As a small business owner, you may assume the IRS has bigger fish to fry than your small business operations. However, recent reports have cited that the IRS has increasingly targeted small businesses for tax audits.
The National Taxpayer Advocate estimates small businesses spend approximately 2.5 billion hours each year preparing tax returns or responding to IRS inquiries about their returns. This is the equivalent of 1.25 million full-time jobs. The study also cited that 70% of small businesses employ tax professionals for tax preparation and to represent their interests before the IRS.
To avoid wasting time, money, and resources, pay attention to your potential tax burden when forming your business. The formation stage is vital to maximizing deductions and minimizing your tax liabilities for the future.
With the Tax Cuts and Jobs Act in full effect, many small business owners are unsure how the new tax law will impact their tax bill. Many business owners don’t even know corporate income tax rates, business tax deductions, or what tax cuts they’re eligible for.
Every small business owner should understand these five important things that can affect the business’s income taxes and overall tax situation.
1. Choose your legal structure wisely
When forming your business, it’s important to be aware of the different legal structures that exist, since each structure has different tax implications. Sole proprietorships, S corporations, C corporations, and limited liability companies (LLCs) are all different legal structures with different tax requirements.
Here are the differences between each.
If you’re operating an unincorporated business and are the only owner, then you’re automatically a sole proprietor. This is the most common business entity with over 23 million sole proprietorships in the United States. It’s the easiest to set up and manage, but also one of the riskiest since you personally assume all financial and legal obligations.
Sole proprietorship taxes are straightforward since you can report business income and losses on your personal tax return (Form 1040), using Schedule C. Your company profits are added to other income (interest, dividends, etc.) on your personal tax return.
With the new tax law, sole proprietors are able to take advantage of the 20% tax deduction, which allows them to deduct 20% of the business’s net income from their taxable income, which reduces their tax liability.
S corporations may pass income directly to shareholders to avoid double taxation. Double taxation means that a firm’s profit is taxed on a business tax return, and any after-tax profits distributed to owners is taxed again as personal income. But this won’t happen if your company is set up as an S corporation.
S corporations must have no more than 100 shareholders, all shareholders must be U.S. residents, and each member is only allowed to own one class of stock. Shareholders report business income, expenses, losses, and deductions on their personal tax returns. S corps are also eligible for the 20% tax deduction, but shareholders pay taxes on business profits at their personal income tax rate. It’s one of the most common types of legal structures for small business owners because they have the same advantages as traditional corporations but with more tax flexibilities.
Traditional corporations are C corporations (C corps). The organizational structure of a C corp consists of shareholders, a board of governors, officers, directors, and employees. Although Fortune 500 firms are the most well-known C corps, it’s still a viable option to structure your small business this way. It provides legitimacy to investors and clients, allowing you to raise funds faster and land larger contracts. If you anticipate quickly transitioning from a startup to a more established company, then the C corporation structure may be right for you.
C corps are the only type of business discussed here that must pay taxes on the company level. The current corporate income tax rate for C corps is a flat 21%. Additionally, in contrast to S corps that lets shareholders report profit and losses on their personal tax returns, shareholders receive dividends (i.e. a share of company profits). Shareholders must pay personal taxes on those dividends.
The taxation structure on both the company and shareholder levels is referred to as double taxation. This turns off many small business owners. When starting out, LLCs tend to be a more popular option than C corps for various reasons.
Limited Liability Companies (LLCs)
Many small businesses tend to form as an LLC. LLC members have two important tax advantages: no double taxation and deductible business losses.
Unlike C corporations, where business income is taxed twice — at the corporate level and at the individual level — LLCs are only taxed once at the individual level. This means that members pay taxes on business income on their personal tax returns in the same way a sole-proprietorship or an S corp does. This treatment is referred to as a “pass-through” tax treatment.
Another advantage of owning an LLC is that you can have an unlimited number of members (i.e. potential shareholders) in your LLC, which makes it easier to raise capital and expand your business. If you have multiple members in your LLC, you have to determine the ownership percentages for each member.
With multiple-member LLCs, you can choose to be taxed as a partnership or as a C corporation. If you choose to be taxed as a partnership, then you’ll report your share of the business income on your personal income tax returns. If you choose to be taxed as a C corporation, you will be subject to double taxation.
Single-member LLCs, on the other hand, are automatically taxed as a sole-proprietorship.
You may pay upfront costs to set up and maintain your LLC with your state. To operate an LLC in California, for instance, small business owners pay $800 in state taxes annually — regardless of how much money the LLC is making or losing.
If you’re in a state where you have to pay annual taxes to operate an LLC, then your job is to grow the business enough to offset that cost. Every state has different annual taxes to operate an LLC and some may not have any annual state taxes, so it’s important to check before you establish your business.
But the tax advantages, pass-through profits, and management flexibilities still make LLCs a popular option. Your tax situation depends on doing your research to determine which legal entity best suits your needs.
2. Use tax deductions to lower your tax bill
New small business owners have to stretch their financial resources.
Small businesses have business expenses that include vehicle expenses, wages, business travel, contract labor (i.e. hiring freelancers and independent contractors), supplies, equipment, depreciation of assets, rent on business property, utilities, insurance (i.e. property, business, health insurance, etc.), and repairs.
Fortunately, as a small business owner, you are able to minimize your business taxes by writing off a lot of those operational expenses come tax season.
Tax preparation software such as the QuickBooks Self-Employed Tax Bundle with Intuit Turbotax automatically tracks your business expenses to minimize your federal tax burden, which allows you to easily claim your deductions.
3. Write off your startup costs
Many brand-new startups make the mistake of thinking initial business expenses aren’t deductible until their businesses are fully operational. However, the IRS allows small business owners to deduct a wide array of startup expenses before beginning business operations.
The IRS allows you to deduct up to $5,000 in business startup costs and up to $5,000 in organizational costs, but only if your total startup costs are $50,000 or less. With the help of your tax software or a tax expert, you can write off typical costs associated with setting up a business during tax filing.
Typical costs to set up a business include business insurance, office space, real estate, office supplies, business cards, business assets, professional fees (i.e. hiring accountants), and small business loan fees. If you’re operating your business from a home office, you can qualify for a home office deduction.
Additional costs can also include employee training, locating suppliers, and advertising to potential clients. While companies cannot deduct licensing and incorporation fees as startup expenses, these costs may be deductible as organizational expenses.
It’s important to remember that startup founders can only deduct those expenses leading to the creation of a viable business entity. If you decide against forming your business, the above costs will be labeled as personal expenses, and you may not be able to deduct any of your costs.
4. Pay quarterly taxes
According to the IRS, individuals, including sole proprietors, partners, and S corporation shareholders, have to make quarterly estimated tax payments if they expect to owe taxes of $1,000 or more when their federal returns or state tax returns are filed.
You can figure out your estimated tax payments as a business owner using Form 1040-ES. It may be helpful to use last year’s income, deductions, and tax credits as a starting point. You can also use your previous year’s federal tax return as a guide.
Once you’ve figured out the number and e-file, you can pay the IRS in a number of ways. These include IRS Direct Pay, which takes money owed out of your checking or savings account, and IRS Pay By Card, which allows you to pay with a credit or debit card online. Another option is paying by phone.
Quarterly estimated tax payments for each respective quarter are due every April 15, June 15, September 15, and January 15 (of the following tax year).
The self-employed and sole-proprietor business owners almost always have to pay estimated quarterly taxes unless their business loses money. Unlike a salaried employee — where their employer withholds a certain amount with each paycheck — sole proprietors, freelancers, and business owners assume the full tax burden.
Additionally, people who are partners in a business, a corporation, or an S Corporation often pay quarterly taxes if they expect to owe at least $500 in taxes.
Business owners who fail to submit at least 90% of the taxes they owe are subjected to severe penalties, so working with a tax professional can be very helpful to double check if the amount owed is correct.
5. Some business taxes you might need to pay
Keeping track of the amount of taxes you’re responsible for can come as a great surprise when you own your business. Here are the most common types of taxes to account for as a business owner.
If you’ve never owned a business before, then you are likely unaccustomed to paying self-employment taxes. Businesses pay a 15.3% FICA tax, which is used to fund Social Security and Medicare. Employees pay 7.65%, and employers pay the other 7.65%.
As a self-employed individual, you’re responsible for the full 15.3%, which is sometimes called “self-employment tax.” However, you can deduct half of the self-employment tax on your personal tax return (Form 1040). Additionally, it’s important to take advantage of all possible startup and operating business expenses to maximize tax deductions.
If you have employees, you’ll be responsible for paying payroll taxes on their wages. Payroll taxes include federal income tax withholding, Social Security and Medicare taxes, and federal and state unemployment taxes. Many businesses hire a payroll service to file their tax forms and manage their payroll tax liabilities on their behalf.
Depending on the nature of your business and industry, you might be responsible for paying excise taxes. Excise taxes are indirect taxes, that are not paid directly by the consumer of a product.
Often the tax is included within the price of the product itself, such as with cigarettes, gasoline, and liquor. Businesses that sell products subject to excise taxes are responsible for collecting the taxes and sending them directly to the IRS.
Although a federal sales tax doesn’t exist in the United States, the majority of states levy sales taxes. Customers pay a sales tax on goods and services at the point of purchase. Business owners are responsible for collecting and reporting sales taxes to local and state governments. As a small business owner, it’s also important to understand state and local tax rules with respect to sales taxes.
If you own commercial property, you’ll have to pay property taxes to the city or county where your business is located.
Maximize your flexibility as a small business owner
Setting up and operating a small business can come with significant initial costs.
Whether you’re flying solo or working with partners, the tax system is set up to help offset those potentially high costs for self-employed professionals at tax season. Maximizing tax deductions by writing off startup and operating costs can limit your tax liability in relation to your business income.
Having quality small business tax software can guide you. As a new business owner, it also helps to work with a tax professional to avoid common pitfalls like underreporting your business expenses or ignoring an important tax form that can save you money.