Start Your Own Business

When it comes to taxes, there’s no way to get around the fact that you have to pay them regularly. Federal, state, and local taxes combined can take a big chunk out of your company’s money, leaving you with less cash to operate your business.

That’s why it’s important to stay abreast of your business’s tax situation and work with a qualified accountant to understand all that’s required of you by federal and state governments. The task is by no means simple. New business owners face a host of tax requirements and ever-changing rules.

If you miss deadlines or fail to comply with specific rules, you may be hit with large penalties, and, in the worst-case scenario, be forced to close up shop. You’ll also want to pay close attention to tax planning, which will help you find legitimate ways to trim your overall tax liability. Your goal is to take the deductions to which you’re entitled and to defer taxes as long as you possibly can.

While a knowledgeable accountant specializing in small-business tax issues will keep you out of potential tax quagmires, you’ll be on more solid footing if you spend time acquiring your own working knowledge and understanding of the tax laws.

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Get the scoop on wage reporting for yourself and your employees at the Social Security website at ssa.gov.

First Things First

One of the first steps you will take as a business owner is to obtain a taxpayer identification number so the IRS can process your returns. There are two types of identification numbers: a Social Security number and an Employer Identification Number (EIN).

The EIN is a nine-digit number the IRS issues. It is used to identify the tax accounts of corporations, partnerships, and other entities. You need an EIN if you have employees, operate your business as a corporation or partnership, or have a Keogh plan. Be sure to include your EIN on all returns or other documents you send to the IRS.

You can apply for an EIN by phone, fax, mail, or online (as long as your business is an entity that is allowed to apply online). You can receive your EIN immediately by phone or by going online. To apply online, go to www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Apply-for-an-Employer-Identification-Number-(EIN)-Online. A completed fax request takes about four to five business days. An online application can be fulfilled in half that time. If you apply by mail, be sure to send in Form SS–4 (Application for Employer Identification Number) at least four or five weeks before you need the EIN to file a return or make a deposit.

Ins and Outs of Payroll Taxes

If you do any hiring, your employees must complete Form I-9 (Employment Eligibility Verification) and Form W–4 (Employee’s Withholding Allowance Certificate). Form I–9 provides verification that each new employee is legally eligible to work in the United States. This form can be obtained from the U.S. Citizenship and Immigration Service (USCIS) by visiting uscis.gov; keep this form in your files in the event an IRS or USCIS inspector wants to see it. Your employees should also complete a state withholding certificate (similar to the W–4) if your state imposes personal income taxes.

Form W–4 indicates the employee’s filing status and withholding allowances. These allowances are used to determine how much federal income tax to withhold from an employee’s wages. To determine how much to withhold from each wage payment, use the employee’s W–4 and the methods described in IRS Publications 15, Employer’s Tax Guide, and 15–A, Employer’s Supplemental Tax Guide. These publications are available online at irs.gov.

You must also withhold Social Security and Medicare taxes—these are known as FICA (Federal Insurance Contributions Act) taxes. The FICA tax actually consists of two taxes: a 6.2 percent Social Security tax and a 1.45 percent Medicare tax. To calculate the tax you need to withhold for each employee, multiply an employee’s gross wages for a pay period by the tax rates. In addition, as an employer, you are required to pay a matching amount of FICA taxes on each of your employees.

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Consider using a payroll tax service to take care of all payroll tax requirements. The fees charged by such services are relatively reasonable. In addition, these firms specialize in this area and know the ins and outs of all the rules and regulations. With a service, you don’t have to worry about making mistakes or being tardy with payments.

Here’s how it works: If an employee has gross wages of $1,000 every two weeks, you must withhold $62 ($1,000 x 0.062) in Social Security taxes and $14.50 ($1,000 x .0145) in Medicare taxes, or $76.50. As an employer, you owe a matching amount as well, so the total amount in FICA taxes to be paid is $153. In the 2014 tax year, the maximum amount of wages subject to Social Security tax is $117,000. The Medicare tax rate is 1.45 percent on the first $200,000 and 2.35 percent above $200,000. The IRS requires any business paying more than $200,000 annually in payroll taxes or other federal taxes to pay them through the Electronic Federal Tax Payment System (EFTPS). If you pay less than that amount, you can still deliver a check for payroll taxes owed to an authorized financial institution able to accept federal tax deposits. To enroll in EFTPS, call 1-800-945-8400 or 1-800-555-4477. You can obtain additional information on EFTPS requirements by accessing Publication 966 (www.irs.gov/pub/irs-pdf/p966.pdf). You can also register online and get more information from www.eftps.gov. You typically pay these taxes monthly, depending on the size of your business. Approximately five to six weeks after you receive your EIN, the IRS will send you the coupon book.

In addition to making your monthly payroll deposits, you are required to file quarterly Form 941 (Employer’s Quarterly Federal Tax Return). This is a form that provides the government with information on the federal income taxes you withheld from your employees’ pay as well as the FICA taxes you withheld and paid. It also tells the government when the taxes were withheld so the IRS can determine if the federal tax deposit was made on time.

Another tax you have to pay is FUTA (Federal Unemployment Tax Act) taxes, which are used to compensate workers who lose their jobs. You report and pay FUTA tax separately from FICA and withheld income taxes.

You pay FUTA tax on your payroll if during the current or prior calendar year you meet one of two tests: You paid total wages of $1,500 to your employees in any calendar quarter, or you have at least one employee working on any given day in each of 20 different calendar weeks.

The FUTA tax is figured on the first $7,000 in wages paid to each employee annually. The gross FUTA tax rate is 6 percent. However, you are given a credit of up to 5.4 percent for the state unemployment tax you pay, effectively reducing the tax rate. As an employer, you pay FUTA tax only from your own funds. Employees do not have this tax withheld from their pay. You generally deposit FUTA taxes quarterly. In addition, you must file an annual return for your FUTA taxes using Form 940 (Employer’s Annual Federal Unemployment Tax Return), which must be filed by January 31 of the following year. Most small employers are eligible to use Form 940-EZ.

Federal payroll taxes are not your only concern. States and localities have their own taxes, which will most likely affect you. Forty-one states have a personal income tax on wages (nine do not), which means you are also required to withhold this tax from your employees’ wages in those 41 states. The same is true if you do business in a city or locality with an income tax.

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If you withhold taxes but don’t deposit or pay them to the IRS, you face a penalty on the unpaid tax, plus interest. If you deposit the taxes late, you will also be hit with a penalty.

When applying for an EIN from your state, which you will need to do business there, ask about the procedures and forms for withholding and depositing state income taxes. The place to start is with your state department of revenue.

At the end of the tax year, you must furnish copies of Form W-2 (Wage and Tax Statement) to each employee who worked for you during the year. Be sure to give the forms to your employees by January 31 of the year after the calendar year covered by the form. Form W-2 provides information on how much money each employee earned and the amount of federal, state, and FICA taxes you withheld. You must send copies of W-2s to the Social Security Administration as well.

Declaration of Independents

You may decide your business can’t afford to hire too many full-time employees, and you’d like to use the services of an independent contractor. With an independent contractor, you don’t have to withhold and pay the person’s income, Social Security, and Medicare taxes.

While independent contractors (ICs) do translate to lower payroll costs, be advised that the IRS scrutinizes the use of ICs very carefully. The IRS wants to make sure that your workers are properly classified and paying the government the necessary income and payroll taxes that are due.

To stay out of hot water with the IRS, be sure the workers you classify as ICs meet the IRS definition of an IC. The determining factors fall into three main categories: behavioral control, financial control, and relationship of the parties. The IRS uses 20 factors when deciding a worker’s status. Here are some of the major ones:

Who has control? A worker is an employee if the person for whom he works has the right to direct and control him concerning when and where to do the work. The employer need not actually exercise control; it is sufficient that he has the right to do so. An independent contractor also has freedom to set his or her own work hours.

Right to fire. An employee can be fired by an employer. An IC cannot be fired so long as he or she produces a result that meets the specifications of the contract.

Training. An employee may be trained to perform services in a particular manner. However, ICs ordinarily use their own methods and receive no training from the employer.

Expenses and payments. Independent contractors are more likely to have unreimbursed expenses than employees do. And they’re more likely to be paid a flat fee for a job or a limited scope of work if paid hourly.

Benefits. Independent contractors do not generally get benefits like insurance, paid vacation, or sick days. And the relationship is not considered permanent—rather the relationship is defined by a specific project or period of time.

It’s a Plan

Employee benefits such as health insurance and pension plan contributions provide attractive tax deductions. With a qualified pension plan, you not only receive a tax deduction for the contributions you make on behalf of your employees, but the money you contribute to your own retirement account is also deductible and is allowed to grow tax-deferred until withdrawn. (A qualified plan meets the requirements of the Employee Retirement Income Security Act [ERISA] and the Internal Revenue Code.)

There are many different plans available, ranging from a Savings Incentive Match Plan for Employees (SIMPLE) to a traditional 401(k) plan (see Chapter 24). The pension design may be slightly different, but they all offer important tax benefits for business owners. So take the time to find out which plan will work best for you.

As far as health insurance is concerned, if your business is incorporated and you work for it as an employee, you can deduct all costs for your own insurance as well as for the coverage for your employees. Self-employed individuals can deduct 100 percent of the premiums paid for health insurance for themselves and their families, as long as the amount isn’t more than the net earnings from the business.

To stay on the right side of the IRS, it is best to document the relationship you have with any ICs in a written contract. This can be a simple agreement that spells out the duties of the IC. The agreement should state that the independent contractor, not the employer, is responsible for withholding any necessary taxes. In addition, have the IC submit invoices. It’s a good idea to have a copy of the contractor’s business license and certificate of insurance as well as his or her business card. Also, be sure you file Form 1099–MISC (Miscellaneous Income) at year-end, which is used to report payments made in the course of a transaction to another person or business that is not an employee. By law, you are required to file and give someone Form 1099 if you pay that person more than $600 a year. The form must be given to the IC by January 31 of the following year; Form 1099 with its transmittal Form 1096 must be filed with the IRS by February 28.

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If you hire independent contractors, make sure you know whether they are covered under your state’s workers’ comp laws. If an independent contractor is injured on the job in a state where he’s not covered by workers’ comp, he’s not limited in the type of civil action he can file against the employer. If he is covered by workers’ comp laws, the contractor is limited to the remedies provided under those laws.

Whether an individual is determined to be an independent contractor or an employee, it is required that you obtain their complete name, Social Security number, and address before any money is paid. If this information is not obtained, you are required to withhold backup withholding taxes for federal income taxes.

If the IRS finds you have misclassified an employee as an independent contractor, you will pay a percentage of income taxes that should have been withheld on the employee’s wages and be liable for your share of the FICA and unemployment taxes, plus penalties and interest. Even worse, if the IRS determines your misclassification was “willful,” you could owe the IRS the full amount of income tax that should have been withheld (with an adjustment if the employee has paid or pays part of the tax), the full amount of both the employer’s and employee’s share of FICA taxes (possibly with an offset if the employee paid self-employment taxes), interest, and penalties.

Be advised that there is some relief being offered. If a business realizes it is in violation of the law regarding independent contractors, it can inform the IRS of the problem and then properly classify the workers without being hit with an IRS assessment for prior-year taxes. The newer Voluntary Classification Settlement Program allows you to receive partial relief from missed federal employment taxes while reclassifying workers for future tax periods. The program is voluntary and has some eligibility requirements. You can apply to participate by filing Form 8952 and eventually entering into an agreement with the IRS that typically involves paying 10 percent of the tax liability that would have been due, without penalties or interest.

Selecting Your Tax Year

When you launch your business, you’ll have to decide what tax year to use. The tax year is the annual accounting period used to keep your records and report your income and expenses. There are two accounting periods: a calendar year and a fiscal year.

A calendar year is 12 consecutive months starting January 1 and ending December 31. Most sole proprietors, partnerships, limited liability companies, and S corporations use the calendar year as their tax year. If you operate a business as a sole proprietorship, the IRS says the tax year for your business is the same as your individual tax year.

A fiscal tax year is 12 consecutive months ending on the last day of any month other than December. For business owners who start a company during the year and have substantial expenses or losses, it may be smart to select a fiscal year (as long as the IRS allows it) that goes beyond the end of the first calendar year. This way, as much income as possible is offset by startup expenses and losses.

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Once you have selected to file on either a calendar- or fiscal-year basis, you have to get permission from the IRS to change it. To do so, you must file Form 1128, and you may have to pay a fee.

Filing Your Tax Return

Your federal tax filing obligations and due dates generally are based on the legal structure you’ve selected for your business and whether you use a calendar or fiscal year.

Sole proprietorships. If you are a sole proprietor, every year you must file Schedule C (Profit or Loss From Business) with your Form 1040 (U.S. Individual Income Tax Return) to report your business’s net profit and loss. You also must file Schedule SE (Self-Employment Tax) with your 1040. If you are a calendar-year taxpayer, your tax filing date is April 15. Fiscal-year taxpayers must file their returns no later than the 15th day of the fourth month after the end of their tax year.

In addition to your annual tax return, many self-employed individuals such as sole proprietors and partners make quarterly estimated tax payments to cover their income and Social Security tax liability. You must make estimated tax payments if you expect to owe at least $1,000 in federal tax for the year after subtracting your withholding and credits and your withholding will be less than the smaller of: 1) 90 percent of the tax to be shown on your current year tax return or 2) 100 percent of your previous year’s tax liability. The federal government allows you to pay estimated taxes in four equal amounts throughout the year on the 15th of April, June, September, and January.

Partnerships and limited liability companies (LLCs). Companies set up with these structures must file Form 1065 (U.S. Return of Partnership Income) that reports income and loss to the IRS. The partnership must furnish copies of Schedule K–1 (Partner’s Share of Income, Credits, Deductions), which is part of Form 1065, to the partners or LLC members by the filing date for Form 1065. The due dates are the same as those for sole proprietors.

Corporations. If your business is structured as a regular corporation, you must file Form 1120 (U.S. Corporation Income Tax Return). For calendar-year taxpayers, the due date for the return is March 15. For fiscal-year corporations, the return must be filed by the 15th day of the third month after the end of your corporation’s tax year.

S corporations. Owners of these companies must file Form 1120S (U.S. Income Tax Return for an S Corporation). Like partnerships, shareholders must receive a copy of Schedule K–1, which is part of Form 1120S. The due dates are the same as those for regular corporations.

“Opportunities are usually disguised as hard work, so most people don’t recognize them.”

—ANN LANDERS

Sales Taxes

Sales taxes vary by state and are imposed at the retail level. It’s important to know the rules in the states and localities where you operate your business, because if you are a retailer, you must collect state sales tax on each sale you make.

While a number of states and localities exempt service businesses from sales taxes, some have changed their laws in this area and are applying the sales tax to some services. If you run a service business, contact your state revenue and/or local revenue offices for information on the laws in your area.

Before you open your doors, be sure to register to collect sales tax by applying for a sales permit for each separate place of business you have in the state. A license or permit is important because in some states it is a criminal offense to undertake sales without one. In addition, if you fail to collect sales tax, you can be held liable for the uncollected amount.

If you’re an out-of-state retailer, such as a mail order seller who ships and sells goods in another state, be careful. In the past, many retailers have not collected sales taxes on the sales of these goods. Be sure you or your accountant knows the state sales tax requirements where you do business. Just because you don’t have a physical location in a state doesn’t always mean you don’t have to collect the sales tax.

Many states require business owners to make an advance deposit against future taxes. Some states will accept a surety bond from your insurance company in lieu of the deposit.

It’s possible for retailers to defer paying sales taxes on merchandise they purchase from suppliers. Once the merchandise is sold, however, the taxes are due. The retailer adds the sales taxes (where applicable) to the purchase. To defer sales taxes, you need a reseller permit or certificate. For more details on obtaining a permit, contact your state tax department.

Tax-Deductible Business Expenses

According to the IRS, the operating costs of running your business are deductible if they are “ordinary and necessary.” The IRS defines “ordinary” as expenses that are common and accepted in your field of business. “Necessary expenses” are those that are appropriate and helpful for your business. Following are some of the business expenses you may be able to deduct.

Equipment Purchases

Under the Internal Revenue Code Section 179, expensing allowance, business owners can fully deduct from taxable income a limited amount of the cost of new business equipment in a year rather than depreciating the cost over several years. In 2014, the maximum federal allowance is $25,000. For more information, get a copy of IRS Publication 946, How to Depreciate Property, and read “Electing The Section 179 Deduction.” You also can find a free Section 179 calculator at section179.org.

Business Expenses

Some common business expenses for which you can take a deduction include advertising expenses, employee benefit programs, insurance, legal and professional services, telephone and utilities costs, rent, office supplies, employee wages, membership dues to professional associations, and business publication subscriptions.

Auto Expenses

If you use your car for business purposes, the IRS allows you to either deduct your actual business-related expenses or claim the standard mileage rate, which is a specified amount of money you can deduct for each business mile you drive. The rate is generally adjusted each year by the IRS. To calculate your deduction, multiply your business miles by the standard mileage rate for the year.

Start Me Up

The expenses you incur when launching a new business can run into a lot of money. But how do you treat them when it comes time to do your taxes? If you start a business, you may deduct up to $5,000 of startup costs in the year you launch it and another $5,000 in organizational expenses, which include costs related to creating a corporation. These deductions are reduced if you have more than $50,000 of either type of expense. Keep in mind that startup costs that are not deductible in the year you started the business can be amortized over 15 years beginning in the month you launched your business.

Amortization is a method of recovering (or deducting) certain capital costs over a fixed period of time. Startup costs include advertising expenses and any wages you paid for training employees and fees paid to consultants.

If you spent time looking for a business but did not purchase one, the expenses you incurred during the search may be deductible.

If you use the standard mileage rate, the IRS says you must use it in the first year the car is available for use in your business. Later, you can use either the standard mileage rate or actual expenses method. For tax purposes, be sure to keep a log of your business miles, as well as the costs of business-related parking fees and tolls, because you can deduct these expenses.

If you use five or more vehicles at the same time in your business, the IRS requires you to use the actual cost expenses method. With the actual cost method, the IRS allows you to deduct various expenses, including depreciation, gas, insurance, garage rent, leasing fees, oil, repairs, tolls, and parking fees. If you use this method, keep records of your car’s costs during the year and multiply those expenses by the percentage of total car mileage driven for business purposes.

While using the standard mileage rate is easier for record-keeping, you may receive a larger deduction using the actual cost method. If you qualify to use both methods, the IRS recommends figuring your deduction both ways to see which gives you a larger deduction, as long as you have kept detailed records to substantiate the actual cost method. For more details on using a car for business, see IRS Publications 334 (Tax Guide for Small Business) and 463 (Travel, Entertainment, Gift and Car Expenses).

Meal and Entertainment Expenses

To earn a deduction for business entertainment, it must be either directly related to your business or associated with it. To be deductible, meals and entertainment must be “ordinary and necessary” and not “lavish” or “extravagant.” The deduction is limited to 50 percent of the cost of qualifying meals and entertainment.

To prove expenses are directly related to your business, you must show there was more than a general expectation of gaining some business benefit other than goodwill, that you conducted business during the entertainment, and conducting business was your main purpose.

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To help you wade through all the tax laws and regulations, the IRS offers these free publications: Tax Guide for Small Business (Publication 334), Business Expenses (Publication 535), Travel, Entertainment, Gift and Car Expenses (Publication 463), Circular E, Employer’s Tax Guide (Publication 15), and Employer’s Supplemental Tax Guide (Publication 15-A). To obtain copies of these publications, you can download them from the IRS website at irs.gov.

To meet the “associated” with your business test, the entertainment must directly precede or come after a substantial business discussion. In addition, you must have had a clear business purpose when you took on the expense.

Be sure to maintain receipts for any entertainment or meal that costs $75 or more, and record all your expenses in an account book. Record the business reason for the expense, amount spent, dates, location, type of entertainment, and the name, title, and occupation of the people you entertained.

Travel Expenses

You can deduct ordinary and necessary expenses you incur while traveling away from home on business. Your records should show the amount of each expense for items such as transportation, meals, and lodging. Be sure to record the date of departure and return for each trip, the number of days you spent on business, the name of the city, and the business reason for the travel or the business benefits you expect to achieve. Keep track of your cleaning and laundry expenses while traveling because these are deductible, as is the cost of telephone, fax, and modem usage.

In the Red?

If you find, after you’ve tallied up all your business deductions and subtracted them from your income, that you’re in the red for the year, don’t despair. There’s something called the net operating loss deduction that will help. It allows you to offset one year’s losses against another year’s income.

The IRS lets you carry this operating loss back two years and use it to offset the income of those previous two years. Doing so may result in a refund. If you still have some losses left after carrying them back, you can carry them forward for up to 20 years. If you don’t want to use the two-year carryback period, you can elect to deduct the net operating loss over the next 20 years. However, once you make that election, you can’t reverse it. Remember, if there is any unused loss after 20 years, you may no longer apply it to any income.

Home Office

If you use a portion of your home exclusively and regularly for business, you may be able to claim the home office deduction on your annual tax return. This generally applies to sole proprietorships. To claim the deduction, the part of the home you use for your office must be your principal place of business, or you must use it to meet or deal with clients in the normal course of business. Keep in mind that you can’t claim the deduction if you have an outside office as well.

Business owners who keep records, schedule appointments, and perform other administrative or management activities from their home offices qualify for a deduction as long as they don’t have any other fixed place of business where they do a large amount of administrative or management work. This holds true even if they don’t see clients or customers in their home offices. The IRS scrutinizes this deduction very carefully, so be sure to follow the rules and keep good records.

Tax Planning

As you operate your business, be on the lookout for ways to reduce your federal and state tax liability. Small-business owners typically have a lot of ups and downs from one year to the next. If you make a lot of money one year and have to pay taxes on all that profit, your business won’t have the reserves needed to tide you over in some other year when business may not be as good.

That’s why it’s important to defer or reduce taxes whenever possible. This is a good way to cut business costs without affecting the quality of your product or service.

Throughout the year, periodically review your tax situation with the help of your accountant. If your income is increasing, look for deductions to help reduce your taxes. For example, if you are a cash-basis taxpayer, think about doing some needed business repairs or stocking up on office supplies and inventory before the end of the year. Cash-basis taxpayers can also defer income into the next year by waiting until the end of December to mail invoices.

For businesses using the accrual method, review your accounts receivable to see if anything is partially worthless. If it is, you can take a deduction for a portion of the amount of the uncollected debt. Check with your accountant to determine whether you meet IRS requirements to claim a bad-debt deduction.

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Believe it or not, the IRS does publish understandable business tax information. Visit the Small Business and Self-Employed Tax Center on its website at irs.gov.

Both cash and accrual taxpayers can make charitable donations before the end of the year and take deductions for them. Beware: If you donate $250 or more, you must obtain written substantiation of the contribution amount or a description of the property given from the charity, as well as a bank record, such as a canceled check or bank statement.

Tax planning is a year-long endeavor. Be sure you know what deductions are available to you, and keep good records to support them. This way, you can reap tax savings, which you can use to successfully operate and grow your business.