Taxes Definition:
Sums imposed by a government authority upon persons or property to pay for government services
While it's important to stay on good terms with Uncle Sam whenit comes to paying the taxes related to running a business, youdon't need to know every detail in the tax code--that's your CPA'sjob--but you do need to know when to ask your CPA's advice so youcan maximize deductions, tax credits and savings, and adapt tochanges in the federal and state tax codes.
As a business owner and employer, you're responsible forcollecting various state and federal taxes and remitting them tothe proper agencies. In addition, you're required to pay certaintaxes yourself. When reading the following information, rememberthat at the time we posted this encyclopedia entry, all taxinformation reflected current law. But Congress passes taxlegislation on a regular basis. Therefore, check with your CPAbefore making any decisions that could affect your personal orbusiness tax planning.
Employer Tax Identification Number
If you have one or more employees, you're required to withholdincome tax and Social Security tax from each one's paycheck andremit these amounts to the appropriate agency. To do so, you needto obtain an employer tax number from the federal government usingIRS Form SS-4, and if your state has an income tax, from the stateas well. Call your local IRS office, which will send you a tax IDnumber along with charts to determine payroll tax deductions,quarterly and annual forms, W-4 forms, tax-deposit forms, and amanual on filling out forms. No advance fees or deposits arerequired.
Income Tax Withholding
The amount of "pay-as-you-go" taxes you must withhold from eachemployee's wages depends on the employee's wage level, the numberof exemptions he or she claims on the withholding exemptioncertificate (Form W-4), marital status, and length of the payrollperiod. The percentage withheld is figured on a sliding basis, andIRS percentage tables are available for weekly, biweekly, monthly,semimonthly, and other payroll periods.
Social Security (FICA) Tax
The Federal Insurance Contributions Act, or FICA, provides for afederal system of old-age, survivors, disability and hospitalinsurance. The old-age, survivors, and disability insurance part isfinanced by the Social Security tax. The hospital insurance part isfinanced by the Medicare tax.
FICA requires employers to match and pay the same amount ofSocial Security tax as the employee does. Charts and instructionsfor Social Security deductions come with the IRS payroll forms.Congress has mandated requirements for depositing FICA andwithholding taxes, and failure to comply with these regulationssubjects a business to substantial penalties. Four differentreports must be filed with the IRS regarding payroll taxes (bothFICA and income taxes) that you withhold from your employees'wages:
1. Quarterly return of taxes withheld on wages (Form 941);
2. Annual statement of taxes withheld on wages (Form W-2);
3. Reconciliation of quarterly returns of taxes withheld withannual statement of taxes withheld (Form W-3);
4. Annual Federal Unemployment Tax return (Form 940).
In addition, employers who pay compensation of $600 or more toindependent contractors must report the payments to the IRS byfiling Form 1099MISC for Miscellaneous Income. Form 1099MISC issimilar to the W-2 form employers give to employees. Businesses arerequired to send the Form 1099MISC to the contractor by January 31of the year following the payment and must also transmit theinformation to the IRS by February 28 along with a summary sheet,Form 1096, Annual Summary and Transmittal of U.S. InformationReturns.
State Payroll Taxes
Almost all states have payroll taxes of some kind that you mustcollect and remit to the appropriate agency. Most states have anunemployment tax that's paid entirely by the employer. The tax isfigured as a percentage of your total payroll (up to a specifiedlimit of annual wage per employee) and remitted at the end of eachquarter. The actual percentage varies from state to state and byemployer.
Some states impose an income tax that must be deducted from eachemployee's paycheck. As an employer, you have the responsibility ofcollecting this tax and remitting it to the state. A few stateshave a disability insurance tax that must be deducted fromemployees' pay; in some states, this tax may be split betweenemployee and employer.
Most states have patterned their tax-collecting system after thefederal government's. They issue employer numbers and similar formsand instruction booklets.
Independent Contractors
Hiring independent contractors requires filing an annualinformation return (Form 1099) to report payments totaling $600 ormore made to any person for services performed in the course oftrade or business during the calendar year. If this form is notfiled, you could be subject to penalties. Be sure your records listthe name, address, and Social Security or Employer IdentificationNumber (EIN) of every independent contractor you hired, along withthe dates they worked, the nature of their work, and how much theywere paid.
Personal Income Tax
Operating as a sole proprietor or partner, you will not be paid asalary like an employee; therefore, no income tax will be withheldfrom money you draw from your business. Instead, you're required toestimate your tax liability each year and pay it in quarterlyinstallments on Form 1040. Request the necessary forms andinstructions for filing estimated tax returns from your local IRSoffice. When applying for the forms, also ask them to send the TaxGuide for Small Business (Publication 334).
At the end of the year, you must file an income tax return as anindividual and compute your tax liability on the profits earned inyour business for that year. Partnerships are required to file apartnership return (Form 1065). Each partner's share of the netincome or expense of the partnership is reported to the partner ona Schedule K-1.
Corporate Income Tax
If your business is organized as a C corporation, you'll be paid asalary like other employees. Any profit the business makes willaccrue to the corporation, not to you personally. At the end of theyear, you must file a corporate income tax return. Corporate taxreturns may be prepared on a calendar- or fiscal-year basis. If thetax liability of the business is calculated on a calendar year, thetax return must be filed with the IRS no later than March 15 eachyear; however, the corporation may file a request for extension ofdue date.
Reporting income on a fiscal-year cycle is more convenient formost businesses because they can end their tax year in any monththey choose. A corporation whose income is primarily derived formthe personal services of its shareholders must use a calendar-yearend for tax purposes. In addition, most Subchapter S corporationsare required to use calendar-year ends.
Sales Taxes
Sales taxes are levied by many cities and states at varying rates.Most provide specific exemptions, as for certain classes ofmerchandise or particular groups of customers. Service businessesare often exempt altogether. Contact your state and/or localrevenue offices for information on the law for your area so thatyou can adapt your bookkeeping to the requirements.
Levying taxes on all states would present no major difficulties,but since this is not the case, your business will have to identifytax-exempt sales from taxable sales. Then you can deduct tax-exemptsales from total sales when filing your sales tax returns eachquarter. Remember, if you fail to collect taxes that should havebeen collected, you can be held liable for the full amount ofuncollected tax, plus penalties and interest.
Advance Deposits
Some states may require an advance deposit on future taxes to becollected. In lieu of a deposit, some states will accept a suretybond for that amount from your insurance company. If you have afair credit record, the bond is usually simple to obtain throughyour insurance agent. The cost varies according to the amount andthe risk-5 percent is a rule of thumb, but 10 percent is notunusual for small dollar amounts.
If your state requires a deposit or bond, you can keep theamount down by estimating sales on the low side-a wise strategy,especially for new business owners who tend to be overly optimisticwhen it comes to estimating their business' sales.
Taxes on Proprietorships, Partnerships andCorporations
The first tax issue business owners face is the legal form of yourbusiness. You can be a sole proprietor, a general partner, or thehead of your corporation. Your choice has a big impact on your taxliability, so make sure to get your CPA's advice first.
Sole Proprietorship Taxes
A sole proprietorship is a one-owner business, which has many orfew employees. This form of organization is simple and requires nofancy legal work. You name your business in accordance withlicensing laws, you apply for a federal EIN number if you haveemployees, and you're all set. A sole proprietor's income isincluded on his or her personal tax return.
Suppose a husband and wife file a joint return. The husband hashis own business, while the wife works part-time for the governmentand makes $25,000 a year. The husband's gross income from hisbusiness was $100,000, and his business made $20,000 in profitsafter business expenses were deducted. His $20,000 profit isincluded on the individual return, along with his wife's $25,000.The business income is considered personal income for the soleproprietor, and there are no special business-income taxes otherthan self-employment taxes.
Partnerships and Taxes
A partnership is a business with two or more owners, and like asole proprietorship, a partnership is not a taxable entity. For taxpurposes, the income or loss from a partnership is considered thepersonal income of the individual general partners.
If Owner A and Owner B are in a partnership that makes $20,000,and they divide everything evenly, the $10,000 Owner A gets and the$10,000 Owner B gets are included on each individual return withwhatever other income they have. Itemized deductions and creditsare taken from that figure.
A partnership agreement must be well-defined regarding capitalinvestment, return, salaries, duties, responsibilities, losses, andso on. What if you're in a partnership with someone who isn't asreliable and hard-working as you are? Whatever mistakes yourpartner makes, you are also liable because of the rule known as"mutual agent." Mutual agent means that you are responsible for theactions of your partner because he or she is an agent for thepartnership. If your partner does something that costs a lot ofmoney or causes your business to suffer great losses, you will bearthe consequences equally. The same is true if your partner doessomething that results in an additional tax liability for yourcompany. You could sue your incompetent or unscrupulous partner,but that is a separate matter.
Taxes on Corporations
Most corporations determine their tax by using the following taxrate schedule:
- Up to $50,000: 15 percent
- $50,000 to $75,000: $7,500 plus 25 percent of the amount over$50,000
- $75,000 to $100,000: $13,750 plus 34 percent of the amount over$75,000
- $100,000 to $335,000: $22,250 plus 39 percent of the amountover $100,000
- $335,000 to $10 million: $113,900 plus 34 percent of the amountover $335,000
- $10 million to $15 million: $3.4 million plus 35 percent of theamount over $10 million
- $15 million to $18,333,333: $5.15 million plus 38 percent ofthe amount over $15 million
- $18,333,333 and above: 35 percent
Your corporation may be subject to several other taxes, such asthe personal-holding-company tax or the accumulated-earnings tax.An additional tax of 39.6 percent is applied to undistributedpersonal-holding-company income. Ask your CPA if any special taxesapply to your corporation.
A corporation's income is taxable, and any distribution ofincome to individual stockholders, known as dividends, is taxable asecond time as ordinary dividend income. If General Motors earns$1, it will in theory pay 34 cents in federal tax, and theremaining 66 cents will be distributed as dividends. If you're astockholder, you pick up that 66 cents as dividends-and-interestincome on Schedule B of your 1040 and pay tax accordingly. If yourtax rate is 28 percent, you'll pay another 20 cents in tax. Thatmeans $1 of corporate income could be reduced to less than 47 centsfor the individual. Of course, with that 47 cents, you'll also payyour property tax, sales tax, and whatever other taxes that may becredited to you or deducted by you from your taxable income.
Subchapter S Corporations Taxes
The disadvantage of double taxation is effectively eliminated ifyou file a Subchapter S election with the IRS. The qualificationsfor electing Subchapter S status were amended in 1982 when theSubchapter S Revision Act liberalized many of the old rules. Thenew flexibility of these corporations makes them popular with smalland medium-sized businesses. Subchapter S allows profits or lossesto flow directly through the corporation to you and othershareholders. If you earn other income during the first year andthe corporation has a loss, you can deduct the loss against theother income, thereby reducing or completely eliminating your taxliability.
To qualify under Subchapter S, the corporation must be adomestic corporation, must not have more than 75 shareholders, musthave only individuals or estates as shareholders, and must not havea nonresident alien as a shareholder. Under current law, anunlimited amount of passive income from rents, royalties, andinterest is now allowed. When profits exceed 25 percent of thegross receipts, Subchapter S corporations may be taxed on passiveincome, according to Section 1375(a) of the Internal Revenue Code(IRC). Pension restrictions have been eased.
Call the IRS at (800) 829-3676 for the appropriate forms toselect for your business entity or download them from the IRS Website at www.irs.gov/formspubs/index.html.
