The Definitive Guide to Small Business Taxes
April 15, 2021 | Last Updated on: July 24, 2022
April 15, 2021 | Last Updated on: July 24, 2022
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Many small business owners were relieved this year when the deadline for filing Federal Income Tax returns for 2019 was extended to July 15, 2020, because of the COVID-19 pandemic.
But now, with the new deadline less than a month away, small business owners – especially newer ones – are starting to get reacquainted with the process of small business tax preparation. Whether that means working with an accountant or other third-party to prepare their returns, or navigating the myriad of small business tax forms and regulations themselves, many small business owners seem to face a new set of rules every tax season.
This year brings even more challenges than usual, given the unprecedented COVID-19 pandemic. In addition, the Tax Cuts and Job Act (TCJA), which was signed into law in December 2017, brought far-reaching changes into the tax code. Many small business owners are still coming to grips with how the TCJA can affect their tax bill. Being aware of the potential implications of the TCJA can have a great effect on how and when small businesses will file their taxes and the deductions and credits they can claim for the 2019 tax year.
The small business tax rate varies from state to state and can frequently change year to year. When it comes to tax rates, business tax deductions or tax cuts, many small business owners are unaware of how these regulations affect them and the structure of their business.
That is why, according to the National Taxpayer Advocate estimates that small businesses spend approximately 2.5 billion hours each year preparing tax returns or answering questions from the IRS about their return. The National Taxpayer Advocate also estimates that about 70 percent of small businesses employ tax professionals to prepare their returns and to represent them before the IRS.
Suffice to say that understanding their tax responsibilities is one of the most complicated parts of running a small business. Each type of business structure has its own unique methods and criteria for paying its taxes. Details about these business structures – and how they are taxed – are below.
Of all business structures, a sole proprietorship is the least complicated when it comes to filing income taxes. Sole proprietors include business income – and losses – on their personal income tax return. That is because sole proprietors – by definition – are the only owner and operator of the business.
To determine at their net business income, sole proprietors typically must complete and file a Schedule C or a Schedule C-EZ with their personal Form 1040. The Schedule C, which is called “Profit or Loss from Business,” walks sole proprietors through the process of arriving at their net income by subtracting all business-related expenses from their gross revenue.
Sole proprietors also must pay quarterly estimated income taxes throughout the course of the year. Estimated taxes allow businesses to pay Social Security and Medicare taxes within their income taxes. Form 1040-ES (Estimated Tax for Individuals) can help self-proprietors determine what quarterly amount they need to pay.
Paying self-employment tax is another responsibility of sole proprietors. The amount of self-employment tax owed is payable along with Form 1040 and is calculated by using Form 1040-SE. Self-employment tax must be paid if the net earnings of a business were $400 or more. Most businesses are responsible for paying half of Social Security and Medicare but, if those who are self-employed must pay the entire amount of these taxes on their tax bill. As is the case with Schedule C, Form 1040-SE must also be filed with Form 1040.
All members of a business partnership must pay income taxes, self-employment taxes and quarterly estimated taxes. A business must have at least two owners to be considered a partnership. A partnership can be considered a general partnership, a limited partnership or a limited liability partnership.
Partnerships must annually file Form 1065 (U.S. Share of Partnership Income). This form details all income, expenses, deductions, gains and losses of the business for the year. The business itself, however, doesn’t pay any income tax. Instead, the respective owners of the business each pay their share of the partnership’s income on their personal income tax returns. This is what’s known as pass-through taxation. Each partner’s share of the income – or loss – of the business are filed on Schedule K-1.
C-Corporations is an example of a double taxation small business. This double taxation is the result of C-Corporations being legal entities that are completely separate from their owners.
C-Corporations pay a flat income tax rate. That C-Corp tax rate is 21 percent. The profits of the business are then distributed to shareholders as dividends. Shareholders must then pay taxes on these dividends on their personal tax returns. This arrangement that mandates taxes be levied both at the source of the income and on the dividends distributed to shareholders of a business is where the double taxation comes in, and is commonly referred to as the dividend taxation system.
C-Corporations typically file their taxes by using Form 1120 (U.S. Corporation Income Tax Return). If a C-Corporation expects to owe at least $500 in income taxes, it’s obligated to pay quarterly taxes.
On the flip side, C-Corporations have several tax advantages. For instance, since dividends are taxed at a lower rate than income from wages, it’s not uncommon for corporate business owners to pay themselves less in salary and more in dividends. Shareholders who are involved in the operations of the corporation are considered employees, and their salaries are subject to self-employment taxes. As a result, these business owners save on self-employment taxes by paying themselves are smaller salary, although the salary must be reasonable for the person and the position they hold. Another way to minimize double taxation is through a process called income splitting. This is a process in which the owners of a business withdraw as much of the corporation’s profits as they need to support their lifestyles, but leave the rest inside the business.
Double taxation can be avoided entirely simply by allowing the corporation to retain all of its profits and not distribute them.
Unlike C-Corporations, S-Corporations aren’t subject to double taxation. That’s because S-Corporations, like sole proprietorships and partnerships, are pass-through entities for tax purposes. There is no designated S-Corp tax rate. The business itself doesn’t pay a corporate tax, but all shareholders report business income and losses on their personal tax return. Any profits are taxed at the personal income tax rate. S-Corporations file an informational tax return by using Form 1120S (U.S. Income Tax Return for an S Corporation).
S-Corporations are similar to C-Corporations in that they can divide the business income of their shareholders between salaries and dividends. Shareholders must make estimated quarterly tax payments if they expect to owe at least $1,000 or more in income taxes.
Salaries are subject to self-employment tax, but dividends are taxed only at the dividend tax rate, which is lower than the rate that salaries are taxed. While paying lower salaries strategically benefits shareholders from a tax perspective, it’s important to note that the IRS requires such salaries to commensurate with the qualifications of the recipient.
A limited liability company (LLC) is a business structure that can combine the pass-through taxation of a sole proprietorship or partnership with the limited liability of a corporation. For the purpose of Federal income tax, LLCs are treated the same as a sole proprietor or partnership. There is no defined LLC tax rate. LLC owners must make quarterly estimated tax payments. But, unlike corporations, LLCs aren’t subject to double taxation. They also have to annually submit a Form 1065.
LLCs have other flexibility and benefits than other types of business structures. For instance, while a business can be an LLC, it has the option to be taxed as an S-Corporation or a partnership.
All businesses must submit an annual income tax return, regardless of whether or not they are profitable. Business owners making less than $400 are exempt from self-employment tax, but still must file a return.
Being late to file tax documents or to make payments can lead to late fees and other penalties. As a result, it’s important to budget during the course of the year for taxes like estimated quarterly payments and additional taxes such as self-employment tax. To keep track of tax law deadlines, many small business owners use a tax software to e-file their payments.
It’s a good idea for small business owners to set aside 30 to 40 percent of their income to pay federal and state taxes. There are several ways to accomplish this, depending on how established a business is. A good strategy for new businesses is to set aside 30 percent of every payment received. Newly profitable business may want to save 30 percent every month. Established businesses may simply divide their income of the previous year by four and pay that amount every quarter.
The fact that income taxes are paid quarterly will help distribute the total tax owed more evenly over the course of the year. Estimated quarterly tax payments are usually due as follows:
But, with the pandemic continuing to wreak havoc, this schedule has changed dramatically for the 2020 tax year. Estimated tax payments for the first and second quarter aren’t due until July 15, 2020. The payment for the third quarter (June 1 – August 31) is due on September 15, 2020. The fourth payment (September 1 – December 31) is due on January 15, 2021.
Knowing what expenses are tax deductible is a common way for that small business owners can save on taxes every year. These savings can range into thousands of dollars a year. Each type of business is entitled to certain expenses that are occurred in daily operations. These expenses are known as “ordinary and necessary,” and can lower your taxable income. The rental of storage space for inventory, for instance, is an example of what could be considered a necessary expense.
Other deductible expenses may not be so obvious and may be relevant only to a specific industry. A video streaming service, for instance, may be tax deductible for an entertainment reporter, but not many other businesses. Becoming familiar with all that you can potentially write off as a small business owner can pay off in a big way. Here are a few of the most common business tax deductions that apply to the majority of small businesses.
The cost of operating any vehicle that is used for business purpose, regardless of whether or not the vehicle is registered to the business, can be deducted from the taxable income of a small business. This can be done in two ways: deducting standard mileage rate and actual car expenses.
Using the standard mileage rate involves deducting the miles that the vehicle is driven for business by the government-approved mileage rate for the year. In 2019, this rate was .58 per mile. Deducting actual car expenses involves keeping track of all the costs of keeping the vehicle on the road, such as gas, oil changes, insurance, repairs, tune-ups and the like.
Most small businesses carry some form of insurance, and in many cases multiple insurance policies. Health insurance, Workman’s Comp, Liability and malpractice insurance are all applicable examples. The cost of all of these policies are 100 percent deductible.
Small business owners can deduct the rent they pay on any spaces that are rented for business purposes, such as offices, warehouses, garages and the like. In addition, rent paid on equipment or machinery is also tax deductible.
Many small business owners operate out of the owner’s home. Rent on the part of the home used for business can also be deducted. Home office tax deductions are common, but there are strict rules that govern them. Other popular small business tax deductions include:
Any costs paid or incurred in starting a business is considered by the IRS to be a business startup cost. These business-related startup and organizational costs are considered to be capital expenditures. Small business owners are permitted to deduct up to $5,000 of business startup costs and up to $5,000 or organizational costs if their total startup costs don’t exceed $50,000.
Should startup costs exceed $50,000, a business owner can initially only deduct $5,000. The balance of the costs can be amortized and deducted over a period of 18 months.
The Tax Cuts and Jobs Act, which was passed in 2017, made it allowable to deduct inventory before it is sold. This applies in cases where a business uses the cash method of accounting or treats items in its inventory as materials and supplies. Before the Tax Cuts and Jobs Act, inventory was only deductible if a customer purchased an item. The wholesale cost of the item purchased could then be deducted as the “cost of goods sold.”
Interest payments on small business loans, business credit cards and mortgages are all tax- deductible.
In addition to business tax deductions, there are many business tax credits that, like deductions, can help make your small business tax-efficient. Tax credits are typically offered to businesses as an incentive to engage in certain activities that have a positive effect on society, such as reducing pollution or strengthening the economy.
Small business tax credits offer more dramatic tax savings than tax deductions. A tax deduction lessens your taxable income, which can move a business owner into a lower tax bracket. As a result, a percentage of the deduction is realized depending on the tax bracket. By contrast, tax credits cut the amount owed by the full amount of the credit. It’s often a good idea to check for recent changes to common small business tax credits.
The Qualified Business Income Deduction is a new small business tax credit that was passed in 2018. To be eligible, a companies must have a taxable income of less than $157,000 for a single person, or $315,000 if married. For companies that qualify, 20 percent of their income is non-taxable.
You can also read more helpful tax-time tips.
Filing small business taxes can be time-consuming and complicated. While small business owners are capable of filing all of the necessary forms and making their quarterly tax payments on their own, doing so can take valuable time away from actually running their business.
That is why many small business owners enlist the services of an accountant or tax preparer to help ensure that their taxes are done correctly and in a timely fashion. But how can a small business owner find such help?
Like all services, there are many tax preparation services to be found online. But the best way to find qualified and competent tax help is through referrals. Local Chambers of Commerce and other business associations can be a great source of information. Business owners can often find qualified referrals for tax help and other services through their bank, attorney and other professional relationships. Knowing what questions to ask is also critical to finding the right preparer.
Tax accountants and income tax preparers are both qualified to help small business owners with preparing and filing their income tax returns. But tax accountants are better qualified to provide more long-term assistance to their clients. That’s because most tax accountants are Certified Public Accountants (CPAs), and thus have the freedom to provide paid services to prepare income taxes and operate in the world of accounting than tax preparers, which are subject to more narrow IRS guidelines.