Having an understanding of and effectively managing taxes is not solely a legal responsibility, but also an essential element in successfully operating an ethical business. It safeguards your financial stability, credibility, and long-term growth potential, all while ensuring compliance with tax laws and regulations.
In this article, we’ll get you up to speed on the basics of business taxes to help you feel more confident not just during tax season, but year-round. We’ll cover the EIN, business structures, tax obligations, and estimated payments.
Do You Need an EIN?
An Employer Identification Number (EIN), also known as a Federal Tax ID Number, is utilized to distinguish a business entity for tax purposes. You can apply for an EIN online.
Not every business needs an EIN. Determining if you need an EIN depends on your business structure. For example, if your business is a corporation or partnership, you will need an EIN. If your business is a sole proprietorship, your social security number will likely act as your business’s EIN. Check if you need an EIN at this link.
You will use your EIN for these purposes:
- Opening a bank account
- Applying for business licenses
- Filing a tax return
- Making an online payment using the Electronic Federal Tax Payment System (EFTPS)
- Passing an IRS Taxpayer Identification Number (TIN) Checking program
Your EIN may need to change if the ownership or structure of your business has changed.
Types of Business Structures
When opening a new business, there are many different business structures to consider, each of which has different tax advantages and protections:
Here are the main types of business structures:
- Sole Proprietorship: A sole proprietorship is a business owned and operated by one individual that is not incorporated. The owner has complete control over the business but is personally responsible for all debts and obligations. The owner’s personal tax return includes the income earned from the business.
- Partnership: A partnership is a business structure where two or more individuals or entities share ownership and management responsibilities. Partners are personally liable for any debts incurred by the partnership. Profits and losses are distributed among partners, who report them on their personal tax returns. There are two types of partnerships:
- A limited partnership (LP) is formed by having at least one general partner who is fully liable for the company’s debts and obligations, and one or more limited partners who have restricted liability. The limited partners usually contribute capital but do not have decision-making power. Their liability is confined to the amount they have invested.
- A limited liability partnership (LLP) provides a structure where all partners are shielded from personal responsibility for business debts. This type of partnership is commonly utilized by professionals like lawyers and accountants.
- Limited Liability Company (LLC): An LLC combines the advantages of limited liability protection from a corporation with the simplicity and flexibility of a partnership. Members, who are owners of an LLC, have limited personal liability for any business debts. Income and losses can be passed through to members, who report them on their personal tax returns. LLCs have the option to choose how they want to be taxed, such as as a sole proprietorship, partnership, S corporation, or C corporation.
- Corporation (C Corporation): A corporation is an independent legal entity separate from its shareholders (owners). Shareholders enjoy limited liability protection where their personal assets are typically safeguarded from company debts. C corporations are subject to corporate income tax, and any profits distributed to shareholders in the form of dividends may also be subject to individual income tax.
- S Corporation (S Corp): An S corporation operates as a distinct entity that opts to transfer its corporate earnings, losses, deductions, and credits directly to its shareholders. By doing so, shareholders include their share of the income in their personal tax filings and successfully evade the issue of being taxed twice on the same earnings. These corporations face restrictions regarding shareholder count and types allowed, along with meeting specific eligibility criteria.
- Nonprofit Organization: Nonprofit organizations exist for purposes beyond generating profits or financial gain. They may qualify for tax-exempt status under Section 501(c) of the Internal Revenue Code. Nonprofits operate within a framework of specific regulations that generally prohibit distributing profits to individuals.
- Cooperative (Co-op): Cooperatives function as businesses owned by their members who actively participate in decision-making through democratic control (customers, employees, or both). Members receive a proportionate distribution of profits based on their level of involvement or usage within the cooperative structure. Cooperatives can adopt diverse legal structures such as agricultural co-ops or consumer co-ops to suit their specific needs and operations
Your business structure serves as the basis for how you pay taxes, so choose wisely and know your business structure well.
Understanding Your Tax Obligations
As a business owner, you have many tax obligations, including federal income tax, self-employment tax, employment taxes, sales tax, and state taxes. Plus, you need to understand tax deductions and credits. Here we’ll cover the basic details of each, but we always recommend seeking a tax professional to learn more about your specific situation to ensure you accurately calculate and pay your taxes.
Federal Income Tax
The United States government imposes federal income tax on individuals and businesses within its jurisdiction in order to generate revenue for government operations, programs, and services. This tax applies to various types of businesses, including corporations, partnerships, sole proprietorships, and certain LLCs.
Taxable income is the portion of a business’s total earnings that is subject to federal income tax. It is calculated by subtracting allowable deductions and credits from total revenue.
The federal income tax system is progressive, meaning that tax rates increase as income levels rise. Different tax rates apply to businesses based on their level of income within specific tax brackets.
Depending on their structure and entity type, businesses must file tax returns by specific deadlines.
Self-Employment Tax
Sole proprietors and partners need to be aware of the self-employment tax, which covers Social Security and Medicare contributions that would normally be deducted from an employee’s paycheck.
Self-employment tax typically relies on the net income generated from your self-employment income. This encompasses the earnings obtained through self-employment activities, after subtracting any eligible business expenses, deductions, and credits.
As of 2023, the combined rate for Social Security and Medicare is 15.3% for most self-employed earners. High-income earners may pay additional Medicare tax.
Employment Taxes
If you have employees, you will also pay employment taxes. Employers are responsible for withholding federal income tax, Social Security tax, and Medicare tax from their employees’ wages. These deducted funds should be deposited with the IRS on a consistent basis, alongside fulfilling the employer’s responsibility of paying their share of Social Security and Medicare taxes (the self-employment tax described above).
Sales Tax and State Taxes
Having a comprehensive understanding of state tax obligations and the rules for collecting sales tax is essential for businesses. Each state has its own specific guidelines and regulations for these taxes, and non-compliance can lead to penalties and legal repercussions.
Sales tax is typically applied to retail transactions, with businesses responsible for collecting the tax from customers at the time of sale and submitting it to the state government. Knowing which goods or services are subject to sales tax and the frequency of payment is crucial.
Tax Deductions and Credits
Tax deductions and credits allow businesses to decrease their taxable income, leading to decreased tax liabilities. Deductions allow businesses to subtract expenses like wages, rent, utilities, insurance premiums, and more from their total income before calculating taxable income. Conversely, credits directly lower the amount of taxes owed by a business.
How Much Should You Expect to Pay in Taxes (and Why)?
A business’s federal tax liability is influenced by a combination of factors, including business structure, taxable income, expenses, and deductions.
The tax liability of a business is greatly influenced by the type of business structure chosen, as unique tax regulations and rates govern each structure. Here’s an overview of how the choice of business structure impacts federal tax liability:
- Sole Proprietorship: The income and expenses of the business are reported on the owner’s individual tax return (Form 1040). Sole proprietors are taxed at their individual income tax rates, which can vary based on their total taxable income. Individual tax rates range from 10% to 37%.
- Partnership: Partnerships are classified as pass-through entities, signifying that the business itself is not subject to income tax. Instead, the partners are responsible for reporting and paying taxes on their individual share of profits and losses. So, like sole proprietors, partners are taxed at their individual income tax rates, varying from 10% to 37%.
- LLC: An LLC is considered a pass-through entity by default, meaning the owners report the income and expenses on their personal tax returns. Similar to sole proprietors and partners, LLC members are taxed at their individual income tax rates – between 10% and 37%.
- C Corporation: Corporations are required to pay corporate income tax on their profits, which can lead to double taxation when shareholders are also taxed on the dividends they receive. C corporations face a fixed federal corporate income tax rate of 21%.
- S Corporation: S corporations are a specialized kind of corporation that have opted for pass-through taxation, allowing them to bypass federal income tax obligations at the corporate level. Instead, any earnings or losses are transferred directly to shareholders, who must disclose them on their personal tax returns. Similar to sole proprietors, partners, and LLC members, individuals holding shares in an S corporation are subject to taxation based on their own individual income tax rates, which vary between 10% and 37%.
As you can see, the largest determining factors of how much you can expect to pay in taxes depends on your taxable income and your tax rate. When you spend some time accounting and planning, you can estimate how much you will pay in federal taxes.
It’s important to note that tax laws can change, and rates may be updated each tax year.
Estimated Tax Payments
Estimated tax payments refer to quarterly payments made by businesses to the IRS and state taxing authorities throughout the year, in order to fulfill their tax obligations. These payments are required for businesses that expect to owe a certain amount of taxes at the end of the tax year and do not have sufficient withholding from wages or other sources.
Not all businesses are obligated to make estimated tax payments. It depends on the business structure and tax amount due whether or not your business will need to pay federal estimated tax payments:
- Individuals, including sole proprietors, partners, and S corporation shareholders, generally have to make federal estimated tax payments if they expect to owe tax of $1,000 or more when their return is filed.
- Corporations generally have to make federal estimated tax payments if they expect to owe tax of $500 or more when their return is filed.
Estimated Tax Payment Schedule
Taxpayers are expected to submit estimated tax payments to the federal government in four equal installments spread out over the tax year. These installments are typically due on April 15, June 15, September 15, and January 15 of the subsequent year. If the 15th lands on a weekend or holiday, the due date is the following business day.
Calculating Estimated Tax Payments
To calculate estimated tax payments, you need to estimate your upcoming annual income and expenses, determine your expected taxable income, and apply the relevant tax rates. The IRS provides Form 1040-ES to assist in this process. You can make these payments using various methods, including electronic payments through the EFTPS or by setting up direct debit agreements with the IRS or state taxing authorities.
However, businesses can employ the safe harbor rule as a means of avoiding penalties for underpayment. This entails making estimated payments based on either their tax liability from the previous year or 90% of their tax liability for the current year. By doing so, businesses can safeguard themselves against penalties even if their income experiences any variations.
Learn more about estimated payments and avoiding tax debt in this article.
It’s Time to Get Started
Understanding the basics of business taxes is essential for any business owner. Determining whether you need an EIN and familiarizing yourself with the different types of business structures will help you navigate the tax landscape more effectively. Comprehending your tax obligations as a business owner is crucial to avoid penalties and ensure compliance with the law. Plus, knowing how much you should expect to pay in taxes will allow you to budget and plan accordingly.
While many business owners want to avoid taxes, it’s best to take the bull by the horns, learn what you can, and get help from a tax professional for the rest. We always recommend working with a tax professional to determine the best business structure, calculate your estimated tax payments, identify deductions and credits, and ensure that you are fulfilling your federal and state tax liabilities. A great tax professional will save you time and money, and educate you on important tax matters. By staying informed about business taxes, you can optimize your financial strategy and maximize your profits.
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