9.6 Taxes and compliance

Taxes and compliance are crucial aspects of running a successful business. Entrepreneurs must navigate various tax obligations, including income, employment, sales, and property taxes. Understanding these requirements helps avoid penalties and ensures legal operation.

Business structure plays a significant role in tax obligations. From sole proprietorships to corporations, each entity type has unique tax implications. Proper recordkeeping, tax planning strategies, and professional assistance can help minimize tax liability and maintain compliance with ever-changing regulations.

Types of business taxes

• Understanding the various types of business taxes is crucial for entrepreneurs to ensure compliance and avoid penalties
• Different types of taxes apply to businesses depending on their structure, location, and activities

Income taxes

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• Taxes levied on the profits earned by a business
• Federal income tax rates vary based on the business structure (sole proprietorship, partnership, corporation)
• State income taxes may also apply, with rates varying by state
• Businesses must estimate and pay quarterly income taxes throughout the year (estimated taxes)

Employment taxes

• Taxes related to hiring and paying employees, including Social Security, Medicare, and unemployment taxes
• Employers are responsible for withholding a portion of employees' wages for Social Security and Medicare (FICA taxes)
• Federal Unemployment Tax Act (FUTA) taxes are paid by employers to fund unemployment benefits
• State unemployment taxes may also apply, with rates varying by state and the employer's claims history

Sales taxes

• Taxes imposed on the sale of goods and services, typically paid by the customer but collected and remitted by the business
• Sales tax rates and rules vary by state and local jurisdiction
• Businesses must register for sales tax permits and collect taxes on taxable sales
• Some states have destination-based sales tax, while others have origin-based sales tax

Property taxes

• Taxes levied on real estate and personal property owned by a business
• Real estate property taxes are based on the assessed value of the property and local tax rates
• Personal property taxes may apply to business equipment, furniture, and inventory
• Property tax rates and assessment methods vary by state and local jurisdiction

Excise taxes

• Taxes imposed on specific goods or services, such as gasoline, alcohol, or tobacco
• Excise taxes are often included in the price of the product and paid by the consumer
• Businesses that manufacture, sell, or distribute these products may be responsible for collecting and remitting excise taxes
• Examples of federal excise taxes include the fuel tax and the alcohol tax

Tax obligations by business structure

• The tax obligations of a business depend on its legal structure, which determines how the business is taxed and who is responsible for paying taxes
• Choosing the right business structure is an important decision that impacts taxation, liability protection, and compliance requirements

Sole proprietorships

• Simplest business structure, with no legal distinction between the owner and the business
• Business income and expenses are reported on the owner's personal tax return (Schedule C)
• Owner is personally liable for all business debts and obligations
• Self-employment taxes (Social Security and Medicare) apply to net earnings

Partnerships

• Business owned by two or more individuals who share profits and losses
• Partnership income and expenses are reported on Form 1065, with each partner receiving a Schedule K-1 for their share
• Partners are personally liable for business debts and obligations, unless structured as a limited partnership
• Self-employment taxes apply to each partner's share of net earnings

Limited liability companies (LLCs)

• Hybrid business structure that combines the liability protection of a corporation with the tax flexibility of a partnership
• LLCs can choose to be taxed as a sole proprietorship (single-member LLC), partnership, or corporation
• Members' personal assets are generally protected from business debts and liabilities
• Self-employment taxes apply to members' share of net earnings, unless the LLC elects to be taxed as a corporation

Corporations

• Separate legal entity owned by shareholders, providing liability protection for owners
• Corporations are subject to corporate income tax on their profits (Form 1120)
• Shareholders pay personal income tax on dividends received from the corporation
• Owners' personal assets are generally protected from business debts and liabilities

S corporations

• Special type of corporation that elects to pass income, losses, deductions, and credits through to shareholders for federal tax purposes
• S corporation income and expenses are reported on Form 1120S, with each shareholder receiving a Schedule K-1 for their share
• Shareholders report their share of income on personal tax returns and pay income tax at individual rates
• Owners' personal assets are generally protected from business debts and liabilities

Tax registration and identification numbers

• Obtaining the necessary tax registration and identification numbers is a critical step in setting up a new business
• These numbers are used to identify the business for tax purposes and are required for filing tax returns and making tax payments

Employer Identification Number (EIN)

• Unique nine-digit number assigned by the IRS to identify a business for federal tax purposes
• Required for businesses with employees, partnerships, corporations, and multi-member LLCs
• Used for opening bank accounts, filing tax returns, and other business purposes
• EINs can be obtained online, by mail, or by fax using Form SS-4

State tax ID numbers

• Identification numbers assigned by state tax agencies for state tax purposes
• May be required for businesses that pay state income tax, hire employees, or sell taxable goods or services
• Registration requirements and processes vary by state
• Some states use the federal EIN for state tax purposes, while others assign a separate state tax ID number

Sales tax permits

• Registration required for businesses that sell taxable goods or services in states that impose a sales tax
• Permits are obtained from the state tax agency and allow the business to collect and remit sales taxes
• Businesses may need to register for sales tax permits in multiple states if they have nexus (significant presence) in those states
• Failing to obtain required sales tax permits can result in penalties and interest charges

Recordkeeping for tax purposes

• Maintaining accurate and organized records is essential for preparing tax returns, supporting deductions, and providing documentation in case of an audit
• Good recordkeeping practices help businesses track income and expenses, monitor financial performance, and make informed decisions

Financial statements

• Primary financial statements include the income statement, balance sheet, and cash flow statement
• Income statement shows revenue, expenses, and net profit or loss over a specific period
• Balance sheet provides a snapshot of assets, liabilities, and owner's equity at a given point in time
• Cash flow statement tracks the inflows and outflows of cash during a specific period

Receipts and invoices

• Receipts provide proof of business expenses and are necessary to support tax deductions
• Invoices document sales transactions and are used to track accounts receivable
• Businesses should establish a system for organizing and storing receipts and invoices, either physically or electronically
• Receipts and invoices should be retained for at least three years after filing the related tax return

Payroll records

• Detailed records of employee compensation, withholdings, and employer taxes
• Include timesheets, pay stubs, W-2 forms, and payroll tax filings
• Necessary for complying with employment tax obligations and preparing year-end tax forms
• Payroll records should be retained for at least four years after filing the related tax return

Asset and depreciation records

• Records of business assets, including purchase dates, costs, and depreciation schedules
• Used to calculate depreciation expense for tax purposes and track the book value of assets
• Important for substantiating the cost basis of assets in case of a sale or disposal
• Asset and depreciation records should be maintained for as long as the assets are owned, plus at least three years after filing the related tax return

Tax deductions and credits

• Tax deductions and credits can significantly reduce a business's tax liability by lowering taxable income or providing a direct reduction in taxes owed
• Understanding available deductions and credits helps entrepreneurs minimize their tax burden and improve their bottom line

Common business deductions

• Ordinary and necessary expenses incurred in running a business, such as rent, utilities, supplies, and advertising
• Salaries and wages paid to employees, as well as employee benefits and payroll taxes
• Depreciation expense for business assets, such as equipment, vehicles, and buildings
• Interest paid on business loans and credit cards
• Insurance premiums for business-related coverage, such as liability, property, and health insurance

Home office deductions

• Expenses related to using a portion of a home exclusively for business purposes
• Deductions can include a percentage of rent or mortgage interest, utilities, insurance, and repairs
• Two methods for calculating the deduction: simplified method ($5 per square foot, up to 300 square feet) or regular method (actual expenses based on percentage of home used for business)
• Strict requirements apply, including regular and exclusive use of the space for business

Startup costs

• Expenses incurred before the business begins operations, such as market research, advertising, and professional fees
• Up to $5,000 of startup costs can be deducted in the first year of business, with the remainder amortized over 15 years
• Organizational costs, such as legal fees for forming a corporation or partnership, are treated similarly to startup costs

Research and development credits

• Tax credits available for businesses that engage in qualified research activities
• Qualified research must be technological in nature, aim to develop new or improved products or processes, and involve experimentation
• Two types of credits: regular research credit (20% of qualified expenses above a base amount) and alternative simplified credit (14% of qualified expenses above 50% of the average for the previous three years)
• Unused credits can be carried back one year or forward up to 20 years

Tax filing and payment deadlines

• Understanding and meeting tax filing and payment deadlines is crucial to avoid penalties and interest charges
• Different deadlines apply to various types of taxes and business structures

Federal tax deadlines

• Sole proprietorships and single-member LLCs: April 15 (or October 15 with an extension)
• Partnerships and multi-member LLCs: March 15 (or September 15 with an extension)
• C corporations: April 15 (or October 15 with an extension) for calendar year filers; 15th day of the 4th month after the end of the fiscal year for fiscal year filers
• S corporations: March 15 (or September 15 with an extension)

State and local tax deadlines

• State income tax deadlines often coincide with federal deadlines but may vary by state
• Local tax deadlines, such as property taxes, vary by jurisdiction
• Businesses should consult state and local tax agencies for specific filing and payment requirements

Estimated tax payments

• Businesses that expect to owe $1,000 or more in federal income taxes must make quarterly estimated tax payments
• Estimated tax deadlines are April 15, June 15, September 15, and January 15 (of the following year)
• Underpayment of estimated taxes can result in penalties and interest charges

Extensions and late filing penalties

• Businesses can request an extension to file their federal income tax returns by submitting the appropriate form (e.g., Form 7004 for partnerships and corporations)
• Extensions provide additional time to file tax returns but do not extend the time to pay taxes owed
• Late filing penalties apply if tax returns are not filed by the due date or extended due date
• Penalty amounts vary depending on the type of tax and the length of the delay

Payroll taxes and compliance

• Payroll taxes are a significant responsibility for businesses with employees
• Proper withholding, remittance, and reporting of payroll taxes are essential to avoid penalties and maintain good standing with tax authorities

Federal payroll taxes (FICA, FUTA)

• FICA (Federal Insurance Contributions Act) taxes consist of Social Security and Medicare taxes
• Employers withhold a portion of employees' wages for FICA taxes and match the amount withheld
• Social Security tax rate is 6.2% each for employees and employers, up to a wage base limit ($142,800 in 2021)
• Medicare tax rate is 1.45% each for employees and employers, with no wage base limit
• FUTA (Federal Unemployment Tax Act) taxes are paid by employers to fund unemployment benefits
• FUTA tax rate is 6% on the first $7,000 of each employee's wages, but credits for state unemployment taxes can reduce the effective rate to 0.6%

State payroll taxes

• State unemployment taxes (SUTA) are paid by employers to fund state unemployment benefits
• SUTA tax rates vary by state and are based on factors such as the employer's industry, claims history, and experience rating
• Some states also have additional payroll taxes, such as disability insurance or workforce training taxes

Withholding and remitting taxes

• Employers must withhold federal income tax, FICA taxes, and applicable state and local taxes from employees' wages
• Withheld taxes, along with the employer's share of FICA and FUTA taxes, must be remitted to the appropriate tax agencies on a regular basis (e.g., semi-weekly or monthly)
• Failure to withhold or remit payroll taxes can result in significant penalties and interest charges

W-2 and 1099 reporting

• Employers must provide Form W-2 to employees and the IRS by January 31, reporting wages paid and taxes withheld for the previous year
• Form 1099-MISC must be provided to independent contractors who were paid $600 or more during the year, also due by January 31
• Copies of W-2s and 1099s must be filed with the IRS and applicable state tax agencies
• Penalties apply for failure to file or furnish correct W-2s and 1099s

Sales tax collection and remittance

• Businesses that sell taxable goods or services are responsible for collecting and remitting sales taxes to state and local tax authorities
• Understanding sales tax obligations and compliance requirements is essential to avoid penalties and maintain good standing

Nexus and sales tax obligations

• Nexus is the connection between a business and a state that triggers a sales tax collection obligation
• Nexus can be established by physical presence (e.g., employees, inventory, or property) or economic presence (e.g., sales volume or number of transactions)
• States have varying nexus thresholds and criteria, so businesses must carefully evaluate their sales tax obligations in each state where they have customers

Collecting sales tax from customers

• Businesses must collect sales tax on taxable sales at the time of the transaction
• Sales tax rates vary by state and local jurisdiction and may include a combination of state, county, and city taxes
• Some states have destination-based sales tax (tax rate based on the customer's location), while others have origin-based sales tax (tax rate based on the seller's location)
• Certain goods and services may be exempt from sales tax, such as food, prescription drugs, or manufacturing equipment

Filing sales tax returns

• Businesses must file sales tax returns with the appropriate state tax agency, reporting total sales, taxable sales, and taxes collected
• Filing frequencies vary by state and may be monthly, quarterly, or annually, depending on the business's sales volume
• Due dates for sales tax returns also vary by state, typically falling on the 15th or 20th of the month following the reporting period
• Many states require electronic filing of sales tax returns and payments

Consequences of non-compliance

• Failing to collect and remit sales taxes can result in significant penalties, interest charges, and legal consequences
• Penalties may include a percentage of the unpaid tax, late filing fees, and even criminal charges in severe cases
• Interest accrues on unpaid sales taxes from the due date until the tax is paid
• Non-compliant businesses may be subject to audits, liens, or even forced closure by state tax authorities

Tax planning strategies

• Effective tax planning can help businesses minimize their tax liability and improve their bottom line
• Strategies involve timing income and expenses, maximizing deductions, and taking advantage of tax-advantaged investment opportunities

Timing of income and expenses

• Businesses can strategically time income and expenses to optimize their tax position
• Deferring income to a later tax year or accelerating expenses into the current year can reduce the current year's tax liability
• Examples include delaying billing for services until the next tax year or making large equipment purchases before year-end
• Businesses should consider their overall financial situation and future tax rates when making timing decisions

Maximizing deductions

• Identifying and claiming all eligible business deductions can significantly reduce taxable income
• Common deductions include business expenses, depreciation, home office expenses, and vehicle expenses
• Maintaining accurate records and understanding the rules for each deduction is essential to avoid disallowance by the IRS
• Consulting with a tax professional can help businesses optimize their deductions and ensure compliance

Retirement plan contributions

• Contributions to qualified retirement plans, such as 401(k)s or SEP IRAs, can reduce a business's taxable income
• Employer contributions to employee retirement plans are generally tax-deductible
• Retirement plans also provide tax-deferred growth for employees, helping to attract and retain talent
• Different types of retirement plans have varying contribution limits, eligibility requirements, and administrative complexities

Tax-advantaged investments

• Investing in tax-advantaged vehicles can help businesses reduce their tax liability and build wealth
• Examples include municipal bonds (interest is exempt from federal income tax), real estate (deductions for depreciation and expenses), and opportunity zones (tax incentives for investing in designated low-income areas)
• Businesses should carefully evaluate the risks and returns of tax-advantaged investments and consult with financial advisors to ensure alignment with their overall financial goals

Professional tax assistance

• Seeking the help of tax professionals can ensure compliance, minimize tax liability, and provide valuable guidance for business owners
• Different types of tax professionals offer varying levels of expertise and services

Certified Public Accountants (CPAs)

• Licensed professionals who have passed the CPA exam and met state requirements for education and experience
• Offer a wide range of services, including tax preparation, financial statement audits, and business consulting
• Bound by a code of ethics and required to maintain continuing education to stay current with tax laws and regulations
• Best suited for businesses with complex tax situations or those requiring audited financial statements

Enrolled Agents (EAs)

• Federally licensed tax practitioners who have passed a comprehensive IRS exam or have relevant experience as former IRS employees
• Specialize in tax preparation, tax planning, and taxpayer representation before the IRS
• Can represent taxp