By Amy Fontinelle
When you become a small business owner, you acquire a responsibility for making tax payments that you didn't have as an employee. Although you probably didn't realize it, your employer was transmitting those taxes withheld from your paycheck to the government. The company was also matching your Medicare and Social Security taxes and filing information returns with the IRS. In this section, we'll explain what tax requirements you'll become responsible for as a small business owner.
Estimated Tax Payments
As a small business owner, you will need to set aside the money from the payments you receive from clients instead of having an employer withhold federal taxes from your paycheck. Unless you are subject to backup withholding (most people aren't, unless they've gotten into trouble with the IRS), your clients will not take any taxes out of their checks to you. You must make estimated tax payments if you expect to owe at least $1,000 in tax for the year after subtracting any tax credits. The amount you need to pay in estimated tax payments for the whole year is equal to 100% of what you owed in the previous tax year or 90% of what you expect to owe in the current tax year.
If your earnings for the year before you opened your business are less than or similar to what you expect to earn your first year in business, paying 100% of your previous year's tax amount for your current year's estimated tax payments is the way to go. This is the simplest method. However, if you think your earnings as an employee were substantially higher than your first year of small business earnings will be, it will probably be a burden for you to pay 100% of your previous year's tax liability and it will result in you making a large, interest-free loan to Uncle Sam that won't be returned until sometime after April 15 of the following year. If this situation applies to you, there's another method to calculate your estimated tax payments.
You'll need to pay at least 90% of how much you'll end up owing for all of the current year. But how do you predict what you'll earn for the year when you've never been in business before? It's difficult, and the IRS doesn't expect you to do it. The Estimated Tax Worksheet on page 5 of IRS form 1040 ES, Estimated Tax for Individuals, provides a formula for calculating how much tax liability you're likely to incur for the year based on your quarterly income. Each quarter, you'll need to run through this worksheet to calculate how much to send in. If you're good at doing your own taxes, you can complete this form yourself. If not, hand the work off to your accountant.
You'll need to submit your estimated federal tax payments along with a corresponding IRS voucher four times a year. You can also sign up for the Electronic Federal Tax Payment System (EFTPS) if you want to make your payments electronically. Memorize these payment due dates or write them down, because they aren't spread evenly through the year: January 15, April 15, June 15, and September 15. One problem with these dates is that if you use the 90% method, you may have a higher tax burden in January, when four months have elapsed since your last quarterly payment. The other problem is that if you owe taxes for the previous year in April, you'll have to make that payment at the same time you make your current year estimated tax payment for April. It's easy to end up sending a huge amount of money to the government in April when you're self-employed, so make sure to calculate what you'll owe as far in advance as possible and keep a large cushion in your business bank account in case the bill is higher than you expected.
If your state has an income tax, you'll need to go through a similar procedure to pay state taxes.
There isn't really a separate tax on the self-employed. Self-employment tax refers to Medicare and Social Security payments. As an employee, 6.2% of your paycheck is withheld for Social Security and 1.65% is withheld for Medicare. Your employer is required to match those amounts. When you are self-employed, you are the employer, so you are required to match those amounts. This matching portion is what is known as self-employment tax. In total, you will pay 15.3% in Social Security and Medicare taxes on 92.35% of your net earnings (unless your net earnings are less than $400). The employer matching portion is tax deductible, but the deduction only cushions the blow by a couple of percent.
Self-employment tax is not paid quarterly but is submitted as a lump sum with your annual tax return using IRS schedule SE, Self-Employment Tax. The need to pay self-employment tax in April is yet another reason why it's important to keep a large cushion in your small business's bank account. It is easy to be caught off guard by just how much you will have to pay in taxes, especially in your first year.
Business Tax Deductions
One perk of being a small business owner is that you get to deduct business expenses from your taxable income. In general, these deductions soften the blow of having to acquire things that an employer normally provides, like a computer and office supplies and even health insurance and retirement benefits. (You might also want to check out 10 Most Overlooked Tax Deductions.)
Let's say your marginal tax bracket is 25%, meaning that any income you earn above the minimum income limit set by the IRS ($33,950 in 2009 if your filing status is single) is taxed at 25%. If you purchase a computer for business use that costs $1,000, the tax deduction will make its actual cost to you only $750.
It's important not to get carried away with purchasing things for your business just because they're tax deductible. You'll still be paying for the bulk of the expense out of your own pocket. Tax deductions absolutely do not make your business purchases free. But for those things that you really do need for your business, the tax deduction helps.
Some important tax deductions you should be aware of include home office costs, health insurance premiums, meals, entertainment, internet, phone, loan interest, business travel, vehicle use, education costs and self-employed retirement plan contributions.
If you hire even one employee for your small business, or if you structure your business as a C corporation (which makes you an employee), your tax situation becomes much more complicated. You'll have to withhold federal and state income taxes and FICA (Social Security and Medicare) taxes on behalf of all employees. You'll also have to pay the matching portion of Social Security and Medicare for each employee, and you'll have to fill out additional paperwork and possibly make more frequent tax payments using IRS form 941, Employer's Quarterly Federal Tax Return, as well as the equivalent state form. If your tax liability is high enough, you will have to make payments monthly or semiweekly instead of quarterly. The details of this system are beyond the scope of this tutorial; see IRS Publication 15 (Circular E), Employer's Tax Guide, for more details.
If you have employees, you may also be required to pay state unemployment insurance, and your state may require you to pay into a worker's compensation fund.
Hiring an Accountant
Does this tax stuff have you totally confused? Most people are mystified by their own personal tax returns, let alone the more complex returns required of businesses. If you're not confident in your ability to understand the requirements and correctly prepare returns and calculate payments, it's worth the expense and the trouble to hire an accountant. The time this will save you in dealing with tax issues will free you up to focus on your business. An accountant's expertise will also help you avoid tax penalties, so the expense of hiring this professional can end up paying for itself. (For more see Crunch Numbers To Find The Ideal Accountant and 10 Tax Benefits For The Self-Employed.)
If you don't want to be dependent on an accountant or have to pay their bills forever, you can transition to doing your own taxes by taking some tax preparation classes and/or seeking instruction from your accountant.
Even if you hire an accountant, you'll still need to keep meticulous records. In the next section, we'll discuss creating and maintaining business records.
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