Most entrepreneurs hope beyond hope that their big business idea will make them rich — but few realize that a successful small business changes more than its founder’s bank accounts. Particularly, starting a small business can make tax season even more of a headache for entrepreneurs who weren’t prepared for filing anything different from their regular 1040 form.
Many entrepreneurs take a major hit every April when their savings cushion is sliced by the government, but by being aware of your business’s tax situation, you can save your small business from the knife.
Business Structure Factors
One of the most important decisions you can make as a future small-business owner is how to incorporate your business. Your company’s filing as a sole proprietorship, limited liability company (LLC), C corporation, S corporation, or something else entirely could determine its success or failure in the coming years.
The main difference among different types of incorporation is the tax structure:
- Sole proprietorship. Legally, the business and the owner are the same entity, which means any business assets and liabilities belong to the owner and must be reported on his or her individual 1040 tax form. General partnerships are generally the same, but require a Form 1065.
- LLC. An LLC operates as a separate entity from its owner(s), but it employs what is called “pass-through taxation.” Thus, earnings must be reported on a Form 1065 as well as an individual’s Form 1040, though it does not incur business tax.
- C corp. Also called a “regular corporation,” the C corp. operates as a separate entity and is taxed by corporate income tax rates on Form 1120. Unfortunately, earnings from this corporation can be taxed twice: once for the business entity and once when owners take their dividends. Thus, owners must also report their dividend income on Form 1040.
- S corp. A combination of an LLC and a C corporation, S corps are separate entities whose owners can elect to receive pass-through taxation. Thus, the business must file a Form 1120S, admitting to its incorporation, but owners can report income and loss on their individual Forms 1040.
Start-Up Cost Deductions
Fortunately, there are a few ways to mitigate the initial taxes your small business incurs: deductions. Perhaps one of the most valuable deductions for new small-business owners are those for start-up costs. Capital expenses you make to research your industry or prepare your business for operation count toward your deductible. Therefore, any money you spend surveying markets, visiting potential locations, hiring consultants, training employees, advertising, and even filing for incorporation could come right back to you after tax season.
The only catch is that you cannot exceed $55,000 with your spending. Businesses that cost $50,000 or less to start will receive an astounding $5,000 deduction on their first year’s taxes; however, businesses that cost $55,000 or more will receive no deductions during their first year. Of course, that money doesn’t go to waste; the rest of your start-up costs are amortized and will eventually get deducted.
A small business with just a single employee — including yourself, if you file as a C corp. — you must consider how you will organize payroll taxes. On behalf of all your employees, you must withhold federal and state income taxes as well as FICA taxes, which includes Medicare and Social Security; then, you must match your employees’ contributions to FICA. Eventually, when your small business starts booming, you might have to submit Form 941 taxes quarterly, monthly, or even semi-weekly, depending on your liabilities. Payroll taxes are exceedingly complex, and for a more accurate description, you should peruse the IRS’s Employer’s Tax Guide.
You probably already know the repercussions of not properly reporting your individual taxes — there are a number of celebrities who can tell you the dangers of tax evasion — and slipping up on your small-business taxes could be even worse. Still, when confronted with new tax rules and regulations, you could easily make costly mistakes. Here are some common errors to watch out for:
- Misunderstanding limitations. The IRS rarely allows you to deduct 100 percent of your expenses. You should avoid overstepping with your deductions, or you risk a costly audit.
- Forgetting to keep records. Without a tax diary, you could easily forget important write-offs. Saving all of your receipts is an organizational nightmare; it is much smarter to invest in a dedicated binder to track travel, entertainment, and other business-related expenses.
- Receiving a refund. It can be exciting to get a check back from the IRS, but ultimately a fat refund means you are lending the government interest-free money. You should tighten your withholding and keep that money in your business.
- Incorrectly labeling workers. Independent contractors are cheaper than employees when it comes to taxes, but there are significant payroll penalties if the IRS discovers you control your workers’ hours and methods.