Small Business Taxes 101
New to Small Business?
Congrats on the new business! Before you get too far down the busy road of entrepreneurship, you are wise to keep the taxman in mind, not just in April…. but year-round.
Creating a solid foundation for your business starts and ends with making sure that you are correctly set up to report your earnings to the government.
In this article, we will broadly cover how what type of business entity you have and how that affects your tax structure, deductions, and more to help set you off in the right direction.
Choosing Your Business Entity Type
There are approximately a half-dozen ways to classify your small business, and the choice you make will have an impact on how you file your taxes, what your tax rate is, and what deductions you can take. These classifications include sole proprietorship, partnership, LLC, S Corporation, C Corporation, and not-for-profit corporation. Most small businesses will find that the LLC structure is the right balance of operating cost and limiting liability, but it’s helpful to know the tax consequences of each.
- Sole Proprietorship
This is the most basic small business entity. If you are a sole proprietorship, it means you and your business are treated as one person. You have personal responsibility for your small business’ assets and debts, and your business taxes are filed on your personal tax return using Schedule C. You also have to pay self-employment taxes.
There are two kinds of partnerships, limited (LP) and limited liability (LLP). An LP consists of at least two partners. One has unlimited liability for his business, and the other partner(s) have limited liability. Only one partner with unlimited liability can be held personally responsible for partnership assets and debts (like a sole proprietor would be). In an LLP, all of the partners have limited liability and none are responsible for the assets and liabilities of either their business or the other partners. For tax purposes, all partnerships are considered “pass-through” entities. This means that the business profits and losses “pass-through” the business to the partners, and are recorded on partners’ personal tax returns. In an LP, the partner with unlimited liability includes all profits on his personal tax return. The other partners have to pay self-employment taxes. In an LLP, each partner includes his share of the profits on his personal tax return. In addition, the partnership has to file its own tax return that lists each partner’s share of the profits and their ownership share in the business. This can get complex and you should consult a CPA when filing a return.
Rather than form a partnership, the next level for many sole proprietors will be forming a limited liability company (LLC). LLCs allow business owners to separate their personal and professional assets and liabilities, which is much less risky for a small business owner. Like a sole proprietor, your profits and losses in an LLC are recorded on your personal income tax return and you will pay self-employment taxes, rather than paying corporate taxes. Thus, an LLC is a step tax-wise in between a sole proprietorship and a corporation.
- S Corporation
The designation of S Corporation means that each business owner is issued stock and becomes a shareholder. The owner(s), and any other shareholders are not personally liable for the business. The big difference is that a shareholder can sell his shares, which eases the process of raising capital for a growing company and taking on investors. A small business that begins to boom might consider transitioning to an S corp. Profits still “pass-through” to the shareholders’ personal income taxes instead of being taxed at the corporate rate. The IRS has special rules for S corps, like limiting the number of shareholders to 75 and allowing only one class of stock.
- C Corporation
A “C corp" is essentially the last step in totally separating a business owner’s personal income taxes, assets and liabilities from those of his business. The downside for a small business owner is the larger volume of paperwork required, and the notion of “double taxation” wherein the company’s profit is taxed on a corporate tax return, filed by the company, and the owner’s share of the profit is taxed on his personal income tax return.
- Not-for-profit Corporation
Nonprofits are subject to special tax rules under IRS Code Section 501(c)(3). They do not pay any state or federal income tax. Employees would pay personal income tax on any salary received.
Paying and Deducting Self-Employment Taxes
Most small business owners, who operate as either sole proprietors or partners or set up an LLC, will be subject to paying self-employment taxes (“SECA”). These taxes are separate from personal income tax levied on whatever salary or profits the business owner generates. They are calculated using Schedule C of the IRS Form 1040 income tax return. SECA taxes cover social security and Medicare contributions for self-employed people, as they are not automatically withheld from a business owner’s salary or profits the way they would be from a W-2 employee’s paycheck by their employer. The general self-employment tax rate is 15.3%. This includes 12.4% for social security and 2.9% for Medicare. Any individual who earns more than $400 in self-employment income must pay the self-employment tax.
Unlike W-2 employees, a small business owner who pays SECA taxes can deduct the employer-equivalent portion from their adjusted gross income on their personal income tax return. Self-employed business owners can also deduct the cost of health insurance from their taxes. This deduction is considered when calculating net earnings.
Making Quarterly Estimated Payments
Small business owners need to keep track of their earnings and make estimated tax payments every quarter, unlike W-2 employees who simply have estimated taxes withheld from their paychecks. Sole proprietors, partnerships, LLCs and S corporations must pay quarterly estimated taxes if they expect to owe more than $1,000 in total tax for a calendar year. The exception is if you had no tax liability in the previous calendar year, which means that businesses in their first year don’t have to worry about this until their second year of operations.
In order to make quarterly payments, it is helpful for small business owners to set aside anywhere from 25% to 35% of their net earnings each quarter in their business bank account, specifically for taxes. To calculate what you owe, you need to work out your anticipated adjusted gross income (AGI), taxable income, tax deductions and tax credits for the year and divide by four. The payments are due in April, June, September, and January. You can use IRS Form 1040-ES to figure out the right amount to pay. If you don’t pay correctly, you may be subject to IRS penalties, so it’s important to do your homework and ensure you’re filling out these forms correctly.
Deducting Your Business Expenses
When figuring out quarterly estimated payments, small business owners need to take into account the different business expenses they can deduct from their taxes in addition to the self-employment tax deduction. These fall into a few categories, including startup expenses, ordinary and necessary business expenses, and a general deduction for owners of pass-through businesses.
- Startup Expenses
Small business owners just starting out can deduct many “startup” expenses on their personal tax returns. The IRS holds that you can deduct up to $5,000 in costs incurred in creating or acquiring an “active trade or business” but that such costs do not include “research and experimental costs”. For most small business owners this is not an issue. However, if you are going to incur a lot of startup costs, it is important to thoroughly consult IRS Publication 535 to understand some of the special rules applied to different kinds of startup costs in large amounts. Costs in excess of $5,000 must be amortized over a certain number of years and will affect your tax returns for those future years.
- Ordinary and Necessary Expenses
In order to deduct a business expense, it has to be both ordinary and necessary. An ordinary expense is an expense that is normal in the course of business in your industry. A necessary expense is one that is “helpful and appropriate” in the course of business in your industry. Examples might include printing, paper and ink costs for work produced by a writer or an artist, or food purchased for preparation by a personal chef. Note that “capital” expenses, including startup costs and business assets (like equipment) do not fall into this category and have to be considered separately, as above.
If you use your home or vehicle for your business, you can deduct some of the associated costs, but special rules apply. To take the home office deduction, you need to make “regular and exclusive” use of your home office for your business and it has to be your principal place of business. So if you have an office space nearby that you work out of and use the home office on other days, it does not qualify. If it does qualify, you can deduct costs like mortgage interest, utilities (Internet connection, electricity, water) and repairs, for the percentage of your home occupied by the office. For example, if you live in a 1500 square foot house and use one 300 square foot bedroom as your office, you can deduct 20% of those expenses. Similarly, you can deduct the proportion of car expenses incurred in using your car for business (rather than personal) purposes. Above all, these deductions require small business owners to keep accurate records and make sure to divide personal and business expenses consistently.
- Other Deductions
There are various other deductions available to small business owners. Most importantly, under the new tax law that went into effect in late 2017, taxpayers who own pass-through businesses can deduct up to 20% of their business income on their personal income tax returns. This means that if your small business generates $50,000 of profits in 2019, you can deduct $10,000 before calculating your income tax rate and applying it to determine tax owed.
Small business owners may also be able to deduct other kinds of taxes, like state and local taxes, which can be properly attributed to their business as a legitimate business expense. The cost of insuring your business is also deductible. Finally, loans taken out in the interest of building your business are deductible. All of these deductions are subject to the same rules as other deductions when it comes to separating personal and business expenses; for example, if you take out a loan and use 90% for your business and 10% to refurbish your kitchen, provided you don’t use your kitchen for your business you can only deduct 90%.
For more information on deductions that could end up saving you tens of thousdands of dollars see our Top 10 Small Business Deductions article.
The above information may seem overwhelming, but it’s important to make sure you understand the ins and outs of taxes for your small business so you’re prepared to pay the right amount on time and not be subject to any penalties. Knowing how taxes work can also help you choose what kind of entity is right for setting up your company, and understanding the different deductions can save you quite a bit in the long run, no matter which kind you choose. When in doubt, it’s best to consult the IRS website or a CPA who can assist you in filing properly.
June 4, 2019
Alyssa specializes in creating content and website copy for law and accounting firms and nonprofit organizations. She has an undergraduate degree in history and a J. D. from Columbia Law School.