This article has been reviewed by tax expert Erica Gellerman, CPA.
Getting a big tax refund each year has its pros and cons. While you may be getting an injection of cash that you can reinvest in your business, you might actually be making a financial mistake if you're getting a big tax refund every April.
Let’s try to decide if getting a tax refund is in the best interest of your business.
Can a small business get a tax refund?
Tax refunds for your business are fairly uncommon. More often than not, a small business itself cannot get a tax refund. The only business entity type that is eligible for a tax refund is a C-corporation. 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. 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-corp can receive a tax refund is if it overpays on payroll or sales taxes. Therefore, this discussion is really about the pros and cons of a small-business owner receiving a large personal tax refund.
Downsides of receiving a tax refund
Interest-free loan to the government
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 or put it 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. Surveys show that 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. If you'd had that money throughout the year, you may be more likely to spend it on your business or have it available in case of an emergency.
Benefits of getting a tax refund
Makes you save more money
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
While many people like to splurge on their tax refund, others spend it responsibly. 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 you get an amount deducted from your earnings each month that leaves you neither owing nor receiving a lot come tax season. If you make estimated tax payments quarterly, you won’t have taxes withheld regularly. You’ll have to adjust how much you pay quarterly in estimated taxes.
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 withholdings to get as close as possible to your tax liability. (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.
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.
A version of this article was first published on Fundera, a subsidiary of NerdWallet