An entrepreneur’s job description is endless, and somewhere on that long list of duties is filing business taxes. Here’s how taxes work for entrepreneurs.
Entrepreneurs have built the U.S. economy’s backbone, evidenced by Small Business Administration data that small businesses make up 99.9% of U.S. businesses and employ more than 60 million people.
There are many entrepreneurs out there, and the number grows every day. Here’s what you need to know about paying taxes as an entrepreneur.
5 common tax deductions for entrepreneurs
Make sure you’re taking all the tax deductions you’re eligible for as an entrepreneur. Once you’re done with the list of greatest hits below, check out our roundup of tax deductions for the self-employed.
1. Business expenses
Reasonable and necessary is the IRS mantra for deducting business expenses. The IRS has strict rules for deducting many types of expenses, but the guiding principle remains that business expenses are only deductible when they’re crucial to operating your business and aren’t overpriced.
Schedule C, the business tax form for sole proprietors and single-member limited liability companies (LLCs), makes space for the most common business expenses. The highlights:
- Independent contractor payments
- Cost of goods sold
- Repairs and maintenance
There’s also a line for “other expenses,” such as dues, subscriptions, and bank fees.
You might notice I didn’t list an equipment or furniture category. That’s because fixed assets, or items of value you intend to keep for more than a year, are subject to depreciation. Instead of immediately writing off the entire purchase of a fixed asset, you write off a portion each year using the IRS’s modified accelerated cost recovery system (MACRS).
However — and this just to make it more confusing — current tax law allows businesses to write off 100% of some fixed assets in the year they’re placed in service using bonus depreciation or the Section 179 deduction.
2. Qualified business income (QBI) deduction
The qualified business income (QBI) deduction gives your taxable income a little haircut. Pass-through businesses — which most entrepreneurs are — can deduct up to 20% of QBI.
The QBI calculation starts with a business’s profits but must be adjusted for certain owner compensation payments, self-employment taxes, and a slew of other types of income and deductions. Your tax software can walk you through the QBI deduction.
3. Home office
If you’re a work-from-home entrepreneur, consider dedicating a portion of your home to your business. When there’s a space in your home that’s “exclusively and regularly” used for business, you’re halfway to being eligible for a home office deduction.
There are two ways to calculate the home office deduction. The simplified method, calculated directly on Schedule C, gives you $5 for every square foot of home office space, up to 300 square feet. You can alternatively file Form 8829 to deduct your actual home office expenses, which is a bit complicated but usually makes for a bigger deduction.
The IRS clearly states the rules and regulations for the home office deduction. Check the breakdown in our guide to the home office deduction.
4. Business use of a personal vehicle
Most entrepreneurs will use their personal cars to buy supplies and meet with clients. You can get a deduction for the wear and tear on your personal car.
Similar to the home office deduction, you have two choices for calculating the deduction. The IRS standard mileage method has you multiply the number of eligible business miles driven by the IRS mileage rate, $0.56 in 2021.
Otherwise, the actual expense method allows for a deduction of qualifying car expenses in proportion to its business use.
Familiarize yourself with the quirky rules — such as excluding commuting as a business expense — with our guide to deducting the business use of your car.
5. Startup and organizational costs
In the weeks and months before you open your business, thousands of dollars might already go out the door. Some startup and organizational costs are deductible in the first year of operations.
The deduction allows up to $5,000 for startup activities and $5,000 for organizational costs in your first year. The deductible amount goes down once startup or organizational expenses exceed $50,000 and goes down to $0 after you reach $55,000.
The nondeductible portion of your startup and organizational costs must be amortized — a fancy word for the depreciation of things you can’t see or touch — over 15 years.
Deducting startup and organizational expenses is complicated, so it’s best to get a tax professional’s help in your first year of operations.
How should you do your entrepreneur taxes?
Entrepreneurs are doers, constantly picking up new skills. However, many newly minted business owners might feel apprehensive about filing taxes for the first time. Err on the side of caution by getting professional help with your business taxes.
When you can do your taxes yourself
When we talk about doing your business taxes yourself, we mean with software’s help. Solutions for accounting, payroll, and taxes grant autonomy to business owners who would otherwise rely on a professional to carry out routine tasks.
Here are some tax tasks you can handle on your own.
- Making estimated quarterly federal tax payments: Entrepreneurs must make quarterly estimated tax payments based on their share of business profits. The IRS makes it easy to submit quarterly tax payments. You might want an accountant’s help calculating your estimated payment the first few times, however.
- Generating and filing Forms W-2 and 1099-NEC: The IRS and your employees expect to receive a Form W-2 every January that details annual compensation. You’re required to file a similar form, 1099-NEC, for independent contractors. Once a payroll professional helps you set up your account accurately, your payroll and accounting can take care of the rest.
- Filing a business tax return extension: Say you need more time to identify a tax professional before you file your business tax return. Requesting an IRS tax return extension can take no more than checking a box on your next estimated tax payment.
When you can use professional help
Taxes are not a time to step too far outside your comfort zone. When something out of the ordinary happens in your business, you’ll want a professional’s help.
- Filing your first-year business tax return: No matter how simple your business appears, it’s best to get a professional’s advice before filing your business tax return, especially during the first year of operations.
- Establishing an LLC, partnership, or corporation: It’s best practice to hire legal help when forming an LLC, partnership, or corporation. Since you’re creating a new business entity, you want to make sure it’s done right, and you’re choosing the most tax-advantaged business structure.
- Selling a fixed asset: When you sell a fixed asset — a piece of machinery or furniture, for example — your business will likely incur a gain or loss on the sale. That creates a new and unfamiliar tax situation that requires an expert’s counsel.
- Responding to an IRS inquiry: The IRS communicates with taxpayers through letters. Should you be so lucky for them to get in touch, call up a tax attorney for guidance.
4 tips for handling your entrepreneur taxes for the first time
You don’t need to be a tax expert to be an entrepreneur, but keep these tax tips in mind.
1. Save your receipts
I’d be remiss not to mention this first. For any business expense you deduct, there must be a financial trail if an IRS audit occurs. Your accountant will thank you for neatly organizing your receipts.
As you track business expenses in your accounting software, attach receipts to the transaction. Several smartphone apps on the market can scan and send physical receipts to your computer for safekeeping.
2. Take advantage of tax credits
Tax credits are one of the most effective ways to reduce your tax bill. Unlike tax deductions — which reduce taxable income — tax credits lessen a business’s tax liability, dollar for dollar. For example, a business with $5,000 in a preliminary tax bill that qualifies for $1,000 credit would only have to pay $4,000 at tax time.
The government introduces tax credits to incentivize small businesses to go green, offer subsidized health insurance, and hire employees from marginalized groups.
Businesses can file tax credits when they file their business taxes. Read more in our guide to small business tax credits.
3. Explore business structures
Entrepreneurs don’t have to be sole proprietors. Other business structures, such as LLCs and S corporations, can provide you with legal and tax benefits. Your best business structure depends on your entrepreneurial activities.
Most entrepreneurs will want to go with a pass-through structure, where business profits are taxed on their individual returns. Your other option is corporation taxation, which makes your business a separate taxpaying entity, potentially subjecting you to double taxation.
LLC owners, called members, enjoy the liability shield built into the business structure. Unless you personally guarantee a business debt, your personal assets can’t be seized to repay a business debt. Sole proprietorships don’t get the same protections.
S corporation status, a special tax designation available to LLCs and C corps, can help business owners avoid some payroll taxes. The IRS keeps a hawkish eye on S corp shareholder-employee compensation, so you’ll need a tax professional’s advice before committing to S corp taxation.
4. Invest in software
Accounting, payroll, and tax software can consolidate many hours of busywork into just a few hours.
Software doesn’t have to be confusing or expensive, and most let you cancel your subscription at any time. Take the time to choose the best software for your business.
Taxes might not spark the entrepreneurial spirit
The word entrepreneur comes from the French, “entreprendre,” meaning “to undertake,” Merriam Webster says. It’s an apt name for a career that requires tenacity in the face of unfamiliar and unforgiving obstacles.
Even if filing taxes doesn’t awaken the entrepreneurial spirit that lives inside you, there are plenty of trustworthy professionals out there who can help.