Beginner's guide to business tax

Updated July 2023

A business often starts with an idea. Maybe you see an opportunity to innovate an existing product. You might be inspired to take your love of crafting to new entrepreneurial heights. But after you decide to take your wood whittling from a hobby to a business, there can be major tax implications. 

Launching a business today often means creating the perfect branding for your business. This is in addition to producing your product or providing your service. You need more than the perfect cookie recipe your future customers will crave. You’ll also want a memorable logo and packaging, so they’ll remember the name of the treat they enjoyed. It also wouldn’t hurt to have solid marketing so they visit your bakery in the first place.

Unfortunately, many business owners wait until after this to think about taxes. However, taxes wait for no one. The IRS expects reporting from businesses big and small. All of them have to file, those that turn a profit and those that don’t. Deadlines, filings, estimated payments, and regulations can be challenging, but procrastination never helps. As soon as possible, begin tracking and managing taxes and business filings, so you never miss a deadline. 

According to U.S business formation statistics, a record number of businesses have been formed in the last two years. Many new business owners will soon discover that taxes wait for no one. The IRS expects reporting from businesses big and small. All of them have to file, those that turn a profit and those that don’t.

That’s easier said than done and probably leaves you with a few questions

• How does business tax work?
• What types of taxes are my business obligated to pay?
• How much will my business have to pay?
• What can I do to stay ahead?

We created Small Business Taxes for Beginners to answer all those questions for two audiences:

1. Full-time business owners and self-employed individuals
2. Individuals with taxable income not withheld via a W2.

Does that sound like you? Then let’s start at the beginning.

Business structure

Knowing your business’s structure is a vital first step. Managing tax deadlines and regulations begins with knowing what applies to your business. This can vary depending on the structure you choose.

About 70% of all small businesses in the US are sole proprietorships. Other common entity types include limited liability companies (LLCs), partnerships, C corporations, and S corporations. However, when considering your federal taxes, know that the IRS doesn’t recognize an LLC. Instead, according to the IRS, it can be treated as “a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”).”

Tax year

A "tax year" is an annual accounting period for keeping records and reporting income and expenses. In the U.S., the tax year for individuals runs from Jan. 1 to Dec. 31. Business taxes may be filed using a calendar year or a fiscal year.

• Calendar year - 12 consecutive months beginning January 1 and ending December 31.
• Fiscal year - 12 consecutive months ending on the last day of any month except December. A 52-53-week tax year is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month.

Most small businesses choose to run their tax year as the calendar year. However, some choose to use a fiscal tax year. This works for a business with a 12-month accounting cycle that doesn’t begin in January. For your first year in business, you’ll probably have to file for a short tax year for cycles that don’t include a full 12 months.

Types of business taxes

Taxes for small business owners are more complicated than to W-2 taxes. W-2 employees have their state income tax, federal income tax, and FICA taxes (Social Security and Medicare) deducted from their paychecks. The federal, state, and local governments impose various taxes on income, profits, capital gains, wages, and more on businesses.

The first step is knowing what those tax obligations are, given your business structure, location, and circumstance.

Income tax

Business owners are still subject to the state and federal income tax rates on their personal tax returns. Federal income tax is progressive and ranges from 10-37%, depending on your tax bracket. 43 states levy income taxes on taxable income. Whether income tax is progressive or a flat rate depends on the state.

All LLCs, sole proprietorships, partnerships, and S-corporations are pass-through entities.

What is a pass-through entity?

This refers to a business that doesn’t pay its income tax. Instead, its income and losses are passed to each business owner’s personal tax return. There, profits are taxed according to each owner’s individual income tax rate. C-corporations are the only business entities not classified as “pass-through”.

C-corporate income tax

C-corporations are not subject to individual income taxes. Instead, they’re taxed at a flat rate of 21% at the federal level on their taxable income. The income tax a corporation pays at the state level is state dependent. C-corporations are subject to double taxation. Profits passed to shareholders are also taxed on their personal tax returns.

Self-employment tax

Self-employment tax is levied upon sole proprietors, LLC members, and partnerships. Self-employment tax is your payroll tax, or Federal Insurance Contributions Act (FICA). These are payroll payments made to pay for Social Security and Medicare. In a traditional employer-employee relationship, these taxes are split 50/50. If you’re self-employed, you’re responsible for paying both sides because you’re the employee and employer.

This applies to traditional business owners and independent contractors like realtors, Uber drivers, and consultants.

A sole proprietor doesn’t just mean an individual with a registered sole proprietorship. You are a sole proprietor if you receive income from services or products you sell and incur expenses to general that income. Hence why independent contractors fall under the “sole proprietor” umbrella.

Employment tax

Employers pay employment taxes directly to the Internal Revenue Service (IRS). If you have employees, you must report and deposit the following:

• Social Security and Medicare (FICA): Your employees pay half, and you pay the other half.
• Federal Unemployment (FUTA): These taxes are not deducted from employee pay; only an employer pays them.

Payroll taxes vs. employment taxes

“Payroll taxes” is a loose term used to define the subset of employment taxes that appear on an employee's paycheck - Social Security and Medicare. Employment taxes refer to all taxes paid or withheld by an employer.

Employment taxes include the following:

• Federal Income Tax
• Federal Insurance Contribution Act (FICA)
• Federal Unemployment Tax Act (FUTA)
• Additional Medicare Tax

Sales tax

Sales tax is a consumption of tax imposed by governments on the sale of goods and services. Usually, they’re calculated as a percentage of the price. Sales tax is levied at the state level, not by the federal government. This tax is passed to the consumer and is just something businesses are responsible for collecting.

Businesses may be required to collect these taxes on sales and remit them to their state. It’s possible that you could owe sales tax in other states where you do business. This is called nexus, in which your status depends on the state. This could mean physical presence, employees in the state, other affiliates, or large sale amounts. 

Excise tax

An excise tax is a tax the government imposes on specific products like cigarettes, alcohol, gasoline, airline tickets, and sports wagering. Taxpayers include importers, manufacturers, retailers, and consumers depending on the specific tax. The purpose of excise tax is to discourage the consumption of specific goods or to make up for their associated social costs.

Estimated taxes

Estimated taxes are a type of tax that individuals and business owners pay on taxable income that has not been withheld via a W2.

Estimated tax payments are quarterly payments toward the tax your business expects to owe at the end of the tax year for the taxable income you received. Taxable income is any income you receive through services provided, products sold, dividends received, interest received, or any other income that is not taxed.

You must pay estimated taxes if you are an individual, solopreneur, entrepreneur, partner, or shareholder who believes you will owe over $1000 in taxes.

Estimated taxes are paid in four (4) payments over a tax year. Payments are due based on the following schedule:

• January 1 to March 31 – April 15
• April 1 to May 31 – June 15
• June 1 to August 31 - September 15
• September 1 to December 31 – January 15 of the following year

Note: If these due dates fall on a Saturday, Sunday, or a legal holiday, payments are then due the next business day.

How to determine the tax rate for your small business?

How you file, and your tax rate on taxable income depends primarily on your business entity structure. 

You can break small business tax rates into four categories:

• Percentages of income
• Percentages of gross sales
• Tax per dollar of property value
• Percentage of wages

Tax filing requirements

To file your taxes, you’ll need to track down several forms. The paperwork will depend on the structure of your business and whether you have employees or partners.

Tax forms and filing requirements broken down by business type:

Tax filing for sole proprietors

Sole proprietors may have a W2 job in addition to their business. All sole proprietorships are pass-through entities, so profits and losses are passed on to the owner. Form 1040 is the individual tax return that reports personal income. They’ll attach a Schedule C, which reports business profit and loss.

Sole proprietors are responsible for paying the following:

• Federal income tax
• State income tax, if this applies in your home state
• Self-employment tax
• Federal and state estimated taxes
• Sales tax, if applicable

Tax filing for partnerships

Partnerships are pass-through entities, meaning they "pass-through" profits or losses to partners. Each partner's share of profits and losses is usually set out in a written partnership agreement. Partnerships must prepare a federal partnership tax return on Internal Revenue Service Form 1065.

There are several Form 1065 schedules:

• Schedule B: Provides information about your partnership, including types of partners, ownership of corporate shares, and distribution types.
• Schedule K-: The form you’ll issue to shareholders and partners. This will show their share of income, deductions, and credits. Partners will use their K-1 to file their personal tax returns.
• Schedule L: The balance sheet with the assets that existed on the first and last day of the tax year.
• M-1,M-2, and M-3: Some partnerships must also complete schedules M-1, M-2, and/or M-3.

Partners are responsible for paying the following:

• Federal income tax
• State income tax, if this applies in your home state
• Self-employment tax Schedule SE (Form 1040)
• Federal and state estimated taxes
• Franchise, sales, and excise tax, if applicable in your home state

Tax filing for LLCs

A Limited Liability Company (LLC) is an entity created by state statute. The IRS will assign one of two default tax designations to an LLC, depending on the number of members.

• Sole proprietorship if an LLC only has one owner. Single-member LLCs report their business income and expenses on Schedule C of the member's personal income tax return.
• General partnership if an LLC has more than one member. In Multi-member LLCs, profits and losses are passed to the partners. They are typically proportional to each member's share of ownership in the company.

An LLC can change its tax designation if it adds or subtracts members. An LLC can also elect to be taxed as a C-corporation by filing Form 8832, Entity Classification Election.

LLC members are responsible for paying the following:

• Federal income tax
• State income tax, if this applies in your home state
• Self-employment tax Schedule SE (Form 1040)
• Federal and state estimated taxes
• Franchise, sales, and excise tax, if applicable in your home state

Paying your business taxes

The first thing to know is that you’re required to make estimated quarterly tax payments as soon as you make money as a self-employed person. Generally, the threshold is if you expect to owe a tax of $1,000 or more when your return is filed. Keeping these reporting and payment deadlines is vital to avoid fees and penalties. 

Of course, you’ll also be responsible for filing your annual tax return. Once you’ve done this, you’ll need to keep solid records. In fact, according to the IRS, it’s best to hold on to important documents for at least three years.

You can pay your taxes at IRS.gov/payments by creating an account or logging in.

Tax deductions

Business owners have some of the best tax advantages. If you use the tax code to your advantage, you can lower your taxable income, sometimes all the way to zero. The IRS considers a business expense deductible as long as it’s an ordinary and necessary expense to the company.

• Necessary expense: Something that is helpful and appropriate for your business
• Ordinary expense: Something common and accepted in your type of business

The best practice for taxing tax deductions is to start early. Set up good bookkeeping practices and keep accurate records of your cash flow. That way, when it’s time to file, you can confidently claim deductions. Start with these tax deductions if you want to bump up your tax savings.

Small business tax tips

If you made it to this point in our Small Business Tax For Beginners guide, you should have an understanding of the following:

• What your business structure is, and what that means
• The types of business taxes you may be liable to pay
• What estimated taxes are, and why they’re important for business owners
• And the tax filing requirements for your business type

Let’s wrap up this guide with some general tips that will make calculating, filing, and staying compliant with your taxes easier.

Claim all income that is reported to the IRS

Do not make the mistake of thinking you don’t need to pay taxes or that you don’t need to claim income because you received it in cash or from a side business. 

The penalty for not filing your tax return is usually 5% of the tax you owe for each month or partial month your return is late. Underreporting your business income to the IRS can lead to fines, penalties, and even jail time.

Collect tax, financial, and business formation records

You'll need good bookkeeping to track the overall cash flow of your business throughout the year. You'll need to account for the movement of money and identification documents. Ideally, at least for a few years, you’ll keep some tangible proof of these expenses and documents. For older records, a scanned or digital copy will often suffice. 

• Identifying documentation: These are the records you’ll probably need to show the IRS to identify you or your business. Examples could include a legal name, an Employer Identification Number, and business licenses. 
• Accounting records: These records help you prove the broader financial state of your business. They should include any interaction you’ve had with the IRS in the past few years. Examples include past tax returns, quarterly tax filings, and statements from your bank and credit card companies.
• Expense receipts: Keep itemized lists with your accounting system to maintain your business expense receipts. Hold on to receipts if you purchase office supplies or furniture or make a charitable donation. Keep invoices from any business-related bills for services like marketing.

Separate business from personal expenses

Separate income from business from your personal checking or savings accounts. This allows you to track tax write-offs and increase your accounting accuracy, as all transactions into and out of the account will be dedicated to your business.

Stay compliant

The more you know about the tax system and business tax requirements, the better equipped you’ll be to stay compliant. Staying compliant will help you avoid fees and penalties, audits, or even losing your status as a business owner.

Have a tax planning strategy

Do you want to owe less in taxes as a business owner, avoid tax season stress, and save massive amounts of time? Then you need a tax planning strategy. Dedicating time upfront to your tax planning now could save your business time and money in the future.

Set money aside

One of the biggest surprises to new business owners is quarterly estimated tax payments. A general rule of thumb is to set aside 30-35% of your income for your taxes. The last thing you want is to owe more than necessary to the IRS and other tax authorities because you failed to save.

Take the complication out of small business tax

After you’ve set up your business and completed your first tax year, it’s essential to maintain best practices going forward. Find a system for bookkeeping and recordkeeping that works for you and your business, and be consistent. It’s also crucial to stay up to date with deadlines with resources like ComplYant and keep an eye on local regulations, as they can change occasionally.