Here is an interesting fact: In 2021, Amazon made 469 billion dollars in gross revenue. They netted 33 billion or around 7% of total sales. Apple in comparison, generated 365 billion in gross sales and netted 94 billion dollars or around 25% of gross revenue. By the way, most small businesses net around 10% of their annual revenue.
Business taxes can be complicated and maybe even a bit scary when you’re just starting out. This article is a general overview of the small business tax system. It will not cover everything you need to know, but it will help to provide a basic understanding of how things work.
When you start a business, you are gifted with three free business partners that each want to be paid: the city, the state, and the federal government. City and state taxes are paid monthly and have a range of 4 - 16%, with Alaska being the lowest and New York being the highest. Federal taxes are usually paid quarterly, but there are certain conditions under which you can pay them annually. Next, I’ll go over some concepts that you might want to know about business taxes:
U.S. Tax Code Is Complicated
First, once you become a real business, realistically, you won’t be able to do your own taxes. And you shouldn’t try to do your own taxes; just as it is not advised for any attorney to represent themselves in court. The system is such that you cannot do it yourself. It’s complicated: maybe on purpose because it would ensure the survival of the CPA industry. Otherwise, they would be eliminated if business taxes were simplified.
Not every business is the same so the tax code may be completely different depending on the type of business. Some businesses deal in agriculture. They’re taxed differently. Some businesses deal in alcohol. They’re taxed differently. Construction, real estate... taxed differently.
Also, there is usually a change in the tax code every year. So, it’s difficult for business owners to keep up with all the changes.
Two CPAs will probably arrive at different numbers if they did your taxes. Let’s say you were running a test and hired two different CPA firms to do your business taxes. Their numbers would differ. The reason is because the tax code allows for some level of discretion. For example, two different CPAs may allocate expenses differently. They may realize deductions differently. Annual amortization amounts can vary. So, it’s impossible that two CPAs would ever arrive at the same numbers in a given tax year; and this is because of the complexities of the tax code.
Understanding the Concept of Tax Write-offs
The concept of tax write-offs is overhyped; and to a larger extent, misunderstood. So, what is a tax write-off? It’s just a business expense that reduces your total tax burden at the end of the year. Tax burden meaning, the amount you would potentially owe in taxes. The thing about tax write-offs is they can be as complicated as the entire tax code. For example, if you purchase a company vehicle for $40,000 dollars, you can do 2 things: you can deduct the full amount on taxes in the year it was purchased. This is usually not a good idea, but there are instances where it makes sense. Or you can deduct the amount of depreciation over several years. Your CPA is going to give you the best advice based on your unique business.
Which Tax Class Should You Choose?
Which tax class is best? Probably not an LLC. An LLC only establishes that a business entity exists. But LLCs are not recognized as taxable entities by the IRS. So many businesses will initially register as an LLC, which is fine when you are just getting started. But by the time they start paying a CPA for tax preparation, most likely they will convert the business to an S-corp. This is true, not only if there are multiple owners, but it is also true if you are the sole owner of a business. Generally, you would think a business with a single owner would be a sole proprietor. But a CPA will probably say that it is most wise to become an S-corp because of the tax benefits.
The Basics of How An S-Corporation Works
In an S-corp, the company is not allowed to profit. The way it works is in the event there is a profit, it is passed down to the owners. This is true even if there is only one owner. Earlier, I said that the average net profit for a small business was around 10%. On gross sales of one million, that means you would have approximately $100,000 in cash in your bank account at the end of the year, right? Because earlier I said any profit from the business is passed on to the owners. Well, yes, but not quite. First, any infusion of cash creates a taxable event. And, unfortunately, the taxes on 100K would be exorbitant. Instead, what happens is this money can be further allocated into things like retirement accounts and other asset classes. When you hear the term "tax shelter," that’s what they are referring to. When the money is sitting in a retirement account, the IRS is essentially giving you the most favorable tax terms. By the way, the profit from an S-corp can also be allocated in other ways that allow you to grow your business.
Not All CPAs Are Created Equally
In general, any CPA will be able to do your taxes without issue. But some may have limited experience with emerging technologies and other fields. Accordingly, they may not be the best fit for your business. Also, CPAs mainly know numbers and are experts in the tax code. But that doesn’t mean they are business savvy. They may lack in areas such as marketing, technology, communication, and business investment advice beyond simply doing business taxes.
Unfortunately, you won’t really know how to assess a CPA when starting out. But the better ones tend to have at least some type of newsletter with best practices and relevant industry news. They should communicate any changes in the tax code that might affect your business. They might offer additional classes on how to plan for retirement. It should be noted that these are not requirements for being a good CPA. But if you were paying a similar price for services, the one giving you more is going to be a better deal.
Who Tracks Business Expenses?
You can definitely do your own bookkeeping. But as your business grows, you will want to delegate those tasks to a specialist. Usually, a bookkeeper does this for you because their hourly rate is significantly less than a CPA. A bookkeeper categorizes all business expenses for the year: so your marketing costs, rent, supplies, any equipment purchases, any interest paid during the year, and so on. These will all be categorized in a ledger, probably using one of the big tax software providers, and then the CPA will take the info and do the final accounting.
Once you are ready to file your return, both your personal and business taxes are usually done simultaneously. A CPA will typically charge two separate fees for the business and personal tax preparation.
How Successful Businesses Use Tax Planning
As the year ends, businesses that have been around the block are able to get the best tax benefits by planning their taxes in advance. This is how successful companies are able to end the year paying minimal taxes. How does tax planning work? Usually, the owners of the business will communicate with the CPA around the third or fourth quarter [as the year is coming to an end]. They then look at where the business is financially. They’re checking out the financial trajectory for the remaining few months that are left in the year. If it appears they are going to have too much of a profit, there are things the business can do to lower or even eliminate any profit, as I touched on earlier. When you lower your profit, you also lower the amount of taxes owed.
If it looks like there will be losses, they can sometimes account for potential losses by having sales or maybe liquidation events to end the year at a break-even point, or possibly in profit territory. So prudent businesses are planning their tax outcomes in advance so that nothing comes as a surprise during tax season. It should be noted that whenever you talk to a CPA, and they have to evaluate, analyze, or look over anything your business does that relates to numbers, they will need to be paid for their time. They are ultimately keeping you out of tax trouble, so their fees are usually worth it.
How to Handle Unpaid Business Taxes
One of the most stressful experiences an owner might face is the threat of IRS penalties that may come as a result of avoiding business taxes for too long. If this sounds like your situation, first off, don’t panic. People who don’t come from wealth often face unique challenges like this. When I first started my business, I was in the same boat. I was maybe a 20-year-old and found myself owing approximately 10K to the IRS that I simply didn’t have. In my case, I believe they categorized my income as 1099, which meant no payroll taxes were taken out during the year. In the end, I was able to pay off the debt within a few years.
So, what are best practices if you find yourself in this situation? The first thing you want to do is contact a CPA: the sooner the better because the IRS has the harshest punishment for business tax avoiders. Regardless of what you may owe, they will work with you. For example, if you owe $20,000 and can’t pay it all at once, they have payment plans available. You can also negotiate various payback terms. You might be able to pay half of what you owe up front and then do a payment plan on the balance.
Here is a tip: The key to reducing the amount you owe is to demonstrate that the business expenses were high and maybe even exceeded revenue. Hopefully, you would have a documentation for purchases of things like equipment, vehicles, and other supplies. This will help to lessen or even eliminate the tax amount owed. But penalties and interest will remain. Also, most businesses don’t begin to profit until roughly their third year in business anyway. So, there’s a good chance that the amount you think you owe in taxes is considerably less than the actual amount.
Let’s go over the main points discussed: The U.S. tax code is complicated. It’s never a good idea to try to do your own taxes. Let a certified professional do your taxes: a CPA. A tax write-off is a business expense that reduces your tax burden at the end of the year. Any purchase you make for business purposes will help to lower the tax amount owed. When it comes to which tax class you should choose, the LLC is the most commonly discussed business structure, but there is a good chance that your CPA will steer you away from an LLC and into a better tax vehicle like an S-corp. Not all CPAs are created equally. Some give you more for your money. Do research and ask questions to find a CPA that is the right fit for your business. With regard to who keeps track of ongoing business expenses, a bookkeeper usually handles this task. A bookkeeper is always cheaper than a CPA. We learned that prudent businesses engage in tax planning throughout the year, which eliminates surprises and allows them to make decisions that lead to tax minimization. Lastly, for businesses that have fallen behind in paying taxes, it’s best to contact a CPA and explain your situation. There are many options to get you on the right track.
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