Small businesses play a huge role in the United States economy. According to Census Bureau data, 98 percent of the more than 28 million businesses in America have fewer than 20 employees [source: SBE Council]. Small businesses produce 46 percent of the U.S. Gross Domestic Product and accounted for 63 percent of net new job creation between 1993 and 2013 [sources: SBA, SBA].
Small businesses must pay taxes just like individual workers or large corporations. The simple story is that small businesses pay taxes on their net profit; that's the sum of all business earnings minus normal businesses expenses. Depending on the size and nature of the small business, figuring taxes can be straightforward or highly complex. This article will give you a strong foundation for understanding the types of taxes that small businesses pay and ways to lower the tax burden.
First, what is a small business? The U.S. Small Business Administration categorizes all business with fewer than 500 employees as small businesses. For tax purposes, though, we're going to narrow that definition to exclude all corporations. Corporations follow a separate set of tax rules from unincorporated businesses. A more useful definition of a small business, for tax purposes, is any business venture that requires the owner to file a Schedule C — "Profit or Loss from Business" — with the IRS.
The following types of small businesses are required to file a Schedule C [source: IRS]:
- Self-employed – also known as an independent contractor, this is a business owner who supplies services to other businesses or clients
- Sole proprietorship – a business owned by one person (with or without other employees)
- Limited liability company (LLC) – only one member is taxed using a Schedule C
- Qualified joint venture – spouses who own and operate an unincorporated business without any other employees; if they have employees, it's a partnership, which requires a different tax form
A small business doesn't have to be a taxpayer's only source of income. You can have a salaried position as a middle manager, but also sell handmade sweaters online. The sweater website qualifies as a small business as long as your intention is to make money. If there's no intention to make money — you give the sweaters away as gifts or donate them to a homeless shelter, for example — then it's a hobby, not a business. The IRS doesn't tax hobbies; not yet, at least.
Keep reading to learn what kind of business income is taxable.
Taxable Small Business Income
To keep things simple, the IRS defines business income as money you earn in connection with a business. Or conversely, money that you would not have earned if you didn't have the business. It doesn't matter if you work full time, part time or one day a year. If the business makes (or loses) money, the IRS wants to know about it on the Schedule C.
Not only does the IRS want to know about income that you receive in the form of money — cash, checks, credit card payments — but the value of any prizes, property or services you receive as a result of doing business. Bartering, for example, involves the exchange of goods or services of equal value. You might assume that if no cash changes hands, then it's none of the IRS's business. Not so. The IRS requires you to include as income the fair market value of any goods or services received through bartering. (Don't worry, you can deduct the price of the stuff you traded away later).
If you are self-employed or an independent contractor, you don't receive regular salary or wages. For tax purposes, your income is called nonemployee compensation [source: IRS]. Every January, you should receive a Form 1099-MISC from each of your clients showing the total amount of nonemployee compensation you received for the tax year.
One important tax consideration for small businesses is what kind of accounting method to use for keeping track of business income and expenses: cash accounting or accrual accounting. The accounting method you choose will determine whether certain income and expenses are tallied during the current tax year or the next.
- Cash accounting: Income and expenses are included in the tax year when the money actually changes hands. This accounting method is good for businesses that don't carry inventories and don't have long lag times between invoicing for goods and services, and receiving payment.
- Accrual accounting: Income and expenses are included in the tax year they are incurred, not when the money changes hand. Many business owners feel that accrual accounting gives a more accurate picture of business finances. If you sell a shipment of product in November, for example, but the client doesn't pay until January, it's not accurate to say you made the sale in January.
One more important note: Federal and state governments collect income taxes year-round. Employers withhold these taxes from their employees' paychecks. If you are self-employed or an independent contractor, you are required to pay estimated taxes quarterly, not just one lump sum in April. Failure to pay estimated taxes results in a penalty.
Next up, the good news: small business tax deductions.
Deductible Small Business Expenses
The tax code offers a ton of deductions to small business owners. Just about every conceivable expense is tax-deductible if you can prove it relates to the running of your business. Whatever you do, don't forget the first rule of business deductions: Save your receipts!
If you run a business that involves buying or making goods to sell, then your first step is to calculate something called cost of goods sold. Essentially, this covers all of the expenses involved in manufacturing or buying goods wholesale and selling them retail. When you subtract the cost of goods sold from gross revenue (income), you get a figure called gross profit. This is your taxable income. Here's where the real deducting begins.
The following are some of the most common and lucrative business tax deductions [source: IRS]:
- Employee pay: If you have employees, you can deduct all salary and wages paid during the tax year.
- Taxes: Certain federal and state taxes on business income are deductible, including employment taxes if you have employees and half of the self-employment tax if you're self-employed.
- Depreciation: Business equipment, vehicles, machinery and tools are tax deductible, but not all at once. The IRS depreciation tables allow you to deduct a percentage of the cost of business equipment over the usable life of the product, so you will take the deduction over a number of years.
- Car and truck expenses: Using the standard mileage deduction, you can deduct the cost of local travel for your business, such as delivering products to stores. Sadly, commuting doesn't count.
- Travel expenses: These are expenses incurred for traveling overnight away from home for business, such as meetings with clients or professional conventions.
- Meals and entertainment: You can deduct up to 50 percent of the cost of meals, sporting event tickets or golf outings if the express purpose is for entertaining current or potential business clients.
- Home office: You can deduct expenses related to a portion of your home — percentage of mortgage/rent, Internet/phone service, office supplies — if it's used exclusively and regularly for business.
For a full list of potential business deductions, read the "business expenses" section of IRS Publication 334: Tax Guide for Small Businesses. Depending on the nature of your business, you also may be eligible for certain general business tax credits, including credits for driving an alternative-fuel vehicle or helping to manufacture low-income or energy-efficient housing.
To wrap up our tax guide for small businesses, let's talk about who is required to pay employment taxes and self-employment taxes.
Employment and Self-employment Taxes
In addition to collecting income tax on businesses, the federal government collects a package of taxes from small businesses collectively known as employment taxes. The amount and nature of the taxes are different for small business owners with employees and for self-employed individuals.
Let's start with small business owners who have employees. First of all, as an employer, you need to apply for an employer identification number (EIN) with the IRS in order to file your taxes. Second, you are responsible for keeping track of three (or four) different taxes related to each of your employees:
- Social Security and Medicare taxes (FICA)– you pay half of these contributions to the Social Security and Medicare trust funds, and withhold the other half from your employees' paychecks
- Federal income tax – your employee is the one who pays, but you are responsible for withholding the amount from each paycheck
- Federal unemployment tax (FUTA) – you pay the full amount for each employee, plus any contributions to state unemployment plans
At the end of the tax year, small business owners with employees must report all of these withholdings to both the IRS and their employees. The employees receive a W-2 form detailing how much taxes were withheld for the year. If you pay independent contractors, you will have to send them 1099-MISC forms showing their nonemployee compensation.
Self-employed people and independent contractors are charged a self-employment tax, which is equal to the full amount of Social Security and Medicare contributions for the year. In 2014, the self-employment tax is 15.3 percent of net earnings (12.4 percent for Social Security and 2.9 percent for Medicare) [source: IRS]. As mentioned earlier, self-employed small business owners can deduct half of the cost of the self-employment tax. Self-employed folks don't have to pay unemployment taxes for themselves because they aren't eligible for unemployment benefits.
For lots more information on employment taxes, federal taxes and running a successful small business, check out the related HowStuffWorks links on the next page.
Author's Note: Tax Guide for Small Businesses
Between my wife and I, we technically run three separate small businesses. You would think this would make me an expert on small business taxes. For the IRS auditors reading this, yes, I am a small business tax expert. For the rest of you, I admit that I'm still getting the hang of it. I'm not worried about breaking the rules; I'm more concerned about not claiming enough deductions. I know that if I kept every receipt from every gas station and office supply store, I could whittle down my taxable income by a few more percentage points. I start every tax year on the right foot, keeping careful track of all expenses in a tidy three-ring binder, but it always devolves into a shoebox full of chaos by December. I promise to do better next year, unless you are the auditor, in which case, I'm perfect!
- IRS. "Closing a Business Checklist" (Dec. 5, 2014) http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Closing-a-Business-Checklist
- IRS. "Publication 334 (2013): Tax Guide for Small Businesses" (Dec. 5, 2014) http://www.irs.gov/publications/p334/
- IRS. "Self-Employment Tax (Social Security and Medicare)" (Dec. 5, 2014) http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Self-Employment-Tax-Social-Security-and-Medicare-Taxes
- Small Business and Entrepreneurship Council, "Small Business Facts & Data" (Dec. 5, 2014) http://www.sbecouncil.org/about-us/facts-and-data/
- TurboTax. "How an S-Corp Can Reduce Your Self-Employment Taxes." (Dec. 10, 2014)
- U.S. Census Bureau. "Statistics of U.S. Businesses (2011)" (Dec. 5, 2014) http://www.census.gov/econ/susb/
- U.S. Small Business Administration. "Frequently Asked Questions" (Dec. 5, 2014) https://www.sba.gov/sites/default/files/FAQ_March_2014_0.pdf
- U.S. Small Business Administration. "Small Business GDP: Update 2002 – 2010." January 2012 (Dec. 5, 2014) https://www.sba.gov/content/small-business-gdp-update-2002-2010