Tax Refunds Can Be Great but There Are a Few Downsides You Should Know About
Tax refunds can be good for W-2 employees, but for business owners, that isn't always the case. What are the downsides of receiving a tax refund?
Jan. 6 2023, Updated 10:46 a.m. ET
It's tax season which means there are plenty of people looking forward to receiving a tax refund. While refunds are usually thought of as useful money, surprisingly, there are some downsides to receiving a tax refund.
Sure, these lump sums of money seem to come in the clutch as you recover from holiday debt, but knowing the downsides to them might actually result in you getting more money this year, next year, and so on. Keep reading to find out why tax refunds aren't always a good thing.
It doesn't benefit business owners to get a tax refund. Here's why.
A business can’t receive a tax refund itself unless it’s a C-corp. In every other business type, including sole proprietorships, LLCs, partnerships, and S-corps, the income is passed to the owners. And in most cases, a C corporation will only receive a tax refund if it overpays on sales taxes or its employee payroll. This doesn't happen very often, as it isn't beneficial to overpay just to get a refund.
The same goes for other business entities. If you’re a business owner who gets a tax refund back, that means you overpaid taxes in that tax year. Whereas overpaying taxes may help avoid audits by the IRS, you shouldn't give the agency free money.
Instead of overpaying, you could reinvest in the business, putting the money toward upgrades and improving salaries, or keep the funds in a business savings account for emergencies. You can use that saved money for future projects, to replace equipment, to pay business taxes, or you may simply earn interest on the money held.
There are ways to avoid overpaying taxes as a business owner.
The best way to avoid overpaying taxes is to have a tax preparer or accountant determine the proper tax withholding for your business. The IRS's tax withholding calculator can help you determine tax withholdings as well, as can tax software such as Intuit TurboTax, H&R Block Tax Prep, Gusto, and ADP.
Some of these offer online payroll services, where employees have income tax automatically deducted from their paycheck before receiving it.
These services send the taxes to the IRS for you and give you the proper documentation when it's time to file. However, they best suit employees of C corporations, S-corps, and LLCs that elect S-corp status. For sole proprietors, who aren't considered employees, this software won’t be as useful.
The downsides of tax refunds for non-business owners explained.
If you receive a tax refund after filing your return, it generally means "you are withholding excess in withholding taxes," according to the principal owner of Epsilon Accounting Solutions, PLLC, Ahmed Baqir, CPA. Basically what this means is that you allowed the government to take more in taxes than necessary.
When tax time rolls around and you file your return, the government then returns the excess money you paid in, sort of like returning the money you let it "borrow." While some might not mind it, others would prefer to have less taxes taken out in order to receive larger paychecks.
This would provide you with more spending money. According to Baqir, "You could have invested this money or used it to pay off your credit card debt or mortgage."
Here's how you can get more money out of your paychecks, but a smaller tax refund.
If you wouldn't mind reducing your tax refund in order to get bigger paychecks throughout the year, contact your HR department to find out about adjusting your W-4. Keep in mind that you don't want to reduce your tax withholding too much as you don't want to have to pay in come tax time.