Small Business Taxes for Beginners

In 2021 a record 5.4 million applications were filed for new businesses. 1.8 million of those applications were for businesses planning to hire employees. These new business owners will be juggling many tasks, most related to operations and profitability.

If you are new to owning a business, starting up, or planning a startup, operational and profitability tasks are critical. Often lower on the urgency list, but still important, is taxes – how to reduce your liability while staying out of trouble with the IRS. Keep more of your hard-earned profits by placing taxes higher in the priority list. Learn the basics of small business taxes for beginners here.

Understanding Taxes For Small Business Owners

The National Federation of Independent Business (NFIB) published its 2021 Tax Survey giving new business owners valuable insights from current small business owners about taxes. NFIB’s survey includes 1032 respondents, of which two-thirds employed fewer than 10 people in varied industries and business segments:

• Retail
• Manufacturing
• Services
• Construction
• Agriculture

This covers a wide swath of new business types, and the data shows the impact of taxes on small business. The chart below shows responses to questions about the financial and administrative burdens business owners attributed to taxes and considered them very/moderately burdensome.

Where better to get this information than from current small business owners? A high percentage of owners find taxes both financially and administratively burdensome. The more you know about small business taxes the better decisions you can make for your business to lower the burden.

How The Business Entity & Filing Status Impacts Taxes

Before you start down the business tax road, knowing the influence of business filing status can help you to start out right. As the business grows, you may find it valuable to change your filing status. Here are the most common business entities/structures for filing with the IRS.

Sole Proprietorship

• Number of owners 1
• Limited Liability? No
• Pass-through tax? Yes
• Tax Forms Schedule C Form 1040

Partnership

• Number of owners 2 or more
• Limited Liability? No
• Pass-through tax? Yes
• Tax Forms Schedule K-1 Form 1065

Corporation

• Number of owners 1 or more
• Limited Liability? Yes
• Pass-through tax? No
• No Tax Forms Form 1120

Single Member LLC

• Number of owners 1
• Limited Liability? Yes
• Pass-through tax? Yes
• Tax Forms Schedule C Form 1040

Multi-member LLC

• Number of owners 2 or more
• Limited Liability? Yes
• Pass-through tax? Yes
• Tax Forms Schedule K-1 Form 1065

S-Corporation

• Number of owners 1 or more
• Limited Liability? Yes
• Pass-through tax? Yes
• Tax Forms Form 1120-S

Filing Status

• Sole Proprietorship – By far the greatest number of new small businesses begin as sole proprietorships. This is especially true in 2020-2021, as many employees left their jobs to work from home as freelancers in the Gig Economy. A Sole Proprietorship is the simplest form of business, with all business reporting done on a Schedule C of the owner’s personal tax return. Business income is “passed through” to the owner’s personal tax return. Many businesses eventually set up a separate business entity giving them additional liability protections and financial reasons.
• Partnership – It’s helpful to think of partnerships as a group of sole proprietors owning one business. Owners still retain liability for the activities of the business. The income is pass-through, so owners report on their individual returns and are subject to self-employment taxes.
• Corporation – Corporation owners are shareholders. They enjoy no liability for activities or obligations of the business. Corporations are what is called “double-taxed”. The corporation pays taxes on income and the shareholders also pay on their personal returns for distributions or dividends from that income.
• Single Member LLC – The primary reason that individuals file as an Limited Liability Company (LLC) is to avoid personal liability for activities and obligations of the business. The single member LLC files as a pass-through entity and pay taxes on their personal return as a self-employed individual.
• Multi-member LLC – The multi-member LLC member can receive pass-through income as well and pays self-employment taxes. Owners report income on Form 1065 and Schedule K-1.
• S-Corporation (Tax Treatment Election, not a Status) Most S-Corporation elections are done on LLCs. Owners who want the IRS to treat their taxes as an S-Corporation file file Form 2553. After the IRS accepts the S-Corporation filing, the business files Form 1120-S to report income distributed to shareholders. They then report on their personal returns. This allows the S-Corporation shareholders to avoid withholding taxes and can significantly reduce self-employment taxes for owners.

Federal Employer Identification Number (EIN)

If you are operating as a sole proprietorship, you can use your social security number for tax reporting. However, corporations, LLCs, and any business that has employees must register for a federal tax EIN. You can request a free EIN online.

Banking

The most important thing to remember about banking is to keep the business separate from your personal finances. You should at least open and maintain a business checking account. Use business debit and credit cards for business expenses. You want a clean record of all banking transactions that relate only to the business. Co-mingling personal and businesses expenses is an easy way to eliminate liability protections of an LLC.

If your bank doesn’t send you canceled checks with your statement, make sure you at least have availability online of images of the canceled checks. The IRS accepts digital records. Make sure that you know how long the bank keeps them online or download regularly to keep your digital records in your control.

Documentation

Documentation is the paper or digital copy of every document related to business transactions, including:

• Invoices
• Cash register receipts
• Canceled checks
• Deposits
• Online purchase receipts
• Refunds
• Bank statements
• Tax related communications
• Form 1099s for contractors and freelancers
• Payroll records
• All receipts for business purchases
• Vehicle business use mileage and expense records

Organize your documentation as your bookkeeper recommends, as if the IRS requests that you document tax return entries, you want to be able to find the requested documents easily. In the event of an audit, the IRS will require all documentation of expenses or claims to deductions and credits. It’s your responsibility provide proof of anything in your tax return, so keep detailed records, receipts, and other necessary documentation.

Income

Small businesses must report all income to the IRS and pay taxes on net income after deducting Cost of Goods Sold (COGS) and business expenses. Income may be from the sale of goods or services as well as fees for freelance services. Document all income received through receipts issued, invoicing, or other documents showing money flow into the business.

Businesses with Employees who Receive Tips

The IRS wants their cut of tip income as well. Unfortunately, this puts a record-keeping burden on both the employee and the employer. All tips received by an employee are taxable income and subject to Social Security and Medicare taxes and withholding.

You should set up a system that makes it easy for your employees to report their tip income and do so in a timely manner so you can meet reporting and withholding requirements. If an employer/business adds a “service charge” to a customer’s bill instead of a tip, this is not a tip for tax reporting purposes. It is reported as business income just as the income from the customer’s bill.

Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) is the cost of all materials and labor to produce products for sale. COGS is deducted from gross income to arrive at Gross Profit before deductions for other business expenses. This calculation is separate because inventory is involved. You take inventory at the beginning of the tax year and purchases to inventory are added to the value. At the end of the year, you take inventory again and the result yields how much was spent for goods or products sold or used out of inventory. Gross profit before expenses is the result.

Business Deductions

Most expenses for business purposes are 100% deductible if they are, according to the IRS, reasonable and customary. Here’s a list of the most common types of expenses for businesses:

• Facility mortgage interest
• Rent
• Utilities
• Office expenses and office supplies
• Insurance premiums
• Communications; phones, Internet services, radios for business use
• Continuing education for an existing business
• Professional fees; attorney, accountant, etc.
• Postage and shipping
• Advertising and marketing
• Payroll
• Employee benefits
• Property taxes
• Interest on business debt
• Professional membership fees
• Bad debts, credit, or collection fees
• Bank fees
• Home office deduction
• Maintenance and repairs
• Office printers and computers
• Vehicle expenses- if a personal vehicle, deduct only for the percentage of business use
• Charitable contributions
• Startup expenses
• Software
• Licenses and permits
• Entertainment, meals, travel for business; these are not 100% deductions in some cases

Depending on your type of business, there are others not listed here. Check with your accountant or tax professional to help you classify expenses.

Depreciation

Certain assets like real estate, vehicles, equipment, furniture, and machinery must be depreciated over time rather than written off as a deduction in the year purchased. There are different allowable lifespans, and some accelerated depreciation is allowed depending on the asset.

Section 179 – This deduction allows a business to write off the complete cost of newly acquired assets in the year purchased. This applies to multiple assets up to $1,080,000 for 2022, but they must be tangible assets. Intangible assets do not qualify. There is a limit of $18,200 for business vehicles that meet certain qualifications.

Business Tax Credits

Small business tax credits are exciting because they’re not “deductions.” A deduction is deducted from income before calculating taxes owed. A credit is a dollar-for-dollar offset of taxes owed. In other words, if your small business taxes owed for a year total $10,250 after all deductions, a $5,000 credit would cut your tax bill to $5,250. Small business tax credits are offered to incentivize businesses for various actions.

For a quick reference list of available tax credits, see the IRS resource Business Tax Credits.

Bookkeeping and Tax Return Preparation

Bookkeeping is the function of keeping ledgers of all the financial transactions of the business. Every expenditure, every income billable and receipt, as well as major purchases that must be depreciated are included. Accuracy and not missing any entries are greatly important to assure accurate tax returns.

Bookkeeping classifies the income and expense items into categories for tax reporting. This function also creates reports for owners/managers to use in making business decisions. These include Income Statements, Profit & Loss (P&L) statements, and Balance Sheets.

Though tax return preparation is a separate function, we include it here because bookkeeping and tax preparation working together assure a smoother and more accurate flow of information. It can be done by two different entities, but they should coordinate so that the data submitted to tax preparers by bookkeeping arrive in the best format and order for tax return preparation.

Is DIY the Best Way to Go?

Many small businesses start out on a shoestring, and the owners may want to take on as many of the functions in this post as do-it-yourself (DIY) activities. If you take a few moments and go back over the information in this post, how many areas could have pitfalls if you make errors or miss opportunities?

You need to be concerned with compliance with all existing and new IRS regulations. You also don’t want to miss any valid tax deductions or credits available. Mistakes in any of these areas don’t just involve the dollar amounts of the mistakes. They can also involve expensive penalties and interest.

Also consider the lost opportunity costs of the time you will spend in handling some or all of this yourself. You could spend that time in income-generating activities. Small business taxes for beginners could be a map, and “X” could mark the spot where your hired experts work to save you money.