Is There a Downside to Receiving a Tax Refund?
Business owners should avoid receiving a large tax refund if they would rather have that money on hand to reinvest in their business. However, some people might decide they like receiving a refund because it allows them to save a bit extra—especially if they don’t have any pressing business expenses.
Getting a big tax refund from the government each year has its pros and cons. On the one hand, you’re getting an injection of cash which you can reinvest in your business, which seems nice. But you might actually be making a financial mistake if you are getting a big tax refund every April.
The question is: Is it better to take enough exemptions to get a refund come tax time, or should you forgo a refund and maybe even owe a little something to the government on April 15? And how will this decision affect your business’s finances?
Let’s break it down and try to decide if getting a tax refund is in the best interest of your business. But first, let’s learn about if and when a small business can get a tax refund.
Can a Small Business Get a Tax Refund?
Tax refunds for your business are fairly uncommon. More often than not, a small business cannot get a tax refund. The only business entity type that is eligible for a tax refund is a C-corporation. This is because, unlike other business entities, C-corps’ profits are taxed separately from their owners’ under subchapter C of the Internal Revenue Code. Therefore, if a C-Corp pays more estimated tax during the year than is due on the final return, it can get a tax refund.
All other business entity types, including sole proprietorships, S-corps, partnerships, and LLCs pass their income through to their owners. This means if the business overpays on its taxes, the business owner will get a larger tax refund. The only situation where a business that is not a C-corporation can receive a tax refund is if it overpays on payroll or sales taxes.
Therefore, when we talk about the pros and cons of receiving a business tax refund, we are really talking about the pros and cons of a small business owner receiving a large personal tax refund.
Downside of Receiving a Tax Refund
There are some real downsides to receiving a large tax refund as a small business owner. We’ll list them here:
Interest-Free Loan to the Government
It seems weird to think getting a big tax refund could be a negative thing for your business. But the thing is, when you get a refund, you’re really just getting your own money back that you overpaid in taxes throughout the year. When you think about it, all you really did was lend the government your money, interest-free. If that had been money you didn’t pay in taxes, you could have reinvested it in your business. At the least, you could have put that money in an interest-earning business savings account. But when people receive a tax refund, that’s not always what they do—which brings us to our second point.
People Like to Splurge on Their Tax Refund
A fat refund check feels like “found money” to most of us emotionally. Therefore, the tendency is to treat it carelessly and spend it on something discretionary—like a vacation, new home furnishings, or some other splurge—instead of putting that capital to better use. Although many people will spend their tax refund wisely, there is still a sizable percentage that will spend it on a major purchase, vacation, or luxury item, according to a recent survey.
What if you needed that money at some point during the year to deal with an emergency business expense? Wouldn’t it be better to have the money available when you need it, instead of treating yourself—or lending that money to the government?
Benefits of Getting a Tax Refund
The downsides to getting a large tax refund are more about what your business could be doing with that money if you weren’t paying it in taxes. But getting a large tax refund in and of itself obviously isn’t a bad thing. Here are some pros to tax refunds:
Makes You Save More Money
Some people look at their tax withholdings as an interest-free loan to the government. But there is also another way to look at it: You’re indirectly saving money. After all, if you are overpaying on taxes, you’ll get that money back come April. And if you’re the type who has a tendency to spend their extra cash, withholding more than you need to is a good way of forcing yourself to save money. However, when that money does come back, you still need to spend it wisely.
Pay off Large Debts and Other Expenses
We mentioned that many people like to splurge on their tax refund. But many people also like to spend it responsibly. According to that survey referenced earlier, 27% of Americans use their tax refund to pay off debt. If that’s what you plan to do, then getting a large tax refund can actually be good for you and your business.
But you don’t just have to use your tax refund to pay off debt. There are a variety of smart ways to spend your tax refund, including:
- Investing in a 401(k) or another retirement plan where it’ll earn interest
- Purchasing disability insurance to protect your future earnings in case you become disabled
- Making a large business purchase
- Purchasing benefits to offer to your employees (this is tax deductible)
- Making sure you have enough life insurance for your family’s financial security
- Building up an emergency savings account or “rainy day” fund for your business
- Using it to support your business through a seasonal downturn
These are just a few ideas. Given your financial situation, you’ll know the best way to spend your tax refund responsibly. If you need some help, talk to a business accountant.
The Alternative to Getting a Tax Refund
If the cons of getting a tax refund outweigh the pros for you, there are steps you can take to make sure you don’t end up getting a large tax refund—and you don’t end up owing a lot of money when you file your business taxes. It starts with changing your tax withholding so that you get an amount deducted from your earnings each month that leaves you neither owing nor receiving a lot come tax season.
The best time to update your tax withholding is right after you file your taxes. That way, you can have the right amount withheld for the year to come. Your tax preparer or accountant can advise you on how to adjust your exemptions to get as close as possible to zero tax. (You’ll probably come out either owing just a little bit in taxes or getting a small refund.) The IRS also offers a calculator on its website that you can use to determine if you’re withholding the right amount. Tax preparers like TurboTax and H&R Block offer similar tools.
The amount withheld is determined by the number of allowances you claim. You can claim allowances based on the number of dependents you care for. The more allowances you claim, the less money that will be withheld from your paycheck—but the more you’ll owe come tax season.
Make sure you’re prepared with a bit of financial cushion as tax time approaches, in case you’ve estimated your tax bill incorrectly or something changes. You don’t want to end up owing too much and running into financial trouble.
Business Tax Refunds: The Bottom Line
If you’re not good with managing your money—you can’t trust yourself to use that extra cash wisely—then getting a tax refund can be a good way of forcing yourself to save money. If you spend it responsibly you can help secure your business’s financial future. Plan in advance how you’ll use it to reach financial goals like paying off a business credit card, putting a chunk of money into a retirement plan, purchasing insurance, or reinvesting in your business.
However, make sure not to use that tax refund as “fun money” that you throw away. You can still treat yourself, though: Take 5% – 10% of the refund to spend on whatever you want, then devote the rest of it to something more important.
Overall, whether you should get a tax refund or not depends on your operating costs and personal financial habits. You know yourself better than anyone, so create a plan that works best for you and your business.