While it’s important to stay on good terms with Uncle Sam when it comes to paying the taxes related to running a business, you don’t need to know every detail in the tax code–that’s your CPA’s job–but you do need to know when to ask your CPA’s advice so you can maximize deductions, tax credits and savings, and adapt to changes in the federal and state tax codes.
As a business owner and employer, you’re responsible for collecting various state and federal taxes and remitting them to the proper agencies. In addition, you’re required to pay certain taxes yourself. When reading the following information, remember that at the time we posted this encyclopedia entry, all tax information reflected current law. But Congress passes tax legislation on a regular basis. Therefore, check with your CPA before making any decisions that could affect your personal or business tax planning.
Employer Tax Identification Number
If you have one or more employees, you’re required to withhold income tax and Social Security tax from each one’s paycheck and remit these amounts to the appropriate agency. To do so, you need to obtain an employer tax number from the federal government using IRS Form SS-4, and if your state has an income tax, from the state as well. Call your local IRS office, which will send you a tax ID number along with charts to determine payroll tax deductions, quarterly and annual forms, W-4 forms, tax-deposit forms, and a manual on filling out forms. No advance fees or deposits are required.
Income Tax Withholding
The amount of “pay-as-you-go” taxes you must withhold from each employee’s wages depends on the employee’s wage level, the number of exemptions he or she claims on the withholding exemption certificate (Form W-4), marital status, and length of the payroll period. The percentage withheld is figured on a sliding basis, and IRS percentage tables are available for weekly, biweekly, monthly, semimonthly, and other payroll periods.
Social Security (FICA) Tax
The Federal Insurance Contributions Act, or FICA, provides for a federal system of old-age, survivors, disability and hospital insurance. The old-age, survivors, and disability insurance part is financed by the Social Security tax. The hospital insurance part is financed by the Medicare tax.
FICA requires employers to match and pay the same amount of Social Security tax as the employee does. Charts and instructions for Social Security deductions come with the IRS payroll forms. Congress has mandated requirements for depositing FICA and withholding taxes, and failure to comply with these regulations subjects a business to substantial penalties. Four different reports must be filed with the IRS regarding payroll taxes (both FICA and income taxes) that you withhold from your employees’ wages:
1. Quarterly return of taxes withheld on wages (Form 941);
2. Annual statement of taxes withheld on wages (Form W-2);
3. Reconciliation of quarterly returns of taxes withheld with annual statement of taxes withheld (Form W-3);
4. Annual Federal Unemployment Tax return (Form 940).
In addition, employers who pay compensation of $600 or more to independent contractors must report the payments to the IRS by filing Form 1099MISC for Miscellaneous Income. Form 1099MISC is similar to the W-2 form employers give to employees. Businesses are required to send the Form 1099MISC to the contractor by January 31 of the year following the payment and must also transmit the information to the IRS by February 28 along with a summary sheet, Form 1096, Annual Summary and Transmittal of U.S. Information Returns.
State Payroll Taxes
Almost all states have payroll taxes of some kind that you must collect and remit to the appropriate agency. Most states have an unemployment tax that’s paid entirely by the employer. The tax is figured as a percentage of your total payroll (up to a specified limit of annual wage per employee) and remitted at the end of each quarter. The actual percentage varies from state to state and by employer.
Some states impose an income tax that must be deducted from each employee’s paycheck. As an employer, you have the responsibility of collecting this tax and remitting it to the state. A few states have a disability insurance tax that must be deducted from employees’ pay; in some states, this tax may be split between employee and employer.
Most states have patterned their tax-collecting system after the federal government’s. They issue employer numbers and similar forms and instruction booklets.
Hiring independent contractors requires filing an annual information return (Form 1099) to report payments totaling $600 or more made to any person for services performed in the course of trade or business during the calendar year. If this form is not filed, you could be subject to penalties. Be sure your records list the name, address, and Social Security or Employer Identification Number (EIN) of every independent contractor you hired, along with the dates they worked, the nature of their work, and how much they were paid.
Personal Income Tax
Operating as a sole proprietor or partner, you will not be paid a salary like an employee; therefore, no income tax will be withheld from money you draw from your business. Instead, you’re required to estimate your tax liability each year and pay it in quarterly installments on Form 1040. Request the necessary forms and instructions for filing estimated tax returns from your local IRS office. When applying for the forms, also ask them to send the Tax Guide for Small Business (Publication 334).
At the end of the year, you must file an income tax return as an individual and compute your tax liability on the profits earned in your business for that year. Partnerships are required to file a partnership return (Form 1065). Each partner’s share of the net income or expense of the partnership is reported to the partner on a Schedule K-1.
Corporate Income Tax
If your business is organized as a C corporation, you’ll be paid a salary like other employees. Any profit the business makes will accrue to the corporation, not to you personally. At the end of the year, you must file a corporate income tax return. Corporate tax returns may be prepared on a calendar- or fiscal-year basis. If the tax liability of the business is calculated on a calendar year, the tax return must be filed with the IRS no later than March 15 each year; however, the corporation may file a request for extension of due date.
Reporting income on a fiscal-year cycle is more convenient for most businesses because they can end their tax year in any month they choose. A corporation whose income is primarily derived form the personal services of its shareholders must use a calendar-year end for tax purposes. In addition, most Subchapter S corporations are required to use calendar-year ends.
Sales taxes are levied by many cities and states at varying rates. Most provide specific exemptions, as for certain classes of merchandise or particular groups of customers. Service businesses are often exempt altogether. Contact your state and/or local revenue offices for information on the law for your area so that you can adapt your bookkeeping to the requirements.
Levying taxes on all states would present no major difficulties, but since this is not the case, your business will have to identify tax-exempt sales from taxable sales. Then you can deduct tax-exempt sales from total sales when filing your sales tax returns each quarter. Remember, if you fail to collect taxes that should have been collected, you can be held liable for the full amount of uncollected tax, plus penalties and interest.
Some states may require an advance deposit on future taxes to be collected. In lieu of a deposit, some states will accept a surety bond for that amount from your insurance company. If you have a fair credit record, the bond is usually simple to obtain through your insurance agent. The cost varies according to the amount and the risk-5 percent is a rule of thumb, but 10 percent is not unusual for small dollar amounts.
If your state requires a deposit or bond, you can keep the amount down by estimating sales on the low side-a wise strategy, especially for new business owners who tend to be overly optimistic when it comes to estimating their business’ sales.
Taxes on Proprietorships, Partnerships and Corporations
The first tax issue business owners face is the legal form of your business. You can be a sole proprietor, a general partner, or the head of your corporation. Your choice has a big impact on your tax liability, so make sure to get your CPA’s advice first.
Sole Proprietorship Taxes
A sole proprietorship is a one-owner business, which has many or few employees. This form of organization is simple and requires no fancy legal work. You name your business in accordance with licensing laws, you apply for a federal EIN number if you have employees, and you’re all set. A sole proprietor’s income is included on his or her personal tax return.
Suppose a husband and wife file a joint return. The husband has his own business, while the wife works part-time for the government and makes $25,000 a year. The husband’s gross income from his business was $100,000, and his business made $20,000 in profits after business expenses were deducted. His $20,000 profit is included on the individual return, along with his wife’s $25,000. The business income is considered personal income for the sole proprietor, and there are no special business-income taxes other than self-employment taxes.
Partnerships and Taxes
A partnership is a business with two or more owners, and like a sole proprietorship, a partnership is not a taxable entity. For tax purposes, the income or loss from a partnership is considered the personal income of the individual general partners.
If Owner A and Owner B are in a partnership that makes $20,000, and they divide everything evenly, the $10,000 Owner A gets and the $10,000 Owner B gets are included on each individual return with whatever other income they have. Itemized deductions and credits are taken from that figure.
A partnership agreement must be well-defined regarding capital investment, return, salaries, duties, responsibilities, losses, and so on. What if you’re in a partnership with someone who isn’t as reliable and hard-working as you are? Whatever mistakes your partner makes, you are also liable because of the rule known as “mutual agent.” Mutual agent means that you are responsible for the actions of your partner because he or she is an agent for the partnership. If your partner does something that costs a lot of money or causes your business to suffer great losses, you will bear the consequences equally. The same is true if your partner does something that results in an additional tax liability for your company. You could sue your incompetent or unscrupulous partner, but that is a separate matter.
Taxes on Corporations
Most corporations determine their tax by using the following tax rate schedule:
- Up to $50,000: 15 percent
- $50,000 to $75,000: $7,500 plus 25 percent of the amount over $50,000
- $75,000 to $100,000: $13,750 plus 34 percent of the amount over $75,000
- $100,000 to $335,000: $22,250 plus 39 percent of the amount over $100,000
- $335,000 to $10 million: $113,900 plus 34 percent of the amount over $335,000
- $10 million to $15 million: $3.4 million plus 35 percent of the amount over $10 million
- $15 million to $18,333,333: $5.15 million plus 38 percent of the amount over $15 million
- $18,333,333 and above: 35 percent
Your corporation may be subject to several other taxes, such as the personal-holding-company tax or the accumulated-earnings tax. An additional tax of 39.6 percent is applied to undistributed personal-holding-company income. Ask your CPA if any special taxes apply to your corporation.
A corporation’s income is taxable, and any distribution of income to individual stockholders, known as dividends, is taxable a second time as ordinary dividend income. If General Motors earns $1, it will in theory pay 34 cents in federal tax, and the remaining 66 cents will be distributed as dividends. If you’re a stockholder, you pick up that 66 cents as dividends-and-interest income on Schedule B of your 1040 and pay tax accordingly. If your tax rate is 28 percent, you’ll pay another 20 cents in tax. That means $1 of corporate income could be reduced to less than 47 cents for the individual. Of course, with that 47 cents, you’ll also pay your property tax, sales tax, and whatever other taxes that may be credited to you or deducted by you from your taxable income.
Subchapter S Corporations Taxes
The disadvantage of double taxation is effectively eliminated if you file a Subchapter S election with the IRS. The qualifications for electing Subchapter S status were amended in 1982 when the Subchapter S Revision Act liberalized many of the old rules. The new flexibility of these corporations makes them popular with small and medium-sized businesses. Subchapter S allows profits or losses to flow directly through the corporation to you and other shareholders. If you earn other income during the first year and the corporation has a loss, you can deduct the loss against the other income, thereby reducing or completely eliminating your tax liability.
To qualify under Subchapter S, the corporation must be a domestic corporation, must not have more than 75 shareholders, must have only individuals or estates as shareholders, and must not have a nonresident alien as a shareholder. Under current law, an unlimited amount of passive income from rents, royalties, and interest is now allowed. When profits exceed 25 percent of the gross receipts, Subchapter S corporations may be taxed on passive income, according to Section 1375(a) of the Internal Revenue Code (IRC). Pension restrictions have been eased.
Call the IRS at (800) 829-3676 for the appropriate forms to select for your business entity or download them from the IRS Web site at www.irs.gov/formspubs/index.html.