It’s never too early to get a head start on planning your taxes — especially if you’re an entrepreneur starting a business of your own. Taxes for entrepreneurs work differently than those for full-time employees receiving annual W-2 forms from their companies.
There’s never a good time to be audited by the IRS, but the early stages of your business may be the worst possible time. Here are five tax tips to keep in mind as you get your business off the ground and lay the foundation for future success.
1. Consider How Business Registration Will Affect Your Taxes
Determining whether to incorporate your business is one of the first big decisions you need to make as an entrepreneur. There are many options available — the most common being sole proprietorships and limited liability corporations (LLCs). When choosing which is right for you, consider the tax impact of each.
Sole Proprietorship
A sole proprietorship means you operate your business as an unincorporated entity. This is often the first option on an entrepreneur’s radar, and for understandable reasons — registration is free and the process is fairly straightforward, as your name is on every legal document.
During tax season, sole proprietorship profit is treated like personal employment income. This is where the drawback of a sole proprietorship arises: you will be taxed for the full profit of your business, even if that isn’t actual income in your personal bank account. In other words, the value of your company becomes your personal value, and you have to pay full taxes on this amount. Registering as a sole proprietorship also means you are personally responsible for paying off any business debts, which is a serious responsibility to assume.
Limited Liability Corporation (LLC)
Limited liability corporations are a blend of the partnership and corporate registration systems. A multi-owner LLC — a business started by two or more entrepreneurs — is treated as a partnership by the IRS.
Here’s how that works for taxation purposes: if you own 80% of a business and your partner owns 20%, you are responsible for paying taxes on your respective percentage of the company’s income. A main advantage of LLCs is that corporate tax rates apply. For a company’s first $75,000, corporate tax rates are lower than individual tax rates, allowing your business to more easily grow toward being able to issue stocks and bring on more partners.
Overall, if your project is more of a side hustle, a sole proprietorship may work best. If you’re looking at scale and profit, an LLC is likely your best option — both for taxes and the ease of business growth.
2. Look Into Quarterly Tax Payments
While full-time employees face tax season once a year, entrepreneurs and small business owners deal with the task quarterly. This is because of estimated tax payments.
Estimated tax payments are quarterly payments based on how much you estimate making in a financial year. According to the IRS, individuals and sole proprietors are required to pay estimated tax payments if they expect to owe more than $1,000 in taxes when their year-end return is filed. A penalty is assessed if you file yearly instead of quarterly, assuming you owe more than the $1,000 threshold.
Estimated tax payments go towards federal income tax and other taxes required by entrepreneurs, including self employment tax and alternative minimum tax. Overestimating your quarterly tax payment is better than underestimating — if you’ve overestimated you will get a refund at year’s end. If not, you risk penalization for withholding.
3. Meticulously Track Everything From the Start
As a self-employed individual, you’re able to deduct professional expenses from your taxes — but it requires a lot of legwork on behalf of you or your accountant. While it’s obvious that you have to track payments to employees or suppliers, you should also be closely tracking items such as training costs, business marketing, meals with potential clients, the purchasing of work-related supplies, mileage, and other expenses explicitly pinned to your business. These are all considered costs of establishing and doing business, and they can be deducted when reporting your taxes.
It’s essential that you record expenses in a categorized spreadsheet and keep original receipts. These deductions are regularly audited, so the ability to substantiate your claims is vital.
4. Know What Constitutes a Home Office
Home office deductions are hugely appealing. When permitted, they allow individuals to write off part of their rent or mortgage, property tax, utility bills, and more. But in order for the IRS to recognize a home office deduction, you need to be working with a bit more than just a laptop on your kitchen counter.
The IRS definition of a home office is still quite traditional — an office is defined as a space that is used exclusively and regularly as your principal place of work. That means it can’t be the place where your family also eats their meals, or the storage closet at the back of your apartment. While the IRS doesn’t require a home office to be an entirely separate room, it should, in theory, be a place where you could hold business meetings and effectively manage administrative tasks. The Wall Street Journal recently offered guidance on the nuances of this deduction.
5. Understand the Difference Between Contractors and Employees
This may not be a tax consideration for all new entrepreneurs, but it will be one if you plan to pay someone to do work for your business. As an entrepreneur, you also become an employer, and that means taking on the tax responsibilities that come with the role.
At the start, most new entrepreneurs choose to work with independent contractors. When you hire contractors, you’re outsourcing the work — and that includes the tax responsibility. Unlike employees you hire, you aren’t required to pay Social Security taxes and other employment taxes, nor are you required to withhold these from the contractor’s pay. These taxes are their responsibility, not yours. As you grow, it may make more sense to hire employees, in which case you’ll need them to fill out W-2 forms and you will be responsible for deducting taxes from their pay. The classification of contractor vs. employee is very specific, and it’s an area regularly audited by the IRS.
Starting a new business is an exciting and challenging time. Understanding these tax tips will help simplify your journey, allowing you to reap the rewards and minimize small business risk.