Understanding Small Business Taxes

Q: Are all business entities taxed the same?

A: No, and the rules differ significantly. But there are some guidelines that generally apply to different types of business entities.

If a business operates as a sole proprietorship, the owners must report income and expenses of the business on their individual tax returns. For federal tax purposes, financial information with respect to the business is usually detailed on a Schedule "C." From one perspective, reporting everything on one tax return can simplify matters a bit. However, it's inevitable that an audit of your individual tax returns will likewise result in an audit of your business, and vice versa. (One of the reasons to consider operating through a corporation or another type of business entity is that the tax consequences of the business would be reflected on separate tax returns.)

If you operate your business through a general partnership, the partnership itself should file a tax return. A key point to understand with a partnership, though, is that it is a tax-reporting entity rather than a tax-paying entity. The partnership reports income and expenses, which are then passed through to the partners in accordance with their ownership interests. Every year, a partner should receive a Form K-1 that reflects the partner's share of income and expenses. Each partner should then reflect this information on the partner's own income tax return.

In contrast to a partnership, a corporation can be a tax-paying entity, but this is not always the case. Federal law generally provides that an incorporated entity would be taxed on net income as a "C" corporation (with this reference coming from subchapter "C" of the Internal Revenue Code) unless you elect to be treated differently. Under certain circumstances, a corporation can elect to be treated as a partnership for tax purposes (and thereby be called an "S" corporation (with this reference being to subchapter "S" of the Internal Revenue Code).

As another alternative, it is sometimes possible for a corporation to be organized as a nonprofit entity. The best-known type of non-profit business entity is probably a public charity with tax-exempt status under Internal Revenue Code section 501(c)(3), but there are plenty of other examples. Even here, though, a nonprofit corporation may still be subject to taxation with respect to "unrelated business income" that is earned on activities unrelated to its tax-exempt purpose.

The limited liability company "LLC") (or a variation known as a "limited liability partnership") is another type of a business entity that is basically a hybrid between a partnership and a corporation. It has many of the limited liability characteristics of a corporation, but for tax purposes is generally treated as a partnership. So an LLC is required to file a tax return for tax-reporting purposes, but the actual tax consequences are passed through to the owners (called "members"). Like a partnership, the members should receive a Form K-1 every year that reflects any income or losses that they are required to report on their own tax returns.

As distinct from federal law under the Internal Revenue Code, each state has different tax rules and regulations. While these rules usually parallel federal tax laws in many respects, there are always significant differences. In many states, for example, a minimum franchise tax is due and payable annually by business entities, regardless of whether they made or lost money.

Q: Can I avoid payroll taxes by hiring independent contractors rather than employees?

A: The short answer may be yes, but the IRS and other taxing authorities will always look to substance over form in analyzing any tax situation. What this means in the case of payroll taxes is that it doesn't make any difference if you hire someone and call him or her an independent contractor if you are really treating that person as an employee. There are well-known checklists of factors that a taxing authority will look to in deciding whether a worker is really an employee rather than in independent contractor. The key consideration, though, is the issue of who controls the right to tell the worker what to do.

Q: What taxes are business subject to?

A: When people think of taxes paid by businesses, income taxes are probably what come to mind first. But income taxes are only one of many different kinds of taxes assessed against businesses by federal, state and local governments. Oftentimes, a tax on a business is called something else like "license fee" or an "assessment," but any payment to the government is essentially a tax.

In the United States, all businesses are subject to federal taxation on their income. But they"re also subject to taxation by state and local governments, each one of which has different rules and regulations:

  • At the local level, most businesses are required to obtain a business license, which is a form of tax. There are also registration fees, fees for permits and local excise taxes. In addition, local governments assess businesses for taxes on both real and personal property, plus special levies and assessments such as for redevelopment projects or infrastructure improvements. Sales or use taxes may be assessed locally, as well.
  • In every state, there are additional taxes on businesses, including corporate income taxes, excise taxes on certain goods and services, franchise tax fees for the privilege of doing business in the state, sales and use tax, and capital gains tax. Businesses are also assessed in most states for payroll and other forms of employment taxes (for example, state disability and unemployment taxes).
  • Many of the taxes at the state level are similar to and supplement taxes that the federal government assesses on businesses. Federal taxes on business include income tax and capital gains tax. In addition, employers are responsible for payroll tax obligations, which include paying the employer's share as well as collecting the employee's portion on social security contributions.

The consequences of not paying business taxes can be severe, because government agencies typically have the power to collect unpaid taxes through placing liens on business assets and ultimately levying on them to satisfy unpaid tax obligations, including fines, penalties, interest and other charges that can be tacked on to the original tax liability. And directors, officers or other business representatives can sometimes be held personally liable for unpaid tax liabilities.

Q: How do sales or use taxes affect my business?

A: Everyone is familiar with sales taxes, which are taxes charged on the sale of taxable goods, products or services. Use taxes are essentially the same thing, except that they're taxed on the use of taxable items. Use taxes most often come into play with taxable items where sales taxes wouldn't apply (such as when goods are sold to someone who is out of the state).

Fundamentally, these taxes affect every company, as they're a cost of doing business. Any time that taxable supplies or equipment are purchased, a business pays the taxes. These taxes can be a significant expense on big-ticket items like computer systems, furniture, company automobiles and other equipment.

There can also be legal issues as to who is responsible for paying the tax. Usually, it's the consumer or the end user who ends up paying the tax. A manufacturer or a wholesaler can secure a "resale" license that allows taxable items to be sold downstream to the retailer, who's then responsible for collecting the tax when the item is finally sold to the consumer.

The rules and regulations on sales or use taxes can be a nightmare, especially for businesses that sell goods out of state. The rules and regulations also apply in situations where it might not be apparent to the owners of a business that they're responsible for collecting them. One example would be equipment leases, where sales tax must usually be collected over the term of the lease. If the lessor doesn't collect these taxes, a taxing authority could come after the lessor.

Sales and use taxes can be an administrative nightmare for businesses that are responsible for collecting them. Every state has different rules and different taxes. Even counties, townships and other local jurisdictions assess sales or use taxes. Some items are taxes; others are not. It can be extremely difficult and a major cost of doing business just trying to keep track of all these rules. If the taxes aren't collected, taxing authorities can come after the business.

Since they could possibly end up being anywhere from five to ten percent of the sales price, sales taxes are also a big issue when selling a business. In some jurisdictions, there are "occasional sales" rules that apply to transactions like the sale of a business, where the parties are not ordinarily engaged in the sale of the business assets being sold.

Q: Should I hire an accountant or a tax preparer?

A: If you're not going to itemize deductions and you otherwise have a simple financial picture, it may make sense to do your own taxes. Even if your tax situation is more complicated, there are many software programs out on the market that help people do their own taxes. At the same time, though, the tax laws are perhaps the most complicated laws in the world, and there is always the possibility that you're going to miss something. So it's probably in your best interest to hire a professional tax preparer.

Regardless of your personal financial situation, you'll be glad you hired someone else to do your taxes if you are ever audited. If you did your own taxes, it may be much more difficult to defend your position against an IRS audit if you're representing yourself. Indeed, many tax lawyers and accountants would advise their clients never to meet directly with a revenue agent on an audit without having the benefit of professional advice. Many people trying to handle their own tax audits, and business owners in particular, have also unwittingly turned a civil audit into criminal investigation.

In business, it's essential to have professional advice with respect to tax preparation. If your business is incorporated, for example, there are many pitfalls that can create adverse tax consequences. And every significant business transaction should be analyzed from a tax standpoint.

Q: What are "after-tax" dollars?

A: At the other end of the spectrum are expenses that are paid for with "after-tax" dollars. Such expenses could be characterized as being twice as expensive as compared to those that can be written off for tax purposes on a "pre-tax" basis.

Your take-home pay represents after-tax dollars, for example. Even here, though, there are lots of deductions that are allowed for taxpayers, even if they aren't in business for themselves. The best examples are probably your home mortgage and charitable donations.

There are many employee-related expenses that can be run through a business on a pre-tax basis. A primary example is healthcare coverage. Many employers provide health benefits at no cost to their employees. The premiums paid by the employer are also tax-deductible. If an employee had to pay for this expense with after-tax dollars, it would be a hardship that would be significant for most people.

Tuition and other costs of education are another very significant "after-tax" expenditure for many families. Paying a child's college tuition is bad enough, but it is even more painful if you realize that you are paying for it with "after-tax" dollars. This underscores a truly significant benefit to scholarship money, in that it isn't taxable.

It's also easy to see the potential benefit of legislation that gives some tax break on educational expenses. An example would be a 529 plan that allows a parent to establish a savings account for a child's education. Even though money that is placed in the account is usually in "after-tax" dollars, additional taxes are deferred or eliminated on any future earnings on this money so long as it's ultimately used for qualified educational expenses.

Under some circumstances, an employer may pay for an employee's continuing education as a deductible expense that isn't income to the employee. But if you're looking to educate yourself further, your expenses are not deductible if the education is required to meet the minimum educational requirements of your job, or is part of a program that will lead to qualifying you in a new trade or business. While the education must relate to your present work, educational expenses incurred during vacation or other temporary absence from your job may be deductible. However, after your temporary absence you must return to the same kind of work. Usually, absence from work for one year or less is considered temporary.

The concept of "pre-tax" dollars also comes into play with retirement plans. With a qualified plan, money contributed to the plan on behalf of an employee is on a "pre-tax" basis, which again means that contributions are made before any taxes are taken out. Taxes are then deferred on the contributions, as well as any increases in value, until such time as withdrawals are made. The tax savings can be incredible.

Q: What are capital gains taxes?

A:One way to think of "capital" is that it is an asset on which you have already paid income taxes. In turn, capital gains can be defined as the difference between the asset's value when you acquired it and the price when you may sell it, when the difference is positive. The gain is oftentimes difficult to calculate, as t here are a number of different factors, such as previous deductions taken for depreciation. Whatever the figure is, though, a capital gains tax can be assessed on the gain you realize from selling the asset.

A capital loss, on the other hand, would be when the same difference the acquisition and the sales price, when the resulting figure is negative. In the usual case, a capital loss can only be used to offset a capital gain. Subject to certain exceptions, it cannot be used to offset ordinary income except to the extent of $3,000 a year.

The effect of capital gains on a business will depend on the nature of the business. If the business is an investment company, for example, the effect could be significant, because capital gains would be an issue every time an investment asset is bought or sold. In other businesses, though, capital gains may not have a big effect on day-to-day operations.

Q: What are excise taxes?

A: Excise taxes are taxes levied on designated goods sold for consumption. They are assessed on various products by the federal government and each of the states. One form of excise tax that profoundly affects almost every business are fuel taxes that make up a major portion of the price of gasoline and other petroleum products. Other examples include "sin" taxes on products such as alcohol and tobacco products.

The effect of excise taxes on businesses is much the same as sales or use taxes, except that they tend to be hidden taxes that people really don't know that they're paying. Fundamentally, these taxes affect every company, as they are a big cost of doing business. Any time a business incurs travel or entertainment expenses, or when goods or products are shipped, excise taxes are a big factor.

There can also be legal issues as to who is responsible for paying the tax. Usually, it's the consumer or the end user who ends up paying the tax.

The rules and regulations on sales or use taxes can be a nightmare, especially for businesses that sell goods out of state. The rules and regulations also apply in situations where it might not be apparent to the owners of a business that they are responsible for collecting them.

Sales and use taxes can be an administrative nightmare for businesses that are responsible for collecting them. Unlike sales or use taxes, the federal government also assesses excise taxes. Every state then has different rules and different taxes. It can be extremely difficult and a major cost of doing business just trying to keep track of all these rules. If the taxes aren't collected, taxing authorities can come after the business and sometimes even the business owners.

Q: What are the tax consequences of buying or selling a business?

A: Inevitably, taxes become a big issue when a business is being bought or sold. From a seller's perspective, any profit realized on the sale of a business is probably going to be subjected to taxation at some level. The goal of the seller will oftentimes be to defer the taxation (for example, by agreeing to accept installment payments), or by getting the most favorable characterization of the transaction so as to minimize the tax consequences (for example, capital gains rather than ordinary income).

From the buyer's perspective, there would be a huge incentive on the other end to characterize a purchase or a sale to maximize tax benefits that can be realized by, for example, being able to expense payments made so as to reduce taxable income. If payments can't be expensed, a company will at least want to depreciate any assets acquired as quickly as possible.

Q: What does the term "pre-tax" dollars mean?

A:The concept of "pre-tax" dollars refers to the ability to use income from revenues to pay for goods or services before having to pay taxes on the income. This may not sound like a big deal until you think about the fact that, if you add everything up, you may very well pay more than 50% of your earnings toward a variety of taxes. (In addition to income taxes that most of us pay, there are also capital gains taxes, estate taxes, social security withholdings, sales and use taxes, personal and property taxes, excise taxes and fees, luxury taxes, transfer taxes, assessments, licensing fees and more.)

To explain the concept further, suppose you have to buy an airplane ticket for $500. Assuming a 50% tax rate, you would first have to earn $1,000 before you could pay for the ticket if it were not a tax-deductible expense (that is, the first $500 would go toward paying taxes and you would then have $500 left over to buy the ticket). However, if you are able to pay for the ticket on a pre-tax basis, you could use the first $500 to pay for the ticket and you would still have the other $500 left over in your checking account to use for something else.

The logic of allowing business-related expenses to be deducted against business income is that, instead of discouraging businesses from spending money to make money, it is better to allow them to deduct the expenses and only then tax them on net income. The corresponding benefits of being able to pay for something on a pre-tax basis are huge. But this can only be done with an expenditure that qualifies as a tax-deductible expense or a tax credit. Usually, this means it has to be in a bona fide business setting.

But you don't have to be a business owner to claim a business expense. If you're employed and itemize deductions on your personal tax return, there are certain employment-related expenses that you can deduct. A limitation, though, is that qualified expenses are deductible only to the extent that they exceed two percent of your adjusted gross income.

People try to stretch the rules all the time. For example, the benefits of pre-tax dollars are a primary reason why people will try to combine a business trip with a vacation. Another example would be people who try to characterize their hobbies as business ventures. However, lots of people get into trouble with the IRS and taxing authorities for stretching things too far, with one result being deductions being disallowed, and penalties and interest being assessed. Claiming an expense that is not for legitimate business purposes can also be tantamount to tax fraud, which in egregious situations can result in criminal prosecution.

Q: What happens if a business doesn't pay its taxes?

A: Given how businesses are subject to all sorts of tax liabilities, a business should exercise due diligence in establishing and defining its potential tax liabilities. Failure to keep on top of such liabilities can lead to serious problems and even potential liability exposure for the principals of the business.

In addition to being responsible for paying their own tax liabilities, business are also responsible for collecting and submitting taxes owed or payable by employees, customers or other third parties. Areas where problems typically arise include:

  • Payroll taxes
  • Sales or use taxes
  • Excise taxes

The consequences of not paying business taxes can be severe, because government agencies typically have the power to collect unpaid taxes through placing liens upon business assets and ultimately levying on them to satisfy unpaid tax obligations, including fines, penalties, interest and other charges that can be tacked onto the original tax liability. In addition, directors, officers or other business representatives can sometimes be held personally liable for unpaid tax liabilities.

Criminal liability can become a reality for intentional acts like tax fraud in connection with a business failing to pay taxes. This liability can be imposed on both the business entity and any representative who was involved in the criminal activity.

Q: What is a "capital" account?

A: If a business is taxed as a partnership, an investor's tax basis is reflected in what is known as a "capital account." An investor's capital account is initially equal to the amount invested in the business. After that, each investor's capital account is adjusted on the books and records of the business, depending on income or losses recognized and on distributions of money made to the investor. Income earned by the business will usually increase a partner's capital account to the extent that the income isn't distributed to the partner. Losses reduce a partner's capital account.

Calculating an investor's capital account can be more complicated than one would think. A cash contribution pretty clearly creates a tax basis and increases a capital account so long as it's treated as a contribution of equity rather than a loan. However, it is sometimes possible for an investor to acquire tax basis under what are called "at-risk" rules by personally guaranteeing a corporate obligation. Losses tend to have the opposite effect, but are sometimes shared disproportionately among investors.

Q: What is a "tax basis," and why do I care?

A: Broadly speaking, the term "tax basis" has two applications in a business setting:

  • From an investor's standpoint, the term refers to the amount a person invests in a business, subject to business profits or losses that have been passed through to or realized by the investor
  • From the standpoint of the business entity, the term usually refers to the amount paid for a business asset subject to depreciation or other adjustments

Right from the outset, tax basis is important to an investor because it's the means by which a determination can be made as to whether or not the investor is entitled to a "write-off" during any given tax year. If a business is organized as a partnership and loses money, for example, the losses would be passed through to investors who may be able to claim them as a deduction that can be written off against other income that the investors have realized, so long as the loss doesn't exceed a given investor's tax basis. If the loss is claimed in any given tax year, the investor's tax basis is reduced to the extent of the loss claimed. Once an investor uses up all of his tax basis, it limits the investor's ability to claim further losses on the investment.

Tax basis is also important to an investor because it's a key factor used in determining the taxable gain or loss realized by the investor upon selling or otherwise disposing of the investment. The higher the taxpayer's basis at the time of selling his partnership interest, the less the taxes are on disposition, and vice versa.

The tax basis of a business asset is also very important from the perspective of the business itself. For each tax year, a business should be entitled to claim depreciation with respect to the business asset. The amount of depreciation that can be claimed depends on IRS rules. Sometimes business assets can be depreciated over a short period of time, which can be a tax benefit to an organization, as the amount of depreciation that can be claimed will reduce taxable income. When and if the business asset is sold, the difference between the tax basis at that point in time and the sales price will determine the gain realized on the sale of the asset, if any.

Q: What is the best way to minimize taxes on my business?

A: The very best way to minimize taxes on your business is to do effective tax planning. You have to think about tax consequences all the time. You also need to retain a good team of tax professionals to assist and advise you in the decision-making process.

The principals of every business should get together routinely with the company's tax advisers to develop strategies for minimizing potential tax liabilities. At a minimum, a business should hold a meeting close to the end of the business's tax year in an effort to come up with year-end tax planning strategies.

As for common strategies, a familiar concept for small businesses is to "zero out" income prior to the end of the tax year. This concept is especially important when a business is subject to being taxed as a separate entity, such as a corporation. If this is the case, the principals of the corporation may essentially be subjected to double taxation if the business must first pay corporate income tax and the owners are then subsequently taxed personally on dividends or other distributions from the company.

One way that small businesses can address the situation is to pay expenses prior to the end of the business tax year that come close to matching business income. These expenses may range from buying anticipated supplies, inventories or equipment to paying out bonuses.

Q: What is the difference between "depreciating" and "expensing" an item?

A: If you're engaged in a bona fide business, the tax laws generally allow you a deduction against gross income for ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. These expenses include:

  • A reasonable allowance for salaries or other compensation for personal services actually rendered
  • Traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business
  • Rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity."

As a general rule, it's better to take tax deductions as quickly as possible. So it's a big plus for a business to be able to expense an item is that the tax benefit is realized all at once.

In contrast, expenditures for equipment, capital improvements or other property used in a business must usually be deducted over the anticipated useful life of the property rather than all at once. The concept involved is "depreciation," which can be defined as a decrease in the value of property over the time the property is being used. By allowing a deduction over the useful life of the property, the idea is that you can get back your acquisition costs in tax savings, so that when property wears out, the business will be in the position to replace it.

Only property used in a trade or business or to produce income can be depreciated. Plus the property must be something that wears out or becomes obsolete, and must have a determinable useful life substantially beyond the tax year. The kinds of property that can be depreciated include machinery, equipment, buildings, vehicles, and furniture. It doesn't include, for example, bare land.

While the general rules relating to claiming business expenses and depreciating business property are fairly straightforward, applying them to a given situation may not be quite so easy. This is an area where the IRS and other taxing authorities pay a lot of attention, as there tends to be a lot of abuse of the rules. It's best not to try to stretch the rules without first relying on the advice of competent tax professionals.

Q: What kind of payroll taxes am I liable for as an employer?

A: Under federal law employment taxes consist of:

  • Federal income tax withholding
  • Social security and Medicare taxes
  • Federal Unemployment tax ("FUTA")

Each state also imposes payroll tax requirements on employers.

As an employer a business is required to withhold federal income tax from each employee's wages. Just as important a business is required to account for and submit these withholding to the federal government. Personal liability exposure can result from a failure to do so.

Social security and Medicare taxes pay for benefits to employees and their families under the Federal Insurance Contributions Act ("FICA"). Social security tax pays for benefits under the old age survivors and disability insurance part of FICA. Medicare tax pays for health benefits. An employer is responsible for withholding and paying over the employee's portion as well as a matching portion that the employer is required to pay on top of what the employee pays.

The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act ("FUTA") that pays unemployment compensation to workers who lose their jobs. The tax is paid by the employer so it's another cost of doing business. The employer reports and pays FUTA tax separately from social security and Medicare taxes and withheld income tax.

The IRS has helpful publications that provide further information on all of these taxes.

Q: Why do some businesses have different tax years?

A: Most businesses now operate for tax purposes on a calendar year which means that their tax reporting periods end on December 31st of each year (except in certain instances such as when going out of business or selling a business). Sole proprietorships and partnerships must use the calendar year for tax purposes.

But most incorporated businesses can choose their own fiscal year meaning that the end of the business's annual tax reporting period could be on any day of the year typically at the end of a month. (There are some limitations such as with respect to professional service corporations such as for lawyers or doctors who must report on calendar years. Limited liability companies and "S" corporations must also use a calendar year because by definition they are treated as partnerships for tax purposes.)

One reason a company would want to have a fiscal year for tax reporting purposes is to conform to the tax reporting requirements with the business cycle. For example if the business is seasonal - where most of its product is made or income is received during a given part of the year - it may make sense to have a tax year that ends shortly thereafter. This tends to make it easier to keep track of the books and records of the business for tax reporting purposes.

Another benefit is that a fiscal tax year can be beneficial for tax planning purposes for the owners of the business. For example suppose a business is on a June 30th tax year. The company may be able to deduct any bonuses or other compensation paid out at year-end and not have to pay taxes on these expenditures. The recipients then in turn would receive the income but may not have to report it until the end of their own tax years on December 31st.

There have been a lot of abuses in this area and the IRS has come down hard on businesses that try to manipulate the rules on use of fiscal years. This is why for example professional service corporations are generally not allow to use fiscal years for tax reporting purposes. So if you want to have a fiscal tax year for your business you should make an election only after consulting with professional tax advisers.

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