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Tax Refunds Can Be Great but Costly: Here's Why

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Mar. 1 2022, Published 5:41 a.m. ET

It’s tax season and many people are looking forward to receiving a tax refund. While they're usually thought of as useful money, there can be some downsides to receiving a tax refund.

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Tax refunds are great for non-business owners who are W-2 employees, but most business owners shouldn't want a tax refund. Here's why.

The downsides of tax refunds for business owners

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-corp will only receive a tax refund if it overpays on sales taxes or its employee payroll. This doesn't happen very often, as it’s not beneficial to overpay just to get a refund.

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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.

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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, or pay business taxes, or you may simply earn interest on the money held.

How 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.

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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-corps, 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

Tax refunds are great for W-2 employees because they often don’t have to worry about overpaying taxes. However, there's always the risk they may not spend the refund wisely. Saving the money for an emergency, especially as we recover from the COVID-19 pandemic's effects, might be a better option.

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