Tackle your taxes: Five questions to consider
Ask yourself these five questions to understand your tax obligations and avoid penalties.
Understanding business taxes is critical to fulfilling your legal obligations and avoiding penalties.
"The basic rule of thumb is, if you fail to pay what you owe in taxes, take the number you would have paid and multiply it by three. That's what you're going to end up paying: a combination of the taxes you owe, plus interest and penalties," says Coco Soodek, attorney and CEO of Profit and Laws, Inc.
As you create or revise your business plan, consider these five questions, which can help you understand and meet your tax requirements.
1. Who owns your business?
Businesses are typically structured as C corporations, S corporations, LLCs, partnerships, or sole proprietorships, each of which has distinct advantages, disadvantages, and tax treatments.
For small businesses and startups, C corporations are often considered the least attractive option, Soodek says, because they're subject to double taxation. That means both the business and its individual owners must pay taxes on income, which can make distributing profits to owners slightly more expensive. On the other hand, the most popular entities for small businesses are S corporations and LLCs, which provide similar legal protections to C corporations without the burden of double taxation.
When choosing your business structure, keep in mind ownership, financing, and tax implications.
2. In which states does your business operate or sell?
State laws can impact your tax burden beyond federal taxes. Where you, your employees, and your customers are based have implications in the form of:
Sales tax: If you have a store, office, warehouse, or employee in a certain state, then you have a "physical presence" there. Some states require you to collect and pay sales tax for sales to customers in the states in which you have a physical presence.
Income tax: In addition to federal income tax, you may be obligated to pay a business or corporate income tax to the state in which you operate.
Franchise tax: You may be required to pay a franchise tax to use a state's infrastructure and do business there. The amount varies by state but is often determined by business net worth or invested capital.
Employment taxes: If you have employees, you may have employment tax obligations to the states in which they work in addition to the federal government.
3. Do you have employees?
As an employer, you have tax obligations not only for yourself, but also for your employees.
From employees' wages, you must withhold federal, state, and — in some jurisdictions — local income tax, as well as Social Security and Medicare tax, the cost of which you split with employees.
"Many companies call their workers 'independent contractors' and leave it to them to deal with their own tax obligations," Soodek says. "Often, however, that person qualifies as an employee under the law, in which case you have an obligation to withhold taxes on his or her payroll and pay it to the government."
For Federal Insurance Contributions Act (FICA) tax and Medicare, you will also have employer tax liability for those same taxes. This becomes an expense to your business. For that reason, it’s critical to understand how your employees are classified and pay taxes accordingly.
4. What assets will you buy, lease, or repair this year?
If you plan to purchase, lease, or repair assets, you may be able to deduct or depreciate (i.e., deduct in stages over time) all or a portion of the costs from your tax bill. This can include transactions related to capital equipment, furniture, and software.
Carefully track your transactions, as the availability and amount of deductions and depreciation may depend on when they occur, says Soodek. Also, talk to your accountant so he or she can help you take advantage of all the deductions and depreciation to which you're entitled.
5. How do you keep records?
Carefully document your income, expenses, and other transactions so you can:
Prepare tax returns more efficiently. "Readily available records make the tax preparation process much more efficient, accurate, and cheaper for you," says Soodek.
Manage an Internal Revenue Service (IRS) audit. The IRS may examine your business's finances if it suspects information has been reported incorrectly or if you've been selected at random for an audit. Keeping thorough records can help you navigate an IRS audit smoothly or avoid one altogether.