This article is part of BizTaxFacts, our Business Tax series on navigating taxes for self-employed individuals and small businesses. We’ll break down tax obligations and considerations, including deductions, credits, and filing across different working arrangements.
Navigating Professional Services Taxes: As a small business owner or self-employed individual in the professional services industry, taxes may be the last thing on your mind. But when it comes to ensuring compliance with federal, state, and local regulations, there’s a lot to keep up with. This article will walk you through the key concepts, definitions, and classifications of professional services taxes, as well as provide expert advice on how to maximize deductions and minimize liability.
What You Need to Know
- Understand the specific rules and regulations in your state and locality for sales tax on professional services.
- Keep accurate records to support business expense deductions, including travel expenses, meals and entertainment, and professional fees.
- Consider entity structuring, compensation planning, and other advanced tax planning strategies to minimize tax liability and maximize after-tax income.
- Beware of audits by understanding common triggers, such as underreporting of income, overstatement of deductions, and failure to file required returns.
Understanding Professional Services Tax
Professional services taxes are levied on businesses that provide intangible services, such as expertise, advice, or guidance. These services can be in various fields, including law, architecture, engineering, accounting, and consulting.
The IRS’s interpretation of “professional services” is context-dependent, varying based on the specific tax code section or regulation being applied. For instance, when determining the Qualified Business Income (QBI) deduction, the IRS utilizes the term “specified service trade or business” (SSTB), which entails a specific list of professional services.
Here are the types of taxes relevant to professional services:
- Income Tax: Applied to business profits.
- Self-Employment Tax: For sole proprietors, partners, and independent contractors.
- Sales Tax: Potentially applicable to certain services, varying by jurisdiction.
- Payroll Taxes: If the business has employees.
- State and Local Taxes: Additional taxes specific to location.
Furthermore, each professional service industry has unique tax considerations. For example:
- Legal and accounting firms often manage client trust accounts, requiring specific accounting practices.
- Architectural and engineering firms may deal with project-based accounting and long-term contracts.
- Advertising and PR businesses face complex sales tax rules, which varies by state.
💡Learn more about how taxes work for consultants.
Managing Sales Tax Obligations
Sales tax on professional services is a complex area of tax law, and the rules and regulations vary by state and locality. Only four states tax services by default: Hawaii, New Mexico, South Dakota, and West Virginia. Five states don’t have sales tax on goods or services: Alaska, Delaware, Montana, New Hampshire, and Oregon. The rest of the states exempt professional services from sales tax, or tax them at a reduced rate.
- Registering for a Sales Tax Permit: If your business provides professional services that are subject to sales tax, you may need to register for a sales and use tax permit. The registration process typically involves filing an application with the state tax authority and providing required business information, such as your business name, address, and federal tax ID number.
- Collecting and Remitting Sales Tax on Professional Services: If your business is required to collect sales tax on professional services, you must collect the tax from your customers at the time of sale or delivery. You must also remit the collected tax to the state tax authority on a regular basis, usually monthly or quarterly, depending on the state’s requirements.
- Filing Sales Tax Returns: Businesses that collect sales tax on professional services must file a sales and use tax return with the state tax authority on a regular basis. The return must include information such as the business name and address, sales tax permit number, total sales, and sales tax collected.
💡Learn more about state sales tax.
Maximizing Deductions for Professional Services
Businesses offering professional services can deduct a wide range of expenses related to their trade or business. Here are some common deductions to consider:
- Travel Expenses: Expenses related to business travel, such as transportation, meals, and lodging.
- Meals and Entertainment: Expenses related to business meals and entertainment, such as client entertainment and business association dues (limited to 50% under certain circumstances; entertainment is generally not deductible).
- Professional Fees: Fees paid to attorneys, accountants, and other professionals for services related to the business.
- Continuing Education: Expenses related to continuing education and professional development, such as course fees and conference registration.
💡Learn more about business tax deductions.
Advanced Tax Strategies: Entity Structuring
One common advanced tax planning strategy for professional services businesses is entity structuring. This involves creating a separate entity, such as a corporation or limited liability company (LLC), to hold the business’s assets and operate its activities.
- Separate entity: Consider forming an S corp or LLC.
- Asset holding: Can shield personal assets from business liabilities.
- Tax impact: Affects how profits are taxed (pass-through vs. corporate).
💡Learn more about entity structuring.
Advanced Tax Strategies: Compensation Planning
Another advanced tax planning strategy for professional services is compensation planning. This involves structuring the compensation package for the business owners and employees in a tax-efficient manner.
- Salary vs. Distributions: For owners of pass-through entities (e.g., S corporations, LLCs), determining the optimal balance between salary and distributions is critical. Salaries are subject to payroll taxes (Social Security and Medicare), while distributions are generally not.
- Benefits and Perks: Offering tax-advantaged benefits, such as health insurance, retirement plans (401(k), SEP IRA), and flexible spending accounts (FSAs), can reduce taxable income.
- Deferred Compensation: Deferred compensation plans can allow employees and owners to defer income to later years, potentially reducing their current tax burden.
- Reasonable Compensation: The IRS requires that owner compensation be “reasonable” for the services provided. Excessive distributions and low salaries can trigger IRS scrutiny.
- Payroll Tax Considerations: Accurate withholding, timely filing, and proper worker classification are essential to avoid costly penalties and ensure compliance with complex federal and state regulations.
💡Learn more about employee compensation and planning.
Managing Audits and Tax Disputes
While the overall chance of an audit may be relatively low, certain factors can increase the risk, and professional service businesses are not immune. It is therefore always best to be prepared. Here are some common audit triggers to watch out for:
- Underreporting of Income: Failing to report all income earned by the business.
- Overstatement of Deductions: Claiming excessive or improper deductions.
- Failure to File Required Returns: Failing to file required tax returns or forms.
💡Learn more about how to avoid a tax audit.
Stay Ahead with Tax Planning
By understanding the key concepts, definitions, and classifications of professional services taxes, as well as maximizing deductions, minimizing liability, and staying up-to-date on the latest trends and legislation, professional services businesses can focus on what they do best – providing expert advice and guidance to their clients.
💡Learn more about tax planning strategies.
Your Professional Services Tax Questions Answered
Q: What taxes apply to professional service businesses?
A: Professional service businesses are subject to standard tax categories (income tax, sales tax, etc.), with specific applications based on their industry. Specific tax rules vary by industry and location, covering fields such as law, architecture, engineering, accounting, and consulting.
Q: Do I need to register for a sales tax permit if I provide professional services?
A: It depends on the state and locality where you operate your business. Some states exempt professional services from sales tax, while others tax them at a reduced rate. It’s essential to check with your state tax authority to determine if you need to register for a sales tax permit.
Q: What expenses can I deduct as a professional services business?
A: Professional services businesses can deduct a wide range of expenses directly related to their trade or business, including travel expenses, meals and entertainment, professional fees, and continuing education. These expenses must be ordinary and necessary to the particular trade of business.
Q: How can I structure my compensation package for tax efficiency?
A: Compensation planning involves structuring the compensation package for the business owners and employees in a tax-efficient manner. This may involve setting up a qualified retirement plan, offering health insurance, or providing other fringe benefits.
Q: What should I do if I receive an audit notice?
A: If you receive an audit notice, don’t worry. Take a deep breath and contact a tax professional, like TurboTax Live Business, for expert guidance and support.
Take Action: File Your Taxes with Ease
With TurboTax Live Business, get unlimited expert help while you do your taxes, or let a tax expert file completely for you, start to finish. Get direct access to small business tax experts who are up to date with the latest federal, state and local taxes. Small business owners get access to unlimited, year-round advice and answers at no extra cost, maximize credits and deductions, and a 100% Accurate, Expert Approved guarantee.