• 05 February 2024
• Public Relations

A Beginner’s Guide to Small Business Taxes

Navigating the maze of small business taxes can often seem intimidating for beginners. However, understanding your tax obligations is crucial to managing a successful and compliant business. This guide aims to demystify taxes, providing step-by-step advice and key takeaways on how to approach small business taxes for beginners. From identifying the correct forms to understanding deductions and credits, we'll walk through the basics to help you start the tax season confidently.

Understanding Your Tax Obligations

While you may be familiar with the personal taxes you pay as an individual, as a small business owner, you will need to acquaint yourself with the taxes that businesses pay.

Depending on the type of your business, the size of your business and your business structure, your business may be subject to multiple taxes, including but not limited to the following:

• Income tax: The tax you or your business pays on its profits.
• Self-employment tax: The tax self-employed business owners pay for Social Security and Medicare.
• Employment taxes: The taxes a business owner must handle on behalf of their employees, including withholding for income, Social Security, and Medicare taxes; paying the employer share of employees’ Social Security and Medicare taxes; paying unemployment tax.
• Estimated taxes: The taxes business owners pay on a quarterly business, based on an estimate of the taxes they will owe for that quarter.

Keep reading to learn more about how to understand your specific business tax obligations.

Determining Your Business Structure

As mentioned above, one of the things that determines what taxes your business pays is your business structure. “Business structure” refers to how your business operates as a legal entity, including how it pays taxes. These structures give business entities different advantages and responsibilities. Here are four common business structures:

• A sole proprietorship is the simplest business structure because the business is not a separate legal entity from the owner. Sole proprietors report their business income and expenses on their personal tax return. They must pay income and self-employment tax on any profits from their business.
• A partnership is a formal arrangement between two or more parties to run a business and share its profits. And while it must report its income, the partnership itself does not pay income tax. Instead, the individual members of the partnership each pay income tax on their share of the profits.
• In a corporation, the business is a separate entity from its owners, called shareholders. There are different types of corporations (e.g., an S corporation, a C corporation). Some of them are subject to double taxation: the corporation itself pays income tax on its profits, and then the shareholders are taxed individually on their share of those profits. One type of corporation (S corp) does not pay the corporate tax; only its shareholders are taxed.
• A limited liability company (LLC) is a hybrid business structure that provides its owners, or members, with some of the benefits of both corporation and partnership structures. Like a partnership and an S corporation, an LLC does not itself pay income taxes. The members of the LLC pay income tax on their share of the profits of the LLC.

A note on taxpayer identification numbers: Generally speaking, if you own a business, you should obtain an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). If you have employees, you must obtain one. But if you have a sole-proprietorship or are a single member LLC, you may use your Social Security Number.

If you're curious about the nuances between each of the business structures and which is right for you, comb through the descriptions on the IRS website to help you decide.

Navigating Federal, State and Local Taxes

As a small business owner, you will need to be aware of your tax obligations at the federal, state and local levels. Below are some of the responsibilities you may have and some of the federal taxes, state taxes and local taxes you may have to pay.

Federal income taxes: Businesses are subject to federal income taxes. Depending on the business structure (see above), either the business itself pays income tax, or income tax is paid by the owner, partners or shareholders.

State income taxes: Most, but not all, states impose their own income tax. If your business is in an income-tax state, you will be subject to its income tax, too.

Federal employment taxes/responsibilities: If you have employees, you will have to withhold their federal income tax and deposit it with the IRS.

• You must pay your share of your employees’ Social Security and Medicare taxes.
• Another federal tax you may pay is the FUTA tax, which pays for federal unemployment insurance for your employees.

State employment taxes/responsibilities: You may also need to withhold state income taxes for your employees, and pass them to the appropriate government body.

• SUTA is the state-level unemployment insurance tax.

State and local sales taxes: Most, but not all, states levy a sales tax. And many states allow their local governments to levy their own sales tax, too. As a business owner, you will not have to pay the sales tax, but you will be responsible for collecting it from your customers and passing it on to the appropriate government entity.

For more information on state or local taxes, contact your state’s Department of Revenue or Taxation, or your county or city government.

For any more questions about navigating taxes for your small business, seek the advice of a professional or resources like the IRS website.

Identifying Applicable Tax Year

When it comes to taxes, there are two accounting periods used for calculating income - a calendar year or a fiscal year:

• Calendar Year: A calendar year runs from January 1st through December 31st, the same time period you use for your personal income tax reporting. Most businesses use the calendar year as their tax year. It can be simpler and less confusing to pay your business taxes at the same time you pay your personal taxes.
• Fiscal Year: A fiscal year is a consecutive, twelve-month period ending on the last day of any month except December. It is less common for a small business to use a fiscal year, but you may want to consider it, especially if your business is seasonal. You can start your fiscal year whenever it best suits your business’s fluctuations. This way you can avoid splitting your selling season and keep your expenses and income more closely aligned.

In general, the IRS allows you to choose the type of tax year you use. But there are exceptions:

• A sole proprietorship must use the same tax year as its owner.
• Partnerships and LLCs must generally use the same tax year as its partners and owners or as the partner or owner with a majority interest.
• S corporations must use the calendar year, or request approval from the IRS to adopt a different tax year.

Under some circumstances, you may want or need to change your tax year:

• If you've changed your business structure.
• If your partnership has grown to include those using a different tax year.
• If you’ve found that it would be more advantageous for your business to change from a calendar year to a fiscal year.

Note that changing your tax year requires approval from the IRS. To request this approval, you must file a form with the IRS.

One more type of “tax year” you might need to be aware of is a “short tax year.” A short tax year is an accounting period of less than 12 months.

Say you start your business in the middle of the year, in June. You would file a short tax return reporting your income from June through the end of the calendar year. Or, if you’ve chosen a fiscal year, you would file for the period from June to the last day before the beginning of your fiscal year.

Essential Tax Forms for Small Businesses

Now that you have an idea of which taxes you will have to pay, it’s time to look at the tax forms you will need to file to fulfill your tax obligations. Like business taxes themselves, the forms you use will depend on your business structure (again, sole proprietorship, partnership, corporation or limited liability company [LLC]).

Below are some essential IRS tax forms that small business owners typically need to be aware of and understand how to complete accurately.

Form 1040 (Schedule C)

• Form 1040 (Schedule C), also known as "Profit or Loss from Business," is used by sole proprietors and single-member LLCs to report their business income and expenses.
• This form is used when preparing your annual tax return to calculate the net profit or loss for your business, which you then report on your personal income tax return.

Form 1120 (Corporation)

• Form 1120 (the "U.S. Corporation Income Tax Return") is used by corporations to report income, gains, losses, deductions, and credits, as well as to figure their income tax liability.
• Corporations must use this form to prepare their yearly tax returns. It provides a comprehensive picture of the company's financial situation, which is essential for accurate tax calculation.

Form 1065 (Partnership)

• Form 1065, also known as "U.S. Return of Partnership Income," is utilized by partnerships to report their income, deductions, and credits to the IRS.
• Partnerships must use this form to prepare their annual tax returns. It gives a detailed financial picture of the partnership, facilitating accurate tax calculation.
• The form is structured in several parts, including income, deductions, credits, and partner's distributive share items.

Understanding Deductions and Credits

We've been focusing on all the different kinds of taxes you may have to pay. Now let’s learn about tax deductions and tax credits your small business may be eligible for that will save you money.

Tax deductions and tax credits are both helpful in reducing your tax liability, but they work in different ways to accomplish that.

Deductions work by reducing the amount of your income that is subject to tax. 

Credits work by providing a dollar-for-dollar reduction of the amount of taxes that you owe. 

In other words, deductions apply your income at the front end, when your tax is being calculated. And credits apply at the back end, to the amount you owe, after your tax has been calculated.

Below we’ll go over some common deductions and available credits. Read on to find out if any of these apply to your small business and could help you reduce the amount of tax you pay.

Common Tax Deductions

Many of the expenses associated with running a business are tax deductible. This means that you can subtract up to 100 percent of the cost of these items from your business’s total income amount. And the lower your income, the lower your tax bill.

Below are some examples of tax-deductible business expenses.

Home Office: If you use part of your home exclusively for your business, you may be able to deduct expenses related to that portion. These can include mortgage interest, insurance, utilities, repairs, and depreciation.

Vehicle Expenses: If you use your vehicle for your business, you can deduct car expenses. You can choose to use the standard mileage rate or actual car expenses like fuel, repairs, and insurance.

Salaries and Wages: Payments to employees, including salaries, wages, bonuses, commissions, and taxable fringe benefits, are deductible expenses.

Supplies: The cost of business supplies used within the tax year can be deducted.

Depreciation: If you buy property, like equipment or a building, for your business, you may be able to claim a depreciation deduction.

Rent: Rent on a business property can be deducted.

Taxes: Certain taxes imposed on your business are deductible.

Insurance: Premiums paid for business insurance are deductible. This can include property coverage, liability coverage, and health coverage for employees.

It pays to educate yourself about what expenses are tax deductible. For more information on deductible business expenses that can save you money, visit the IRS website.

Available Tax Credits

Tax credits can be offered for a variety of reasons, such as to encourage certain business activities or to provide relief to low-income taxpayers. And remember, tax credits are applied to your tax bill after your tax has been calculated.

Any credits you are eligible for will be subtracted from your tax bill, lowering the amount you will have to pay.

See below for some of the available tax credits.

Work Opportunity Tax Credit: This credit is available to employers who hire individuals from certain targeted groups that have faced barriers to employment.

Disabled Access Credit: Businesses that make their operations accessible to persons with disabilities can claim this tax credit.

Energy Investment Tax Credits: Businesses that add renewable energy technologies, like solar panels, to their property may be eligible for this credit.

Small Business Health Care Tax Credit: For small businesses that provide health care coverage to their employees, this credit helps to offset some of the costs.

Research & Development Tax Credit: Small businesses engaged in qualified research activities may be eligible for this credit.

Record Keeping for Deductions and Credits

Good record-keeping is essential when it comes to deductions and credits. Accurate records can help ensure that all eligible deductions and credits are claimed, thereby reducing your business's tax liability.

Below are some tips to help you organize your record-keeping.

• Keep receipts, invoices, payroll records, and any other documents related to your business's expenses together in the same place. For each expense, your record should contain the amount, nature, and purpose of the expense.
• Organize your records according to categories of deductions. This can simplify the process of preparing your tax return and make it easier to locate specific records if they are needed.
• Consider using a digital record-keeping system to store and organize your business documents. These systems can offer features like automatic data entry from digital receipts, categorization of expenses, and secure storage of your records.
• The IRS recommends keeping tax records for a minimum of three years from the date you filed your original return, or two years from the date you paid the tax, whichever is later. However, it's wise to keep these records for longer to cover any contingencies.
• If you're unsure about what records to keep or how to organize them, consider consulting with a tax professional or a Certified Public Accountant. These professionals can provide guidance tailored to your specific business situation.

Hiring Professional Help

As you navigate the complexities of business taxation, a professional tax advisor can be a valuable investment to ensure accuracy, compliance, and optimization of your financial situation.

Deciding If You Need a Professional

If you’re still on the fence about doing taxes yourself or hiring a professional to help or do them for you, consider the following points to help you decide.

• Complexity of Transactions: If your business deals with complex transactions, such as international operations or large-scale investments, a professional can help navigate the intricacies of related tax laws.
• Recent Changes in Business: If your business has undergone significant changes, like a merger, acquisition, or expansion, hiring a professional can ensure these are correctly factored into your tax planning.
• Time and Resource Constraint: If you're finding it difficult to manage your business's taxation responsibilities along with your regular duties, a professional can take over these tasks, freeing you to focus on your core business operations.
• Risk of Audits: If your business has a high risk for audits, a professional can ensure your records and reports are audit-ready and can represent you in case of an audit.
• Need for Tax Planning Strategies: If you're looking for ways to reduce your tax liability through strategic planning, a professional can help identify opportunities based on your unique business situation.

Choosing a Tax Professional

If you decide to move forward with hiring professional tax help. Here are some qualities to look for in someone or a team to ensure they’re the right fit for you and your business. 

• Credentials and Expertise: Ensure the professional you are considering has the necessary qualifications, such as being a Certified Public Accountant (CPA), tax attorney, or Enrolled Agent (EA). Verify their expertise in your industry and their familiarity with the tax issues pertinent to your business.
• Reputation: Check reviews and references and ask for recommendations from other taxpayers in your industry. A professional with a good reputation is more likely to provide quality service.
• Communication: Your tax expert should be someone who can communicate complex tax issues in a manner that you understand. They should be easily accessible to answer your queries or clarify your doubts.
• Fees: Understand how the professional charges for their services. It could be a flat fee, hourly rate, or fee per service. Choose a professional whose fees align with your budget.
• Audit Support: In case of an audit, your tax expert should be able to represent you before taxing authorities, help you prepare, and guide you through the process. Make sure they are willing and equipped to provide this support.

Preparing for the Tax Season

As tax season approaches, proactive preparation is crucial to ensure a smooth, stress-free process and optimal tax outcomes.

Organizing Your Financial Records

One of the best things you can do to effectively prepare for tax season is to stay organized. While there is a lot of documentation and details that need to be organized, consider the following steps to make sure nothing gets overlooked: 

• Start Early: Don't wait until the last minute to get your financial records in order. The sooner you start, the more time you'll have to ensure everything is accurate and complete.
• Track Expenses Regularly: Make it a habit to record and categorize your expenses regularly. This ongoing effort can save you significant time and stress as tax time approaches.
• Categorize Expenses: Review and categorize your expenses. This will help ensure that you don't miss any potential deductions.
• Reconcile Accounts: Make sure all your financial accounts (bank accounts, credit cards, loans, etc.) are reconciled. This means checking that your records match your statements.
• Review Payroll Records: Ensure your payroll records are up-to-date and accurate. You'll need this information for tax filings, and errors can result in penalties.
• Inventory Evaluation: If relevant to your business, conduct an inventory evaluation to determine the cost of goods sold during the year.
• Collect Income Records: Gather all your records of income. These include sales records, invoices, and receipts.
• Check Deductions and Credits: Review the deductions and credits you're planning to claim and ensure you have the necessary documentation to support them.

Separate Personal and Business Expenses

Another tax tip that could be helpful when trying to stay organized and have a seamless tax filing experience is to always separate personal and business expenses as early as possible. Here are a few tips on how:

• Avoid 'Commingling' Funds: Avoid using business funds for personal expenses, or vice versa. Such 'commingling' of funds can make it difficult to accurately track business expenses and could potentially cause issues in an audit.
• Establish Separate Accounts: To simplify your record-keeping and tax preparation, establish separate bank and credit card accounts for your business. This will help you clearly distinguish between your personal expenses and those of your business.
• Use a Business Credit Card: Dedicating a credit card to business use only can make it easier to track and categorize these expenses and keep things organized.
• Consider Using Bookkeeping Software: Consider using a bookkeeping software that can track and categorize your business expenses. This can be especially helpful if you're a sole proprietor or run a home-based business, where the lines between personal and business expenditures can often blur.

Prepare and Review Your Tax Return

When the time finally comes to prepare your tax return, take these steps to help ensure it is accurate and complete.

Understand Tax Forms

Make sure you have the correct tax forms for your business as determined by your business structure (sole proprietorship, partnership, corporation, etc.). If you plan to claim deductions or apply for credits, there are additional forms you will need.

Gather Necessary Information

Collect all necessary documentation and data required to complete your tax return. This includes income records, expense reports, payroll information, and records of deductible expenses.

Fill Out Forms Accurately

Ensure that all information is entered accurately on your tax forms. Mistakes necessitate the filing of amended returns and can lead to delays, audits, or penalties from the IRS.

Double-check Numbers

After completing your tax form, double-check all numbers and calculations before filing. Errors can cause discrepancies and potential issues with the IRS.

Consult a Tax Professional

If you're unsure about any aspect of completing or filing your tax return, consult with an expert. They can provide guidance and help you avoid mistakes, saving you time and money.

Submit On Time

Make sure to submit your tax return by the due date to avoid late filing penalties. If your business uses a fiscal year, you must file your return by the 15th day of the fourth month after your fiscal year ends. Calendar year users must file by April 15th.

For more helpful information or resources that can help you run an efficient small business, visit The UPS Store Small Business Services Center.