When you start your own business, knowing the income tax implications of your decisions can save you money and headaches. Learn about paying estimated income taxes, keeping track of expenses and how to take a tax deduction when you use your car for business.
From lemonade stand to estimated taxes
Remember that lemonade stand you started when you were a kid? Things were easier then. Now, if you’re starting a business, you have to remember to give Uncle Sam his due. We’ve got advice for you on:
- Which accounting method to choose
- How to pay estimated taxes
- Keeping track of expenses
When you start a small business, you put all your time and energy into making sure it succeeds; taxes may be the farthest thing from your mind. But there are plenty of tax considerations that go along with your new venture.
We've made a list of some important tax-related issues you need to be aware of as you're getting started and going through your first year.
Businesses must figure their taxable income and file a return for a tax year or annual accounting period. You'll need to select an accounting method, which is a set of rules that determines when and how you report your business income and expenses:
Cash: When you use the cash method of accounting, you count income or expenses at the time you actually receive a payment or pay a bill. A cash-basis report shows income only if you have received it, and expenses only if you have paid them. For example, if you bill for services you provide in mid-December 2021 but don't receive the check until mid-January 2022, you would include the payment in your 2022 income. The cash method is used by most sole proprietors and other self-employed individuals with no inventory.
Accrual: Under the accrual method, you record income when you earn it and expenses when you incur them. The point where you enter a transaction on your books and when you actually pay or receive cash may be two separate events. Following the example above, a taxpayer who uses the accrual method and provides services in December 2021 would include them in income for 2021, regardless of when they are actually paid for the services.
Employer ID number
When you start out, you'll need to apply to the IRS for an Employer Identification Number or EIN, which must be on your return and other documents you file with the IRS. (If you're a sole proprietor with no employees or you have a single-owner Limited Liability Company, you can use your Social Security number instead.) To get an EIN, you can apply with the IRS online or call the IRS at (800) 829-4933.
Estimated tax payments
As a small business owner, you’ll need to make estimated tax payments during the year to cover your federal income tax liability, unless you expect to owe less than $1,000. Generally, estimated taxes are due in four quarterly installments.
For the 2021 tax year, the four estimated tax payment dates are: April 15, June 15 , September 15 of 2021 and January 15, 2022.
If you’re mailing payments to the IRS, use Form 1040-ES. Or you can pay electronically by enrolling in the Electronic Federal Tax Payment System (EFTPS). When you start up your business and request an employer identification number from the IRS (see below under “Employment Taxes”), the IRS automatically enrolls you in EFTPS.
If you have employees, you must pay the employer share of their Social Security and Medicare taxes, and withhold their share of those taxes from their wages. You must pay 7.65% and your employee must pay 7.65% on the first $146,700 of the worker's wages in 2022.
For income above that level, you and your employee must keep paying only the Medicare portion of the tax, which is 1.45% for each of you. The taxes must be deposited with the IRS periodically; how often you send in these funds depends on how large the deposits are. You can deduct the employer share of these employment taxes as a business expense on Schedule C.
What about your own employment tax liability?
If you're a sole proprietor, partner, independent contractor or are otherwise self-employed, you must pay the full freight—15.3% in 2022 on the first $146,700 of your net earnings from self-employment, which you calculate on Schedule C. For net earnings above that amount, you'll still owe Medicare taxes of 2.9%. You can deduct half of your self-employment tax when figuring Adjusted Gross Income on your 1040. That's not as good as paying half the liability—as employees do—but it's better than nothing.
Employee or Independent Contractor?
It's important to distinguish between workers you hire as employees and contract labor, because your tax liability and reporting are different depending on which type of worker you use. You don't pay or withhold employment tax for independent contractors as you would your employees. At year-end, you'll report payroll information for employees using Forms W-2 and W-3, while you'll use Form 1099-MISC for anyone who is a contractor.
The IRS monitors employers to make sure they aren't avoiding employment tax liability by classifying workers as contractors when they really are employees. The IRS looks to see how much control the employer has over the details of a worker's performance and whether the employer also exerts financial control. If, for example, you pay your workers an hourly wage, reimburse all their work-related expenses, dictate where they do their work, train them and provide them with equipment, you'll have a hard time making a case for classifying them as contractors.
For more information, review IRS Publication 15-A: Employer's Supplemental Tax Guide.
Here's the good news about business taxation: In general, you can deduct the costs of running your business in the same year that you pay them. The tax treatment is different for assets you buy that are expected to last more than one year. You generally must depreciate these assets, or spread their cost over several years.
But the IRS has a special rule known as the Section 179 deduction that is designed to allow small businesses to deduct the full cost of assets in the year they are purchased. This is also known as "expensing," because you get to deduct the cost of new assets just as you do current expenses. Property that is eligible for this special first-year expensing includes machinery, tools, fixtures, computers, software and vehicles used in your business.
In 2021, a business can expense up to $1,050,000 of the value of section 179 assets during the tax year. The amount you can expense is reduced if you purchase more than $2,620,000 in eligible property during the year.
Bonus depreciation has been changed for qualified assets acquired and placed in service after September 27, 2017. The old rules of 50% bonus depreciation still apply for qualified assets acquired before September 28, 2017. These assets had to be purchased new, not used. The new rules allow for 100% bonus "expensing" of assets that are new or used. The percentage of bonus depreciation phases down in 2023 to 80%, 2024 to 60%, 2025 to 40%, and 2026 to 20%. After 2026 there is no further bonus depreciation. This bonus "expensing" should not be confused with expensing under Code Section 179 which has entirely separate rules, see above.
The 100% expensing is also available for certain productions (qualified film, television, and live staged performances) and certain fruit or nuts planted or grafted after September 27, 2017.
50% bonus first year depreciation can be elected over the 100% expensing for the first tax year ending after September 27, 2017.
Keeping track of expenses
Don't lose those receipts!
To make sure you get all the tax deductions you're entitled to, you need to maintain good records of your company's expenses. And because you can't deduct any personal expenses, it's important to keep them separate. For example, you may want to have a bank account just for your business and a credit card for business purchases. If you incur an expense that combines personal and business use, you must divide up the total cost and take the deduction only for the business use.
Two types of business expenses that require special record keeping are:
Business Meals and Entertainment
You must identify the business purpose of any meal or entertainment expense for it to be deductible. Don't forget that 50% of the total expense is deductible. Also keep in mind:
- A deductible meal is usually with a business contact.
- An entertainment event usually follows a business meeting.
- Write on your receipts with whom you met, as well as the business purpose of the meeting. Save these receipts with the rest of your tax records.
Autos Used in Your Business
When figuring your automobile expenses, you can choose between taking the standard mileage rate or deducting your actual expenses. The standard mileage rate for 2021 is 56 cents per mile. For the first half of 2022 the rate is 58.5 cents per mile and increases to 62.5 cents per mile for the last half of 2022. If you deduct actual expenses, allowable costs include what you spend on such items as gas, oil changes, tires, repairs, preventive maintenance, insurance and registration fees plus depreciation (a non-cash expense). In either case, add what you pay for parking and tolls.
Using the standard mileage rate is much easier, but depending on the type of vehicle you drive and the number of expenses you have, recording your actual expenses may be a better deal. If you’re self-employed you can also deduct the business part of interest on your car loan on Schedule C, along with the business portion of personal property taxes on your vehicle.
Home offices for sole proprietors
If you are running your business out of your home, you may qualify for the home office deduction. To get this deduction, the IRS requires that you use your home office "exclusively and regularly" for your business. It has to be a separate area in your home where you don't mix business with other activities. So keep the kids and the TV out of your workplace. If you want to take the deduction, your playroom can't double as the office.
Here are some things to keep in mind:
- You can take the home office deduction, even if you perform your main work elsewhere, if you use the home office for all your administrative and management activities, including billing customers, ordering supplies and setting appointments. For example, if you're an electrician and perform your work in other people's homes, doing all your paperwork in your home office can qualify you for the home office deduction.
- You can claim the deduction if you store inventory or product samples there, or if you operate a day care facility.
- The size of your deduction depends on the amount of your home that is used for business. If your total business expenses exceed gross income from business use of your home, your deduction will be limited.
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