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Why Do Business Owners Reinvest Their Profits?

Why Do Business Owners Reinvest Their Profits?
Susan Guillory
Susan GuilloryUpdated September 30, 2022
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Once your small business starts earning a profit, you have a key decision to make: Should you distribute those profits to yourself (and any other owners) or reinvest them back into the business?While it can be tempting to pocket your company’s profits, funneling at least some of that money back into the business is worth considering. For one reason, reinvesting can help improve the company or expand operations, leading to even higher profits down the line. For another, reinvested money is generally considered a business expense, which means you likely won’t have to pay income taxes on it.Read on for a closer look at why you may want to reinvest a percentage of your profits back into your business, how this can impact your business taxes, and ways you might use profits to help expedite business growth.

What Constitutes Profits for a Business

Profit is the money a business pulls in after accounting for all expenses. Any profits earned funnel back to business owners, who can choose to either pocket the cash, distribute it to shareholders as dividends, or reinvest it back into the business.Whether you own a small dog grooming business or a multinational corporation, the main goal of any business is to earn money. Thus, a business’s performance is based on profitability. For accounting purposes, companies will often report gross profit, operating profit, and net profit (the "bottom line")

What Are Businesses Taxed On?

Any profits that aren’t reinvested in a business are typically taxed as income. How that tax is paid depends on the structure of the business.Most small businesses are pass-through entities, which means that the gains or losses are passed through to the owners on their personal income tax returns. Corporations, on the other hand, pay a flat tax on business profits.Recommended: How Much Can a Small Business Make Before Paying Taxes? 

Types of Business Taxes

When we refer to “taxes” for a business, we’re actually using an umbrella term for many different types of taxes a business may have to pay. Let’s take a closer look.

Income Taxes

Income taxes are based on the net income of your business for the tax year. Net income is the same thing as profit (income minus expenses). If you share a business with others, the net income is divided among the owners, based on your business agreement. Most small businesses pay both federal and state income taxes.

Estimated Taxes

Employees have taxes withheld from their paychecks, but as the owner of your business, no one is withholding taxes from the money you take out of the business.Instead, you need to file estimated taxes throughout the year, based on the income you have earned up to that point in the year. Typically federal and state estimated tax payments are due on April 15, June 15, September 15 and January 15 for the previous tax year.

Self-Employment Tax

Employees generally have Social Security and Medicare taxes withheld from their paychecks. If you are a self-employed business owner, however, you must calculate and pay your own Medicare and Social Security tax through self-employment taxes.

Excise and Sales Taxes

Depending on which state you operate in, and what type of goods or service you sell, you may need to set up a system to collect sales tax from your customers and report and pay that tax to your state. You may also need to pay federal and local excise taxes. An excise tax is a legislated tax on specific goods or services, such as fuel, tobacco, and alcohol. 

Payroll Taxes

If you have employees, you must withhold payroll taxes from their paychecks and pay applicable federal, state, and local taxes. The taxes usually withheld from employee paychecks include FICA (Medicare and Social Security taxes) and federal, state, and local income taxes. Employers and employees each pay half of the FICA tax.

Reducing Taxable Income

As a business owner, there are many strategies you can use to reduce the portion of your business income (or profits) that can be taxed. Here are some you may want to consider.

Reinvesting Business Profits Into the Business

Reinvesting means retaining net profits (the income left over after all operating costs and overhead are paid) and investing them in activities or expenses that can help increase the value of the business. As a business expense, reinvested income  generally isn’t taxable.You may, however, want to reinvest only a portion of your profits and look for other ways to infuse capital into the business, such as applying for a small business loan. Interest paid on business loans is typically tax deductible as a business expense.

Finding Deductions

There are numerous business tax deductions you may qualify for and, when you add them all up, they can amount to a significant reduction in your taxable business income. Here are some of the most common small business deductions.
  • Inventory
  • Business property rent
  • Startup costs
  • Utilities
  • Company vehicle expenses
  • Insurance
  • Rent and depreciation on equipment and machinery
  • Office supplies
  • Furniture
  • Advertising and marketing
  • Business entertainment
  • Travel expenses
  • Interest paid on all types of small business loans 

Tax Audits

As a small business owner, it makes financial sense to explore all your options for reducing your tax bill. However, when it comes to deductions, you need to be careful. It’s particularly important, for example, to keep your business and personal expenses separate. If your deductions look suspicious to the IRS, the agency could potentially audit your business.

Investing in Employees

One great way to reduce your company’s taxable income is to invest in your employees. Generally speaking, any wages, bonuses, or other compensation you pay your workers in a given year are tax deductible as a business expense. That includes  any fringe benefits you offer — such as gifts, health plans, employee discounts — as well.Rewarding your workforce can do more than lower your tax liability, however. It can also help boost their morale, increase productivity, attract the top talent, and grow your business.

Choosing Purchases and Investments Wisely

While it's clearly important to invest in your business, the question remains: Where should you focus your funds? Here are a few purchases and investments you may want to consider.
  • Equipment It can be smart to reinvest profits into new machinery and equipment as your current assets age and become expensive to maintain. Upgrading equipment can increase efficiency and help you stay on the cutting edge of your industry.
  • Software Investing in software, such as payroll and accounting software, can help streamline tedious tasks and free you up to focus on more important matters, such as growing your business.
  • Inventory In some cases, using business profits to buy more inventory can be a smart business move. If you often sell out of popular products, for example, beefing up inventory can help you capture sales you’ve been missing out on.
  • More marketing You might consider hiring a marketing person or agency to help create buzz about your business, improve search rankings, and expand your customer base.

How Can a Business Be Tax Efficient?

One of the best ways to make your business tax efficient is to pay attention to tax credits and not just deductions. Tax credits are particularly valuable because, unlike deductions, which reduce your taxable income, credits reduce your tax bill on a dollar-for-dollar basis. For example, if your small business owes $25,000 in taxes, a $5,000 tax credit means you can subtract $5,000 from your tax bill and only owe $20,000.There are a number of tax credits your business might qualify for, including:
  • Credit for Small-Business Health Insurance Premiums
  • Employer Credit for Paid Family and Medical Leave
  • Work Opportunity Credit
  • Credit for Increasing Research Activities 
  • Disabled Access Credit
  • Credit for Employer-Provided Childcare Facilities and Services
  • New markets credit

The Takeaway

It takes hard work to establish and grow your business. But once you’re able to cover all your expenses, pay yourself a salary, and still have money left on the table, it may be time to consider putting that extra money into your business.Reinvestment means pouring a percentage of your company's profits back into your business. It can be a great way to increase the value of your company and to help your company grow. What’s more, reinvesting can reduce your business tax liability at the end of the year, for the ultimate win-win.

3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. Traditionally, lenders like to see a business that’s at least two years old when considering a small business loan.
  3. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.

Photo credit: iStock/Pixelimage
This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. LCSB0822013

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About the Author

Susan Guillory

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.
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