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Updated: March 27th, 2020
While starting a business can be exciting, new business owners may have a steep learning curve ahead of them. You may be surprised, and perhaps disappointed, to find how much you could have to pay in taxes.
Your city, state, and the federal government might all want a piece of your profits, and you could have to pay business-specific types of taxes, such as payroll tax, excise tax, and self-employment tax. However, your federal income taxes will likely be the largest portion of your business tax payments, so it’s important to understand how they can impact your business and profits.
While your overall tax situation could be very different once you start a company, your federal income tax rate might not — it depends on your profits and the type of business entity you formed.
If you formed a pass-through business entity (e.g., you’re a sole proprietor, in a partnership, or with some types of LLCs), all your business profits get passed on to your individual tax return. With S corporations and LLCs with S corp designations, you pay yourself a salary and can take other profits out of the company through owner distributions. Still, the profits get passed on to your individual tax return.
Although you may have to file additional forms with your annual tax return, the same federal tax brackets apply to your income. The big differences happen before you fill out your return, when you’re determining your business profits and finding out how much you have pay in federal income tax.
C corporations are taxed differently, though. Your business will have to file its own tax return and pay a 21 percent federal income tax (as of 2018). Then, you may have to pay individual taxes on the income you made as an employee and owner of the company. C corporations can lead to double-taxation, but you may be able to minimize the corporate-level taxes and come out ahead.
You may have more options to lower your tax bill as a business owner than you did as an employee. Your business could qualify for tax credits, and there are a variety of business expenses that can lower your business income.
For example, you may be able to claim a research and development (R&D) tax credit. R&D tax credits aren’t just for scientific discoveries or large corporations — you might be eligible if you’re designing a novel product, developing a patent, or creating software that increases your business’ productivity.
Another option could be to hire one of your children to help in your new venture. As long as your child contributes to the business, perhaps by cleaning the office or doing basic data entry, you can pay a reasonable wage for the work. The wages would be a business expense, and children who are 18 and under might not need to pay income or FICA taxes on the first $12,000 they make from working each year.
Everyday expenses might also help lower your tax bill. You can write off the cost of driving between different client meetings or sites, although the route from your home to the first site and from the last site home are non-deductible commuting miles. If you have a home office, you might even be able to write off part of your utility bill.
You can also write off expenses that exceed your income for the year, resulting in a net operating loss that can offset other income. Or, you can carry the loss forward and deduct it from your income when you file a tax return in the future.
As an employee, your company would have paid payroll taxes to the federal government every month. Now as the business owner, you’re responsible for keeping up with ongoing tax payments throughout the year.
If you have an S corporation or C corporation, you may need to run payroll and make payroll tax payments at least monthly. However, even if you don’t run payroll, you could need to make estimated tax payments every quarter.
Keep in mind that the quarters don’t evenly divide the year. If your business uses the calendar year, your estimated tax payments will be due on April 15, June 15, Sept. 15, and Jan. 15 (or the following non-holiday weekday when those dates fall on a Saturday, Sunday, or legal holiday). You’ll need to calculate how much you have to pay based on your income, and you might need to also make estimated state income tax payments.
Failing to file quarterly taxes could lead to penalties and interest if you wind up owing at least $1,000 in federal income tax when you file your annual return. However, you’re off the hook if this is your first year in business — though it’s good to get in the habit early.
Now that you’re working for yourself, you may have to pay both the employer and employee portion of your Social Security and Medicare taxes. These aren’t technically income taxes but could be a surprise if you’re new to business. Combined, they come out to 15.3 percent (12.4 percent for Social Security and 2.9 percent for Medicare).
One slight benefit is that you can deduct the employer-half of the tax payments from your income, which can lower your income tax. However, you could still wind up paying more in taxes than if you earned an equal amount of money as an employee.
Business owners can choose between several types of tax-advantaged retirement accounts and might be able to more than they could as employees. Your retirement contributions may be tax deductible, which can lower your taxable income this year, and the money can grow tax-free in the account until you need to it during retirement.
There’s a lot to learn when it comes to finances and business. Federal income taxes are an important piece of the puzzle, as are local and state taxes, and business financing in general. Keeping up to date can be difficult as the tax laws change and as your business grows. It’s worth it, though, as making a regular practice of learning about business taxes and financing could help you save money and stay ahead of the competition.
Funding Circle believes informed consumers are better consumers. We strive to provide informative and educational content useful for you and your business. However, please note that tax laws and regulations are complex and subject to change. We strongly recommend consulting your financial or tax professional regarding your specific circumstances.