If you’re planning to start up a new business this year, you’ll experience tax time as a business owner soon enough. The following tips will help you prepare well in advance. And if you started a business in 2018, you’re likely wrestling with your company’s first experience with taxes right now.
As an entrepreneur, you already have plenty of important issues that require your attention on a daily basis. If there’s any way to simplify the tax filing process, jump on that opportunity. Bookmark this brief primer and refer back to it regularly as you navigate your first tax year as a business owner.
DIY or CPA?
Every taxpayer is legally allowed to prepare and file his or her own taxes (and those of any business they fully own) if they wish. If your financial circumstances are incredibly simple and you’re reasonably handy with a calculator, that’s usually the way to go. It’s fairly quick and easy, and it costs nothing.
However, as your financial situation grows more complicated (and includes things like investments and business ownership), the cost to benefit analysis starts leaning more toward investing in a Certified Public Accountant or other professional tax preparation service.
That’s not to say you can’t prepare and file your own taxes as a new entrepreneur. But if you choose to do so, you need to be prepared for it to require many forms different from your personal returns. You’ll also need to be mindful of additional due dates that you weren’t previously concerned about before you were a business owner (more about this in the “Getting Organized” section below). Plus, there’s the distinct possibility that inexperience could cause you to miss something important, which could cost you a lot.
As a result, many entrepreneurs decide that having a professional in their corner is well worth the investment. If that’s the direction you’d like to go, learn how to choose a tax preparer.
If you’d still like to go it alone, do your research. Here are some great tax preparation resources to get you started.
How is your company set up legally?
There are plenty of things to consider when deciding on the legal structure of your business, but each structure’s tax implications are often among the most important. And, as a company grows and matures, it often makes sense to change the business type to accommodate the company’s current situation.
For the simplest of startups (i.e. freelance work, side hustles or professional services in which the owner handles everything) it’s rarely beneficial during the first year to set up a partnership or corporation. As employees enter the mix, and/or as the business becomes consistently more profitable, most organizations choose to legally separate the business from the owner’s personal finances, a move that has distinct benefits, both in terms of legal and tax liability.
In a nutshell, the way your company is legally structured has an impact on your taxes for the following reasons:
- A sole proprietorship is viewed as a legal extension of yourself as the owner. You file the business income and expenses on a Schedule C as part of your personal tax return, so it’s taxed at your personal tax rate.
- A partnership splits the income, expenses and legal liability equally among the partners, but is otherwise much like a sole proprietorship for tax purposes.
- A C-corporation is viewed as an independent legal entity. Taxes are filed completely separate from the owner’s personal tax returns and business income is taxed at a corporate rate (which is often different from the personal income tax rate).
- An LLC or S-corporation offers many of the tax and legal liability benefits of a C-corporation, but at (generally) a lower cost to the business.
While filing taxes for a sole proprietorship can be nearly as simple as filing a personal tax return, tax preparation for partnerships and corporations are significantly more complicated and should really be handled by a professional.
Which accounting and depreciation methods will you use?
The two accounting methods that matter from a tax-prep perspective are cash and accrual. Here’s the basic difference between them:
- Cash accounting counts income the date it’s collected, and an expense the date it’s paid.
- Accrual accounting counts income the date it’s earned, and an expense the date it’s incurred.
When considering the annual tax bill, these differences become very important. After all, large accounts receivable and accounts payable balances as the calendar year rolls over can mean much lower taxable income under the accrual method. And, since many young companies find themselves in such a situation in their first year, accrual accounting may be the best choice. However, if the company’s cash flow improves in year two and beyond, cash accounting often offers the better balance of countable income and expenses from a tax perspective.
Depending on their total revenue and the volume of inventory they possess, some businesses are required to use accrual accounting only, as are publicly traded companies.
Depreciation is also a tax issue that requires consideration, especially in a startup’s first year. That’s because the IRS allows first-year companies to apply up to $100,000 in depreciation to furniture and equipment as opposed to the normal 5 to 7 year period over which those items would need to be depreciated. Depending on how much of these expenses you’ve incurred during your first year, this can have huge tax implications.
For a more thorough treatment of how cash flow and depreciation will impact your business taxes, check out these resources.
Handling employees and independent contractors
If your startup is strictly a one-person show, and will be for the foreseeable future, you can safely skip this section. But, if you’ve already hired help in any form, this is an important one. And, it’s important to note that few if any startups can effectively scale without leveraging employees and/or contractors at some point.
The first thing you need to understand is the difference between an employee and an independent contractor. According to the IRS, approximately 15 percent of employers misclassify at least one employee as an independent contractor, costing the U.S. about $3 billion in revenue each year.
Again, in a nutshell, here’s the difference:
- An employee is someone whose schedule is under your control, who relies on you for all or most of their income, and who you can require to go about their work in a specific way.
- An independent contractor is in control of their own schedule, does not rely solely or mostly on your company for income, and has more freedom to decide how to accomplish the tasks you assign them.
These somewhat vague definitions can lead to a number of gray areas, which explains the relatively high number of errors being made across the country. The fact that choosing one option over the other can have huge tax implications may explain why a lot of those “errors” are not so accidental.
Hiring employees means you’re taking responsibility for all that goes into payroll taxes, including withholding their half of the obligation and covering the other half yourself. Employee status also brings the entirety of employee law into the mix.
When working with independent contractors, on the other hand, they are responsible for their own taxes and are not legally connected to your business beyond whatever contract you have both signed (which is usually project-based or very short term in nature).
As with most of the items in this article, deciding which of these options is better for your unique financial and legal circumstances is best done with the help of an attorney and/or accountant. For some more insight on the decision, read this article.
Once all the preceding items are considered, you’ll be able to determine which business and financial records you’ll need to maintain throughout the year, and which forms or records will be required at tax time. You’ll also be able to set up the most appropriate schedule to make sure your tax obligations are being met on a weekly, quarterly and annual basis.
While the following resources won’t include everything you need to know, it will give you an idea of what to keep in mind, especially if you’re handling tax preparation on your own:
- Keeping Records All Year
- Banish Bookkeeping Nightmares
- Managing Taxes in the Gig Economy
- Tax Deductions Every Startup Should Know About
For more powerful learning opportunities that could save you big time, no matter how many years you’ve been paying business taxes, subscribe to StartupNation’s newsletter for more tax-related content.