Starting a small business is hard enough without adding taxes to the mix. Taxes don’t have to be as challenging (or painful) as they’re cracked up to be though, especially if you put in the work during the setup phase.
We’ve written an article focusing on the nitty-gritty of getting the right business licenses and permits based on your location; this article focuses specifically on taxes.
Taxes Start with Your Business Structure
The structure of your business — whether you choose sole proprietorship, partnership or LLC — influences your tax status. If you haven’t already decided your business structure, think about taxes before making your choice.
The simplest business structure is the sole proprietorship. A sole proprietor reports income and losses from the business on Schedule C attached to their individual income tax return, Form 1040. Creating this type of entity does not require the services of an attorney.
If a sole proprietor’s business runs into financial trouble, creditors can bring a lawsuit against the business, and if the suit is successful, the owner would have to pay the business debts with their own money.
Sole proprietors can deduct expenses that are “ordinary and necessary” for conducting their trade or business. Ordinary expenses are ones that are common and accepted in your trade or business. Necessary means the expense is helpful and appropriate.
For example, an ordinary and necessary expense would be purchasing business cards and attending networking events to promote your business and generate new clients. An unreasonable business expense could be chartering a helicopter to take you to a networking event in a nearby city.
While the IRS does not provide a comprehensive list of the types of business expenses that can be deducted, you can find more discussion and general rules in the IRS Publication 535.
Although your business income and losses are reported on your personal tax return, keeping your business accounts separate from your personal accounts, while not technically required, is a good idea. This way, it’s easier to track your business expenses when they aren’t mixed in with personal expenses. Having a separate business checking account can help increase the credibility of your business and avoid the IRS’s hobby loss rules. Hobbies have limitations on the amount of expenses that can be deducted.
A partnership is similar to a sole proprietor, but it consists of two or more partners. Income or losses from the business are reported on an informational return, Form 1065. The partnership doesn’t pay income taxes directly. Instead, partners are taxed on their share of partnership income, regardless of whether they take money out or reinvest it back into the business.
Say a partnership is formed by two individuals and they purchase property to rent out to a tenant. During their first year of business, they earn a net income of $20,000. Rather than split the profits 50/50, the partners agree to use the $20,000 as a down payment on a second rental property for the business. Even though they’ve reinvested their share of profits back into the business, each partner has to pay taxes on their share of the $20,000. Like a sole proprietorship, partners have personal accountability for business debts.
A limited liability company (LLC) is a business structure allowed by state statute but the IRS can treat an LLC as either a corporation, partnership or, in the case of a single-member LLC, a sole proprietor.
An LLC has the benefit of allowing business owners to operate like a traditional partnership, distributing income to the partners to report on their individual tax return, but offers the personal protection from business debts.
Consider the example of the partnership that purchased the rental properties. If that partnership elects to be an LLC, the owners will be taxed on their share of net income, regardless of whether they reinvest the profits back into the business.
The advantage of an LLC structure is the legal protections that come with it.
If the partnership ran into financial trouble, the financial exposure of the members would be limited to their investment in the business. Creditors couldn’t come after them personally for business debts (unless the partners personally guaranteed the loans).
S-corporations and C-corporations get a lot more complicated and are in a whole different league as far as taxes are concerned. If you’re starting a business from scratch, establishing yourself as a corporation isn’t a good option, since these entities require you to have shareholders and a board, and also require corporate taxation.
If you’re a new owner and are unfamiliar with the corporation tax structure, but are taking over an already established corporation, consider working with a professional to avoid any missteps.
Taxes Depend on Your Business Licenses
Only certain industries are required to obtain a business license on a federal level. These include: agriculture, alcohol, aviation, firearms, ammunition and explosives, fish and wildlife, transportation, mining and drilling, nuclear energy and broadcasting.
Virtually every state, city and county has their own requirements for business licensing. And these requirements have everything to do with taxes and revenue tracking. Check the Secretary of State website in your state, city and county for details on business licensing in your geographical area.
Business licenses also protect the public. Certain professions — accountants, cosmetologists and medical professionals, for example — must apply for professional state licenses to signify they have the level of expertise required to operate their business. This is to prevent the amature dentist who didn’t get his DDS from practicing out of his living room, for instance.
Tax/Employer Identification Number (TIN/EIN)
A Tax Identification Number (TIN) and an Employer Identification Number (EIN) are different names for the same nine-digit number.
C-Corps, S-Corps, partnerships and LLCs are all required to obtain an EIN. Any business that pays wages or files pension or excise tax returns is required to get an EIN.
Sole proprietors are not required to have an EIN, but they often choose to, simply to avoid using their Social Security number (SSN).
For example, an agency contracting with a freelance graphic artist (operating as a sole proprietor) may ask the freelancer to complete a Form W-9 before they issue payment for a job. The Form W-9 is used to gather information so that at the end of the year, the agency can issue a 1099 to the freelancer. If the freelancer doesn’t want to use her Social Security number on her forms, she’ll need to apply for an EIN.
To obtain an EIN, the business owner should complete Form SS-4 or apply online via the IRS website. Applying online takes just a few minutes, and you’ll receive your EIN immediately.
Every small business owner pays payroll taxes, regardless of the legal structure of the business.
When your business is a one-man show…
Self-employment taxes — required of anyone making more than $400 for the year — are designed to account for the fact that FICA taxes (Social Security and Medicare) are not taken out of a person’s wages. The Self-Employment tax is simply Social Security tax (12.4 percent) and Medicare tax (2.9 percent) bundled together to create a 15.3 percent tax.
Sole proprietors pay self-employment taxes on Schedule SE attached to their individual tax return, Form 1040.
When you work for an employer and receive W-2 wages, your earnings are taxed at half this rate (6.2 percent for Social Security and 1.45 percent for Medicare); your employer contributes the other half, for a combined total of 15.3 percent. Self-employed people are responsible for paying both the employee and employer portions of FICA taxes, though half the amount (7.15 percent) is deductible. Wage thresholds apply to the self-employment tax and change annually, so check on current IRS rates before you file.
Members of partnerships, LLCs, and corporations also pay self-employment taxes via Schedule SE on their share of business income.
When you’re paying employees…
When you have employees, your business has numerous payroll tax withholding and payment obligations.
Employers must withhold federal income tax from an employee’s wages. The amount to withhold is based on entries made on the employee’s Form W-4 and withholding tables provided by the IRS in Publication 15.
Employers are also responsible for withholding the employee portion of FICA taxes: a 6.2 percent Social Security tax, a 1.45 percent regular Medicare tax (and a 0.9 percent Medicare surtax when the employee earns over $200,000).
New employers who did not have any employees during the previous 12 month period ending the preceding June 30th (known as the “look-back period”) can deposit withheld payroll taxes to the IRS on a monthly basis. Monthly deposits must be made by the 15th day of the following month.
If your payroll tax obligation is less than $2,500 in a quarter, you can deposit those taxes with a timely filed Form 941.
The IRS requires that all payroll taxes be made electronically using the EFTPS online system. You will need to enroll on the website using your business’s EIN and business checking account information. Any new business that requests an EIN and indicates that it will be required to make federal tax deposits for payroll and other business taxes is automatically pre-enrolled in the EFTPS system.
After you apply online for an EIN, the IRS will send you notification of your enrollment in the EFTPS system. You can then activate your enrollment by calling a toll-free number and entering bank account information.
You know about sales tax and payroll taxes, but an excise tax might be a foreign concept. This is fair, because they’re not nearly as common and is only applicable on some products.
Excise taxes are a tax on the intermediary and are usually included the price of a product. Examples include taxes on gasoline, cigarettes and alcohol. For a complete list of products requiring federal excise taxes, see IRS Publication 510.
Federal excise taxes are paid quarterly by filing Form 720.
Excise taxes and payroll taxes withheld from employees are considered trust fund taxes, meaning they are collected by the business and held in trust before being paid to the government at specific times. Business owners must be very cautious about paying trust fund taxes on time and to never use those funds for another purpose. If the full amount is not paid when it’s due, large penalties are imposed.
Most businesses involved in the sale or lease of goods and services are subject to sales or use tax. States can collect state and local taxes, though not all opt to collect both.
Forty-five states collect statewide sales taxes. The ones that don’t are: Oregon, Montana, Delaware, New Hampshire and Alaska. Thirty-eight states collect local sales tax, including Montana and Alaska (which don’t collect state).
A business typically collects sales taxes from the customer at the point of sale, then sends those funds to the state or local jurisdiction via monthly or quarterly sales tax returns.
The idea of filing for and paying taxes can sometimes muddle the excitement of starting a new business. Don’t get bogged down. Once you’ve got the basics, calculating and filing taxes will become a routine sidenote, which means you can get on to the fun part of running your venture.