This is Part 2 of our 2 part series on Starting a Business. I recommend you start here. Now that you are caught up lets jump right in to business taxes.
Federal Tax ID
The US federal government provides what is called a EIN to identify a business. These numbers act similar to a social security number for a business. They are required for all business types except sole proprietorship in order to file your taxes.
While a sole proprietorship does not require a EIN I still would strongly recommend one. Most banks require an EIN to open a business account or business credit card. Also when doing business it reduces your identity theft risks. Without an EIN every time you do significant business with a specific customer you need to provide the owners social security for identification purposes. With an EIN you would provide that instead. Ultimately the less people have your social security number the better.
You can apply for an EIN online.
Investments and Accounts
In general I would recommend you get a business bank account for your activities regardless of the business type. A number of companies offer free business accounts, Capital One for example. (Link is not an affiliate link). All you need is the aforementioned EIN. Also if you need to make any purchases of equipment in order to run your business you may want a business credit card. Many of these are also available for little to no fee. Some people even credit card hack business cards for additional income, so there are plenty of options.
The reason a separate account or cards is so important is to separate expenses. When it comes to tax time you will want to remove expenses from your company’s revenue to determine your taxable net income. The more separate those expenses are from our day to day purchases the less issues you will have tracking them. (Also the less likelihood if the IRS comes calling you’ll fail an audit).
Don’t let Tax Rules Run Your Business
A note on investments, there is a tendency for some to think I can write this investment off so I should just do it. That’s a bad mindset to have. If it is an expenditure not related to your business the IRS could catch you subjecting you to an audit and potentially heavy fines. If the expenditure is tied to the business you need to remember you are only getting the tax off the expenditure back, not the whole amount. So if you are in the 25% tax bracket then an investments deduction only returns to your pocket at max 25% plus the 15.3% for the self employment tax or 40% on the dollar. If the income is not additive your effective tax rate and thus the deduction may be worth much less. Also as noted later the deduction may have to be spread across multiple years further diluting that rebate. In general don’t spend money on the business that won’t provide an increase in business, be required by law, or provide a reduction in cost.
Estimated Taxes and All Things Tax Deductible
Speaking of Tax Deductions, you should do your homework on how each expenditure you make is treated for tax write offs. Some things are deductible in the current year and others are expensed across multiple years. Depending on your business structure the year of the expenditure and income can count as the date of invoice (c-corp) or the date of payment (sole proprietorship/s-corp). You actually have a choice for a smaller income (not in the millions) sole proprietorship. Given the broadness of this topic and how much tax law changes from year to year all I can recommend is if you have significant business expenses consult with a tax preparer your first year to get an initial idea of how your expenses can financially be managed. These are different then the tax deductions you are use to if you itemize as your income is calculated for personal taxes after you make these deductions.
And speaking of taxes, your taxes will not be withheld by the government on a periodic basis like w-2 income. This means if you don’t send the government it’s cut quarterly in the form of estimated taxes you will likely incur a penalty. You can read more about estimated taxes here. One option if this is a side business is to play with your withholdings for your w-2 job to otherwise make up for your self employment income.
Self Employment Tax
A final note, tax rates for the self employed are also slightly different. More advanced company structures may require corporate tax rate application and taxes based on what the business passes along to you. This is beyond the scope of this post and would definitely require an accountant for a first pass. But even if you are a sole proprietorship who is only paying your tax rate on your net income, remember unlike a W-2 employee you have an extra 7.65 percent for the employer social security and medicare portion you otherwise would avoid. This amount is known as 1/2 your self employment tax. Your full self employment tax is your Social security and Medicare contributions and equals 15.3%. Remember to set aside tax money as the year goes along. Estimated or otherwise, You will need to have enough to pay the tax bill when it becomes due.
Retirement and Health Care
Regardless of your business structure you should consider creating a company retirement account. Even if you already max out your personal contribution to a company 401k you can invest 20% of your business profits after self employment tax into a self employed 401k. The key here is you must open the account before December 31 of the filing year to do so. Some other types of self employed retirement options like a SEP IRA can be opened later. You can insert the money until you file taxes for that year. I would recommend waiting to contribute until you do your taxes the first time to ensure you get the amounts correct. There are no easy do overs for incorrect deposits. If you get it right, much of this money becomes tax free the same as a normal 401k.
In addition if you have no health care at a W-2 job you can setup a self employed health care plan. This would be tax deductible from your business income. An HSA is also an option though you can do this with or without the business.
Hopefully this post helps you get started. From choosing your business name and type, to handling taxes and licensing. Please let me know if you feel I missed anything.
As always this post is for entertainment purposes only. Do your research before starting a business to ensure you are in compliance with all rules and regulations/are properly protected.