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What Is Income Tax Liability and How Do You Calculate It?

A tax liability is what you owe to the IRS or other taxing authority when you finish preparing your tax return. Check out different types of income tax...

As a small business, you're looking to streamline your finances in the best way possible. One of the key areas to focus on every year is paying your taxes and reducing your federal income tax liabilities.

Managing your tax payments most effectively has several perks. It helps you save money, keep your company safe from the scrutiny of the Internal Revenue Service (IRS), and of course, you get props for being a stand-up citizen.

If you are one of many small business owners looking to save taxes, this guide to tax liabilities will simplify things.

What Is Tax Liability?

Your tax liability is the taxes you owe to the IRS or government. It consists of your income tax, employment tax, and any past taxes you are yet to pay.

As a small business, several factors influence how much tax you will need to pay the government:

  • The type of entity your business is listed as
  • Tax deductions made
  • Tax credits availed
  • Equipment purchased for your business
  • The number of employees in your company and the benefits offered to them

Smart businesses prep for their tax filing through the year. Planning and savvy decision-making are key factors in this journey.

What Is Your Business Entity?

When filing taxes, a business must be classified as the right entity.

C Corporation

Every business with employees can be classified as a C corporation. This is a legal structure for a business, where the owner/s and shareholders are taxed separately from the entity.

C corporations need to pay a separate corporate income taxation, and the profits are taxed at both corporate and personal levels. As a C corporation, you can bring in investors, have access to certain tax advantages, and even launch an IPO someday.

Jay is the founder of a digital media company in New York. He has 30 employees and two investors who put in $300,000 to help him expand the business. His company is registered as a C corporation.  

Sole Proprietorship

If you have no employees, your business will be classified as a sole proprietorship. This includes single owners businesses that span the spectrum of freelancers, consultants, and service businesses.

Cheryl, 35, a logo and graphic designer in New York, has corporate, agency, and small business clients across the world. She makes around $80,000 a year and runs a one-woman show. Her business is classified as a sole proprietorship.

In this case, you don't need to register with the IRS and can use your Social Security numbers as the business tax ID.

Partnerships Without Employees

Finally, you have partnerships, which have more than one owner and no employees. Here's an example.

Human resource professionals Max and Jenny decided to launch a recruiting enterprise with a difference. Their focus is to help businesses hire people from diverse backgrounds. Max and Jenny own an equal stake in the company but do not have any employees.

The key difference here is that partnerships are additionally subject to FICA tax.

How Much Taxes Do Small Businesses Pay?

If you're wondering what your federal income tax liability will be alongside your state tax liability, it's a safe bet to set aside 30-40% of your income to cover both.

However, you might end up paying less. According to Small Business Administration, the average taxes paid by small businesses is 26.9%. But it can also go as low as 13%.

As a small business, here are some of the main federal taxes that you will need to pay:

  • Income Taxes: All types of businesses except partnerships must file an income tax return every year. Your income tax calculation will change according to the structure of your business. Partnerships report their income via an annual information return.
  • Self-Employment Tax: If you are self-employed, you need to pay your Medicare tax and Social Security tax through self-employment taxes. You are liable to pay these taxes if you earn more than $400 from self-employment. This is calculated using Schedule SE on Form 1040.
  • Employment Tax: Employment or payroll taxes involve filing a portion of your employees' Social Security and Medicare taxes, along with income tax.
  • Excise Tax: The government levies an excise tax on certain products such as fuel, airline tickets, and indoor tanning services. Check if the product or service your business offers is subject to excise tax. You can collect it from your customers by including it in the price of your products.
  • Other Taxes: Based on the assets you own as a business, you may need to pay additional tax, such as property tax. You will also need to pay state and local taxes, which tend to be lower than federal sales taxes.

Make sure you understand all the tax categories and when you need to pay them to avoid being fined by the federal, state, and local authorities.

Taxes must be paid quarterly, so plan your expenses accordingly. Try not to default on the quarterly payment. Otherwise, the IRS may penalize your business for underpaying.

If you make a profit, it's a great idea to have a plan to save at least 30 to 40% right away. This helps because your tax payments are not dependent on ongoing cash flows.

How to Calculate Income Tax Liability

An easy way to figure out your liabilities is to use a tax liability calculator.

You need to fill in the category your business is classified under, revenue and expenses, as well as your filing status.

For instance, Roy's business offers hair tattoo services and makes $100,000 a year. His business expenses amount to $30,000.

The amount of income tax he pays also depends on his filing status. If his filing status is "single" or "married, filing separately", then his estimated tax liability is $12,720. However, if he files under "married, filing jointly", the tax liability is $5,520.

Estimated taxes are the income tax that you need to calculate suta tax and pay every quarter. Federal tax brackets must be paid on the 15th of April, June, September, and January.

If you're a new business owner and will be filing taxes for the first time, you could also hire the services of a tax specialist or certified accountant. A professional bookkeeping service like Fincent can also help you reduce your tax liabilities.

How to Reduce Your Taxable Income

Many small business owners tend to leave money on the table by not availing of deductions and credits.

As a business, you incur crucial expenses that can be deducted from your gross income to reduce your taxable income. Here are some common deductions to keep on your radar:

  • Expenses related to travel and transportation
  • Cost of business equipment like computers, printers, monitors, and phones
  • Rent and utility costs
  • 50% of meal and entertainment expenses incurred by and for partners, employees, contractors, and clients
  • Mobile phone bills for business
  • Set-up up costs and contributions made to the retirement plans of your employees
  • Advertising and marketing

Timing the purchase of equipment or a new marketing campaign launch can also help you strategically manage your tax payments.

Another way to reduce tax liability is to avail all tax credits available for your enterprise. A tax credit is a reward offered by the government for certain actions taken by a business.

There are at least 16 tax credits available to small businesses! These include:

  • Alternative fuel usage
  • Credit for medical leave, including family leave for employees
  • Health insurance for employees
  • Increased research activities
  • Extended paid leave benefit credits

The Takeaway

Once you file your taxes a few times, it becomes easy to stay on top of things and ensure that you never get penalized by the IRS. However, tax laws do change every now and then. So, keep an eye out and visit the official IRS website to stay updated.

You could also get assistance from Fincent, a professional service that provides quality bookkeeping for creative small business owners like yourself.

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