When it comes to business tax, you need to consider many questions before filing your first tax return: what type of entity is your business, what kind of expenses can you deduct, what kind of income is taxable, what type of tax must you pay, and so much more. Here is a quick overview of what to know before filing business taxes for the first time.
When you register your business, you choose an entity type: sole proprietor, limited liability company, partnership, corporation, etc. The type of entity you choose will dictate the type of tax return you must submit, the kinds of deductions you can claim, and what kind of tax you pay.
Sole proprietor, doing business as, and single owner LLCs are the simplest entity structures. If this is your business, then you file your business tax return with your individual income tax return on a Schedule C. You, not the business, pay taxes on business income. You can claim all reasonable business expenses including the cost of a home office and driving your personal vehicle for business purposes.
Partnerships and multi-member LLCs require their own tax return: Form 1065 where the business reports income, expenses, and partners' share of profits. Like sole proprietors and single member LLCs, these entities are also pass-through, so the individual owners pay tax on the income, not the business. Unlike sole proprietors, partnerships and multi-member LLCs cannot deduct certain expenses such as a home office or the use of a personal car unless those costs are reimbursed by the business or there is an agreement between the business and partners for reimbursement.
Corporations are the most complicated of all business entities. They are subject not only to tax reporting but also tax payment. Any income paid to owners is taxed separately and in addition to the corporate tax. Corporations may not deduct home office or use of a personal car expenses unless the corporation reimbursed the owner or employee who incurred such costs. Unlike the other entities, failure to file a corporate tax return even if that income is reported on the owner's individual income tax tolls the statute of limitation. This means that the IRS can go back to the first year you opened your business and asses tax and penalty against the business for all the years you failed to file Form 1120 even if you paid tax on that income on your personal tax return.
Look carefully at your business's entity status before filing your first tax return. Make sure that you are filing it on the correct form or schedule and applying the correct tax law. If you're not sure what your business entity type is, check your registration with the Secretary of State.
Most reasonable and necessary business expenses are deductible. However, be aware of certain rules that limit how expenses must be deducted.
For example, you can only deduct $5000 of start up costs and $5000 of organizational costs in the year you open your business. Any amount over that must be amortized over the lifetime of your business. Start up costs are expenses incurred before your business opened its doors to consumers. That can include purchasing furniture, training employees, prepaying software, and the like. Organizational costs are expenses incurred before you began your business such as attorney fees to draft an operating agreement and business registration costs.
Another common mistake new businesses make is expensing the cost of assets. Assets, as defined by the IRS, are any tangible goods that have a useful life span of over one year. This includes furniture, equipment, computers, phones, cars, trailers, tools, and more. You must depreciate assets over their useful life spans, which varies from asset to asset. Be aware that tax law frequently changes regarding depreciation and sometimes you need to make written elections to opt out of certain initiatives, such as the current Bonus Depreciation, or risk losing the ability to continue depreciating an asset. Failure to correctly depreciate can result in tax adjustments and needing to pay capital gains on the sale of assets, even when sold at a loss.
Other tricky deductions include owner's salary, home offices, vehicle expenses, and tax payments. Unless your business ran proper payroll (withheld tax, filed payroll tax returns, paid unemployment tax, etc.) for the owners, owner payments are not deductible. Home offices are limited only to spaces used exclusively and continuously for business purposes, and any costs associated with the home office must be deducted in proportion to the size of that space. When deducting vehicle expenses, you must choose between reporting mileage or actual expenses, and not all miles are deductible. Sales, use, property, and employer portion of the FICA tax are deductible; estimated tax are not.
When filing your first business tax return it's important you understand and correctly deduct business expenses.
All income is taxable unless specifically excluded by tax law. This includes cash payments, tips, exchange of service or property for your service or good, crypto, gains from the sale of property, interest earned, and more. When in doubt, report the income. If audited, you don't want your business to get in trouble for understating income because that comes with serious civil and criminal penalties. Unlike expenses that must be traceable and provable, income does not. Don't fall for the trap of not reporting cash income just because you did not document the exchange.
Types of Taxes
There are different types of taxes you or your business may own to the government: ordinary income tax, capital gains tax, self employment tax, corporate tax, sales tax, use tax, payroll tax, and estimated tax.
Ordinary income tax is tax on all income other than long-term capital gains. It is based on the business owner's individual income tax rate which varies from 10% to 37%. Capital gains tax applies to long-term gains, that is property held for over a year. Capital gains tax rate varies from 0% to 20%.
Self-employment tax is social security and medicare tax on earned income, meaning income generated from working. This does not apply to capital gain, awards, unemployment income, and the like. The tax rate is 15.3%. Even if your total income is less than the standard deduction, you will end up owing self-employment tax because the tax is calculated based on all earned income, not taxable income.
Corporate tax is a flat 21% tax on all income generated by a corporation. This does not apply to pass through entities. Sales tax are owed to state and local governments. See your state laws to learn if your business is subject to sales tax. The rate varies by location. Use tax is the tax owed when your business purchases a good without having paid sales tax on the purchase to the state where the business is located. This applies even if you paid sales tax to another state. This varies by industry and location, so check with your state and local governments for more information.
Payroll tax includes money you withheld from your employees for income, social security, and medicare tax as well as the employer portion of the social security and medicare tax. The income tax will vary depending on each employee's individual income tax rate. The combined employee and employer portion of the medicare and social security tax will equal to 15.3% of each employees income.
Estimated tax is tax you or your business must pay into the system throughout the year. Think of it like tax withholding by an employer. Except, instead of the employer withholding tax each pay period, you manually make the payments to the IRS and state government each quarter. You are required to pay either 100% of the prior year's tax liability or 90% of the current year's tax liability. Failure to pay estimated tax throughout the year will result in penalties.
Has all this information overwhelmed you? You are not alone. Preparing business taxes is a complicated task, which is why it is so important to find the right tax advisors for your business. We are experts at business tax law and would love to work with you to help your business grow and be compliant.