Starting a business requires time and preparation, and preparing to meet tax obligations can affect many of the steps you must take when you open your business. In fact, you must deal with several items related to taxes before you even can obtain your business license.
The earliest stages of opening a business usually involve writing a business plan, including financial projections. To ensure you correctly estimate all of the costs that will be involved in starting your new business, you must understand the basics of the various taxes you will encounter so you can factor them into your calculations. Even if you are opening a business where you will be the only employee, and do not feel it is necessary to create a formal business plan, there are still many tax-related issues you need to address.
Starting your business
There are several steps you need to follow before you can obtain your business license and permits, but the choices you make at this stage can have a significant impact on your future:
Determine your legal structure
Among the earliest tax-related decisions you must make is which legal structure best suits your new business entity. Potential legal structures include:
- Sole proprietorship
- Limited liability company (LLC)
Your legal structure determines which taxes you must pay, and how you must pay them. There are five basic types of business taxes:
- Income tax
- Self-employment tax, which is the other half of your social security and Medicare taxes that are usually paid by an employer, but you must pay yourself when self-employed
- Estimated tax, which many businesses (including self-employed individuals) are required to make payments of quarterly
- Employer tax
- Excise tax
If you are unsure which structure to choose, a tax professional can walk you through the pros and cons of each type and offer advice about which would be most beneficial at this stage. Please note that this choice is not necessarily permanent. As a business grows over time, it is common to convert to a different legal structure to better serve the business. While this may happen eventually, you do not need to worry about it when you are starting out. Choose the structure that is best for the business you have now, not the business you hope to have in the future!
Register for state and local taxes
Once you have chosen the appropriate legal structure for your small business, most states require that you register your business name. Once this is done, you can register for your state and local taxes. You will receive your tax identification number and be set up for workers’ compensation, unemployment and disability insurance.
Obtain your business license and permits
Once you have your tax identification number, you can move forward with obtaining your business license and any permits that are necessary. The permits required depend on the type of business you are starting and where it is located.
Running your business
Identify eligible deductions
Once you have begun business operations, you should identify tax deductions for which you are eligible. Keep in mind that taxes are not something that happen only once a year. Deductions may present themselves almost every day, so you need to be on the lookout for them. Keep your records updated year-round and keep track of receipts, invoices and other relevant documents. Complete and detailed record keeping is vital. If you are audited, you will be required to provide documentation that proves your deductions are legitimate.
Many everyday business expenses are eligible tax deductions. These include, but are not limited to:
- Equipment and supplies
- Business travel, including mileage, tolls, fuel and parking
- Meals and entertainment expenses related to business dinners and entertaining clients
- Training classes and materials to help improve or maintain your skills relevant to your current business
- Marketing expenses
- Health insurance premiums paid by the business
You may be able to deduct up to $5,000 of your startup costs when they result in the creation of a viable business. Eligible startup costs include expenses related to investigating and creating your business entity, legal fees and other organizational costs and a variety of other expenses related to preparing your business to open.
Home office deduction
If part of your home is reserved exclusively and used regularly for business, you may qualify for a home office deduction. Homeowners and renters with an office in any type of domicile are eligible. The regular method for calculating the home office deduction uses figures such as the percentage of your home’s square footage that is occupied by your home office and actual expenses including mortgage interest, insurance, utilities, repairs and depreciation.
A simplified method was introduced for tax year 2013 and beyond, which calculates the deduction in an easier way. You can choose which method to use, and must apply a single method to the entire tax year.
Taxes can feel daunting even when you are your business’ only employee; when you hire additional workers, new tax challenges arise. One of the most commonly misunderstood issues is the correct classification of your workers. The IRS is especially vigilant about pursuing companies that misclassify workers, as this can mean billions of dollars in lost tax revenue annually. A business may face serious financial consequences if an auditor discovers misclassified workers, so it is crucial to understand the distinction.
Employees and independent contractors
Employees and independent contractors are not interchangeable. The primary difference between the two is how much control the employer takes over how, when and where work is performed. An employee is eligible for benefits and protections such as overtime pay, medical and family leave, unemployment benefits and much more.
An independent contractor does not receive these benefits, but trades them for the ability to work independently, setting their own schedule, deciding where they will perform the work, and so forth. If the employer dictates those conditions, then the worker is actually an employee and must be classified as such.
Start your business with confidence
Tax laws change each year, so the IRS publishes an annual Tax Guide for Small Business. Still, many new business owners may benefit from consulting a tax professional who can help them identify missed deductions, mistakes and other potential issues. Startups often have tight budgets, but hiring a reputable tax professional may prove to be a valuable investment.
Do you have tax-related questions about starting a new business? Any tips to offer? Let us know in the comments below!