There’s a lot to figure out when starting a new business. But when you throw taxes into the mix, it can feel especially overwhelming.
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Hiring an accountant is definitely a good place to start. So is knowing the answers to these five common tax-related questions inside and out.
1. What type of business am I starting?
When starting your own company, you need to decide what type of business entity you will be. The entity you choose determines how you’ll file taxes and how much protection you’ll have if you find your business in the middle of a lawsuit.
Choosing your business entity type is a big question that has both legal and tax implications. To discuss the legal implications, you’ll want to reach out to a small business attorney, and to determine how it will impact your individual tax situation, consult an accountant who has experience working with businesses like yours.
If you’re just starting out or looking to optimize your business structure, here’s an overview of what you’ll need to know from a tax perspective- (along with all the forms you’ll need to file)
This is the simplest form of business entity. As the only owner, you’ll file:
- Your individual income tax return, Form 1040, along with
- Schedule C, Profit or Loss from Business. The Form 1040 is due to be filed by April 15th each year or, if you file for an extension, by the extended deadline of October 15th. When those deadlines fall on weekends or a holiday, the deadline is the next business day.
You will be required to pay self-employment tax on the net profit reported on your Schedule C and may be required to pay quarterly estimated tax payments using Form 1040-ES. For more information on filing as a sole proprietor, see Publication 334
A business partnership has two or more partners, and each partner includes their share of the partnership’s income or loss on their individual income tax return.
- A partnership must file Form 1065, U.S. Return of Partnership Income, to report its income, deductions, gains, losses, etc. by March
15th,or file for an extension to September 15th.
- A partnership does not pay income tax, but instead “passes through” profits or losses to its partners according to the terms of the partnership agreement using Schedule K-1 (filed with Form 1065 and issued to each partner).
You will be required to pay self-employment tax on the net profit reported on Schedule K-1 and may be required to pay quarterly estimated tax payments
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a popular structure that many sole props and multi-member partnerships use to protect their personal assets.
- Single-member LLCs will still file a Schedule C with their personal 1040 return.
- Multi-member LLCs will file a separate return called Form 1065 (along with K-1s) by March 15th, or file for an extension to September 15th.
- The LLC can also elect to be taxed as a corporation and file an 1120 or 1120S
form,if the business meets the qualifications for the S-Corporation or C-Corporation elections.
Corporation (aka C Corporation)
In forming a corporation, shareholders exchange money, property, or both, for the corporation’s capital stock. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity [from you/its founder/its shareholders].
- Corporations, on a calendar year, are required to file Form 1120, U.S. Corporation Income Tax Return by April 15th, or file for an extension to October 15th.
The profit of a corporation is taxed to the corporation when
S corporations are corporations with 100 shareholders or fewer that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
- A calendar-year S-Corporation must file Form 1120S, U.S. Income Tax Return for an S Corporation by March 15th, or file for an extension to September 15th.
- Shareholders of S corporations report the flow-through of income and losses on their personal tax returns by using the K-1 form generated with the 1120S return.
Shareholders are assessed tax at their individual income tax rates, which allows S corporation shareholders to avoid double taxation on the corporate income.
2. What accounting method am I using?
It’s important to choose one type of accounting method for tracking your income and expenses—and stick with it. While you can change your method down the road, it’s a bit of a pain and can lead to confusing calculations come tax season, so it’s easier to pick one from the start.
Your two choices are cash or accrual-based accounting, and here’s the deal with each:
- Cash Accounting – You record income when it’s received and expenses when they’re paid. This is the most common method for small business owners because you’re only paying taxes on money that’s actually in the bank. Thanks to the Tax Cuts and Jobs Act, a small business can use the cash method as long as their average annual gross receipts for the past three years are $25 million or less. Gross receipts are the total amount your business received in a year from all sources, excluding expenses. This method is best for service providers.
- Accrual Accounting – You record income once you finish a service, or deliver all the goods a contract calls for, rather than when you actually receive the payment. Likewise, you record an expense once the service is completed or all goods have been received, rather than when you pay the cash. This could mean you end up paying taxes on money you haven’t received yet. This method is best for businesses with inventory and those that deal a lot with sales made on credit or other delayed payments.
3. Am I paying self-employment tax?
Hint: The answer to this question should be yes if you’re part of a sole prop or partnership. Self-employment tax covers Social Security and Medicare. Most wage-earners (those who receive a W-2 at the end of the year) have this automatically deducted from their pay by their employers, but self-employed folks have to pay this on their own (in addition to their regular income tax).
Generally, your net earnings from self-employment are subject to self-employment tax at a rate of 15.3% (12.4% for Social Security and 2.9% for Medicare).
- If you’re self-employed as a sole proprietor or independent contractor, you’ll use Schedule C or C-EZ to calculate net earnings from self-employment.
- If you’re part of a partnership, your share of income reported on a Schedule K-1 is likely subject to the self-employment tax. You’ll calculate the tax using Schedule SE and file it with your individual annual income tax return.
- There’s also a silver lining. If you pay self-employment tax, you get to deduct half of it from your taxable income on the personal part of your tax return.
4. Am I taking full advantage of the tax deductions I’m eligible for?
As a small business owner, there are many deductions that can help reduce your taxable income, and it’s worth researching all of the ones available—you might find some that surprise you.
Commonly-overlooked deductions include:
- Health savings account deduction
- Contributions to a self-employed SEP, SIMPLE, and qualified retirement plans
- Self-employed health insurance deduction
- IRA deduction
- Home office deduction
And that’s just the start. Do your research (here are some great lists of deductions for shop owners, online sellers, and tech startups), keep digital and/or paper receipts for everything you’re going to deduct, and make sure all of these are reflected on your forms come tax season.
5. Do I qualify for the new 20% deduction available for pass-through entities?
Tax laws are always changing, and beginning in 2018, taxpayers will be allowed a 20% deduction on qualified business income. What does that mean exactly? Eligible business owners may be able to lower their taxable business income by 20%, which lowers their overall tax bill.
Qualified business income is defined as “ordinary” income minus ordinary deductions that you earn from a sole-proprietorship, partnership, or S-corporation. Note that it does not include any wages you earn as an employee.
This deduction is available to pass-through entities—in other words, sole proprietorships, LLC’s, partnerships, and S-corps, but only if your business is NOT a “specified service trade or business,” defined as any business that works in the following fields:
- Actuarial science;
- Brokerage services;
- Financial services;
- Performing arts;
- Any business that consists of investing and investment management, trading or dealing in securities, partnership interests or commodities.
- Any business where the principal asset is the reputation or skill of one or more of the employees or owners;
Determining whether your business truly qualifies for the deduction is complicated, as is calculating the amount of the deduction. You should work with your accountant to find out more about the deductions to which you’re entitled. But, if you do qualify, it could save you a whole lot of money, so it’s worth knowing the right questions to ask.
Take some time before things get too busy in your new business to understand the answers to these five questions. When tax time rolls around, understanding the structure of your business and how it affects the numbers can give you a much better understanding of why you’re paying the taxes that are due.