Starting a small business involves a host of little details -- some more complicated than others. One of the most complex involves how your business will be taxed.
Like individuals, businesses face a host of taxes imposed at every level of government, from the federal Internal Revenue Service, to state departments of revenue, to county and city tax assessors. Not only will you have to pay taxes on your business profits, but you may also have responsibilities for withholding, collecting, and remitting certain other taxes, such as payroll and sales taxes, to the appropriate authorities. Although rules specific to your state and city may have special quirks, we can still cover some general issues about which you should remain aware.
Federal income taxes
If your business makes a profit, you'll probably owe income tax. However, what you pay depends on the form of business entity you choose. If you operate your business as a sole proprietorship, partnership, or limited-liability company, then the income tax is usually not imposed on the business entity itself, but on the owners. Those owners will then include their respective shares of the total profit on their individual tax returns, usually by filing Schedule C to Form 1040.
If you operate a partnership with one other person, and the business makes $1,000, then if you have agreed to split profits equally, each of you will report income of $500 on your individual income tax returns. Businesses set up in this fashion are sometimes referred to as pass-through entities. For partnerships and LLCs with more than one member, your business will generally need to file an information return with the IRS to report the overall profits of the business, and to allow the IRS to make sure the various individual owners report all of their income.
If you choose to incorporate your business, you will have a choice to make. Most small businesses can qualify to be treated as a subchapter S corporation, the name referring to the part of the Internal Revenue Code that governs such companies. By electing S-corporation status, your business will be treated as a pass-through entity that needs to provide only an information return. However, if you choose not to elect this status, then your corporation will be an entirely separate business entity, requiring a separate income tax return and incurring its own tax liability. If the corporation makes payments to you, you may have to treat those payments as income; you therefore will either have to find a corresponding corporate deduction, or end up paying tax twice. The potential for double taxation leads many small-business owners to choose S-corporation treatment, if they form a corporation at all.
Every state has some unique tax rules. That can make it harder for businesses operating in multiple states to calculate tax liability and conduct proper tax planning. Business taxes at the state level come in many different varieties, and it's crucial for you to understand the way your state works so that you are prepared when you have to pay.
For the most part, states tend to tax businesses using one of two different figures as a tax base: the net taxable income of the business or the total revenue of the business. For states that use a tax on net income, the rules often closely resemble those for individual income taxes -- the business reports income and deductible expenses, and it pays tax on the net taxable income using a rate schedule that the state legislature sets.
States that base their tax on the total revenue of the business, however, use rules that more closely resemble sales-tax rules -- a tax rate is applied to the gross receipts of the business, without regard to whether the business made a profit. As a result, you may well owe tax to your state, despite having no federal tax liability, and even though your business may have lost money during that year.
In addition, if your business owns inventory, equipment, or other property, you may need to pay property tax. Again, the specific aspects differ greatly from place to place. Some jurisdictions impose property taxes on even small amounts of property, while others impose no tax unless the business owns property with a value above a certain amount.
Most states have excellent resources for new business owners, available either on the state's website or by getting in touch with the state agency responsible for collecting tax. In reviewing a state's materials, you should especially consider a few important issues:
- If your state imposes business taxes, determine whether they apply to the type of business entity you have chosen. Some states impose taxes only on corporations, but allow pass-through entities to follow federal income-tax rules and collect individual income tax from the owners of the business.
- Find out whether your state follows federal income-tax rules for calculating deductible expenses. While some states have self-adjusting laws that automatically incorporate changes in federal tax law, other states use the federal law in effect on a certain date in the past, and still other states have their own special rules that may differ completely from federal tax rules.
- Speak to your taxing authority to get more information about anything you don't understand. It's far better to spend time now than to wait until an unexpected tax notice arrives in the mail.
Federal and state taxes imposed directly on new businesses can be extremely complicated. But even once you get a handle on them, you may still be responsible for collecting some other types of taxes, such as payroll tax and sales tax. The rules for these taxes are often just as complicated as income-tax rules are, and the consequences of making mistakes can be equally devastating to your business.
Payroll and self-employment tax
If you hire employees, your responsibilities don't end once you hand them their paychecks. You have to make sure you withhold the proper amounts from their paychecks for the various taxes that your employees must pay, and your business will have to pay employment-related taxes of its own. You don't even have to have employees to incur employment-related taxes. Even a sole proprietor who works completely independently without any employees must pay a self-employment tax.
As an employer, you have an obligation to withhold certain taxes from the paychecks of your employees. These taxes include Social Security and Medicare withholding, federal income-tax withholding, and any additional withholding your state imposes, including state income tax, unemployment, and disability-insurance withholding.
Determining the proper amount to withhold for federal and state income tax requires that you consult withholding-tax tables. To use the tables, you will need to know the number of withholding allowances your employees wish to claim; your employees will make this election on federal tax form W-4, which you should provide to them when you hire them. Depending on the amount of your total payroll, you must turn over these withheld taxes to the IRS on a regular basis, either twice a week or monthly. IRS Publication 15 contains additional information for employers about their obligations. Similar provisions apply to any taxes that your state requires you to withhold from employee pay.
In addition to withholding employment-related taxes from your employees' pay, your business itself incurs taxes that result from hiring employees. The employer is required to match the amount withheld from employee pay for Social Security and Medicare. In addition, the employer must pay federal unemployment tax for each employee. This amount may be reduced if your state requires your business to make payments into a state unemployment fund.
New businesses often have cash-flow problems. However, making payments of withheld payroll taxes is the single most important thing for you to do as a business owner. The IRS takes it very seriously when an employer diverts money withheld from employees' wages. Congress has given the IRS substantial power to deal with situations involving a failure to pay withheld taxes. In addition to large penalties, the IRS can collect not only from the business itself, but also directly from the personal assets of the business owners, officers, and directors responsible for making financial decisions for the business. You may be tempted, but you don't want to go down this road.
Many states and some cities and counties charge a sales tax on purchases. Some states limit the application of sales tax to physical goods, while others also impose sales tax on services. In most cases, it is the responsibility of the business to collect the tax from customers and to remit collected funds to the state government.
Although many commentators have suggested that replacing the federal income tax with a national sales tax would simplify the tax system dramatically, there are still many things to keep in mind in dealing with sales tax. For instance, most states provide exemptions from sales tax for certain items, such as food or clothing. Other states charge different rates for different categories of purchases. In addition, you may not need to collect sales tax if the purchaser intends to resell the item as part of the purchaser's business.
For example, if you own an auto-parts store and sell a part to a consumer, then you probably need to collect sales tax. However, if you sell a part to a repair-shop owner who will then resell the part to a customer, then you may not need to collect sales tax because the repair shop-owner will get the tax from the final customer. Most states require such purchasers to present a sales-tax exemption certificate.
Other tax issues
As a new business owner, you have the ability to start your business on the right foot when it comes to taxes. It's best to take tax matters very seriously; many potential problems can be solved very quickly if you address them early. Conversely, if you try to bury problems rather than deal with them, you will quickly find yourself in big trouble that will likely be far more difficult or even impossible to resolve in a timely manner.
Keeping track of all of the taxes your business must pay can be a daunting task, but remember that you have many resources available to assist you in complying with all of the applicable laws. Although there are many responsibilities in being a business owner, the rewards are worth it.
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This article is adapted from an article included in The Motley Fool's tax center collection. It has been updated by Dan Caplinger. The Fool has a disclosure policy.