Filing Small Business Taxes For The First Time
If you began operating a small business in 2020, filing your annual tax returns for the first time may be a daunting prospect. However, understanding what is required of your new business and having the correct information available can remove some of the uncertainty from the process and ensure that file successfully.
Filing small business or freelancer taxes can sometimes get complicated--there are entire books on the topic--but if you are operating as a freelancer or independent contractor and have no employees, it is likely that filing your tax returns will be a fairly straightforward procedure. In the sections that follow, we will discuss which taxes you need to pay, how your taxes will be calculated, which deductions are available to you, which forms you should use, and other topics.
Which Taxes Will You Need to Pay?
Whether you are operating your small business as a sole proprietor who owns an unincorporated business by yourself, partnership, limited liability company (LLC), or a corporate entity, you will likely need to file returns for and pay the following types of taxes:
- Income Taxes. You will need to pay the federal income tax on your profits. Whether you pay the tax on your individual return or on the company return depends on your chosen business form. Additionally, 43 states impose an income tax on individuals and 47 states impose one on corporations.
- Payroll Taxes. Businesses that utilize employees--as opposed to independent contractors--will need to pay Social Security taxes, unemployment insurance taxes, and Medicare taxes for those employees. You will also be required to withhold the appropriate payroll taxes from each of your employees’ paychecks.
- Self-Employment Taxes. While the self-employment tax is generally viewed as only applying to self-employed individuals, it also applies to the owners of a partnership, LLC, or S corporation who receive an untaxed share of the business’s income. This 15.3% tax covers both the employee and the employer’s share of the owner’s payroll tax. Use this self-employment tax calculator to see how much you'll owe.
- Sales Taxes. Sales taxes are imposed by some states, counties, and municipalities on the sale of certain products or services. While the tax is usually imposed on the customer, it is the business’s responsibility to collect and submit it.
Since some of these taxes, such as state taxes and local taxes, can vary substantially based on where you live, we will concentrate on your federal tax obligations here.
How is Your Business’s Income Tax Calculated?
If you operate your business as a sole proprietorship, LLC, partnership, or S corporation, it is treated as a pass-through entity under federal income tax law, and you will be responsible for paying taxes on the business profits. A pass-through entity is one where all of a business’s profits are passed through directly to the owner or owners and they are responsible for paying any income tax due on those profits. The business itself is not subject to the income tax.
Your business’s taxable profit is its business revenue, minus any deductions you claim for business expenses on your federal tax return.
Because the income from pass-through entities is taxed through your personal tax returns, your tax bracket will be based on your total taxable income for the year, not just your business income. If you are filing a joint return with your spouse, your tax bracket will be based on your income as a couple. In essence, that means that if you have received pass-through income from a small business, it will be added to the taxable income received from all sources and will usually be taxed in the same manner as income you received as an employee working for someone else.
You can also use this free income tax calculator to easily figure it out.
Are Traditional Corporations Treated Differently?
It is pretty uncommon, but some small businesses will choose to incorporate as a traditional corporation--known as C corporations--that have issued ownership shares. Assuming all of the legal formalities have been followed, your C corporation will be taxed separately. You will only be taxed on any salary you receive for services or dividends.
While operating your business as a C corporation may end up reducing your personal income tax bill, utilizing it as a business structure usually results in you paying more taxes on your business’s profits. That is because C corporations are subject to what is often referred to as “double taxation.” In other words, any income you earn from your C corporation will be taxed when the corporation reports it as a profit and then you will pay taxes on the income when it is passed along to you as a salary or dividend.
However, the passage of the 2017 Tax Cuts and Jobs Act (TCJA) has resulted in some limited situations where high-income business owners will pay less in income taxes if they have organized their business as a C corporation. That is because the TCJA imposed a 21% flat tax on C corporations. Before the passage of the act, the top corporate tax rate had been 35%. Since the new 21% rate is lower than the 37% rate on individual income of more than $518,401 ($622,051 for couples filing jointly), if you are willing to leave your profits in the business, that reinvested income will not be subject to additional tax at your individual income tax rate.
Another reason small businesses are rarely structured as C corporations is that their tax filings usually become far more complex, which means you will usually need to hire a CPA to handle your business’s taxes.
The Pass-Through Tax Deduction
Since the TCJA did not offer a reduced income tax rate to the owners of pass-through entities, it granted them another tax benefit by letting them deduct qualified business income (QBI) up to 20% from their income taxes. C corporations are not allowed to claim this deduction. A taxpayer can claim this deduction on up to 20% of the QBI for each pass-through business he or she owns.
QBI is the profit a pass-through business earns in a year and is calculated by subtracting any business deductions from its total business income. Generally, QBI does not include the following:
- Capital gains or losses
- Income from dividends
- Wages paid to shareholders in an S corporation
- Income from outside of the United States
- Interest income
If your total taxable income did not exceed $163,300 for 2020 ($326,600 if married filing jointly), then you can claim the entire 20% deduction for QBI income. If your income was higher than that amount, QBI you can deduct is calculated based on several factors, including whether your business qualifies as a service provider.
What Business Expenses Can I Deduct?
Most small business owners understand that they can deduct expenses for business purposes, but many are unsure which expenses may qualify. As a general rule, the Internal Revenue Service will accept a business expense as deductible if it is necessary, ordinary, and reasonable. Common business use deductions include the following:
- The mileage you put on a personal vehicle when you are using it for business is deductible at 57.5 cents per mile for 2020.
- Health insurance for employees is deductible. But self-employed health insurance for yourself and your family is only deductible in certain circumstances.
- 50% of the self-employment tax you pay is deductible.
- Advertising costs
- Software purchases
- Banking fees
- Depreciation of business assets
Deductions for Startup Costs
In addition to the costs that all businesses may deduct, the IRS provides special deductions for startup expenses. Common deductible startup expenses include:
- Market and product research
- The costs of acquiring an existing business
- Legal, accounting, and consulting fees
- Licenses and permits
- The purchase or rental of equipment
- Wages and salaries for training
Here's a more comprehensive list of 1099 tax deductions for small business owners.
What Tax Forms Will I Need to File?
You must still file an annual Form 1040, U.S. Individual Income Tax Return, if you own a small business, but you will also be required to file additional forms to report the income earned by your business. The form that you will use to file depends on how your business is structured. The list below shows which forms need to be filed for each business structure:
- Sole proprietorships must file a Form 1040 Schedule C to show your profits and losses and a Form 1040 Schedule SE for self-employment taxes.
- S corporations must file a Form 1120-S, U.S. Income Tax Return for an S Corporation.
- Partnerships must fill out a Form 1065, U.S. Return of Partnership Income, and each partner must file a Form 1065 Schedule K-1.
- Single-Member LLCs are treated by the IRS as sole proprietorships and their owners must file a Form 1040 Schedule C and a Form 1040 Schedule SE.
- Multi-Member LLCs are treated as partnerships by the IRS and must file a Form 1065. Each member must complete a Schedule K-1.
- C corporations use a Form 1120, U.S. Corporation Income Tax Return, when filing.
The owners of businesses operating as a sole proprietorships or single-member LLCs must file a Form 1040 Schedule C along with their personal income tax returns on April 15. C corporation tax returns are also due on April 15. Partnership, S corporation, and LLC tax returns have a due date of March 15.
What are Estimated Taxes?
Sole proprietors, partners, shareholders in S corporations, and LLC members are usually expected to make quarterly estimated tax payments if they expect that they will owe $1,000 or more in taxes when their return is filed. The IRS requires C corporations that expect to owe $500 or more in taxes when their return is filed to make estimated tax payments.
The IRS requires businesses to pay estimated taxes four times a year so that small business owners are not hit with their tax bill for the entire year when they file their annual returns. Your estimated tax payments are applied to the tax you owe for the year and, if you have paid more than in estimated taxes than what you owe for the year, you will receive a tax refund.
Sole proprietors, partners, and shareholders in an S corporation, and LLC members usually use the Form 1040-ES, Estimated Tax for Individuals, to calculate their estimated tax using your expected adjusted gross income, taxable income, deductions, credits, and taxes for the year. Corporations will usually calculate their estimated tax using a Form 1120-W worksheet.
If you are working another job while operating your business, you may avoid making estimated tax payments by asking your employer to withhold additional taxes from your earnings. There is a line on the Form W-4, Employee’s Withholding Certificate, for listing additional amounts you would like your employer to withhold.
The IRS will not require you to make estimated tax payments for the current year if you meet the three following conditions:
- For the prior year you had no tax liability and were not required to file a return.
- You were a U.S. citizen or resident during the entire year.
- Your prior tax year included a 12-month period.
Finally, if you file your taxes and discover you did not make large enough estimated tax payments, the IRS may require you to pay an underpayment penalty. However, the penalty is usually waived if the taxpayer owes less than $1,000 for the taxes for the year, has paid at least 90% of the tax due for the year, or made payments totaling at least 100% of the tax due for the prior year.
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