Understanding Business Taxes
What different types of tax does my business have to pay?
As a business owner, there are several types of taxes you must familiarize yourself with to ensure compliance with both federal and state tax laws—principal among these are Federal Income Tax, Self-Employment Tax, State Income Tax, and Franchise Tax.
- Federal Income Tax: The federal income tax is a mandatory part of business operations with owners reporting the LLC’s earnings as personal income on their individual tax return. When an LLC includes multiple owners, each has the responsibility to report a share of the company’s revenue equivalent to their ownership percentage.
- Self-Employment Tax: This tax is another crucial taxation aspect that LLC owners need to pay attention to. It’s a type of tax levied on owners and co-owners for their Social Security and Medicare. Owners file these taxes known as “self-employment taxes” for themselves individually.
- State Income Tax: Almost every state requires LLCs to pay state income tax alongside the federal income tax. If the LLC has multiple owners, each reports their income share identical to the federal income tax. There are, however, nine states—Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming—that do not enforce a state income tax.
- Franchise Tax: Franchise tax or business entity tax is not a universal state-level tax but is required in some states. It’s a privilege tax imposed on corporations, including LLCs, for the right to operate within the state. Franchise taxes are typically payable to the Secretary of State’s office and are due annually. It’s imperative for businesses to be aware of this tax, as failure to pay may result in the loss of the right to do business within the state.
In summary, it’s crucial for small business owners and self-employed individuals to understand the complexities of different types of taxes. Taxes vary from federal to state levels, depend on specific business situations, and failure to comply can have serious implications for your business. It’s always advisable to seek professional advice or utilize tax preparation software to ensure accurate and timely tax filing.
The four (and only four) different IRS tax structures for all businesses
Understanding the legal structure of your business is crucial when preparing for tax filing. The Internal Revenue Service (IRS) classifies businesses into one of four types: Sole Proprietorship, S Corp, Partnership, and Corporation.
- Sole Proprietorship: If you run a small business alone, the IRS most likely classifies you as a Sole Proprietor. The business income passes .through the personal income of the business owner, and the tax liability is assessed based on the federal income tax rates for individuals. For tax filing purposes, Sole Proprietorships use Schedule C or C-EZ (Form 1040).
- S Corp: An S Corp is also termed as a “pass-through” entity, where the business income is filtered through the personal income of the business owners. Their tax obligations are similarly based on individual federal income tax rates. S-Corps must file Form 1120S.
- Partnership: A partnership is a business owned by two or more persons. Like sole proprietorships and S Corps, they are also considered “pass-through” entities for tax purposes. The tax is assessed based on the personal income of the owners. Partnerships need to file Form 1065.
- Corporation: A Corporation (also referred to as a C Corporation) stands as its own legal entity, separate from its owners. C Corporations file their own tax return using corporate tax rates. For tax filing purposes, they need to employ Form 1120.
General Guidance for Allowable Business Tax Deductions
The IRS defines “necessary and ordinary” business expenses as those that are common and accepted in a particular industry and crucial for managing and operating a business. These expenses must be directly associated with conducting the business and not extraneous or personal in nature. For example, a deduction can cover everything from office supplies and utilities to employee wages and not so obvious expenses like business insurance.
As per IRS guidelines, these expenses should be both necessary and ordinary. ‘Necessary’ is an expense that is helpful and appropriate for a business or trade, while ‘ordinary’ signifies a common or frequent expense in the type of business concerned. An unusual yet legally deductible expense is the cost of cat food. According to an IRS Tax Court ruling, a junkyard owner was allowed to write off the cost of cat food as a business expense as he used the cats to control snakes and rats on the property, proving beneficial for safe business operations. This deduction was deemed ordinary, given the nature of the junkyard business, and necessary for maintaining a hazard-free work environment. It’s a noteworthy demonstration of how an unusual expense can become an allowable tax write-off given the right circumstances.
Understanding pass through business income
LLCs taxed as S Corps and partnerships operate with a pass-through tax structure. This means the income or loss the business generates is passed directly onto the owners, partners, or investors, who then report it on their personal income tax return. Essentially, rather than the company paying corporate tax, the individuals tied to the company pay tax based on these reported earnings or losses on their personal tax rates.
Corporations, or specifically C Corporations, by contrast, are subjected to what’s commonly called double taxation. Firstly, the corporation pays tax on its profits at the entity level, relatively flat at 21%. Secondly, when these post-tax profits are distributed among shareholders as dividends, the recipients must again pay tax on their personal returns. For instance, if a company like Money Makeover Inc. made a profit of $175,000 after all relevant deductions, it would pay corporate tax at 21%, leaving $138,250. If then this post-tax profit is distributed as dividends, shareholders would further pay tax on these received dividends based on their personal income tax rates.
Why S Corps are the preferred entity for many small businesses and solopreneurs
S-Corp profits are distinct in taxation from sole proprietorships in the sense that they are not subject to Self-Employment taxes. This distinction offers a fundamental cost-saving advantage. For instance, if you own an S-Corp, your income splits into two categories: salary and distributions. Tax obligations only apply to the salary portion with regard to Self-Employment taxes. In contrast, the net profits of a sole proprietorship are entirely subject to Self-Employment taxes, resulting in a potentially hefty tax bill.
The Self-Employment tax rate is around 15.3%, comprising 12.4% for Social Security and 2.9% for Medicare. On top of that, there is an additional 0.9% Medicare tax on income exceeding specific thresholds ($250,000 for joint returns, $125,000 for married filing separately, and $200,000 in all other cases).
However, the IRS imposes a criterion of reasonableness on salary versus distribution splits for S-Corporations. It’s not permissible to avoid Self-Employment taxes entirely by paying oneself a minuscule salary and substantial distributions. The ‘Reasonable Compensation’ requirement ensures your salary is comparable to what other businesses pay for similar services.
In summary, S-corporation owners can save on Self-Employment tax through salary-distribution splitting, provided they observe the IRS’s ‘Reasonable Compensation’ requirement. Meanwhile, sole proprietorships face a more considerable tax liability due to their total net profits being subject to Self-Employment tax.
How to Use This Business Tax Calculator
Step 1: Determine your tax filing status for your personal tax return
This is required because Scorp’s and partnership’s are pass through tax structures where the profit or loss is passed to your individual tax return.
Step 2: Determine your business’s tax filing entity
Begin by clarifying your business structure. The IRS generally classifies businesses as sole proprietorship, partnership, LLC, S corporation, or C corporation. Don’t worry if you’re unsure, most small businesses default to a sole proprietorship.
Using the Business Tax Calculator is simple. Enter your revenues, total and entertainment expenses, and estimated tax payments, then click on the calculate button. Just remember, our tax calculator is just for educational purposes, so it’s always a wise move to consult a certified accountant with your data.
Remember, understanding and calculating your business taxes correctly is crucial for financial health. So take your time and do it right.
Step 3: Enter the business’s net profit or loss
Simply enter the total revenue and then the expenses and depreciation expense. Don’t forget expenses such as home office, Cell Phones, Internet and any other expenses that are deemed necessary and ordinary for your specific business.
Step 4: Determine your “reasonable wage” paid as an S-Corp (for S-corps only)
Starting to calculate a “reasonable wage” for an S-Corp? Alright, let’s do it! Use these simple, expert-backed steps.
- First, grab your Business Tax Calculator. Input your company’s total earning in the designated field. For this example, we’ll use an earning of $75,000.
- Deduct your legitimate business expenses. This can include office rent, equipment purchases, or any other operating costs.
- Now, you’re left with your profit. From this, you will pay yourself as an employee. This is your “reasonable wage”. It should be comparable to what others in your industry and geographical area earn. For example, if your profit is $50,000, you could consider a “reasonable wage” of about $35,000.
- Remember, the remaining profit can be taken as a distribution, which can have tax advantages. For complex scenarios, consider consulting a qualified tax pro!
Step 5: Understand the different ways that your business entity can be taxed, and choose the right one for you
Hey there, business owner! It’s a big deal to understand your business entity structure because it frames your tax obligations. Before touching those spreadsheets, consider if you’re a sole proprietorship, partnership, LLC, S corporation, or C corporation – the IRS will categorize you under one of these. If you’re a tad confused and manage a small business, chances are you’re a sole proprietorship. Pausing to ponder, and it doesn’t feel right? Brush up on the types, what they mean for your financial responsibilities, and make an informed choice. Don’t sweat too much, consulting an accountant or financial advisor for clarity always works! Remember, managing your business structure sagely translates to easier tax times.
Step 6: Review strategies to reduce taxes below those discussed in step 5 above
Calculate Your Quarterly Estimated Tax Payments
Failure to make estimated tax payments can result in penalties by the IRS and state authorities. The penalty is typically calculated separately for each due period, so you may owe it for any quarter that you underpaid, irrespective of if you’ve paid enough tax later. It’s typically charged on the amount underpaid from the due date of the installment to the date of payment or the due date of the return, whichever comes earlier. The rate of interest changes quarterly.
Nonetheless, there are exceptions where you won’t owe a penalty. This includes cases where the tax you owe, less any withholding and refundable credits, is less than $1,000, you didn’t owe any tax the previous year, or you paid at least 90% of the tax for the current year, or 100% of the tax shown on your previous year’s return.
Online tools and calculators could be utilized to estimate your income tax accurately and plan accordingly to avoid penalties.
The detailed due dates for the four quarters of estimated tax payments are not explicitly provided in the given research. However, it typically follows a standard fiscal year schedule:
- Estimated tax payments for income earned between January 1 and March 31 are due on April 15.
- The second quarter payment, for income earned between April 1 and May 31, is due on June 15.
- For income earned between June 1 and August 31, the third quarter payment is due on September 15.
- The fourth quarter payment, for income between September 1 and December 31, is due on January 15 of the following year.
It should be noted that if a due date falls on a weekend or legal holiday, the due date is moved to the next business day. It’s important to consult an accountant for personalized advice and to confirm the exact payment dates for each quarter.
Calculating your quarterly estimated tax as a self-employed or small business isn’t as daunting as it seems. Let’s break it down!
- First, estimate your taxable income for this year.
- Second, figure out how much this means you’ll owe in income and self-employment taxes. There are online calculators to help with this if you’re unsure.
- Next, break your estimated total tax down into quarterly payments.
- Lastly, make your estimated quarterly tax payment to the IRS.
Remember, online calculators aren’t a replacement for professional advice, so always consult a certified accountant before making major decisions.