This is the fifth week of my series on Starting a Business 101. Last week, I talked about tax id numbers. This week, we are going to talk about determining your tax responsibilities.
In this series, I cover the topics below that are central to starting a new business.
Introduction - Why make it complicated?
Week 1 – Choose a name for your business.
Week 2 – Determine the legal structure.
Week 3 – DBAs and business licenses.
Week 4 – Get a federal tax id number.
Week 5 – Determine your federal, state and local taxes.
Week 6 – Record Keeping.
Week 7 – Other good information.
I think this is one of the parts that we all dread. Taxes. As a new business owner, this can be something that is overlooked and can get terribly confusing.
I cannot promise to hit on every detail, but I’ll do my best to give you a pretty good overview. I am going to just write about the two basic types of businesses that would most likely apply to design and Etsy-type of businesses – Sole Proprietorship and Limited Liability Company (LLC). Keep in mind that your form of business entity will determine the taxes you need to pay and tax forms you need to file.
If you haven’t read Week 2, this is the time to read it so you can decide what type of entity your business is.
General federal taxes that you may need to pay:
- Income tax
- Self-employment tax
- Employment tax
- Excise tax
General state and local taxes that you may need to pay:
- State income tax
- Sales and use taxes
- Unemployment taxes
Be sure to learn of deadlines so you can pay taxes on time. Large penalties can apply if you miss a deadline.
Income tax is a tax that everyone pays on their income. Generally, most businesses pay income tax by making regular estimated tax payments. If you expect to owe taxes (your earnings are $400 or more), you make estimated tax payments each quarter. You use IRS Form 1040-ES to pay these payments. Income tax is based on your tax bracket.
If your state has income tax, this can also apply at the state level.
Self-Employment Tax (SE)
This tax combines Social Security and Medicare tax for people who do not receive W2’s for their work (i.e. you work for yourself and you aren’t on payroll). This takes the place of what would be deducted on your paycheck if you worked for someone else. You generally pay SE tax on your net earnings if they are $400 or greater for the year.
SE taxes total 15.3%. These taxes are essentially the same as the employment taxes that you see below, but you do not just pay it on payroll like employment taxes. You pay it on your entire profit.
If you are a sole proprietor, this applies to you. If you are an LLC filing as a sole proprietorship, this applies to you as well. However, if you are an LLC filing as an s-corp, you pay employment taxes instead since you pay yourself on payroll and then you pay income taxes on any additional profit, rather than SE taxes.
This applies to any employees that you have. If you have none, you can ignore this section. However, if you have an LLC filing as an s-corp and you pay yourself on payroll, you are an employee. This section will be important if that is you.
Did you know that you don’t just pay employees the salary you owe them, but you also must take taxes out of each paycheck and pay employer taxes, which are above and beyond their pay?
If you have employees, you will also want to set up payroll with a service so they can take out the appropriate taxes from the paycheck. What all do you take out of a paycheck and pay out to federal and state agencies?
- Federal withholding. You must withhold federal income taxes from the employee’s wages. The employee will need to fill out a W4 form in order for you to figure out how much to withhold.
- Social Security and Medicare. These taxes pay for benefits under the FICA act. Many times these taxes are referred to as FICA for that reason. You withhold these and also pay a matching amount yourself, as the employer. So, factor that in as an additional expense of being an employer.
- Federal unemployment (FUTA). This is a state tax that pays unemployment compensation to workers who lose their jobs. If you aren’t employed and your employer isn’t paying FUTA (i.e. you are just a contractor), you cannot later receive unemployment should you lose your job. Only employers, not employees, pay this tax.
This totals 15.3%, with 7.65% being paid by the employee and the other 7.65% being paid by the employer.
With the specifics of these taxes changing often, I highly recommend a payroll service if you have employees. These services cost $30-50 a month, on average.
Also, keep in mind that at the end of the year, you will need to issue a W2 for all employees. This form will let them know exactly what was withheld so they can file taxes.
If you do employ yourself (if you are an LLC filing as an s-corp), you just pay the 15.3% on the amount that you are paid via payroll. The rest of the business profit would then be transferred to your personal return and you’d only pay income tax on that portion. That saves you 15.3% in taxes on the extra profit. However, you must pay yourself a reasonable salary.
This only applies to businesses that manufacture or sell certain products such as alcohol, guns, or tobacco. Most small businesses do not need to worry about excise tax.
Most states (some exceptions are Oregon and Montana) have sales tax. If you sell products (and some services also apply), you will be responsible for state and local sales tax on those items. That means you must collect the sales tax and then pay it in to the state and local governments.
Some states and local governments require you to pay sales tax in to them each month, while others require you to send in your payment each quarter. Even if you have nothing to report, you MUST file zero. Do not just not file.
Sales tax is based on the sales price, not the profits. And, it will be paid to the state, county and city – so be sure to hit on all of those pieces when you file.
You will need a sales tax permit prior to selling anything, in most states. In order to collect and pay sales tax properly, you must have this sales tax permit. In Texas, this was easy to register for online and only took a few minutes. While registering for a sales tax permit, you should also find out just what exactly must be taxed in your area. For instance, what kinds of services must be taxed.
When you have your sales tax permit, you can usually buy stuff tax free since you know that when you sell it to your client, you will charge them sales tax and pay it in at that time. However, should the item not sell and end up being used by you, you will need to pay use tax in many states. Check to see if your state has use tax.
Pay close attention to deadlines for payments. Remember the story about Sarah in the introduction post? She missed her monthly sales tax payments as a new business owner and ended up with $1500 in fines. Be careful.
How to Pay Your Quarterly Taxes
Estimated tax is the general method that small businesses use to pay Social Security, Medicare taxes and income tax when you do not have an employer withholding these taxes for you.
Use the worksheet found in Form 1040-ES, Estimated Tax to find out if you are required to file quarterly estimated tax. Form 1040-ES also contains blank vouchers you can use when you mail your estimated tax payments or you may make your payments using the Electronic Federal Tax Payment System (EFTPS). You can enroll there and receive a pin number so you can pay your taxes easily.
What Does Your State Require
SBA.gov provides a great list of links by state to help you get an idea of what your state may require.
In conclusion, this is why I have a CPA. This stuff can get complicated. She helps me make sure I’m paying all of the right taxes at the right times. In addition to our CPA, we also have a payroll service that helps me make sure that all payroll taxes are taken out. This gives us peace of mind.
And, never ever just skip filing anything, even if you have done no business – in that case, you still must file the forms letting them know you did no business.
Though a CPA helps a great deal with taxes, I do still have my share of bookkeeping. I still have to keep records, record receipts in Quickbooks and actually issue the paychecks. So, having a CPA doesn’t mean your business runs without you and your effort on the admin side. It just helps when it comes to taxes and business questions. And, most people greatly appreciate that help.
I use my Outlook calendar for everything that I need to remember, including taxes. I set reminders for every deadline and have it remind me a week or two out. This helps tremendously.
To learn more about these taxes, visit the Internal Revenue Service’s (IRS) Guide to Business Taxes.
Next week we will talk about record keeping.
I hope you enjoyed Week 5 and that the information is helpful. Please add your own insights into this step in the comments.
As a disclaimer, I am not a CPA, lawyer or business expert. I am simply sharing what I’ve learned in case you have no idea where to start.