6 Difficulties With Small Business Taxes
Editor’s Note: In this post, we’ll review aspects of small business taxes that may surprise you…
There are more than 28 million small businesses in the United States. New sharing economy opportunities like Airbnb and Uber, and even self-employment gig websites like Upwork and Fiverr, host more opportunities for individuals to become their own boss. Some side hustlers or gig economy workers may not realize they are small-business owners.
While owning a small business offers many positives – like freedom from having a boss and the ability to set your own schedule – there are unintended tax consequences with small business taxes; one of them is being at a higher risk for IRS audits and notices.
In fact, IRS statistics show that small businesses are the largest segment of noncompliant taxpayers. Why is this the case? Where all of a W-2 worker’s salary must be reported to the IRS and state governments by their employers, small businesses must accurately report their business income and deductions on their tax returns. Additionally, small businesses also have more complex tax responsibilities, including:
- Quarterly estimated tax payments
- Payroll tax deposits and filings
- Reporting payments to contractors each year
- Sales tax reporting
- State and local licensing requirements
Small Business Taxes – The Elements to Consider
Because of extra tax responsibilities, small businesses may experience more interaction with the IRS and state Departments of Revenue. Here are the most common difficulties that new small business owners may encounter:
Small business owners may be surprised when filing their tax return for the first time, that in addition to income taxes, they owe another 15.3% in self-employment tax on their net self-employment income. While employees and employers share the burden of Social Security and Medicare taxes equally by paying 7.65% each, a self-employed individual must pay the full amount.
On the bright side, these taxpayers can deduct half of their self-employment tax to directly offset their income. Also keep in mind that the tax is paid on only on net self-employment income, that is, income after expenses have been deducted.
Quarterly Tax Filing
Small business owners don’t have taxes withheld from a paycheck like traditional employees. Generally, if they expect to have a tax liability of at least $1,000, they must send tax payments each quarter to the IRS.
Not knowing or forgetting about quarterly estimated tax payments may result in a significant tax balance and penalties.
Owing a Large Annual Tax Bill
Small business owners may wind up with a seemingly impossible-to-pay annual tax bill. There can be many reasons for this, including not paying quarterly estimates (as explained in the previous section), unexpected additional income, defaulted installment agreements from a prior year, and additional penalties and interest.
Reporting (Or Not Reporting) Cash Payments
Cash-based companies, in particular, require detailed record keeping to substantiate income and expenses. With cash-based businesses, Forms 1099 can be used to substantiate income but all income must be reported, whether shown on a 1099 or not. Each IRS small business audit starts with scrutiny about whether the business reported all of its income.
Phones, home offices, travel, and entertainment expenses are all commonly deducted by small business owners to lower their taxable income, yet the IRS rules around business versus personal expenses are, for some, confusing. In fact, the IRS perceives many of these expenses to be personal in nature (and therefore not deductible). This means good record keeping is essential. The small business owner must prove their expenses are business-related in the case of an IRS audit. Again, detailed record keeping is crucial.
Failing to File
Some small business owners don’t file because they simply can’t pay the tax balance due. This procrastination equates to larger tax bills and penalties, including a 25% failure to file penalty, which is tacked onto the overall tax bill if it is five months or more late.
As a business owner, you must embrace a small business taxes year round. That starts with keeping good records throughout the year, continues with making estimated tax payments to limit the tax balance at filing, and culminates with filing an accurate return at the end of the year.
Remember: you do not have to tackle this alone. Let a Tax Advisor at Block Advisors help you establish a game plan for your taxes this year to help avoid potential IRS scrutiny. Book an appointment now.