The two types of taxes to which you will devote most of your time are business income taxes and employment, or payroll, taxes.
Most people do not find themselves staying up late at night reading the tax code with the eagerness that they would show for the latest page-turner. But if you develop a basic familiarity with business income tax rules, you just may find it interesting to see how you can manage your business with an eye toward minimizing taxes.
In general, you will find that the IRS gives a wide range of expenses that it allows as deductible. The term “ordinary and necessary” is operative here. If a deduction is “ordinary,” or common to your industry, the odds are good that it will be allowed. The way your business is taxed will depend on the form of business you have selected.
The type of tax treatment and form you file will depend on the form of business entity that you have selected. This chart gives a quick overview.
|Form of business||Tax treatment||IRS schedule to use|
|Proprietorship||Business does not pay the tax||Form 1040, Schedule C|
|Partnership||Business does not pay the tax||Form 1065|
|C Corporation||Corporation files return||Form 1120 or 1120-A|
|S Corporation||Business does not pay tax||Form 11-20 S|
|LLC||May file as sole practitioner (Form 1040, Schedule C), corporation (Form 1120 or 1120-A ) or partnership (Form 1065)|
As indicated on the chart above, a proprietorship, partnership, S corporation and possibly an LLC will not pay taxes itself. The tax burden is passed along to the business owner, and the income is taxed at the individual’s personal tax rate.
A corporation, which is treated as a separate entity or “person,” pays taxes at a graduated rate. Currently, the first $50,000 of net income is taxed at a 15 percent rate. The next $25,000 of income is taxed at 25 percent. Rates for net income over $75,000 vary between 34 percent and 39 percent.
What about business tax deductions?
You can be fairly certain that just about any expense incurred to benefit your business will be deductible for tax purposes. Remember the “ordinary and necessary” guideline.
The IRS has been specific in its rulings regarding some types of deductions. Depreciation, travel expenses, meals and entertainment and auto expenses fall into that category. If it is ordinary or necessary to your industry, it normally will be deductible.
First, here are just a few deductions your business can take:
- interest payments
- office supplies
- fees and commissions
- expenses for attorneys
- accounting services and other professional advisors
- repairs and maintenance of your equipment
- vehicles the business owns
- office supplies and expenses
Employee-related expenses can also be deducted, such as:
- payroll taxes
- benefits and retirement contributions
- pension and profit-sharing plans
Expenses related to selling your products are allowable deductions:
- marketing and advertising costs
- trade publications
- fees and commissions
- association memberships
- business conventions and trade shows
Health, dental and group life insurance are all allowable deductions, as are moving expenses. There are other qualified benefit plans which are deductible for the business. In addition, these benefits are not taxable to employees.
In general, the IRS wants to make sure that the business owner does not set up a business plan that benefits himself or herself more than his or her employees.
What do I need to know about depreciation?
Although depreciation is not a cash expense, it is deducted from income on your taxes and thus reduces your tax liability.
If you buy equipment or machinery that has a useful life of more than 1 year, you will most likely deduct the cost over a number of years. This rule recognizes that you will be using the asset for more than 1 year.
Can I buy a truck for my business and write it off right away?
This is where depreciation kicks in. You will most likely have to depreciate it over a period of years.
How do you figure the amount of depreciation?
There are two types of depreciation: “straight-line” and “accelerated.”
Straight-line is the simplest. Divide the cost of the asset by the number of expected years of life.
Accelerated depreciation means that the tax deduction for a purchase is sped up; you are allowed to take a larger amount as a write-off in the first years after you have made the purchase.
So I can deduct the full cost of equipment when I buy it? Are there any exceptions?
The answer is yes. A small business is most likely to qualify. You can choose to deduct up to $100,000 worth of depreciable assets in the year you make the purchase.
Of course there are exceptions. If you buy more than $400,000 of depreciable assets in the year, this rule does not apply; you will need to make adjustments to the $100,000 first year write-off as it phases out.
A second exception is that the amount you deduct cannot be greater than your taxable income for that year.
Can I deduct travel, meals and entertainment?
The IRS wants the business to distinguish between travel for business purposes and personal travel. Deductions for business travel covers almost all expenses you would encounter on a business trip: any form of transportation that takes you to your destination, meals, lodging, cabs or limos from the airport or while in a city, tips, laundry and cleaning expenses.
If a trip is partly business and partly personal, you are allowed to deduct only the business portion.
As for meals and entertainment, the IRS allows a business to deduct only 50 percent of the expense. This applies to you and a guest that you might pay for—you can deduct half of each meal or entertainment.
If you are a sole proprietor paying taxes through your personal Form 1040, you will take the deduction on Schedule C. A corporation may reimburse its employee-owner or employee for 100 percent of the meal and entertainment expenses, but it will still only be able to deduct 50 percent for tax purposes.
Can I deduct my automobile expenses?
There are two ways to compute your automobile expenses.
Each year, the IRS states a per-mile allowance for deductions, and that might be the simplest way to calculate the expense. The alternate method is to keep track of all car-related expenses like gas and oil, tires and repairs and use the actual costs.
Can I deduct all of my automobile expenses?
As with business and personal travel, you will need to allocate expenses if you use your car for both business and personal reasons. Commuting expenses are not deductible, and neither are parking fees at your normal place of work; these are considered personal expenses.
Can I depreciate automobile expenses?
The business entity can depreciate an automobile that it has purchased.
Can I deduct software that comes separate from a computer?
Yes, you can deduct 100 percent of the software cost in the year you make the purchase.
Most of the employment taxes your business pays fit under the “payroll” category, although self-employment tax is closely related. In a sense, federal and local governments have asked you to be the tax collector, since you are required to withhold a number of taxes—income, Social Security, Medicare and unemployment, among others. It is vital to stay timely with your payments to the tax authorities, as penalties for delayed payment are steep.
What is a W-4?
Every employee that you hire will be asked to fill out a W-4 form, which helps calculate the amount of income tax your business will withhold. Geared to meet an employee’s personal income tax obligation, the form includes the employee’s marital status and how many exemptions he or she expects to claim. Using the frequency of the payroll period and the individual’s wages, the IRS provides charts and other ways to calculate the appropriate amount to be withheld.
All but a handful of states and even a few cities have imposed their own income tax, and you will be responsible for withholding an appropriate amount for those taxes as well.
How much of my employees’ Social Security and Medicare do I have to pay?
Social Security and Medicare taxes are shared equally by the employer and the employee. Unlike income tax, these taxes are calculated as a flat percent of wages. The Social Security portion has a ceiling of $90,000; there is no ceiling for Medicare.
The rate for Social Security is 6.2 percent of wages and for Medicare is 1.45 percent. This totals 7.65 percent; the employer pays 7.65 percent of total wages and withholds the employee’s contribution of an additional 7.65 percent of wages.
In what situation will I need to pay unemployment tax?
You are responsible for a federal unemployment tax (FUTA) based on total wages you pay employees. This is not a withholding situation; the business pays the tax directly.
You will be liable for FUTA if you pay wages totaling $1,500 or more in a quarter, or if you have at least one employee during 20 “calendar weeks” in 1 year.
Currently, the tax is a flat rate of 6.2 percent on the first $7,000 that you pay each employee.
Do I not have to pay state unemployment insurance taxes too?
Yes, state unemployment insurance taxes fund programs for unemployed workers. Paying a state unemployment insurance tax may mean you can claim credits against the federal unemployment tax.
I am self-employed. What kind of employment taxes do I have to pay?
If you do not incorporate the business and thus do not pay yourself as an employee, you have a special situation where you pay your own self-employment taxes. This process parallels paying employees with some exceptions.
First, you will not have income taxes withheld as an employee would. Instead you may need to make estimated tax payments to the IRS each quarter. Also, you effectively pay your own Social Security and Medicare taxes at the rate of 15.3 percent. You do not have an employer to pick up half the tab for this. Schedule SE is where you report your net self-employment income for Form 1040.