How to Calculate Taxes for Your Business
For many people, completing their income tax return is a lot like the lottery. They have no idea how it works, but they hope to “win” money when the process is over. While you may be able to get away with that type of thinking as an individual, misunderstanding your tax obligations as a business owner can be the difference between having a successful year and having to pay a significant portion of your revenue in back taxes, penalties, and interest.
This article provides some basic information that you need to know as a business owner who may be filing their taxes for the first time. We also offer some tips and insights for those who want to get a better handle on how their company is taxed and start learning how to decrease those tax obligations.
The Basics: How Is Your Business Taxed?
Before you can get down to the dollars and cents of how your tax obligation is calculated, you need to have an understanding of how your entity is taxed and what returns you should file. There are several types of businesses, and each one is taxed slightly differently.
Sole proprietorships are by far the most common business entity in the United States. Most businesses operate under this structure because it requires no additional legal filings, fees, or annual maintenance. Taxes are also much more straightforward in this type of entity.
A sole proprietorship is an extension of you. That means that the tax rate that applies to you individually will also apply to your business. You file a Schedule C with your Form 1040 to report your business income, and a separate tax form is not required for a sole proprietorship.
A general partnership functions very similarly to a sole proprietorship, but there is more than one person involved in the ownership of the business. Partnerships are also taxed at the individual level (known as a “pass-through” entity), and they share the same tax rate as the individual owner.
Partnerships can have their own tax reporting form, however. Form 1065 sets out all of the income and expenses of the partnership, and the final revenue number is reported on the individual partner’s tax return.
S-Corporations and Limited Liability Companies (LLCs)
S-corporations and LLCs are separate legal entities, but they operate like a partnership or sole proprietorship in terms of taxes. They are also pass-through entities. Like a partnership, there may be separate tax forms to file (Form 1120-S, 1120, or 1065), but owners will only pay tax at their individual tax rate.
A C-Corporation is a traditional corporation. These entities are separate legal entities, which means that they also need to file their own tax returns (Form 1120). They also have their own tax rate that only applies to the entity as well.
Once revenue is determined, a corporation will pay its own taxes. Then, the revenue after taxes is reported on the individual owner’s return, and that individual owner pays their own personal tax rate (that varies based on a variety of factors) on the revenue as well. This “double taxation” is one of the primary reasons that small business owners may shy away from using this type of legal entity.
Calculating Your Tax Obligations
Unlike individuals, a business can deduct all of its expenses from its income. The result of this calculation is the “net income” for the company. The IRS only taxes the net income, rather than the total income that business receives (like it does for individuals).
As part of determining your net income, you will subtract expenses that may include things like:
- Operating expenses
- Inventories or supplies
- Employment taxes
You then apply any applicable deductions and credits to the total income as well. Finally, the amount of net income is then multiplied by your respective tax rate to determine how much tax your business should pay.
C-corporations operate slightly differently compared to all of the other business types because of double taxation. Instead of using your tax rate, the corporation is first taxed at a flat rate of 21% in 2020. Then, the dividend that you receive as an owner of the corporation is included as part of your individual return and taxed again at your individual rate. There are some exceptions to this general rule for lower dollar amounts, but, as a rule, you can expect that you will pay tax twice for C-corporations.
As a business owner, you are required to pay income taxes more than just once per year. Instead, you must make quarterly payments if you expect your revenue to reach above a certain limit. If you do not make those payments, then you will likely pay a penalty and may have to pay interest as well.
In general, you should plan to pay one-fourth of your total tax obligation at each quarterly payment. However, estimating your tax obligation can be a difficult task, and your estimate may not always be accurate. The IRS gives you some leeway if you are off in your calculation, but an underpayment can result in penalties and other fees. Waiting to pay your entire income tax obligation in April is generally not a good idea.