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 when
it comes to paying the taxes related to running a business, you
don't need to know every detail in the tax code--that's your CPA's
job--but you do need to know when to ask your CPA's advice so you
can maximize deductions, tax credits and savings, and adapt to
changes in the federal and state tax codes.
As a business owner and employer, you're responsible for
collecting various state and federal taxes and remitting them to
the proper agencies. In addition, you're required to pay certain
taxes yourself. When reading the following information, remember
that at the time we posted this encyclopedia entry, all tax
information reflected current law. But Congress passes tax
legislation on a regular basis. Therefore, check with your CPA
before making any decisions that could affect your personal or
business tax planning.
Employer Tax Identification Number
If you have one or more employees, you're required to withhold
income tax and Social Security tax from each one's paycheck and
remit these amounts to the appropriate agency. To do so, you need
to obtain an employer tax number from the federal government using
IRS Form SS-4, and if your state has an income tax, from the state
as well. Call your local IRS office, which will send you a tax ID
number along with charts to determine payroll tax deductions,
quarterly and annual forms, W-4 forms, tax-deposit forms, and a
manual on filling out forms. No advance fees or deposits are
required.
Income Tax Withholding
The amount of "pay-as-you-go" taxes you must withhold from each
employee's wages depends on the employee's wage level, the number
of exemptions he or she claims on the withholding exemption
certificate (Form W-4), marital status, and length of the payroll
period. The percentage withheld is figured on a sliding basis, and
IRS 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 a
federal system of old-age, survivors, disability and hospital
insurance. The old-age, survivors, and disability insurance part is
financed by the Social Security tax. The hospital insurance part is
financed by the Medicare tax.
FICA requires employers to match and pay the same amount of
Social Security tax as the employee does. Charts and instructions
for Social Security deductions come with the IRS payroll forms.
Congress has mandated requirements for depositing FICA and
withholding taxes, and failure to comply with these regulations
subjects a business to substantial penalties. Four different
reports must be filed with the IRS regarding payroll taxes (both
FICA 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 with
annual 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 to
independent contractors must report the payments to the IRS by
filing Form 1099MISC for Miscellaneous Income. Form 1099MISC is
similar to the W-2 form employers give to employees. Businesses are
required to send the Form 1099MISC to the contractor by January 31
of the year following the payment and must also transmit the
information to the IRS by February 28 along with a summary sheet,
Form 1096, Annual Summary and Transmittal of U.S. Information
Returns.
State Payroll Taxes
Almost all states have payroll taxes of some kind that you must
collect and remit to the appropriate agency. Most states have an
unemployment tax that's paid entirely by the employer. The tax is
figured as a percentage of your total payroll (up to a specified
limit of annual wage per employee) and remitted at the end of each
quarter. The actual percentage varies from state to state and by
employer.
Some states impose an income tax that must be deducted from each
employee's paycheck. As an employer, you have the responsibility of
collecting this tax and remitting it to the state. A few states
have a disability insurance tax that must be deducted from
employees' pay; in some states, this tax may be split between
employee and employer.
Most states have patterned their tax-collecting system after the
federal government's. They issue employer numbers and similar forms
and instruction booklets.
Independent Contractors
Hiring independent contractors requires filing an annual
information return (Form 1099) to report payments totaling $600 or
more made to any person for services performed in the course of
trade or business during the calendar year. If this form is not
filed, you could be subject to penalties. Be sure your records list
the name, address, and Social Security or Employer Identification
Number (EIN) of every independent contractor you hired, along with
the dates they worked, the nature of their work, and how much they
were paid.
Personal Income Tax
Operating as a sole proprietor or partner, you will not be paid a
salary like an employee; therefore, no income tax will be withheld
from money you draw from your business. Instead, you're required to
estimate your tax liability each year and pay it in quarterly
installments on Form 1040. Request the necessary forms and
instructions for filing estimated tax returns from your local IRS
office. When applying for the forms, also ask them to send the Tax
Guide for Small Business (Publication 334).
At the end of the year, you must file an income tax return as an
individual and compute your tax liability on the profits earned in
your business for that year. Partnerships are required to file a
partnership return (Form 1065). Each partner's share of the net
income or expense of the partnership is reported to the partner on
a Schedule K-1.
Corporate Income Tax
If your business is organized as a C corporation, you'll be paid a
salary like other employees. Any profit the business makes will
accrue to the corporation, not to you personally. At the end of the
year, you must file a corporate income tax return. Corporate tax
returns may be prepared on a calendar- or fiscal-year basis. If the
tax liability of the business is calculated on a calendar year, the
tax return must be filed with the IRS no later than March 15 each
year; however, the corporation may file a request for extension of
due date.
Reporting income on a fiscal-year cycle is more convenient for
most businesses because they can end their tax year in any month
they choose. A corporation whose income is primarily derived form
the personal services of its shareholders must use a calendar-year
end for tax purposes. In addition, most Subchapter S corporations
are 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 of
merchandise or particular groups of customers. Service businesses
are often exempt altogether. Contact your state and/or local
revenue offices for information on the law for your area so that
you 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 identify
tax-exempt sales from taxable sales. Then you can deduct tax-exempt
sales from total sales when filing your sales tax returns each
quarter. Remember, if you fail to collect taxes that should have
been collected, you can be held liable for the full amount of
uncollected tax, plus penalties and interest.
Advance Deposits
Some states may require an advance deposit on future taxes to be
collected. In lieu of a deposit, some states will accept a surety
bond for that amount from your insurance company. If you have a
fair credit record, the bond is usually simple to obtain through
your insurance agent. The cost varies according to the amount and
the risk-5 percent is a rule of thumb, but 10 percent is not
unusual for small dollar amounts.
If your state requires a deposit or bond, you can keep the
amount down by estimating sales on the low side-a wise strategy,
especially for new business owners who tend to be overly optimistic
when it comes to estimating their business' sales.
Taxes on Proprietorships, Partnerships and
Corporations
The first tax issue business owners face is the legal form of your
business. You can be a sole proprietor, a general partner, or the
head of your corporation. Your choice has a big impact on your tax
liability, so make sure to get your CPA's advice first.
Sole Proprietorship Taxes
A sole proprietorship is a one-owner business, which has many or
few employees. This form of organization is simple and requires no
fancy legal work. You name your business in accordance with
licensing laws, you apply for a federal EIN number if you have
employees, and you're all set. A sole proprietor's income is
included on his or her personal tax return.
Suppose a husband and wife file a joint return. The husband has
his own business, while the wife works part-time for the government
and makes $25,000 a year. The husband's gross income from his
business was $100,000, and his business made $20,000 in profits
after business expenses were deducted. His $20,000 profit is
included on the individual return, along with his wife's $25,000.
The business income is considered personal income for the sole
proprietor, and there are no special business-income taxes other
than self-employment taxes.
Partnerships and Taxes
A partnership is a business with two or more owners, and like a
sole proprietorship, a partnership is not a taxable entity. For tax
purposes, the income or loss from a partnership is considered the
personal 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 with
whatever other income they have. Itemized deductions and credits
are taken from that figure.
A partnership agreement must be well-defined regarding capital
investment, return, salaries, duties, responsibilities, losses, and
so on. What if you're in a partnership with someone who isn't as
reliable and hard-working as you are? Whatever mistakes your
partner makes, you are also liable because of the rule known as
"mutual agent." Mutual agent means that you are responsible for the
actions of your partner because he or she is an agent for the
partnership. If your partner does something that costs a lot of
money or causes your business to suffer great losses, you will bear
the consequences equally. The same is true if your partner does
something that results in an additional tax liability for your
company. 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 tax
rate 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 amount
over $100,000
- $335,000 to $10 million: $113,900 plus 34 percent of the amount
over $335,000
- $10 million to $15 million: $3.4 million plus 35 percent of the
amount over $10 million
- $15 million to $18,333,333: $5.15 million plus 38 percent of
the amount over $15 million
- $18,333,333 and above: 35 percent
Your corporation may be subject to several other taxes, such as
the personal-holding-company tax or the accumulated-earnings tax.
An additional tax of 39.6 percent is applied to undistributed
personal-holding-company income. Ask your CPA if any special taxes
apply to your corporation.
A corporation's income is taxable, and any distribution of
income to individual stockholders, known as dividends, is taxable a
second time as ordinary dividend income. If General Motors earns
$1, it will in theory pay 34 cents in federal tax, and the
remaining 66 cents will be distributed as dividends. If you're a
stockholder, you pick up that 66 cents as dividends-and-interest
income on Schedule B of your 1040 and pay tax accordingly. If your
tax rate is 28 percent, you'll pay another 20 cents in tax. That
means $1 of corporate income could be reduced to less than 47 cents
for the individual. Of course, with that 47 cents, you'll also pay
your property tax, sales tax, and whatever other taxes that may be
credited to you or deducted by you from your taxable income.
Subchapter S Corporations Taxes
The disadvantage of double taxation is effectively eliminated if
you file a Subchapter S election with the IRS. The qualifications
for electing Subchapter S status were amended in 1982 when the
Subchapter S Revision Act liberalized many of the old rules. The
new flexibility of these corporations makes them popular with small
and medium-sized businesses. Subchapter S allows profits or losses
to flow directly through the corporation to you and other
shareholders. If you earn other income during the first year and
the corporation has a loss, you can deduct the loss against the
other income, thereby reducing or completely eliminating your tax
liability.
To qualify under Subchapter S, the corporation must be a
domestic corporation, must not have more than 75 shareholders, must
have only individuals or estates as shareholders, and must not have
a nonresident alien as a shareholder. Under current law, an
unlimited amount of passive income from rents, royalties, and
interest is now allowed. When profits exceed 25 percent of the
gross receipts, Subchapter S corporations may be taxed on passive
income, 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 to
select for your business entity or download them from the IRS Web
site at www.irs.gov/formspubs/index.html.