An Extremely Simple Guide to Taxation for Small Business Owners

An Extremely Simple Guide to Taxation for Small Business Owners

Tax reporting responsibilities can be a confusing and complex aspect of operating a small business. Nevertheless, reporting and paying taxes is a critical responsibility. Unlike personal tax returns, which typically involve filing a few forms once a year, reporting and paying business taxes can be much more complicated.

This guide outlines the different types of taxes that a business owner may incur, identifying how business structure affects tax filing responsibilities.

The Different Types of Federal Taxes

Business structure dictates the type and amount of federal taxes an enterprise incurs. According to the IRS, a business can incur four basic types of federal taxes.

1. Employment Tax

All employers are required to pay employment taxes covering Medicare and Social Security contributions. They are also required to pay federal income tax and federal unemployment tax (FUTA) for employees.

The employer pays 50 percent of Medicare and Social Security contributions for each employee. The employee pays the other 50 percent, which is deducted from the employee’s paycheck. The employer covers the full cost of FUTA.

For the sake of convenience, the IRS allows employers to pay employment tax by check, electronic deposit, money order, or cash.

2. Self-Employment Tax

The IRS levies self-employment taxes to cover Medicare and Social Security contributions. This is advantageous for the taxpayer, providing them with retirement benefits, hospital and disability insurance, and paying benefits to a survivor in the event of the payee’s death.

As of 2021, the self-employment tax is 15.3 percent, with 12.3 percent going towards Social Security contributions, which are only paid on the first $106,800 in income earned by the taxpayer.

The IRS definition of a self-employed person is an individual who carries on a business or trade as sole proprietor or member of a partnership carrying on a business or trade; an independent contractor; or someone who is otherwise in business for themselves.

3. Income Tax

With the exception of sole proprietorships and partnerships, the IRS requires small businesses to file an income tax return every year.

Some businesses pay estimated taxes, settling their tax liability when they file their annual tax return. Others operate via a withholding method, paying taxes as they earn income.

Some states levy their own income tax on certain types of business.

4. Excise Tax

The federal government charges certain types of businesses excise tax depending on a range of criteria, including the type of business operated; what they manufacture or sell; the products and types of equipment they use; and whether they are paid for providing particular services.

Excise tax is industry specific, including: fuel taxes; communications and air transportation taxes; environmental taxes; and taxes on retail sales of tractors, trailers, and heavy trucks.

State Taxes

In addition to federal taxes, individual states have their own tax legislation, with many states applying additional levies. Many states levy their own state employment taxes to cover workers’ unemployment insurance and compensation insurance. Several states pay taxes to cover temporary disability insurance.

Property business tax is levied at a local level according to where the business is based. It is a tax incurred on real estate, land, or commercial property owned by the business.

There is no federal sales tax, but 45 states have their own sales tax requirements, obligating anyone who sells services or goods to calculate, report, and collect sales tax.

The Impact of Business Structure on Federal Taxation

The structure of a small business dictates which taxes it is liable to pay. Business structure can also affect when and how business taxes are paid, as well as impacting the overall tax burden.

1. Sole Proprietors

A sole proprietorship is owned by one person. Since they are flying solo, sole proprietors simply report business losses and income on their own personal tax return, paying tax on personal income.

2. Partnerships

Business partnerships are operated by two or more owners. Partnerships have to file a Form 1065, detailing annual income, gains, losses, and deductions. Income tax is not levied against the partnership itself, however. Rather, partnerships are treated as a “pass-through” entity, with partners reporting income and losses via their personal tax returns.

3. C-Corporations

A C-Corporation is a legal entity in its own right, paying income tax at 21 percent. Shareholders are also taxed on income, culminating in double taxation.

4. S-Corporations

S-Corporations that have elected to operate as a pass-through entity for tax purposes file an information tax return via Form 1120S. However, they are not liable for corporate tax. Instead, shareholders pay income tax on income via their personal tax return.

It is critical to handle small business taxes correctly to avoid incurring IRS penalties and legal sanctions. Underestimating or ignoring business taxes could be an extremely costly mistake. It is vital to learn about which taxes apply to your small business upfront, seeking out trusted expert advice from seasoned professionals when necessary.