you report on your tax return. The IRS has access to these forms, and discrepancies can easily raise red flags.
  • Leverage Tax Software to avoid tax mistakes: Use trusted tax software that can automatically flag mismatches and guide you through your filing to ensure every income source is reported accurately.

2. Failing to Separate Business and Personal Expenses

Mixing business and personal expenses is a common mistake for small business owners, but it can lead to complications when filing taxes. Not only does it increase the chances of missing deductions, but it can also make the IRS suspicious.

Why it matters:

When you mix personal and business expenses, it becomes difficult to track deductible expenses properly. This could mean that you miss valid deductions or, worse, find yourself subject to an audit. For instance, claiming personal expenses, like groceries or a family vacation, as business expenses could trigger penalties. If the IRS notices discrepancies or suspects fraudulent reporting, you could face serious consequences.

Prevention Strategies:

  • Use Separate Accounts: Set up a dedicated business bank account and credit card. Keep your personal and business finances separate to avoid confusion and errors.
  • Track Expenses to avoid tax mistakes: Use accounting software to categorize and track business expenses properly. This will help ensure that only valid business expenses are claimed.

3. Misclassifying Employees vs Contractors is one of the crucial tax mistakes

Many small business owners wrongly classify their employees as independent contractors. This is not just an oversight, it can lead to back taxes, penalties, and legal issues with the IRS.

Why it matters:

Misclassifying workers is a significant problem for businesses worldwide. In fact, according to the U.S. Department of Labor, businesses that misclassify employees as independent contractors could face penalties of up to $1,000 per misclassified worker.  The IRS has strict guidelines for worker classification, and with increased scrutiny from tax authorities, businesses must be vigilant about ensuring they follow the correct guidelines to avoid significant penalties and retroactive tax liabilities.

Prevention Strategies:

  • Review IRS Guidelines: Make sure you understand the legal distinction between employees and independent contractors by reviewing the IRS guidelines.
  • Document Roles Clearly: If you classify someone as an independent contractor, make sure the contract is detailed and reflects the true nature of the working relationship.
  • Consult a Professional: When in doubt, seek the advice of a tax or HR professional to ensure proper classification

4. Avoiding Tax Mistakes from Missing Tax Deadlines

Tax deadlines are not suggestions, they are legally binding dates. Missing these deadlines can lead to costly fines and interest                        charges, which are entirely avoidable with some simple planning.

Why it matters:

In the U.S., the IRS imposes penalties on businesses that file taxes late. The penalty is typically 5% of the unpaid tax for each month or part of a month that a tax return is late, with a maximum penalty of 25%. For example, if a small business owes $1,000 in taxes and files 3 months late, the penalty could be as much as $150. In addition to the fines, interest on the unpaid tax continues to accrue until the amount is fully paid.

Prevention Strategies:

  • Use Digital Tools: Set automatic reminders in your calendar for key tax dates.
  • Get Ready Early: Begin assembling documents and reviewing your tax situation well before the due date to avoid last-minute stress.
  • Enlist Help: Hire a professional to handle the filing process, especially if you’re unsure about complex forms or calculations.

5. Avoid Tax Mistakes by Addressing International Tax Issues for Global Operations

If your business operates internationally or even accepts foreign clients, it’s crucial to understand international tax treaties, VAT                  obligations, and transfer pricing rules. Many small businesses neglect to track income generated abroad, leading to discrepancies                  when filing.

Why it matters:

A U.S.-based small business owner working with clients in the EU faced severe penalties after failing to report Value Added Tax  (VAT) due on sales made in Europe, resulting in an unexpected bill from both local tax authorities and the IRS.

Prevention strategies:

  • If your business operates internationally, stay updated on the tax obligations of the countries where you do business. Consulting        with a professional who understands international tax law can help you avoid costly mistakes.

6. Incorrectly Handling Digital Assets and Cryptocurrencies

In recent years, digital currencies like Bitcoin, Ethereum, and others have gained traction in business transactions. However, many              small business owners fail to realize that these digital assets must be reported on their tax returns. The IRS treats cryptocurrencies as          property, meaning that any sales, exchanges, or income from mining and staking activities must be accurately reported. In 2024, the          IRS emphasized the importance of reporting digital asset transactions to avoid costly penalties and interest.

Why it matters

In 2024, the IRS clarified that taxpayers must report all transactions involving digital assets, including sales, exchanges, and income from activities like mining or staking. Failure to report these transactions can lead to substantial penalties, interest charges, and possible audits. The IRS cross-checks these transactions with the information it receives from exchanges and other third parties, so any discrepancies in your tax return are likely to trigger scrutiny. Proper reporting helps avoid these risks and ensures compliance with tax regulations.

Prevention Strategies:

  • Track Every Transaction: Keep a detailed log of each crypto transaction, including the date, amount, and fair market value at the time of exchange or sale.
  • Use Crypto Tax Software: Leverage platforms like CoinTracker or Koinly that integrate with exchanges to automate tracking and reporting, ensuring accuracy.
  • Consult a Tax Professional: If you’re involved in cryptocurrency transactions, it’s crucial to consult with a tax professional experienced in digital assets to ensure you’re compliant with IRS reporting requirements.

7. Not Taking Advantage of Available Tax Credits

Small businesses can save a lot of money on taxes by claiming various tax credits, but many business owners miss out on them. These  credits, like the Research and Development (R&D) Tax Credit or the Work Opportunity Tax Credit (WOTC), are meant to  help businesses save money for doing certain activities, like creating new products or hiring people from specific groups. Not claiming these credits means businesses could end up paying more in taxes than they need to.

Why it matters:

Tax credits are a way to directly reduce the amount of tax a business has to pay. For example, businesses that invest in sustainable practices may qualify for green energy credits, or might be eligible for the R&D Tax Credit, but many businesses don’t apply for it, missing out on potential savings. This means businesses could pay more in taxes than they should.

Prevention Strategies:

  • Stay Informed: Make sure you know about the credits available to your business. Websites like the IRS and other tax resources often provide updates on new or existing credits.
  • Get Help from a Professional: A tax expert can help you avoid tax mistakes by determining if your business qualifies for any credits and ensuring they are claimed correctly.
  • Check Credits Every Year: Tax credits can change, so it’s a good idea to look over them every year to ensure you don’t miss any new opportunities.

8. Overlooking Tax-Free IRA Rollovers & Mixing Up Tax-Exempt with Taxable

When managing retirement accounts, mistakes involving IRA rollovers are more common than you might think. A typical error                    occurs when a tax-free IRA rollover is mistakenly entered as a taxable distribution, leading to unnecessary taxes and potential                        penalties.

Why it matters:

The IRS treats rollovers differently than regular withdrawals. If you roll over funds from one IRA to another and mark it as taxable income, you’ll end up paying taxes on money that you don’t owe taxes on because rollovers are typically tax-free if done correctly. This mistake could trigger both immediate taxes and penalties. Even though tax software can help prevent some errors, it’s crucial to  carefully review all the information before submitting.

Prevention Strategies:

  • Double-Check Your Forms: Carefully go over the distribution forms for your IRA rollover. Ensure you don’t place the tax-free rollover amount in the taxable section by mistake.
  • Verify Entries in Tax Software: Tax software can flag potential errors, but you should always cross-check your final return. Confirm that every detail is in the right place, especially with rollovers.
  • Consult a Professional: If you’re unsure about how to handle your IRA rollover, consider reaching out to a tax expert. They can help you avoid costly mistakes and ensure you’re following all the IRS rules correctly.

Running a small business is tough, and tax season can make it feel even harder. It’s easy to make mistakes, and even small ones can cause big problems down the road. But you don’t have to go through it alone. Understanding these common tax pitfalls and taking the right steps now can save you from stress, unnecessary penalties, and lost opportunities.

At nVest Advisors, we truly care about the success of your business. We understand the challenges small businesses face, and we’re here to help you navigate through all of it without all the confusion and worry. Whether you need guidance on keeping your finances separate or making sure you get every tax break you’re entitled to, we’re here to support you every step of the way.

If you’re ready to tackle tax season with confidence, book a meeting with us today. We’re excited to help your business thrive!