- Small Business Taxes
Small Business Taxes: From Frustration to Financial Freedom
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- Small business structures
- Taxes to file
- Tax write off
- Tax filing tips
- Tax planning and strategies
Understanding Small Business Taxes
In every meticulously crafted propaganda poster, there have to be illustrations of giant industrial factories in the background. Such images are there to remind the viewers of the country's economic prowess.
Interestingly, it is the small businesses (not big industrial giants) that collectively power the massive US economy. All 33.2M of them make up 99.9% of all US-based businesses and create 62.7 % of new jobs.
However, small businesses come with their own challenges. Labor shortage and recession obviously would rank at the top of the list, but taxation wouldn’t be far behind; in fact, it is the third biggest problem.
After all, it’s easy to lose track of all those regulations, deadlines, and tax breaks. But if you mess up your tax filing, you may have to face consequences in the form of heavy penalties and IRS audits. Even outsourcing your taxes to questionable third parties can land you in hot water.
Therefore, it’s better to have a decent grip on small business taxes.
Understanding the Foundations: Exploring Small Business Structures
The structure of your small business determines which tax forms you file, which tax benefits you get, and how your business and personal income get affected. Therefore, it makes sense to touch on the subject.
Usually, most US-based small businesses adopt one of these popular businesses structures (there are a few others) before getting registered:
- Sole proprietorship
- Limited Liability Company (LLC)
- C -corporation and S-corporation
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Sole proprietorship is a popular small business entity option because of its simplicity: Just register a DBA name, get an EIN, collect all the required licenses, and you are good to go.
You don't need any stakeholder or partner, and that saves you from tedious paperwork.
The key characteristic of a sole proprietorship is your business not being a separate entity. It has two implications:
- You don't pay taxes on your business income separately. Instead, your net business income is passed down and considered a part of your net personal income, and you pay income taxes on the total sum (income from other sources + business income).
- Your business liabilities are your own. If you end up on the receiving end of a business lawsuit, you might have to pay with personal assets.
Sole proprietorship small businesses often include small service providers, freelancers, and single owner businesses who want to start without much hassle. However, once your business scales, you can change sole proprietorship to other entities.
When your business involves more than one partner, registering it as a partnership is an option. You can go about it in two ways.
It is a relatively informal arrangement between two or more persons working together in a business. All it takes is a contract (though not mandatory), shared interests, and may be a good ol' handshake. This simplicity comes with a downside: All the partners are equally liable for any issue or lawsuit.
It is a type of partnership where at least two partners are involved: a general partner and a limited partner. The general partner has unlimited personal liability and great influence over business decisions. On the other hand, in return for giving up management power, the limited partner benefits from personal liability protection.
There is another subdivision of partnership entities: limited liability partnership (LLP). In an LLP, every partner is protected by limited liability. Also, there are contracts in place chalking out clear boundaries and terms. Partners are easily replaceable when their contract term ends. Such flexibility makes LLPs and LPs quite a convenient business structure.
From a tax perspective, the profit gained from a business registered as a LLP passes through partners. They report their individual gains on their personal tax returns.
A corporation, or C corp, is a separate legal entity from its owners. It can generate profits, be taxed, and can be sued.
The biggest plus of corporations is they offer the strongest protection to their owners from personal liability. But this perk also makes forming a corporation pretty harsh on the pocket compared with other structures. Not to mention, corporations also require more extensive record-keeping, operational processes, and reporting.
Unlike sole proprietors, corporations pay income tax on their profits. In some cases, corporate profits are taxed twice, first when the company makes a profit and again when dividends are paid to shareholders on their personal tax returns.
Corporations have a completely independent life separate from their shareholders. If a shareholder leaves the company or sells their shares, the C corp can continue doing business relatively undisturbed.
Corporations have an easier time while raising capital because they can raise funds through the sale of stock. Therefore, Corporations can be a good choice for medium- or higher-risk businesses, those that need to raise money, and businesses that plan to "go public" or eventually be sold.
An S corporation, also known as an S corp, is a special type of corporation that avoids the double taxation drawback of regular C corps.
If you registered in California, keep double taxation in mind. It works like this: S-corps and LLC first pay business taxes on their incomes. Then once the profit “passes through” to business owners, they pay income taxes on that profit too.
S corps allow profits, and some losses, to be passed through directly to owners' personal income without ever being subject to corporate tax rates. Not all states tax S corps equally, but most recognize them the same way the federal government does and tax the shareholders accordingly.
S corps must file with the IRS to get S corp status, a different process from registering with their state. There are special limits on S corps, and so don't forget to check for eligibility requirements.
S corps have an independent existence, just like C corps. If a shareholder leaves the company or sells their shares, the S corp can continue doing business relatively undisturbed. S corps can be a good choice for businesses that would otherwise be a C corp, but meet the criteria to file as an S corp.
Limited Liability Company
An LLC is a business structure that combines elements of partnerships (pass-through taxation) and corporations (limited liability). Each state has different LLC regulations, so do your research before forming one.
Why is this popular? Because with LLC, you get some flexibility in how you want to file your business taxes.
If you are the sole owner of your LLC, feel free to file your taxes as a sole proprietorship or a corporation. Either report your business income on your personal tax return (pass-through taxation) or create a separate tax entity and pay taxes at the corporate rate.
If your LLC has more than one owner, you can do your taxes either as a partnership or a corporation. A partnership means that owners share the profits and report them on their personal tax returns. A corporation in the sense you and the other owners are shareholders of the business and pay taxes at the corporate rate.
One of the advantages of an LLC is that it protects you from personal liability. If your business gets sued or goes bankrupt, you don't have to pay with your personal money or assets.
Another advantage is that you can change how your LLC is taxed if your situation changes. For example, if you start as a sole proprietorship and then add more owners, you can switch to a partnership or a corporation.
An LLC is a hybrid legal entity because it combines features of different business structures, so it offers you more options and protection than some other types of businesses.
Which Taxes Should Small Businesses File?
Tax laws have made it mandatory for business owners to file returns at three different levels: Federal, state, and local levels. And taxes applicable in your case depends on factors such as revenue, business structure, type of business, etc.The following section covers various small businesses taxes that you want to pay attention to.
Federal taxes are levied by the IRS. You need to file various forms and stick to deadlines to perform your tax duties. Here is a small list of the most common Federal taxes.
Income is a very important tax consideration for all US small businesses. There are two ways small businesses are taxed:
- As corporations
- As pass-through entities
The nominal federal corporate income tax rate is 21%. And your corporation may need to pay state level taxes on top of that. Ideally, you should set aside around 30% of your business income (after deduction) for tax purposes.
On the other hand, “pass-through” business entity (sole proprietorship, S-corporation, partnerships) incomes are taxed at the owner’s personal tax rate (10%-37%).
1. Employment tax
Employment tax is an umbrella term for various taxes such as Federal unemployment tax, social security tax, medicare tax, etc. All of these taxes are calculated based on employee wages.
The IRS wants you to withhold a part of these taxes from your employees and contribute the rest from your own pocket. You need separate forms (W-2, for example) for reporting these taxes.
2. Self-employment tax
Self-employed sole proprietors don’t come under employment taxes (since they don’t have any employees). Instead, they pay self-employment tax (15.2% of net earnings). This tax is a combination of the social security tax (12.4%) and the medicare tax.
Important: One can actually deduct the employer portion of self-employment tax while calculating his adjusted gross income (AGI). However, this deduction will not affect that individual’s net self-employment earnings.
How to guide 8 min
04 Oct 2022
3. Excise tax
If you run a business that sells certain products or offers some specific services, you need to pay Excise tax. Alcohol, tobacco, sports betting, etc. are some of the business categories that are subject to excise tax.
State and Local
Your business may need to pay state and local taxes. Since tax laws change with location, you want to check with local authorities first to know the full extent of your tax responsibilities.
For taxpayers who itemize their deductions, SALT stands for state and local taxes related to the federal income tax deduction.
The formerly unlimited SALT deductions now have a $10,000 cap that is effective for taxpayers between 2018 and 2025.
Among the most common state taxes, two deserve mention: income tax and employment taxes. Income tax is applicable on net business income, and employment taxes are determined based on employee wages.
However, some states are lenient in the matter of business taxes. For example, in New Hampshire, there is no sales tax, and government resources are easily accessible. Wyoming and South Dakota levy zero corporate/personal taxes.
It’s always smart to register your business in such business-friendly states.
2% rule for tax deductions: Miscellaneous deductions - The new law suspends the deduction for job-related expenses or other miscellaneous itemized deductions that exceed 2 percent of adjusted gross income. This includes unreimbursed employee expenses such as uniforms, union dues and the deduction for business-related meals, entertainment and travel.
Some states require businesses to pay franchise taxes in exchange for having the right to be chartered and to operate in those states. It applies to all LLPs, LLCs, and corporations,franchise model or not.
Please note, the franchise tax doesn’t depend on your business profit and you need to pay it on top of your business taxes.
Key Tax Forms for Small Businesses
Solving the small business tax maze also requires some understanding of key tax forms. As you probably guessed, tax forms vary based on business structures.
However, some Forms are used more frequently than others. Let’s have a look on few such small business tax forms:
What about the deadline?
Since you need to file 941 quarterly, the IRS set four deadlines- April 30, July 30, Oct. 31, and January 31. If you miss your deadline, you will be paying 5% of tax due for each month after the deadline.Book a demo
Tips for Filing Small Business Taxes
Knowing your taxes and forms is not enough. You need to actually put that knowledge to use to file your taxes correctly.
You’d be surprised how many taxpayers fail to submit correct tax files. In 2022 alone, the IRS spotted 17M math errors. As you can expect, sometimes wrong filing can cost your mental peace, productive hours, and some extra cash (as a penalty).
The following tips would assist you in not ending up on the list of taxpayers with a history of incorrect filings.
Gather tax paperwork and records
Every taxpayer must keep records of all the transactions, invoices, legal documents, and other proofs.
You will have a much easier time filling out your forms when you have all the records right beside your hands. It also helps you to avoid rounding numbers (a major audit trigger).
Also, in an IRS audit situation, you need those records to support your claims. As we mentioned while discussing how to avoid IRS audits, IRS auditors have biases against sole proprietor businesses. So you need to be extra careful here.
The most common ways for small businesses to keep records are Excel sheets and bank statements. To be honest, excel sheets have some benefits like affordability, easier data comparison etc. However, a bookkeeping solution like Fincent covers Excel’s limitations while bringing a lot more to the table.
For instance, once you link your bank account to Fincent, it will keep track of all the transactions and save relevant invoices and documents.
You also need to gather some information, including:
- Social security numbers
- Bank account numbers
- Various tax forms such as 1099s, w-2 etc.
Report all types of returns
It’s a no-brainer, right? Yet many taxpayers fail to report everything on their tax forms for various reasons- from not keeping records to not knowing what to report while filling out tax forms.
Nonetheless, the IRS always verifies your tax returns from other sources. If any discrepancies are found, your tax files will raise some eyebrows at the IRS office, which can lead to audits.
To avoid such situations, you want to pay attention to the following list of most common misreported income sources.
- Goods or services sold/offered on online platforms.
- Occasional gig work.
- Frequent cash transactions via apps like PayPal.
- Large capital gain.
File electronically with direct deposit
The IRS prefers that you file your small business taxes through tax software instead of paper returns. Since most tax applications guide taxpayers using a question-answer format, the chances of making mistakes go down significantly.
There is no shortage of great applications for tax filing. Also, the IRS offers a free tax filing alternative: IRS free file. It’s a public-private partnership between the IRS and tax software companies that offer their service for free to any taxpayer under $73,000 adjusted gross income.
Those who fall into the over $73,000 AGI bracket can use Free File Fillable Forms. These forms are electronic versions of IRS paper forms. If you are comfortable with filing your taxes, this method is pretty convenient.
Use online resources before calling IRS
It’s not unusual to have tax-related questions, and you might want to dial the IRS helpline. However, you might have to wait on hold for a long time occasionally.
It’s better to give the IRS's online tools and resources like “Interactive Tax Assistant tool” and "Let Us help You” a try first. These are fast, available 24/7 and get your answers promptly.
Additionally, the IRS suggests small business owners (or any taxpayer for that matter) should follow IRS’s social media handles and newsletters to stay updated on recent changes.
Tax Planning and Strategies for Small Businesses
- Sole proprietorship
1. Look for ways to reduce your adjusted gross income
As we touched on before, small business taxes and personal taxes are intertwined in many situations (sole proprietorship for example). So the first step of your tax planning is reducing Adjusted Gross Income.
AGI is your gross income (which is the total of gig work income, business income,dividends,capital gains etc.) minus adjustments such as student loan, alimony payment, IRA contribution etc.
Why is this important? Because a lower AGI puts you in lower tax brackets which can translate into several tax benefits. For example, you can deduct your medical expenses on Schedule A (Form 1040) if those expenses exceed 7.5% of AGI. Therefore someone with $200000 has more chances of getting this adjustment than someone with $500000.
Tl:dr; You want to sit with your CPA and figure out how to minimize your AGI by maximizing adjustments.
2. Write off your startup costs
Starting up your small isn’t cheap. All those licenses, permits, advertisements, travels and inventory bite off a big chunk out of your capital. Many small business owners think of this as unavoidable cost and move on.
However, it doesn’t have to be that way. The IRS allows you to get this amount back as tax write off. If your startup cost was under $50,000, you can go for a maximum yearly deduction of $5000. For the remaining amount, the IRS wants you to divide it equal installments and claim it over 15 years.
Therefore your small business tax planning should include this deduction.
3. Utilize fringe benefit plans for employees
If you want to take care of employees, one of the go-to solutions is increasing their wages, right?
However, as we discussed before, the easiest solution isn’t the best one here. With increased wages, both you and your employee have to bear higher payroll taxes. Result? The effective raise your employees get is less than the actual raise.
A great workaround here is, offering fringe benefits plans. These benefits often tax deductible and your employees get to enjoy the full benefit.
For example, instead of offering a bigger paycheck, increase your employer contribution to employee 401(k) accounts. You will get a tax deduction and your employees will enjoy bigger retirement savings and gains.
Other fringe benefits may include medical insurance, assistance with childcare, transportation reimbursement etc.
4. Optimize your retirement plan
Your personal retirement plan should be part of your tax minimization strategy. Because some retirement plans like 401(k) allow contributions to be made with pre-tax dollars. In other words, the IRS will deduct the amount you pay as retirement savings from your gross income before determining the taxable income.
Since you are self-employed, your contribution limit to solo 401(k) is $66,000 in 2023. If you count catch contributions, the ceiling goes even higher. So, you are writing off as much as $66,000 from your taxable income right off the bat.
However, as great as this is as a tax-saving route, think before you make a decision. 401(k) withdrawals are not tax-free. Later in life, when you will be in higher income tax brackets, taxes on your retirement withdrawals might sting. So, if you are early on your career path, go for Roth 401(k) instead. Roth contributions can not be made with pre-tax dollars. However, your retirement withdrawal will be taxless. So, think about this tread-off before making a choice.
Keeping track of your small business expenses with all the hustle and bustle can be a bit too overwhelming at times. Moreover, manual handling and monitoring of your accounts can halt your business’s growth.
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How to Get Your Small Business Ready for Tax Season
Keeping track of all those transactions and managing your books can get overwhelming if you sit on those for months. This is why many business owners feel anxious during tax season.
Therefore, one of the best pieces of advice we can give for getting you to tax ready is to start early. You want to review your financial statements, transactions and reports on a monthly or bi-monthly basis. In this way, you will not have a massive mess to clean at the end of year and you will have time to plan your taxes (and avoid your tax penalties too).
However, even if you are already behind schedule, you might want to sign up for catchup bookkeeping services. Once signed up, expert bookkeepers will go through your unmanaged book, re-organize it, spot errors, and make you ready for tax filing.
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Tax season can be haunting, but early tax preparation and the right tools can reduce stress and maximize your savings. StayingBook a demo
Small-business tax glossary
Includes income reported on Form 1099-NEC that independent contractors or the self-employed receive from customers and clients in a year. Learn how to correct
Double taxation is a tax theory that refers to paying income taxes on the same source of income twice. It might happen if income is subject to both corporation and individual taxes. When the same revenue is taxed in two distinct nations, double taxation also happens in international trade or investment.
The self-employed are responsible for paying both the employer and employee components of Social Security and Medicare taxes under SECA. For instance, as a sole entrepreneur, you would be required to contribute 2.9% of your income to Medicare and 12.4% of your income to Social Security.
The taxes certain entities and individuals, including businesses, pay each quarter, generally based on an estimate of the taxable income for the year
Non-deductible fine levied in certain circumstances, including on taxpayers who have underpaid quarterly estimated taxes or have not paid them on time.
Social Security and Medicare taxes generally levied against those who don’t work for an employer
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Can a Small Business Get a Tax Refund?
Small businesses are required to deposit payroll and income taxes every quarter. If you are one man/woman army ( aka self-employed/sole proprietor), you still pay estimated taxes.
Sometimes, you might end up overpaying to the IRS. Let's say you run a freelance business and pay Estimated taxes quarterly. Initially, you underestimated your expenses( hence less tax deduction )and estimated your tax amount based on that. However, during your tax filing, you realize expenses have exceeded your initial calculations and you can claim tax deductions on these extra expenses. That means, effectively, you paid more than what you owe to the IRS.
In such cases, you can go in one of these two routes:
- You don’t do anything about it. Since you already overpaid, you won’t face any penalties or fines ( even if you don’t file your returns).
- You file your tax return and request the IRS to pay your money back. You do it by filling up the lines 34-36 on your 1040 form.
Once you efile, you can go to Where’s my refund link and check your refund status. In case of a paper return, you should wait 4 weeks before checking your status.