Building a Business

Small Business Taxes: How They Work and What You’ll Pay This Year

Updated on February 3, 2020 Updated on February 3, 2020
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Small businesses are a big part of our country’s economic growth, so you would think the government would make starting a business as easy as possible. Of course, this is not the case. If you need a business tax strategy, listen up.

Not filing your taxes properly can cost you and your business tons of money. Believe me; Listen Money Matters has had their fair share of fines. Like us, many new businesses start out choosing to file their taxes using products like TurboTax, and that’s a huge no-no.

If you don’t cross all your T’s and dot all your I’s, it will cost you. Big time. There are so many regulations for tax credits and deductions, and the rules vary between locations and business structures. This is why we recommend hiring a CPA to help you.

Regardless of whether you hire a tax professional or not, you need to research all of the federal, state, and local requirements for your business. Because once you understand the rules, you can start using them to your advantage both during and outside of tax season.

What Are Small Business Taxes?

First, it’s important to know what small business taxes actually are. While state and local income taxes will vary, your federal business taxes will consist of income taxes and self-employment taxes.

Income Taxes

These are the taxes people traditionally think of when it comes to tax season. They’re determined by your tax bracket, which is determined by your filing status (single, married filing jointly, married filing separately, head of household, or qualifying widower).

You’ll pay federal income taxes on all of your income, like wages, self-employment income, and retirement income.

Self-Employment Taxes

Self-employment taxes are imposed on the net profit of your business. Once you’ve deducted your business expenses from your business income, you will pay 15.3% in taxes on that income.

This 15.3% covers your social security and medicare taxes. When you’re an employee, you and your employer split this 50/50. You each pay 7.65%. When you’re self-employed, you pay the full 15.3%.

The actual calculation is a little more complicated than just multiplying your business income by 15.3%. Also, the percentage decreases if your business income exceeds $132,900. You can check out Schedule SE to see the full breakdown.

We recommend estimating your self-employment taxes at 15.3%. This is both for simplicity’s sake and to give yourself a buffer in case you owe more income taxes than you planned.

All of your small business income is subject to both types of taxes, so remember to plan for both the 15.3% self-employment tax and the income tax for whichever tax bracket you fall under.

Is It a Hobby or a Business?

small-business-hobby

Before you start having nightmares about how much you’ll owe this tax season, you first have to determine if your income is subject to those pesky business taxes.

When you’re still working on growing your business, it can be referred to as a hobby. You may have heard that if your business has not made any profit after three years, it will be considered a hobby and not a legitimate business. This is a myth.

After a few years with no profit, the government will look at each business case-by-case. However, if after five years you still haven’t managed to make a dime, you should maybe think about investing your money elsewhere.

To figure out whether you have a hobby or a business, the IRS has a list of nine factors for your consideration. The main takeaway from this list is the intent to make a profit.

You can show this intent by keeping detailed records of income and receipts. Get a business license. Make a business plan, and keep a calendar or journal showing the time and effort you’re putting into your business.

Business vs. Hobby Taxes

If it’s a business, you can deduct expenses from income, and losses can reduce your personal taxable income. The bad news is you have to pay those 15.3% self-employment taxes in addition to your regular income tax.

If it’s a hobby, you don’t have to pay self-employment taxes. The bad news? Prior to 2018, you could deduct hobby expenses to the extent of hobby income on Schedule A as miscellaneous 2% itemized deductions. The Tax Cuts and Jobs Act removed these 2% deductions, so you can no longer deduct hobby expenses.

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How Does Business Structure Affect Taxes?

This part can be confusing, and these are just the basics. There are tons of technicalities and state variations, so please consult your attorney and accountant to figure out what works best for your business.

Whether you’re just starting your business or are already established, you need to understand business structure. This isn’t just a legal matter; it’s also a tax planning strategy.

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There are four main types of business structure:

  • Sole Proprietorship
  • Partnership
  • S-Corporation
  • C-Corporation

Each type of business is taxed differently and requires a different tax form.

Pass-Through Entities

These are sole proprietorships, partnerships, and S-corporations. Because they are pass-through entities, income is “passed-through” to your individual tax return and taxed at your personal income tax rates.

A sole proprietorship offers the least amount of separation between you and your business. This is because you are the only owner, and it is unincorporated. You report your sole proprietorship income on Schedule C with Form 1040 (your personal tax return) by April 15th.

If you’re in a partnership with at least one other person who isn’t your spouse, you need to file a business tax return that’s completely separate from your 1040. This return is called a Form 1065 and needs to be filed by March 15. If you’re in a partnership with your spouse, you are a qualified joint venture and can each file a Schedule C on your joint return.

An S-corporation is an incorporated business with one or multiple owners. You will need to file a business tax return separate from your individual return no later than March 15. This form is called Form 1120S.

Taxwise, the biggest difference between a partnership and an S-corporation is the fact that S-corporation owners can receive a salary. Partnership owners cannot.

As long as you pay yourself a reasonable salary, you can take distributions from your S-corporation. These distributions are not subject to self-employment tax, so you can enjoy the perks of having a profitable business without the extra tax burden. They are, however, still subject to income tax.

C-Corporations

A C-corporation is the only type of business listed that is not a pass-through entity. Income is taxed on the business tax return (Form 1120) at a flat corporate tax rate of 21%. You need to file Form 1120 by March 15.

C-corporations pay out their profits in the form of dividends. These dividends are then taxed on your income tax return.

This brings about the concept of double taxation, meaning you pay taxes at both the business level and the personal level.

gavel from courtroom

On the legal side, one of the most important things to understand is the concept of the Limited Liability Company (LLC). LLCs are legal – not tax – structures and can be sole proprietorships, partnerships, or S-corporations (basically anything besides a C-corporation).

An LLC allows you to separate your business and personal assets. This means that if your business gets sued, only your business assets are at risk and vice versa. Your home, personal vehicle, investments, etc. would be safe.

And let’s face it: this is America. Getting sued is a real possibility, so make sure you’re protecting yourself and your business.

The important thing to remember is that some states are not LLC friendly, like California, so do all your research before filing.

Maintaining Good Tax Records

The best way to avoid an unexpected tax bill and a massive tax headache at the end of the year is by maintaining good books. This will also provide you with the best possible records to defend yourself in an audit.

You should be keeping track of the following matters throughout the year:

  • Income
  • Cost of goods sold (if applicable)
  • Expenses
  • Asset purchases

The simplest way to do this is by creating a business bank account and/or credit card. For income, deposit checks and transfer any income received into your checking account.

Make sure any expenses or purchases run through your business accounts. This can be with a debit card, credit card, or check. If you write a check, write something in the memo section to show what it’s for.

Try to avoid paying with cash. If you do, make sure you have a receipt to go with it.

Every week, month, or unit of time that makes sense to you, log your business transactions in Quickbooks, Xero, or Excel.

Certain software will let you directly import your bank statements. This can be a huge time-saver, but always make sure you review it. Make sure everything has been recorded, is in the right account, and has a description if needed.

If you enter and summarize your information periodically, tax time is a breeze. Just run the totals, check everything over, and file your taxes.

How to Keep Receipts for Tax Purposes

Know that just having a receipt isn’t proof enough to validate the expense. If you’re holding business meetings at restaurants, you’ll need to keep track of dates, attendees, locations, a dollar amount of the tab and the agenda of the meeting.

While receipts are great at showing the date and location of purchase, they aren’t always very descriptive. Glance at your receipt before you file it away. If it says something to the effect of “1 x Item #455381” for a total of $14.65, you’re going to need to explain that.

Nobody has time to waste trying to remember what those expenses are, so get in the habit of notating your receipts the day or week you get them.

If this all seems like overkill, know that you can never have enough documentation. If you’re audited, you might need different forms of proof. For example, a receipt shows you purchased the item, but a bank statement shows you were the one who paid for it.

Noteworthy Business Tax Deductions

These deductions are direct business expenses, meaning they will be exempt from self-employment and income taxes.

Business Use of Home: If you have a home office, you can deduct the cost of maintaining it. Utilities, mortgage interest, insurance, and other expenses allocable to that office can be deducted directly from your business income.

Mileage and Business Use of Car: Except for your commute to and from your office, you get a deduction for using your car in your business. You have the option of deducting mileage or actual expenses, like gas and repairs.

The 2019 mileage rate is 58 cents per gallon, and the 2020 rate is 57.5 cents per gallon. Let’s say you drove 5,000 business miles in 2019. Multiply that by .58 for a total deduction of $2,900.

person behind the wheel of a car

Meals: Any business-related meals are 50% deductible. So if you and your business partner go out to lunch to discuss a possible new product line, you can deduct 50% of the meal, sales tax, and tip from your business income. Just make sure you keep a detailed receipt.

Interest and Fees: If you have a business credit card, any interest or fees you pay on that card are deductible business expenses. If you also use the card for personal reasons, you will need to allocate these expenses based on the percentage of business use. This is one more reason to keep a separate business card.

Taxes: State and local taxes count as business expenses. Things like real estate, business license, and property taxes are deductible. You can also deduct the employer portion of any payroll taxes you pay. Sales tax is deductible only if you include it as income.

Adjustments to Income

The following deductions are adjustments to income. They reduce taxable income but do not reduce business income. They won’t help you with self-employment taxes, but they will be exempt from income tax.

Self-Employed Health Insurance: If you aren’t able to get health insurance through an employer, you can deduct the cost of health insurance without itemizing your deductions.

SEP IRA: When you’re self-employed, you have more retirement plan options. Consider the SEP IRA with a 2020 contribution limit of $57,000. That’s much better than the $6,000 limit for Traditional IRAs.

Self-Employment Tax: The good news about self-employment tax is that you can deduct one half of the tax you pay. So if you pay $2,000 in self-employment tax, $1,000 of that will be exempt from income tax.

Qualified Business Income (QBI) Deduction: This is a new deduction that came from the 2018 tax reform. In short, you deduct 20% of your business income before you calculate income tax.

This means you’ll pay self-employment taxes on 100% of your business income, but you’ll only pay income taxes on 80% of that income.

You’ll have to deduct things like SEP IRA contributions, self-employed health insurance, and your deductible self-employment taxes from your business income before you calculate the 20% deduction.

And if that’s not confusing enough, the entire deduction has even more limitations depending on what type of business you own and how much taxable income you have. This is another reason we recommend having a tax professional prepare your taxes.

General Tax Tips and Tricks

tax forms

Amended Returns: If you’ve done your taxes before and fear you may not have done the best job, no fear! You can revise your returns for up to three years. Anything before that you can kiss goodbye. Consider it a donation to your country.

Keep Your Documents: A good rule of thumb is to save all your tax paperwork for at least seven years in case of an audit. The only exception is the “important” paperwork (example: the closing statement from the purchase of your office space).

Estimated Tax Payments: Avoid a huge tax bill at tax time by paying quarterly estimates. The due dates for estimates are April 15, June 15, September 15, and then January 15 of the following year.

One option for calculating estimates is to divide the prior year’s tax bill by four and pay that each quarter. Another option is to pay 30% of your business income for that quarter. This covers the 15.3% self-employment taxes and roughly 15% in income taxes.

Don’t forget to check your state’s income tax rates and pay estimates there, too.

Extensions: You can file for an automatic six-month extension for your tax return. But remember: this is an extension of time to file your return and not an extension of time to pay your taxes. Any taxes not paid by April 15 will incur penalties and interest.

Get Help: If you are interested in keeping more of the money you earn and decreasing your tax liability, contact our podcast guest Diane Gardner for help. She offers a free tax analysis for those interested in finding out if they are overpaying their income taxes.

Final Thoughts

Whether you’re figuring out how to structure your business or are trying to get all the right tax deductions, the world of small business taxes is a challenging one. Tax law is both complex and boring, so they’re not making it easy for small business owners to understand the rules.

The good news is that a majority of the federal tax code is about how to deduct expenses, and the purpose of business deductions is to stimulate the economy.

Being a good citizen doesn’t mean just paying your taxes. While you do need to pay them, the best way to help your country is to take advantage of these incentives and help the economy.

With all this in mind, ditch the DIY tax software and find yourself a good CPA or tax professional. Doing it yourself is great if you’re an individual, but the software lets you get the bad kind of creative as a small business owner.

The last thing you want to do is get your taxes wrong, both because you don’t want to pay too much and because you don’t want to get flagged for an audit. With your CPA’s help, you can be well on your way to keeping your hard-earned money where it belongs: in your hands.

Caitlin Ward - Contributor
Caitlin Ward works as a tax accountant at a small-town Virginia CPA firm. When she isn't writing about personal finance, she's studying for the CPA exam. She has a B.A. in Business Administration and a slight obsession with all things money. She contributes to Listen Money Matters to share what she's learned with more than just her husband and their cats.

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