If you’re a small business owner, the amount of taxes you owe on your business income might come as a shock.
“Part of this surprise stems from the fact that many business owners pay their entire tax bill for the year when they file their tax returns,” explains Logan Allec, a CPA and founder of Money Done Right.
“This is different from income earned as an employee, where the IRS mandates that a certain amount of taxes be withheld from each paycheck,” he says.
To avoid being blindsided by your taxes, you’ll want to keep tax planning top of mind during the startup stages of your new business. We consulted with these tax professionals to give you some key tax planning pointers to help you run a smooth operation.
Get an EIN for Your Business
An EIN — or employer identification number — is a nine-digit number assigned to your business by the IRS. If there are multiple owners in your business, you’ll definitely need an EIN. If you set up a corporation for your business or elected to be taxed as either an S Corp or a C Corp, you’ll also need to get an EIN. Does your business have employees? If so, you’ll need an EIN.
Even if you’re not required to get an EIN, it might still be a good idea to do so, says Allec. For example, if you’re an independent contractor and will be working with clients who plan to issue you 1099 Forms, you’ll need to provide them with your Social Security Number — unless you have an EIN to give them. Also, many banks will require you to have an EIN for your business before opening a business bank account.
Open a Business Bank Account
It’s sound practice to keep your personal and professional finances separate. Tai Stewart of Saidia Financial Solutions warns about keeping money set aside for taxes in a personal account:
“It’s too easy to spend that money, and then later get hit with an underpayment penalty for not making required estimated tax payments throughout the year,” she says.
And according to Allec, keeping your business inflows and outflows separate from your personal accounts will make bookkeeping and taxes a lot easier, as well as start a conversation with business bankers who could potentially help you with funding down the line.
Implement a Bookkeeping System
When doing startup planning for your small business, you’ll want to set up an automated bookkeeping system. Without a solid bookkeeping system, you could be missing out on valuable tax deductions.
“Obviously you need a set of books to do your taxes,” says Alec, “But beyond that, knowing exactly how much your business is making every month is essential to making good business decisions.”
Allec also points out that you can’t deduct a business expense if you don’t know what it is! To keep track, he says, you need a streamlined bookkeeping system to make sure that you are properly recording all of your income and expenses.
Factor in Self-Employment Tax When Setting up a New Business
Besides paying business income tax, there’s also the issue of the self-employment tax. In addition to regular income taxes that are calculated based on the tax brackets for the year, small business owners also have to pay self-employment tax on their business income.
This self-employment tax is comprised of the Social Security tax and Medicare tax. It adds up to 15.3 percent of the first $132,900 of your net income, plus 2.9 percent for any amount over that $132,900.
“Employers by law pay half of these taxes for their employees, with the employees only having to pay the other half,” says Allec. “But a small business owner is responsible to pay 100% of their Social Security and Medicare taxes all on their own via the self-employment tax.”
Note that this only applies if you’re being taxed as a sole proprietor (which includes many LLCs utilizing pass-through taxation). If your small business is taxed as an S Corp or C Corp, you won’t need to pay self-employment tax on your distributions — only income tax on the salary you collect as an employee.
Track Qualified Deductions
If there are expenses that you legitimately incur in your business, then you can legitimately deduct them on your taxes. But remember that these expenses have to be necessary and ordinary to your business — otherwise, trying to deduct them could raise red flags with the IRS.
Let’s say you work as an artist, and you have a dedicated studio in your home to work on your paintings and sculptures. Think of all the costs that you incur in your business: paintbrushes, canvas, tickets to art functions, freight charges for your artwork, etc. These are all legitimate tax deductions, so be sure to keep track of them.
“Also, if the only thing you use your studio for is making art, you may be able to write off a portion of your housing expenses as a home office deduction,” says Allec.
Track Your Mileage
Do you work from your home office but drive around town to meet clients? If so, be sure to track the total miles you drove during the year. That’s because there are actually two ways to calculate your mileage deduction: by taking a standard deduction for each mile driven, or by figuring out what percentage of the miles you drove during the year were business-related.
If using the second method, you’ll multiply that percentage by all your vehicle expenses for the year, such as gas, maintenance, insurance and depreciation. Allec recommends calculating your deduction using both methods, and then selecting whichever one will yield the greatest deduction.
Figure Out If You Would Save on Taxes By Forming an S Corp or a C Corp
If you don’t set up any entity for your business, you’ll be taxed as a sole proprietor, meaning you report all your business income directly on your personal tax return.
But this might not provide you with the most advantageous tax treatment. You should sit down with a tax professional to determine whether you should make an election to have your business treated a certain way for tax purposes.
“An S Corp makes sense for many small businesses, but it shouldn’t be the only option you consider,” says Allec. “Sometimes, remaining a sole proprietor for tax purposes — meaning that you simply report your business income on your personal tax return — is the most advantageous route.”
For example, if you have other W-2 income on top of wages you will pay yourself out of your S Corp, he explains, the additional administrative costs of having your business taxed as an S Corp might not outweigh the tax savings. And you should also note that there might be higher costs in forming such a business entity.
“Some [entities] require payroll to be issued, in which case your expenses would be even higher because you have to account for payroll tax,” explains Stewart, adding that you’ll also want to reconcile all business bank accounts and credit cards every month. “That way you’re not scrambling at tax time trying to figure things out.”
Invest in a Tax Plan
Allec points out that a common pitfall of new small business owners is forgoing professional tax advice because they believe that money would be better put toward revenue-drivers such as marketing and sales.
“What they don’t realize is that by putting in place a proper tax plan, small business owners can save thousands of dollars,” he says. “These are dollars they can reinvest back into their business to grow both their top and bottom lines.”
Allec provided the following example: Let’s say a small business owner is in the marginal 24 percent tax bracket. Add the 15.3 percent self-employment tax, and you’re looking at a marginal 39.3 percent federal tax rate on each additional dollar of income you earn in your business. Throw in state income taxes, and you could very well be looking at anywhere from 40 percent to 45 percent marginal tax rate on the next dollar your business brings in.
“So if you make another $50,000 in your business, that’s over $20,000 paid in taxes,” says Allec. “Don’t you think it’s worth it to invest in a solid tax plan?”
If you would like help with your tax planning or are curious about the benefits of setting up your business as an S Corp or C Corp, reach out to an Incfile representative. We can provide information and resources on how to create a company startup plan to integrate all this tax planning advice and more.