Tax Planning

Consequences of Misunderstanding Taxes for Small Businesses

Dec. 8, 2022

Everyone can make mistakes when it comes to handling business finances. Even those with a financial background. But sometimes, these mistakes can be costly, and the punishment may even exceed the crime, especially regarding taxes.

Doing your taxes is mandatory, doing them well is vital. But you will need a thorough understanding of the tax system to do a good job. Otherwise, you could face some of the following consequences.

Late Filing Penalties

Misunderstanding the taxation system for small businesses is common among business owners. Even worse, it’s common among accountants and bookkeepers who don’t operate within industries they understand completely.

But why is this bad if so many companies make the same mistake?

Misunderstanding taxes can mean many things. However, one of the worst problems is failing to meet the filing deadlines.

You might think it’s not a big deal. After all, you won’t go to jail for missing the deadline. That doesn’t mean you can’t end up dipping into your profits to pay the penalties.

Late filings incur 5% of the total tax bill in penalties. As if that’s not bad enough, the penalty is actually 5% of your tax bill for every month you’re late for up to five months. By law, this can’t exceed 25% of an unpaid tax bill.

That said, failure to file penalties can be compounded with failure to pay penalties. It’s safe to assume that if you don’t know when to file or the importance of filing on time, you’re not quick to make payments either.

The failure to pay the penalty kicks in after you reach 25% of your unpaid bill or the filing penalty maxes out. Unlike the filing penalty, failing to pay the penalty keeps adding interest to your debt until it’s paid in full.

If you knew how the taxation system worked in your industry, you’d know when to file to avoid penalties or at least how to apply for a filing extension, should you require more time to sort out your tax documents.

Paying Too Much in Taxes

You should know one thing about the IRS and how taxation works. While there are clear guidelines for managing your finances and reporting earnings, the IRS won’t go out of its way to help you be more profitable.

What does this mean?

It means that misunderstanding small business taxes can cause you to miss out on great opportunities.

You may end up paying too much in taxes if you’re unaware of all the deductions you’re eligible for. There are many deductions, grants, tax credits, and other tax breaks that your business might qualify for.

For example, some of these deductions may include startup costs, unpaid goods, education expenses, loan and credit card interests, business services like transfer fees, etc.

But if you don’t make deductions on time, you’ll pay the full amount owed as indicated by your books. Since that means more money goes to the IRS, don’t expect anyone over there to notify you that you overlooked certain tax advantages.

The only time the IRS reaches out is when it finds a reason to penalize you. This is one of the main reasons to always work with expert accountants and bookkeepers. No one else will keep you up to date on tax benefits and deductions to help reduce your taxes.

Raising Red Flags With the IRS

A poor understanding of creating and filing tax paperwork is a quick way to raise red flags with the IRS. Even reporting more income than you actually make can put you on the IRS’s radar. The IRS doesn’t just look for fraud. It also looks for inconsistencies.

Why is that a bad thing for you and your business?

When the IRS notices inconsistencies with your reporting, it will likely perform a tax assessment. This process requires you to give an auditor access to your financials, provide more paperwork, etc. It gives you the opportunity to prove that your documents are correct and the IRS has nothing to worry about.

The IRS fully understands that not all improperly filled documents are intentional. People can make mistakes. But the agency also must determine if you made a genuine mistake or willfully committed fraud.

The unfortunate aspect of raising red flags is that the IRS has started coming down harder, even on honest mistakes. Misunderstanding how to navigate the tax documents and deadlines can still cause you to commit tax evasion unwittingly.

In the worst-case scenario, this could result in a five-year jail sentence. Both individuals and corporations can be served with penalties of hundreds of thousands of dollars.

Even those honest mistakes can be classified as financial negligence and may still incur penalties of up to 20% of any unpaid taxes. Hence, it’s mandatory to understand your tax bracket and responsibilities to avoid huge fines and sentences.

Destroying Your Borrowing Power

Many businesses need funding to improve their operations, solve cash flow issues, survive inflation, expand, innovate, etc. Unless you have a listed company and can count on individuals or trusts, borrowing money is the fastest way to increase your capital.

But no lender will give you money out of the goodness of their heart. It’s all about making a profit.

Apart from interest rates being generally high, there’s another issue with borrowing money. If you can’t show that you can repay debts, you won’t get a loan.

No private or institutional lender will risk their money. Showing your borrowing power requires sharing tax returns.

This is where many small businesses hit a roadblock. Misunderstanding your tax bracket, paperwork, filing guidelines, and financial statements can prevent you from qualifying for a loan.

A lender may see your income as being too low due to what’s on your tax return, even if that’s not true. Additionally, lenders can also reject loan applications when they notice inconsistencies in your financial reporting. They’re potential red flags indicating the business isn’t being run correctly.

Developing Poor Recordkeeping Habits

Every small business must adhere to the IRS’s strict recordkeeping and taxation guidelines for a specific industry.

But if you already have a misunderstanding of how it all works, you could struggle with basic requirements like properly managing statements, receipts, and other financial statements.

Why is this detrimental to your business?

These days there’s a tendency to become paperless. Everyone wants to digitize and automate recordkeeping to eliminate the need for storage, cut costs, and make everything more organized.

While that’s great in theory, you can’t simply ditch physical copies of your financial statements, receipts, tax filing, and other documents. Those must be kept in physical form for a period determined by the IRS.

Another issue you may face is not having sufficient statements and proof to back up your tax filings. In the event of an audit, you must provide the required evidence to substantiate your claims. If you don’t know what documents, receipts, payment stubs, checks, and other evidence to keep, you stand little chance of settling IRS disputes in your favor.

Creating Overlap in Your Personal and Business Finances

If you don’t know how each tax bracket works, you risk picking the wrong legal entity for your business. Many small business owners create the wrong business ownership structure and end up at a disadvantage come tax season.

Things can get even more complicated when dealing with corporate structures. Therefore, if you’re unsure how to best manage your tax fillings, working with professionals in this field and with experience in your industry brings nothing but advantages.

Gaining the Wrong Kind of Reputation

Raising red flags with the IRS is bad enough. But doing it consistently can earn you a special kind of reputation.

You must address the issue quickly if you don’t understand how to file tax paperwork correctly and on time. The more mistakes you make, no matter how small, the fewer chances you have of creating an audit-proof business.

Regular IRS audits can become a reality. As a business owner, those company audits can lead to personal audits. It’s a common sense response from the IRS when auditors notice you’re doing a poor job of fulfilling your financial responsibilities.

Furthermore, if you’re unorganized, an audit can take a long time, stress everyone in the business, and tarnish your reputation with customers, partners, vendors, and others.

It’s Time to Find Your Tax Expert

You probably started your business to provide a service and make more money than you would’ve as an employee. If you want that freedom to last and those riches to pile up, it’s time to get serious about managing your taxes better.

It’s a real shame how even some honest mistakes can come between you and your financial freedom. If you’re unsure how to get ahead of some of these consequences, using a service like Swyft Books can help. Proper accounting, bookkeeping, and financial guidance are necessary to clarify your tax responsibilities and identify ways to save money.