Photo by Federico Gutierrez
Disclaimer: The following is not tax advice. It's a guide to help business owners and the self-employed understand their tax obligations.
Small businesses and their owners have a plethora of ways they can and may be required to pay taxes. From Federal to local taxes, once you start to wrap your head around the American tax system, you'll realize it's kind of a hodgepodge of laws and rules put together over time. Think of it as an ugly collage of regulations, but it's much worse because percentage math is involved. Another frustrating aspect is that the laws may change. We saw this most recently in 2019 with the Tax Cuts and Jobs Act. Although a good accountant will help you navigate through the ever-changing tax code, as a business owner or freelancer, it's your responsibility to get a foundational understanding of the world of business taxes.
This guide is to help business owners and the self-employed understand their tax obligations. Once you can wrap your head around how small business taxes work, you'll be able to use this knowledge to make better decisions and to ask your tax advisor (your accountant) better questions.
Let's dive in.
Self-employment and business ownership can make a person's tax situation less straight forward than with traditional employment. There are just more factors that can impact how you pay taxes and whom you pay taxes to, like the kind of entity you do business as, the type of product or service you sell, your role in the business, and where you do business.
1 All businesses pay Federal income taxes, but how they pay them can differ
Federal income taxes are one layer of the cake that makes up all the taxes you'll be required to pay as a freelancer or small business owner. All businesses have to pay income taxes on the company profits, no matter what kind of business you set up. Profit is business income minus the business expenses. How income taxes get reported and paid are determined by the type of business you've formed (or not formed).
Pass-Through Entities VS. C Corporations
Sole proprietors, single-member LLCs, partners in partnerships, and S-corporation owners are all small businesses that pay income taxes from business profits through their personal income tax returns. These types of companies are referred to as pass-through entities or disregarded entities because the business profit and taxes owed on those profits, pass through the business, to the individual pers, on and gets reported on their personal tax return. Pass-through entities are different from the c corporation. C corporations must pay income taxes on profits at the company level.
Sole proprietorships and Partnerships
Sole proprietorships and partnerships are the simplest way to form a business. They are not separate business entities. They don't require you to file any paperwork legally; they are the default type of business for folks who don't actively form a company. If you set up a lemonade stand and sold lemonade all summer long, you were a sole proprietor. If you and a friend have been getting paid to DJ together for years, but you haven't filed any paperwork to form a business, you're probably in a partnership. Sole proprietorship and partnership taxes are pretty straight forward. Business income and losses are reported on a personal tax return, using a Schedule C form.
When your business profits "pass-through" the business to your personal income tax return, the amount you owe in federal income taxes depends on your tax bracket. Here is a simple example to illustrate how tax rate applies to business profits: Let's say Sarah is a single-filer sole proprietor with business profits of $100k, and a personal income tax rate is 24% - the rate profits are taxed. In this example, Sarah will owe $24,000 in Federal income taxes on her $100k sole prop profits.
However, with the new Tax Cuts and Jobs Act, sole proprietors and partnerships may take advantage of the qualified business income (QBI) deduction. The QBI deduction is a 20% tax deduction, which allows them to deduct 20% of the business's net income from their taxable income, reducing how much one owes in taxes. Caveat: there are limits to this deduction based on income and filing status. Let's apply this deduction to Sarah's $100k profit for the year. The 20% QBI deduction creates tax savings in two ways. The first is by reducing taxable profit by 20%, to $80k. Then at $80k, Sarah moves tax brackets down to a Federal income tax rate of 22%. Sarah now must pay $17,600 in federal income taxes, a $6,400 tax savings.
The numbers: Here are the Federal income tax brackets.
Limited Liability Company (LLC)
It's important to realize there aren't any inherent tax advantages or disadvantages to forming an LLC. Your LLC won't change anything for federal income tax purposes. LLC members pay taxes on business profits on their personal tax returns in the same way a sole-proprietorship or partnership does. If Sarah formed an LLC, her profits would be taxed the same way as if she were a sole prop.
So why would anyone choose to form an LLC if it doesn't save them on taxes? Because an LLC can offer liability protection and flexibility in its structure. For some business owners, those reasons may be more compelling than tax savings.
However, LLCs can have federal tax advantages, but you have to elect them. With LLCs, you can choose to have the LLC taxed as an s or c corporation, instead of the default way they are taxed - as a sole proprietor or partnership. The classification you choose will determine how taxes are reported and paid.
LLCs are also eligible for the 20% QBI tax deduction.
The numbers: Here are the Federal income tax brackets.
S Corporations
A corporation is a type of business entity. And an S corporation, or an S corp, is a designation regular corporations choose to make by filling out a form with the IRS. Business owners decide to elect S corp status because of its tax advantages. A Limited Liability Company (LLC) can also choose to be an S corp for tax purposes. If it sounds like, you fill out a particular form with the IRS, then everyone uses their imagination and believes your company can now benefit from the S corp tax laws, that's because that's what is happening. Honestly, it's shit like this that makes me realize how much abstract creativity is involved in the world of forming businesses and paying taxes. It all requires extraordinary feats of imagination to understand and believe in it.
Shareholders and owners of S corps pay federal income taxes on their portion of the business profits, just like a sole proprietorship, partnership, and LLC. Profits get allocated to owners based on how much of the business they own. For example, a $100k business profit split amongst two 50-50 owners means each of them will have to pay income taxes on their $50k of the profits. Regardless of whether or not they receive the profits, they will still owe taxes on their portion. While it may not seem like an s corp has any tax advantages compared to LLCs or sole props, s corporations have benefits in the other layers of taxes. Profits aren't subject to self-employment taxes (which we will cover later) the way they are with sole props, partnerships, and LLCs, and owners who work in the business or manage it can cleverly structure how they report business profits and income.
Here's how and why that is. S corps, by law, state that any owner who is employed by the business or manages it, must get paid a reasonable salary. "Reasonable" is a word used in the tax regulations, and different accountants have different definitions of what reasonable is. Let's say, Sarah is the sole owner and operator of her s corp, and her business has a profit of $100k. Since she works in the company, she legally must pay herself a reasonable salary. Since she owns the company, she also must pay federal income taxes on the profit. Here's where it gets abstract. Instead of paying federal income tax on the full $100k, Sarah can (and legally, must) pay herself a salary. She and her accountant decide $50,000 is reasonable. So now, the $100k profit is reduced to $50k profit, and she's paid the other $50k as a wage. Her wage is not tax-free, it's subject to payroll taxes (more on that later), and the $50k profit will be taxed at her personal income tax rate.
Form 1120S is the form used for an S-corporation's annual tax return. S corps are also eligible for the 20% QBI tax deduction, subject to limits based on filing status and income.
The numbers: Here are the Federal income tax brackets.
C Corporations
C corporations pay taxes at the corporate level. Unlike all the types of companies we've discussed thus far, the c corporation is responsible for paying taxes on the business profits. The significant disadvantage of a c corporation is that distributions or dividends are subject to double taxation. If Sarah formed a c corp, the corporation would pay taxes on the company profit. And then Sarah, as the owner, would pay taxes at the personal federal income tax level when those profits get distributed to her. Distributions or dividends are taxed twice, once at the corporate level, then again when it's distributed.
Owners choose to form c corporations because the advantages of the actual corporate structure are more important than saving on taxes. For example, the ability to issue stock makes a corporation more attractive if business owners are looking for investors.
State income taxes will vary state to state
Some states like Texas, Wyoming, and Florida don't have state income taxes. Generally, state income taxes range from 0% to 13%. Whether you're trying to determine how much of your business income should save for taxes or what you should set your prices at, make sure to take your state income taxes into account.
2 The kind of business you run determines taxes
If you sell products, those sales may be subject to state or local sales tax
In most states, businesses that sell products must set up a system where they charge their customers' sales tax, collect that sales tax, and then pay it to the state. Depending on state law, some services may also be subject to sales tax. Each state will have its own sales tax laws, so it's essential to make sure you understand what your state's reporting, collecting, and payment requirements are.
If you have business with employees, there are payroll or employment taxes
Like sales taxes, if your company has employees, you'll be required to collect, report, and pay payroll taxes (AKA employment taxes) on your employee's wages. If you've ever had a paystub, you'll see that employment taxes get paid to the IRS, Social Security Administration, medicare taxes, and federal and state unemployment taxes. Employment taxes can be complicated. There are multiple taxes, multiple payers (the employer and the employee), and filing requirements. Failure to file and pay on time can result in penalties and, in some rare cases, criminal prosecution. The best way to handle payroll tax reporting and payment is by using a done-for-you payroll service provider. Gusto is a favorite of ours. The monthly service fee includes the required regular filings and handling all the tax collection and payments.
The numbers: In 2020, the payroll tax rate that goes toward Social Security is currently 6.2%. In 2020, employees' wages only up to $137,700, are subject to Social Security. They will not have to remit to the Social Security side of FICA above $8,527.40 or 6.2% of $137,000. The tax rate for Medicare is significantly lower, at 1.45%, but โ all covered wages are subject to this tax.
If you are self-employed, you may be responsible for self-employment taxes
Sole proprietors, partners, and LLC owners whose last year's net earnings were at least $400 are required to pay self-employment taxes on those net earnings. (Remember net earnings is the amount left over after you subtract expenses from income).
Self-employment taxes are for Social Security and Medicare. Think about it like this: since business owners are not employees, there is no paycheck to withhold Social Security and Medicare taxes (payroll taxes) from, so self-employment tax is the alternative. Both employee and employer and responsible for paying payroll taxes. With self-employment taxes, the business owner is essentially paying both sides of that payroll tax, but since it's not income through payroll, it's subject to self-employment taxes.
The owners of corporations who work as employees do not have to pay self-employment tax.
The numbers: For 2020, the self-employment tax rate is 15.3% on the first $137,700 worth of net income, plus 2.9% on net income over $137,700. The rate consists of 2 parts: 12.4% for Social Security and 2.9% for Medicare.
If you own commercial property, there are city and county property taxes
If you own commercial property, land, or a brick-and-mortar location, then you'll have to pay property taxes to the city or county where your real estate is.
If your business engages in certain types of activities or sells certain types of products or services, you might be responsible for excise taxes
There are also various excise taxes depending on the type of business you operate. These types of activities vary, from selling cigarettes, operating big trucks that have a significant negative impact on the environment, selling cigarettes, operating a sweepstakes giveaways, or playing daily fantasy sports. Businesses that sell products or services subject to excise tax are responsible for collecting the taxes and sending them to the IRS.
3 Where you operate and do business determines taxes
State taxes vary, but here are some common ones
Most states, but not all, require residents to pay income taxes. Beyond income taxes, each state may have different tax requirements. Most states will have some sort of fee due each year for operating and maintaining a business entity, like an LLC or a corporation. For example, in the state of California, there is an $800 Franchise Tax fee due each year for LLCs and S corporations.
Local city taxes and county taxes
Your business might also be subject to local city or county taxes. Some states, like Nevada and Texas, impose a gross receipts tax on businesses instead of a state income tax. And the city of Los Angeles imposes a city business tax on all businesses.
You can find out what your local tax requirements are by doing some research online, speaking to someone in the local office that handles small business taxes, or asking your accountant. An excellent place to do some initial research is your city's website. Find out what department or office handles business taxes and supporting local businesses. You can search that database for information. You can also call someone in that office, and they should be able to help you. Your accountant is also a great resource. They may already know what local taxes and filings you'll be required to submit, along with deadlines and filing fees.
4 Keep track of your income and expenses and save for taxes
Keeping track of how much money your business earns and spends is a vital first step if you want to be able to plan and save for taxes. You can do your own bookkeeping, hire a professional or make an arrangement with your accountant where they periodically review your work (disclaimer: not all accountants will provide this kind of support, so make sure to ask yours).
Once you start tracking your income, you can start saving for income taxes. Open up a separate savings account strictly for your income taxes. Yes, this is annoying because you have one more account to "worry about." But it's totally worth the hassle. Ask your accountant how much of your income (or net income) you should be saving. Most accountants will agree with the general rule of thumb that you should save between 15 - 40% of your income for taxes. Our bookkeeping service works with our clients and their accountants to make sure they are always aware of how much they should be putting into their tax savings accounts.
If you have other tax obligations, you may consider opening up multiple savings accounts. If you have to collect and pay sales tax, having a savings account where you stash it until it's due is a smart way to make sure you don't accidentally spend money that isn't yours.
5 Pay taxes as you earn income (quarterly tax payments)
Estimated taxes are not a different kind of tax, like the types, we went through above. Estimated taxes are income taxes that you pay throughout the year, every quarter. The amount you pay each quarter is an estimate of what you think your taxable income at the end of the year is going to be. Accountants will often use last year's earnings as a starting point.
Technically and legally, we must pay income taxes as we earn income - just like an employee would with a paycheck. Other taxes, like sales tax, are on a different schedule and might be paid to various taxing authorities. And local taxes might only be paid once yearly.
Federal and state quarterly estimated income tax payments are due in April, June, September, and January each year. Here are the key dates:
Q4 (for the previous year) - January 15
Q1 - April 15
Q2 - June 15
Q3 - September 15
Don't let it bring you down
One harsh lesson you might learn when you start actively saving and paying quarterly taxes is that you may need to reevaluate how much income you need to earn. Saving for taxes might mean you're taking a haircut on income. If you put 30% of your income into a tax savings account this year, was that income money that you were counting on using? Do you need to earn more money to meet your business or personal needs? Actively participating in your businesses means getting to know the tax piece and what impact taxes have. If you do need to increase revenue, does that mean increasing your price, the number of customers you serve, or the number of things you sell to current customers? Perhaps it's a combination of all of those things.
You may choose to view the tax part of business ownership negatively. But the reality is, as a business owner or freelancer, you have considerable power that you can exercise. You can create new products or services, or stop offering them. You can choose to serve a different type of customer. And you have the choice and the power to learn more about how taxes work so that you can make better decisions about how you earn, save, and invest money.