For many new business owners, taxes are THE most intimidating part of starting a business. They’re like the mean girls from high school. Not only are they utterly unapproachable, but if you get on their bad side, you’re screwed.
But, with a little bit of knowledge and a few best practices, you can totally stay on the good side of your taxes. Read on to learn how to successfully file your business taxes for the first time.
Run payroll and benefits with Gusto
Business Tax Basics
Before we dive into the details about filing your taxes, it’s important to understand how you get taxed as a small business owner.
First, you get taxed on your profit
Sole proprietors, LLCs, partnerships, and S-corporations are pass-through entities, which means the business profits are passed through to the owner (that’s you!). You are then taxed on your business’s profits as an individual and don’t have to pay taxes at the corporate level.
Profit does not equal your gross receipts, which is all the money your business receives in a tax year. Profit is your revenue minus your expenses. For tax purposes, you’re taxed on your revenue minus your tax deductions. (Note: Expenses and tax deductions are similar but not always the same. For example, entertainment costs are a business expense for bookkeeping, but they are not deductible for tax purposes.)
Revenue – Tax Deductions = Taxable Profits
For example, if you have $100,000 in revenue and $30,000 in tax deductions, your taxable profit is $70,000.
But what if you leave a portion of your profits in your business bank account? Do you still have to pay taxes on it? Yes! In the eyes of the IRS, your profits are automatically passed through to you regardless of whether you USE the profits personally or not.
For companies with multiple owners, the profits are divided between the owners according to the company’s operating agreement, which specifies how much of the company each owner owns. If you and your bestie co-own a business and each own 50 percent, you will each be taxed on 50 percent of the profits.
Next, you have to pay self-employment tax
In addition to income tax, most self-employed people have to pay self-employment tax. The entities not subject to self-employment tax are S corps and C corps. (To learn more about how S corps are taxed read this article.)
The self-employment tax is what makes small business taxes feel unbearably expensive. Unlike employees—whose employers cover Social Security and Medicare payroll taxes—self-employed people are responsible for paying the whole shebang.
How much does that add up to? A whopping 15.3 percent of your taxable self-employed income. Which is your profit right?
Wrong! You only pay self-employment tax on 92.35 percent of your profit. The other 7.65 percent is considered the “employer portion” of your payroll taxes. As in, if you were an employee, your business could deduct the 7.65 percent contributed to your Social Security and Medicare. So you DO get to deduct it!
|Income subject to self-employment tax||92.35% of profit|
|Income not subject to self-employment tax||7.65% of profit|
Here’s an example of how this works:
How to calculate self-employment tax
$100,000 (revenue) –- $30,000 (expenses) = $70,000 (profit)
$70,000 x 92.35% = $64,645 earnings subject to self-employment tax
$64,645 x 15.3% = $9,890 self-employment tax
Keep in mind that $9,890 is just what you owe for your self-employment tax. You also pay income tax on top of that.
Saving for and Paying Your Estimated Taxes
At this point, you may be asking yourself, “How am I ever going to afford my taxes?!”
The answer is by saving for and paying your estimated taxes!
What are estimated taxes?
Estimated taxes are quarterly payments that you make toward your final yearly tax bill. Since you don’t know how much you’ll owe until you file your tax return, these payments are—you guessed it—estimates!
The idea behind estimated taxes is that you pay a portion of what you think your final tax bill will be throughout the year. Then, when you file your taxes, your quarterly payments are applied to your total tax bill, and you pay the difference or get a refund.
Paying your estimated taxes is like paying off a big purchase in installments. Instead of having to muster up the cash to pay a huge tax bill, you pay small bits over time. That way, come tax time, you’re not scrambling to pay your taxes or going into tax debt with the IRS.
Save for your taxes monthly
While you only pay your estimated taxes four times a year, it’s a best practice to create a monthly tax saving habit. Saving monthly for taxes ensures you have the cash available to make your payments—and it’s better for your cash flow. Putting away $1,000 a month is a lot more doable than paying $3,000 out of the blue!
To save for your taxes monthly you need to know two numbers:
- Your monthly profit and
- The percentage of it you will save for taxes—aka your tax savings percentage
There’s no one-size-fits-all tax savings percentage. Everyone’s tax situation is unique, and factors like your income, filing status, dependents, and personal deductions impact your tax savings percentage.
If you have a tax preparer, ask them how much you should save for taxes. This is the very best way to figure out your tax savings percentage. If you don’t have a tax preparer, start by saving 30 percent of your monthly profit.
Here’s what the process looks like:
How to calculate monthly tax savings
$10,000 monthly revenue – $3,000 monthly expenses = $7,000 monthly profit
$7,000 x 30% = $2,100 in tax savings
(Note: “Tax savings” here means how much you’re saving to put toward your tax payments, not how much you avoided paying in taxes.)
Once you’ve figured out how much to save, transfer the amount into a dedicated tax savings account. Keeping your tax savings separate from your general business savings prevents you from dipping into your tax fund and ensures you can make your estimated payments.
Pay your estimated taxes quarterly
Your estimated taxes are due:
- April 15
- June 15
- September 15
- January 15
If any of those days falls on a weekend or holiday, the due date is moved to the next business day.
Calculating your estimated taxes is similar to calculating your monthly tax savings. Simply multiply your quarterly profit by your tax savings percentage. If you’ve been keeping up with your tax savings monthly, you’ll have exactly that amount in your tax savings account.
How to calculate quarterly tax payments
$30,000 quarterly revenue – $9,000 quarterly expenses = $21,000 quarterly profit
$21,000 x 30% = $6,300 quarterly tax payment
There are two ways to pay your quarterly estimated taxes:
- By mail using the IRS Form 1040-ES. For each payment period, fill out the payment voucher and mail it in with your check.
- Online at IRS Direct Pay or the Electronic Federal Tax Payment System website. Both of these sites let you submit your tax information electronically and pay online using a bank account.
Prepping to File Your Taxes
So what do you actually need to DO when it’s time to file your small business taxes?
Here’s how you prep for your annual taxes:
Step 1: Decide who will file your taxes
The very first step is deciding if you will file your taxes yourself or hire a tax preparer. If you decide to hire a tax preparer, start your research early. Really good tax preparers get booked up quickly and you need time to interview potential preparers so you find someone who is a good fit for your business.
Step 2: Complete your bookkeeping for the previous year
You must complete your previous year’s bookkeeping before you can file your taxes. This means you should:
- Categorize all your income and expenses.
- Address any questions and fix any mistakes or errors.
- Reconcile all your bank accounts. In other words, review the transactions in your bookkeeping and cross-reference them with your bank statement to ensure you’re financial data is correct. If you use a digital bookkeeping program, you reconcile your accounts within the software.
Step 3: Run and review year-end reports
After you’ve completed your bookkeeping, run and review your year-end reports. If you’re using a bookkeeping program, you can generate year-end reports in the program. If you work with a bookkeeper, ask your bookkeeper to send you your year-end reports.
Give yourself time to do a thorough review of your reports so you can catch errors. My favorite year-end reports are a standard Profit & Loss and a Profit & Loss Detail.
Start with the standard Profit & Loss report and look through your income and expense category totals. Does everything make sense? Does something seem too high or too low? If so, investigate it.
Next, move on to the Profit & Loss Detail report. This report shows you all your transactions broken out by category. Scan this report and look for miscategorizations. If you find something wonky, fix it.
Step 4: Total your mileage or car expenses
If you’re taking the standard mileage deduction, all you have to do is total your annual business mileage. Donezo!
If you’re using the actual cost method for writing off your car, the process is a bit more complicated. First, calculate your total mileage for the year and your business mileage. These numbers will be used to figure out the deductible portion of your auto expenses.
Next, calculate your total auto expenses for the year, including insurance, gas, repairs, oil changes, and car washes. You’ll be writing off a percentage of these expenses.
Step 5: Total your home office expenses
Measure the total square footage of your home and the square footage of your home office. Your tax preparer will use these numbers to determine what percentage of your home expenses you can write off.
Next, calculate your total home expense for the year, which includes your rent or mortgage, renters’ or homeowners’ insurance, utilities (like gas, electric, and water), and repair and maintenance costs.
Step 6: Total your home internet and cell phone expenses
Home internet and cell phone expenses are split between your personal expenses and your business. During your tax prep, calculate your yearly home internet and cell phone expenses. Then, you’ll work with your tax preparer to determine what percentage of these expenses are deductible.
See my full breakdowns on deducting each of these expenses in my ultimate list of tax deductions.
Pro tip: Keeping tidy records of your deduction calculations—especially for your home expenses—will go a long way toward keeping you in the clear in the event of an audit.
Step 7: Organize your tax paperwork
The final step is to organize your tax paperwork. In January you’ll receive a TON of tax-related mail. Instead of throwing it in a pile, open your mail, review your documents for accuracy, and put everything in a folder that can easily be handed off to your tax preparer.
By following these tax prep and saving tips, you’ll be eating at the cool kid table and effortlessly filing your taxes in January. Now, instead of worrying about your taxes, go try to make fetch happen.