This is a an article from our archives. An updated article on Small Business Taxes is available to read containing more recent information.
There are more Small-to-Medium enterprises (SMEs) in the United States than any other business type. With estimates that up to 98% of US businesses employ less than twenty people, it’s no surprise that taxation is such an essential factor in the country’s economy. For those that run their own SME, it can often seem as if taxes are unnecessarily confusing, especially when you include the fact that you also have to pay your personal taxes as well. If the whole notion of taxes is confusing you, or you’re perplexed by some of the jargon, it can lead to stress and worry that you’re doing it wrong. If that sounds familiar, here’s what you need to know about you, your small business, and your taxes.
Identifying an SME
Small to medium enterprises are officially different from corporations and employ less than 500 people. The US Small Business Association classes any business with fewer than 500 employees as a small business, but for taxation, it is wise to remember the difference between your company and registered corporations. That’s because corporations follow a different set of tax rules. When looking at defining your business, if you have to file a Schedule C (also known as a Profit or Loss from Business) with the IRS, you are a small business. It can mean that your business comes under one of the following classifications:
- Self-employed – If you provide services to other businesses or clients, you are self-employed (or an independent contractor) who will be required to file a Schedule C.
- Sole Proprietorship – This is the type of business that is owned by just one person. It may or may not have employees, and whichever category you fall into, your employee numbers will play a factor in your overall taxes.
- Limited Liability Company – An LLC can be a complicated business model to organize taxes for, but ultimately only one owner of the company will be required to pay taxes for the business.
- A Qualified Joint Venture – This is for those businesses that are run and owned by married couples, and who do not hire any additional workers. Spouses that do hire staff will need to look at other tax forms.
It’s important to remember that your small business does not have to be your sole source of revenue. If you make money from any other type of work, whether that’s a full-time position or part-time, that money can play a factor in your tax payments. If you run a small business from home in your spare time, then you are an SME and will have to pay taxes on the profits that you make.
The IRS defines business income as any money that you make that is connected to a business. This is money that you have made that you would not have received if you did not have your SME. Whether you dedicate all of your waking hours to your business or just an hour a week is largely irrelevant. If you have a company that makes money then you will need to let the IRS know through your Schedule C. It’s not just about money either. If you collect any property, company acquisitions, or services through your business, then they will need to be included on your Schedule C as well. Don’t make the mistake of thinking that the IRS is solely concerned with the hard cash that you collect. A cash advance, checks, and credit cards will need to be factored into your income generation, as well as anything that you gain through fair market value bartering.
The Salary Factor
For those who are self-employed (or classed as independent contractors), the chances are that you do not receive a regular set salary. It can make it seem harder to work out your tax requirements, but the process is largely simplified. If you are registered as a self-employed business owner, then you will receive Form 1099-MISC every January from your clients. That form will show how much nonemployee taxation you will have gained on an annual basis, and will make it much easier for you to understand your tax necessities.
There are two ways that SMEs can tackle their accounts, and the method that you choose will affect how much tax you pay. For cash accounting or accrual accounting, there are stark differences when it comes to determining your income sources and how your expenses are worked out. The main differences are:
- Cash accounting: All of your income and any expenses will need to be paid in the same year that the transactions occurred. If your SME is a model that does not have an inventory or long periods of time between invoicing and payment, then this is the most efficient and straightforward accounting method to use.
- Accrual accounting: This is when the exchange of money is less relevant than the tax year when that exchange happened. Many owners of an SME prefer this form of accounting because it is viewed as a better means of knowing where your business is financially at all times. A simple way of looking at accrual accounting is to consider sales where you may ship a product in October but do not receive a cash advance or payment for that product until January. Accrual accounting means that you will not have to pay tax on that October sale until you receive payment for it in the next fiscal year.
Income Tax Payments
It’s vital that you remember the fact that you will need to pay your employee’s income tax all year round. This is the tax that you take from your employees’ wages. If you are classed as being self-employed, then you will have to pay your income tax on a quarterly basis. Many SME owners make the mistake of thinking that this payment is only expected to be received in April, and that can have long-term repercussions such as financial penalties.
One of the reasons why you should pay more attention to your taxes is due to deductions. The tax code means that there are plenty of options for deducting business expenses, as long as you can prove that those expenses were essential for the running of your SME. That’s why it is vital that you keep track of your receipts at all times. If your SME buys or makes goods that you then sell, you need to know the cost of goods sold. It can help you cover your manufacturing or purchasing expenses, and means that you will only pay taxes on your gross profits. Once you have that assessed, you can start to look at other expenses that you may be able to deduct from your final gross profit figure. These can include:
- Wages for employees: If you employ people, you will be paying employee tax, which is different from your own tax requirements. If you have paid workers, then you can deduct that total from your gross profits.
- Depreciation: You will be able to get a tax deduction if you have business equipment, any vehicles related to your SME, industrial machinery and even tools. You will not be able to deduct the overall taxes, but instead spread out these deductions over the estimated lifespan of those tools and equipment types. If you used industrial equipment financing, you will be able to spread your tax payments over a number of years.
- Travel expenses: If your SME means that you have to travel to meet suppliers or potential clients, those are deductible expenses. Even if you are traveling to a networking event that is related to your business, you can deduct those costs from your overall tax payments.
- Workspace: This is one of the areas of tax deductions that are growing in use because more people than ever are working from home. Setting up your home office is tax deductible, although you will need to ensure that any equipment or resources that you are claiming a deduction for is used exclusively or primarily for business purposes. If you have taken out an interest only business loan, then you can use that money to establish your workspace, with the relevant tax breaks reducing your overall spending.
These are the most common tax deduction claims made, but there are many more areas to explore. The IRS Tax Guide for Small Businesses can help you identify what you can and can’t make a deduction claim for.
Managing your tax obligations can be very frustrating, but it may be more beneficial than you think. Take the time to explore your tax requirements and look for tax credits and deductions that can help you reduce your annual payments. The more that you understand your taxes, the less you might end up paying.