Taxes are important to consider when starting a business. Business owners must know the types of taxes that may apply to their business and understand the requirements and processes for paying them. It is also important that owners account for these taxes in their operational and financial plans. In this post we will discuss several types of taxes, how they are calculated, and how to pay them, as well as advance planning considerations. Please note that this information is not intended to be tax advice or guidance, nor is it a comprehensive coverage of tax issues. Business owners should consult qualified, knowledgeable professionals for tax advice.
Types of Business Taxes
Income tax is based on net profit from business operations. When customary and necessary expenses to operate a business are subtracted from the revenue generated in that business, the remainder is net profit.
Owners of sole proprietorships, partnerships, limited liability companies, and s-corporations report net profit on their personal income tax forms. The income tax obligations are said to be a “pass-through” from the business to the individual owner(s) and the business does not pay corporate income taxes. Regular corporations report corporate profits on separate tax return forms and must pay corporate income tax.
Besides federal tax obligations to the Internal Revenue Service, in most cases business owners will also be charged state income tax and possibly city and county taxes as well.
Self-employment tax will generally apply to an owner who is in business for him or herself. Basically, you're self-employed for this purpose if you're a sole proprietor (including an independent contractor), a partner in a partnership (including a member of a multi-member limited liability company (LLC) that is treated as a partnership for federal tax purposes), or are otherwise in business for yourself. The term sole proprietor also includes the member of a single member LLC that's disregarded for federal income tax purposes and a member of a qualified joint venture.
You usually must pay self-employment tax if you had net earnings from self-employment of $400 or more. Generally, the amount subject to self-employment tax is 92.35% of your net earnings from self-employment. You calculate net earnings by subtracting ordinary and necessary trade or business expenses from the gross income you derived from your trade or business.
You can be liable for paying self-employment tax even if you currently receive Social Security benefits. The law sets a maximum amount of net earnings subject to the Social Security tax. This amount changes annually. All of your net earnings are subject to the Medicare tax.
Owners become obligated to pay employment tax if they hire one or more employees. Employment taxes, including Social Security and Medicare taxes on wages, are paid by both the employer and the employee:
- Employers are required to withhold and remit federal and state income tax from employees’ wages.
- Employers withhold and remit part of Social Security and Medicare (FICA) taxes from employees’ wages and also remit a matching amount.
- Employers generally pay state and federal unemployment insurance (FUTA) tax. This is paid separately from other taxes.
- Employers also pay into state disability insurance programs.
Excise taxes are paid by manufacturers or sellers of certain products, owners of certain kinds of businesses, or users of certain types of equipment. For example, indoor tanning services and businesses that operate heavy vehicles (such as trucks) on highways pay excise taxes.
Most states require sales tax to be collected by retail sellers. Each state has its own process to follow for these taxes to be remitted to the state. See the section below on state and local taxes for more information regarding sales tax remittance. We will discuss sales tax in more detail in a future post.
Collection and remittance of local taxes may be required for real estate and personal property taxes, depending on individual circumstances and the location of a business. In addition, some jurisdictions charge taxes on end-of-year inventory. Owners should check with state, county, and city agencies to determine local requirements.
Federal Tax Forms
A taxpayer identification number (TIN) is required by the IRS to process tax returns. The two most common types are social security numbers (SSN) and the employer identification number (EIN). An EIN is issued by the IRS to sole proprietors, partnerships, limited liability companies, and corporations. An EIN is required if the business has employees, has a qualified retirement plan, is a corporation or partnership, or files returns for employment taxes.
The organizational structure of the business impacts which income tax return forms are used and how taxes are paid. A short list of federal income tax forms as used by each of the four major business types can be found in Table 1.
Table 1. Federal Tax Return Forms
||Income Tax Return Forms
- 1040, U.S. Individual Income Tax Return
- Schedule C, Profit or Loss from Business
- 1065, U.S. Return of Partnership Income
- Schedule K-1 (Form 1065), copies to each partner showing individual share of partnership income
- Partners each file 1040, U.S. Individual Income Tax Return
|Limited Liability Company
- Structure not recognized by IRS. Owners may file a tax return as either sole proprietor, partnership, or corporation. Choose whichever tax return form option is most convenient or agreeable to you.
- 1120-S, U.S. Tax Return for an S-corporation
- Schedule K-1, copies to each shareholder showing individual share of partnership income
- Each shareholder files an individual tax return as a sole proprietor
- 1120, U.S. Corporation Income Tax Return
- After corporate income taxes are paid, any distributions of income to shareholders are taxed again as dividends on individual tax returns using form 1040
Employment and other tax forms are listed in Table 2. Employment taxes include taxes that employers are required to withhold from their employees’ wages and taxes the employer pays. They also include any self-employment taxes for self-employed business owners.
Table 2. Employment and Other Tax Forms
|Employers Annual Federal Unemployment (FUTA) Tax Return
||Filed with the IRS annually to report the amount of FUTA for all employees
|Employers Quarterly Federal Tax Return
||Used by employers to report employment taxes, withholding amounts, deposit amounts, and amounts due the IRS.
|Employee’s Withholding Allowance Certificate
||Completed by an employee to communicate exemption status to the employer so that the correct amount of tax can be withheld from paychecks.
|Wage and Tax Statement
||Sent by employer to an employee and the IRS each year reporting the employee’s annual wages and the amount of taxes withheld from paychecks.
||Used by employers to report payments totaling more than $600 annually to an independent contractor, other than a corporation.
||Used by employers to report payments to persons, other than corporations, that are not independent contractors (eg, royalties above $10, rent and other payments above $600, and direct sales of at least $5,000 of consumer products to a buyer for resale anywhere other than a permanent retail establishment).
State and Local Income Tax
The Illinois Department of Revenue has established e-services to support and expedite the remittance of state income and sales tax and other taxes. More information can be obtained on the IDOR website.
As mentioned at the start, owners should plan ahead and anticipate the taxes that will be due and how that obligation will impact business operations and cash flow. It is of the utmost importance to get qualified advice from tax professionals. The IRS has developed a course on managing taxes: Small Business Taxes: The Virtual Workshop.
Some business owners make the mistake of spending tax money on business operations. When taxes come due, these owners are short of funds. There are significant penalties when taxes are paid late. Business owners should maintain separate accounting of tax funds so that taxes can be paid when due.
Accounting employees or third-party accounting services can be hired to provide proper bookkeeping oversight and financial management to maintain adherence to proper accounting principles. Taking responsible action regarding the money and tax operations will go a long way in assuring a successful business.
More instruction on this and related topics can be obtained in the NaperLaunch Academy Workshop Series. Registration information is found on the NaperLaunch website. Mentoring or one-to-one appointments can also be arranged with a NaperLaunch Coach, SCORE Volunteer, or Business Librarian by visiting the mentoring page.