What tax considerations should I make before starting a new business?
Congratulations on your plan to start a new business. Self-employment is the path to control of your financial future. While you can get rich operating your own business, how much of your income do you want to turn over to Uncle Sam? If you think that’s not up to you, you’re in for a treat, as you have more control over your business tax bill than you think.
Along with that control however, you will have some extra scrutiny and reporting requirements from the I.R.S. The best time to plan is before you begin to generate income and incur expenses in your new business. You can change things later, but it’s more complicated and can result in extra taxes or penalties.
Start with Your Business Structure
Most entrepreneurs begin as sole proprietors. They form their new business as an individual, and for all intents and purposes they are the business. There is nothing wrong with this structure, but you do incur liability for what your business does, and you’re taxed on profits at your individual income tax rate. You’re also responsible for paying all self-employment and Medicare taxes. You’ll pay both the employer and employee sides of the taxes, as you are both.
You can opt to form an S Corporation, a simple corporate structure that makes you a shareholder and changes how your income is taxed. One advantage of the S Corp. is that you can pay yourself a salary, with the corporation paying half of the self-employment and Medicare taxes as deductible expenses. Then if you draw more of the profits out as a shareholder dividend, you will not have to pay self-employment and Medicare taxes on the dividends. You must pay yourself a “reasonable salary” according to the I.R.S. if you want to take this approach.
Remember that any profits after allowable expenses and deductions are taxable, even if you decide to invest back into the business. Of course, if you do put money back through purchases or deductible expenses, you’ll get the appropriate deductions at that time.
It’s more complicated than the information here, and it’s a decision you should talk over with accounting or tax experts first. They can look at your business plan, expected income, and expenses, and then advise you of the best approach.
Extra Tax Reporting Requirements
You will be required to file extra tax forms, or Schedules, at a minimum:
- Schedule A – Itemized Deductions
- Schedule C – Profit/Loss from Business
- Schedule SE – Self-employment Tax
Depending on how much you love doing paperwork, you may want to add a small amount to your budget for an accountant to help you set up easy bookkeeping and who can do your taxes for you.
While you’re planning with accounting and tax advisors, ask their advice on whether you should use a cash or accrual basis for your business accounting. What’s the difference?
- Cash Basis Accounting – In this accounting method, you recognize income and expenses as taxable in the year they’re received or paid. This means that you don’t consider income as such for taxes until that invoice is paid. The same goes for expenses. They’re deductible when you pay for them.
So, if a client pays your December 2019 invoice in January 2020, it’s not taxable on your 2019 return. If you pay for a repair in January 2020 that was billed to you in December 2019 then it’s not deductible as an expense on your 2019 return. Instead, both the income and expense examples would be reported when actually paid or received, so on your 2020 return.
- Accrual Basis Accounting – In this accounting method, you recognize income and expenses as they’re booked, whether paid or not. In the above examples, both the December income and expense items would be reported as such on the 2019 return even if the money didn’t change hands until 2020.
Depending on your business, one of these methods may be preferable to the other; another question for an accounting or tax expert.
Getting Your Employer ID Number
If you anticipate having employees, you’ll need to file with the I.R.S. for an E.I.N., Employer Identification Number. You’ll use that number on all forms and returns you file with the I.R.S. If you’re going to be the only person in the company with no employees, you can use your Social Security Number.
Estimated Tax Payments
The I.R.S. understands that self-employment doesn’t provide the same steady predictable income of a job. The government wants its tax money but doesn’t want to rely completely on the entrepreneur to hold back what they’ll owe at the end of the year. For this reason, you’ll be required to pay quarterly estimated tax payments.
Underpayment of taxes due will result in penalties. Once you have a year of history and a tax bill for that year, you have an estimation for the next year. If you divide last year’s taxes due by four and pay that amount or more quarterly, you’ll avoid penalties for underpayment that results from higher income.
You will gain some tax advantages operating your own business, but along with them comes a bit more scrutiny from the I.R.S. Deductions for personal vehicle use, client meals, entertainment, and other deductions must meet rules and restrictions, or you risk an audit or at least a hassle.
There you have it; the main considerations when you’re about to start a new business. It’s an exciting time, so you should just dig into them and get started right to build a solid financial future.