Tax Basics for Small Business

If you are starting a business, it is essential that you familiarize yourself with all of the necessary tax forms you will need to file with the IRS and the various taxes you will be required to pay.

Every business is required to file a federal tax or information return. The type of business entity you have selected will determine the manner in which you will file and subsequently pay taxes. A “C” Corporation, for example, will be responsible for paying corporate taxes, while the owner of a sole proprietorship will report the income or losses from his or her business on his or her personal income tax return. Payment will then be based on the sole proprietor’s personal income tax rate.

In this article we take a broad overview of the various types of taxes that you will encounter when going into business. It is highly advisable that you seek professional guidance from an accountant before filing your tax return. Look for someone who is familiar with your type of business.

Before You Start, Obtain an Employer Identification Number

As soon as you form a business, you will need to obtain an employer identification number (EIN) from the IRS. Your EIN, combined with the individual Social Security numbers of your employees, will provide the tax identification data needed by the IRS. You can apply online for your EIN by going here.

The Basics on Income Taxes

A business is typically expected to pay estimated taxes quarterly throughout the fiscal year. Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed.

Corporations generally have to make estimated tax payments if they expect to owe tax of $500 or more when their return is filed.

You may have to pay estimated tax for the current year if your tax was more than zero in the prior year. See the worksheet in Form 1040-ES, Estimated Tax for Individuals, or Form 1120-W, Estimated Tax for Corporations, for more details on who must pay estimated tax.

With the potential of facing IRS penalties, it is important to pay such quarterly estimated taxes on time or request an extension in advance of the due date.

Deducting Business Expenses

Business expenses are the cost of carrying on a trade or business. These expenses are usually deductible if the business operates with the goal of making a profit.

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

It is important to separate business expenses from the following expenses:

The expenses used to figure the cost of goods sold
Capital expenses
Personal expenses

Capital expenses

You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called capital expenses. Capital expenses are considered assets in your business. In general, there are three types of costs you capitalize:

Business startup costs
Business assets
Improvements

Note: You can elect to deduct or amortize certain business startup costs. Refer to chapters 7 and 8 of IRS Publication 535, Business Expenses.

Personal versus business expenses

Generally, you cannot deduct personal, living, or family expenses. However, if you have an expense for something that is used partly for business and partly for personal purposes, divide the total cost between the business and personal parts. You can deduct the business part.

For example, if you borrow money and use 70% of it for business and the other 30% for a family vacation, you can deduct 70% of the interest as a business expense. The remaining 30% is personal interest and is not deductible. Refer to chapter 4 of IRS Publication 535, Business Expenses, for information on deducting interest and the allocation rules.

Business use of your home

If you use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses may include a portion of your mortgage interest, insurance, utilities, repairs, and depreciation. Refer to Home Office Deduction and Publication 587, Business Use of Your Home, for more information.

Business use of your car

If you use your car in your business, you can deduct car expenses. If you use your car for both business and personal purposes, you must divide your expenses based on actual mileage. Refer to Publication 463, Travel, Entertainment, Gift, and Car Expenses. For a list of current and prior year mileage rates, see the Standard Mileage Rates.

Other types of business expenses

Employees’ pay: You can generally deduct the pay you give your employees for the services they perform for your business.
Retirement plans: Retirement plans are savings plans that offer you tax advantages to set aside money for your own and your employees’ retirement.
Rent expense: Rent is any amount you pay for the use of property you do not own. In general, you can deduct rent as an expense only if the rent is for property you use in your trade or business.
Interest: Business interest expense is an amount charged for the use of money you borrowed for business activities.
Taxes: You can deduct various federal, state, local, and foreign taxes directly attributable to your trade or business as business expenses.
Insurance: Generally, you can deduct the ordinary and necessary cost of insurance as a business expense if it is for your trade, business, or profession.

This list is not all inclusive of the types of business expenses that you can deduct. For additional information, refer to IRS Publication 535, Business Expenses.

Properly Documenting All Income and Deductible Expenses

Every business needs to employ a record-keeping system that accurately and completely captures all income and deductible expenses. Some businesses use an ordinary checkbook for this system, but many businesses choose to use electronic accounting software programs, such as QuickBooks.

The IRS suggests that these are the types of records a small business should keep by category:

Gross Receipts of the income you receive from the business:

Cash register tapes
Deposit information (cash and credit sales)
Receipt books
Invoices
Forms 1099-MISC
E-commerce sales

Purchases are the items you buy and resell to customers. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. Your supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following:

Canceled checks or other documents that identify payee, amount, and proof of payment/electronic funds transferred
Cash register tape receipts
Credit card receipts and statements
Invoices

Expenses are the costs you incur (other than purchases) to carry on your business. Your supporting documents should show the amount paid and a description that shows the amount was for a business expense. Documents for expenses include the following:

Canceled checks or other documents that identify payee, amount, and proof of payment/electronic funds transferred
Cash register tapes
Account statements
Credit card receipts and statements
Invoices
Petty cash slips for small cash payments

Travel, Transportation, Entertainment, and Gift Expenses

If you deduct travel, entertainment, gift, or transportation expenses, you must be able to substantiate certain elements of those expenses. For additional information, refer to IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses.

Assets are the property, such as machinery and furniture, that you own and use in your business. You must keep records to verify certain information about your business assets. You need records to compute the annual depreciation and the gain or loss when you sell the assets. Documents for assets should show the following information:

When and how you acquired the assets
Purchase price
Cost of any improvements
Deductions taken for depreciation
Deductions taken for casualty losses, such as losses resulting from fires or storms
How you used the asset
When and how you disposed of the asset
Selling price
Expenses of sale

Employment taxes

There are specific employment tax records you must keep. Keep all records of employment for at least four years. For additional information, refer to IRS Recordkeeping for Employers and Publication 15, Circular E Employer’s Tax Guide

Pass-Through Taxes

The business entity you select will determine whether or not there will be pass-through taxation. Partnerships, LLCs, and S corporations are examples of businesses that have pass-through taxes. In each of these forms of business, taxes are passed through to the owners, who then report the income or loss on their own personal income tax returns.

Unlike a C Corporation, in which there may be double taxation since the corporation pays taxes as a separate entity, and any shareholder receiving dividends is also subject to tax, an LLC or S corporation can pass through profits or losses without paying any additional corporate taxes.

According to the IRS, in the case of a pass-through entity classified as a partnership, tax returns must be filed by the 30th day of the 4th month following the end of a pass-through entity’s taxable year. In the case of a pass-through entity classified as an S corporation, tax returns must be filed by the 30th day of the 3rd month following the end of such a pass-through entity’s taxable year.

Sales Taxes

Although Congress has toyed with it several times over the years, there is still no federal sales tax. Most states, however, charge sales tax on retail products sold. Sales tax rates vary from state to state and may also be imposed by a city or local government. The amount is determined as a percentage of the gross receipts for the items sold, not the net profit the seller makes on the items.

Some states allow for specific goods, such as food, clothing, or footwear, to be exempt from carrying sales tax. Make sure you know which, if any, retail items are exempt from sales tax in your state. Sales tax may also be imposed on rentals, leases, and certain services depending on statewide regulations. If you are doing business in any state that has a sales tax, as a business owner, you will be responsible for charging, collecting, and recording the tax.

The manner in which sales taxes are imposed also varies. The sales tax is typically imposed on the purchaser of the item, but in some states the tax is imposed on the seller, who usually passes the tax liability along to the customer.

Prior to filing sales tax, you will need to apply for and secure permits or licenses for your various business locations. Such permits or licenses should be displayed at each of your business locations.

Having what is considered a “presence” in a state is the criteria used by the IRS to determine whether or not you are liable for paying state sales tax.

If you do not have a physical presence in another state but sell items via the internet or by catalog in that state, you can be subject to a state’s “use tax” or sales tax (although the law is evolving in this area). A “presence” in another state does not necessarily mean that you have a retail outlet in that state. If you have an office, warehouse, or have employees working for you in that state, the IRS may consider you to have a presence in that state. Make sure you are aware of your sales tax responsibilities in all states in which you are doing business.

Sales tax must then be reported and paid in a timely manner to the appropriate state collection office. This is usually done on a monthly basis. You need to check the requirement carefully for your state. Failure to pay sales tax or making late payments might cause you to incur a tax audit and/or potentially heavy penalties.

How can a business determine what it needs to do to comply with the sales tax rules? There are numerous tax software services, easily found via a web search, that can help you determine what is owed and set up the required tax filings.

Payroll Taxes

Payroll taxes are due either semi-weekly or monthly, depending on the size of your payroll. The IRS will dictate the schedule.

You may consider using a payroll software program to handle your payroll needs. If your company is growing and you have an increasing number of employees, you might opt for an outside payroll service. Such services include QuickBooks and ADP both specialize in handling your payroll needs.

Social Security and Medicare (FICA)

The Social Security Program, created in 1935 by an act of Congress (the Federal Insurance Contributions Act, or FICA) has relied primarily on withheld payroll taxes from employee paychecks to generate retirement savings. The goal was to provide American citizens with retirement income or financial assistance in the event of disability or death of the primary wage earner. Today, more than 90% of retired Americans receive Social Security. Unfortunately, because the rate of inflation has outpaced Social Security, the impact of the program on retirees’ income is less significant than in the past.

Medicare, meanwhile, is designed to help people over the age of 65 pay for medical costs. While it does not pay for many types of medications, it does help nearly 98% of Americans over the age of 65 with some portion of their medical bills.

In addition to the money that, by law, is withheld from each employee’s paycheck for FICA, the employer is also required to match the amount. The amount for FICA is currently 7.65%, which is comprised of 6.2% for Social Security and 1.45% for Medicare (plus a 0.9% additional Medicare tax from employees earning more than $200,000 a year). To determine how much Social Security and Medicare tax to pay, see IRS Publication 15.

The time frame in which you are required to pay FICA will depend on the size of the payroll. The larger the payroll, the faster you need to send in the payments. For example, a very small business with one employee might file quarterly, while a large company with a $100,000 weekly payroll will need to file within three days after payroll is completed. Again, this schedule is available at www.irs.gov.

Some Common IRS Tax Forms You Should Know About

SS-4: Application for Your Employer Identification Number (EIN)
W-2: Employer’s Wage and Tax Statement
W-4: Employee’s Withholding Allowance Certificate
940: Employer’s Federal Unemployment Tax Return
941: Employer’s Federal Quarterly Tax Return
1040: Estimated Tax
1099: Miscellaneous Income: Used to report compensation for non-employees
1120: US Corporate Income Tax Return
8109: Federal Tax Deposit Coupon: Used to deposit taxes

Each business is required by law to withhold federal income taxes from the wages of its employees.

Employment Taxes

Federal withholding taxes

Withholding taxes are filed in accordance with the W-4 Employee’s Withholding Allowance Certificate, which is filled out by each employee. The W-4, in conjunction with IRS Publication 15, is used to determine how much federal income tax you are required to withhold. Amounts will vary depending on:

The number of withholding allowances claimed by the employee
The marital status of the employee
Any exemptions from withholding taxes claimed by the employee

Employees can change the amount withheld by submitting a new W-4 Withholding Certificate and changing the number of withholding allowances (dependents) and their tax status.

If you do not withhold the proper amount, fail to pay federal withholding taxes, or pay late, you are subject to penalties by the IRS.

Note: All businesses that employ other people on the books must have an individual EIN, or Employment Identification Number. Therefore, if you are partners in more than one company, or you purchase a new business in addition to your own, you will need a separate EIN for each business entity or company. By filing an SS-4, Application for Employer Identification Number, you can obtain additional EIN’s from the IRS service center in your state for each business.

Unemployment taxes

To insure that unemployment pay is available to employees who have lost their jobs, the Federal Unemployment Tax Act of 1939 was passed by a vote in Congress.

According to the Department of Labor, “The Federal-State Unemployment Insurance Program provides unemployment benefits to eligible workers who are unemployed through no fault of their own (as determined under state law), and meet other eligibility requirements of state law.”

Businesses are required to report federal unemployment tax on IRS form 940 and pay both federal and state unemployment tax. Unlike FICA and federal withholding taxes, unemployment taxes are not withheld from the employee’s wages, but are paid entirely by the business. The state unemployment tax rate is a percentage based on the total number of employees you have and the number of former employees that are collecting unemployment at any given time.

If you pay the full amount to the state, the federal government only requires you to pay 0.8% for up to $7,000 in income, for each employee on your payroll, which is a minimal amount ($56). However, the federal unemployment tax is 6.2% if you do not receive the maximum state credit.

Who qualifies as an employee or as an independent contractor?

The proliferation of contractors, freelancers, and consultants can blur the definition of who qualifies as a company employee. For tax purposes it is important that you understand which individuals are considered your employees by the IRS, regardless of common terms such as “consultants” or “contractors.” Typically, an individual is considered an employee if he or she meets several requirements including, but not exclusive to:

Receiving his or her primary income through working for your business
Receiving direction from you on a regular basis
Having his or her pay rate controlled by your decisions
Being specifically trained to perform tasks or jobs for your company
Working on your schedule, in your facilities, and not having a business location of their own
Receiving benefits from your company

Together these criteria can indicate, by IRS definition, that someone is considered your employee.

Non-employees doing work for your company, including all independent contractors, freelancers, and consultants who earn over $600 in a given year from your business, are required to receive an IRS Form 1099. The form will state the amount of money earned from your business during the calendar year. You are not required to withhold any money, and the independent contractor is, therefore, responsible for reporting the income on his or her own personal tax return.

Granting Stock Options and IRS 409A Issues

Stock Option Plans are an extremely popular method of attracting, motivating, and retaining employees, especially when the company is unable to pay high salaries. A Stock Option Plan gives the company the flexibility to award stock options to employees, officers, directors, advisors, and consultants, allowing these people to buy stock in the company when they exercise the option.

Stock Option Plans permit employees to share in the company’s success without requiring a startup business to spend precious cash. In fact, Stock Option Plans can actually contribute capital to a company as employees pay the exercise price for their options. The spectacular success of Silicon Valley companies such as Facebook and Google, and the resulting economic riches of employees who held stock options in these companies, have made Stock Option Plans a powerful motivational tool for employees to work for the company’s long-term success

The primary disadvantage of Stock Option Plans for the company is the possible dilution of other stockholders’ equity when the employees exercise their stock options. For employees, the main disadvantage of stock options in a private company—compared to cash bonuses or greater compensation—is the lack of liquidity.

The primary tax issue for the company in granting stock options is that the company needs to make a determination of the fair market value of its common stock in order to set the exercise price of the option, pursuant to Section 409A of the Internal Revenue Code. This is often done by hiring a third-party valuation expert.

In the case of a company that is organized as an LLC, “profits interests” may be issued instead of stock options. These profits interests, like options, entitle employees to participate in the future income and appreciation in the value of the company, with capital gain treatment applicable to any capital gain generated by the LLC and passing through to the employee.

Tax Software

There are a number of software products on the market designed to handle your tax-related needs including payroll taxes, sales taxes, and tax planning. When in the market for tax software products, you should:

Compare prices.
Make sure the program meets your system requirements.
Carefully evaluate the various features.
Make sure the program interfaces with software programs that you may currently be using and can import tax data.
Look for a program that is “user friendly” for your staff and offers a demo.

Tax software programs are typically updated annually to take into account new tax laws and changes on tax forms. Be careful that you are not using a system that has become outdated.

Among the many popular software programs you’ll find are:

Turbo Tax Business: One among several popular business software programs from Intuit, TurboTax is designed to help various types of businesses prepare tax documents. Included are tax-saving tips, deduction finding capabilities, IRS-approved forms, and a tax reference library. It is also designed to interface smoothly with Intuit’s QuickBooks bookkeeping software programs.
H&R Block: Among the best software for simple filings.
TaxSlayer: Among the best software for self-employed individuals.

Tax Planning

Tax planning should be done in conjunction with the guidance and expertise of your accountant. One of your first priorities will be to make an informed decision regarding the structure of your business. That decision, with help from your accountant, will make a significant impact on your tax status and subsequent planning.

Typically, a good tax professional will consider all aspects of your current business and personal financial situation. The size and nature of the business, number of employees, along with the most recent federal, state, and local tax laws, will all play a significant role in such planning.

The bottom line will be to have a plan that limits your tax bite, while not hindering your ability to have the capital or resources you need on hand to conduct business. In addition, you want to make sure that any tax loopholes you decide to slip through, as part of your tax strategy, are legal and won’t lead to a tax audit or to IRS penalties.