How to Understand Tax Planning as a Small Business Owner

As a small business owner, you likely wear a lot of hats. And if you’re a solopreneur, you function as CEO, human resources, operations and marketing all in one. As you handle your day-to-day duties, it might be easy to lose sight of one critical function in your business: tax planning. Poor planning can result in unexpected tax bills and penalties that impact your business’s cash flow. Here’s what you need to know.

There’s a Difference Between Gross Revenue and Net Profit

As a small business owner, you pay taxes on your net profit, not your gross revenue. To determine your net profit, deduct any reasonable expenses necessary to run your business from your gross revenue. These expenses may include software, equipment, supplies, home office costs, education and training, lawyer’s or accountant’s fees, and travel expenses.

You Need to Turn a Profit

Don’t allow your business to run at a loss for too long. To meet the IRS safe harbor rule, you must generate a profit in at least three of five consecutive years. If the safe harbor is met, the IRS will presume that you are engaged in business for profit. This allows you to continue deducting your business expenses.

The Income Tax Rate You Pay Depends on Your Business’s Legal Structure

Sole proprietorships and partnerships, for example, are both considered pass-through entities. That means any income flows through to your personal tax return and is taxed at your personal tax rate. C Corporations get taxed at a flat 21% corporate tax rate.

It’s Essential to Keep Business and Personal Finances Separate

Start by opening a separate bank account for your business. Maintain accurate, detailed records of your business income, related expenses and any tax payments you made during the year. Good recordkeeping will make your tax planning and filing much easier. Bookkeeping software, such as QuickBooks or Wave, can help.

You’re Responsible for More Than Just Income Taxes

In addition to federal withholding taxes, which vary depending on how much you earn, you may also be responsible for state and local income taxes, Social Security and Medicare taxes, unemployment taxes, excise taxes and sales taxes. In addition, you may need to issue a Form 1099-NEC to any contractor you paid $600 or more to during the year that isn’t registered as either a C Corp or an S Corp.

You May Need to Pay Quarterly Estimated Tax Payments

A W-2 employee usually has income tax withheld from their pay. If you do not pay your taxes through withholding or do not pay enough that way, you might have to pay quarterly estimated tax payments. If you’re not required to make estimated tax payments, you may pay any tax due when you file your return.

Estimated tax payments are generally due on April 15 for the first quarter of the year, June 15 for the second, September 15 for the third and January 15 of the following year for the fourth quarter. A good rule of thumb is to calculate your running profit each quarter and set aside an appropriate percentage for estimated tax payments.

Don’t Panic If You Owe Money When You File Your Tax Return

Pay what you can as soon as possible and contact the IRS to set up a payment plan if you can’t pay it all right away. Update or increase your tax withholdings at work using Form W-4 or, if you are fully self-employed, set aside more money for taxes going forward.

Seek Qualified Advice as Your Business Grows

As you scale up your small business, hire financial professionals who can guide you in the right direction. This team might include a tax professional, such as a certified public accountant or enrolled agent, to help you with tax filing and compliance; a lawyer to whom you can go to for legal advice and who can help draft essential business documents; and a CERTIFIED FINANCIAL PLANNER™ professional, who can help you manage your personal finances. You can find your CFP® professional today at www.LetsMakeAPlan.org.