Understanding Small Business Taxes: A Comprehensive Guide

Taxes are a cost of doing business, and small businesses face federal, state, and local taxes. However, small businesses may benefit from special tax deductions and credits. Here is what you need to know about taxes if you run a small business.

Types of Small Business Taxes

Small businesses may be subject to various taxes on both the federal and local levels. These taxes may include the list below, though every small business may not need to pay each of these taxes depending on where they are located and the nature of their business.

Income Tax

All businesses, with the exception of partnerships, are required to file a federal income tax return each year. Partnerships must only file information returns (Form 1065) instead; this is because partnership income is passed through to the partners, who are taxed on it individually.

The type of tax return that's required varies, depending on how the business is legally structured:

• Sole proprietorships file either a Form 1040 or 1040-SR, along with a Schedule C, or Schedule F in the case of a farm business.
• Individual partners in a partnership also must file a Form 1040 or 1040-SR, as well as a Schedule E. The same is true of individual shareholders in S corporations.
• C corporations and S corporations must file a Form 1120 or 1120-S, respectively. The 1120-S form is also an information return; the S corporation doesn't pay federal taxes but passes that obligation on to its individual shareholders.

The filing requirements and tax obligations for a limited liability company (LLC) depend on how it was established. LLCs may be set up as partnerships, corporations, or as “an entity disregarded as separate from its owner” (meaning that the owner is taxed as an individual, much like a sole proprietor).

Self-Employment Tax

Sole proprietors and individual partners in a partnership are also subject to self-employment tax for Social Security and Medicare and must attach Schedule SE to their 1040 or 1040-SR form. The self-employment tax rate is currently 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare.

Employment Tax

Sole proprietors, partnerships, and C or S corporations are all subject to employment taxes if they have employees.

Employment taxes include Social Security and Medicare taxes, for which employees and employers each pay a portion. They also include the income withheld from an employee's pay to cover their income taxes. Finally, they include unemployment taxes (FUTA), which the employer pays in their entirety.

Except for FUTA, employment taxes are filed using Form 941, 943, or 944. FUTA taxes are filed with Form 940.

Excise Tax

Sole proprietors, partnerships, C corporations, and S corporations may all be subject to excise taxes. An excise tax is a tax on specific goods and services, such as various types of fuels, air transportation, certain vaccines, sport fishing gear, and even indoor tanning services.

Excise taxes can be imposed by both the federal government and the states. Depending on the good or service involved, the payer may be the manufacturer, retailer, importer, or consumer.

Some excise taxes, referred to as sin taxes, are levied with the intention of discouraging certain frowned-upon activities or at least making them more expensive. For example, most states impose an excise tax on cigarettes.

Companies file their excise taxes on one of several forms, depending on what is being taxed. Those are Forms 720, 730, 2290, and 11-C.

Sales Tax

Sales taxes are imposed by most U.S. states, as well as many counties and cities. The United States does not have a national sales tax.

Small businesses may be required to collect sales taxes, and then pass them along to the relevant taxing authority if they sell taxable goods or services. What constitutes a taxable good or service and the amount of the tax will vary from one place to another, as will tax filing deadlines.

For a small business that isn't already collecting sales taxes, the first step is for it to register with its state taxing authority.

Other State and Local Taxes

States and local governments can impose a wide variety of other taxes that small businesses need to be aware of. They include: 

• Income taxes. Sole proprietors pay state and local income taxes (if any) as part of their personal income taxes, as do individual partners in partnerships and shareholders in S corporations. C corporations and S corporations file corporate tax forms and are taxed on that basis, although whether and how S corporations are taxed varies from one state to another. Partnerships also may or may not be taxed, depending on the state.
• Property taxes. Businesses that own buildings, land, or other real property may be taxed on it on the state and local levels, just as individuals are. In addition, some state and local governments tax tangible personal property, which in the case of a business might mean machinery, office equipment, or inventory, for example.
• Franchise taxes. Roughly a dozen states impose a franchise tax on businesses of various kinds (not specifically franchises) that want to do business in that state.
• Business license fees. The federal government, as well as many state and local governments, require certain types of businesses to obtain licenses and pay the appropriate fees for them—in effect, a type of tax. According to the U.S. Small Business Administration, "States tend to regulate a broader range of activities than the federal government. For example, business activities that are commonly regulated locally include auctions, construction, and dry cleaning, farming, plumbing, restaurants, retail, and vending machines."
  

Estimated Taxes

Estimated taxes are not separate taxes in their own right; they are a way of paying other taxes throughout the year. Sole proprietors, C corporations, and S corporations, as well as individual partners in partnerships and individual shareholders in S corporations, may all need to file estimated taxes, using either Form 1040-ES in the case of individuals or Form 1020-W in the case of corporations.

Estimated taxes are filed quarterly rather than annually, and failure to pay them, or to pay enough in total, can result in underpayment penalties once the individual or corporation files their annual tax return.

What Is an EIN?

For tax purposes, many small businesses need to obtain an employer identification number (EIN), also known as a federal tax identification number. These numbers are available online and free of charge from the Internal Revenue Service (IRS). In addition, some states issue their own ID numbers for businesses.

Sole proprietors with no employees may not need an EIN but can simply use their Social Security number as an identifier when they file their taxes. However, they might still want to get one in case they hire employees in the future.

Tax Deductions and Credits for Small Businesses

Like individual taxpayers, small businesses can claim a variety of deductions and credits when they file their taxes. Among them: 

Business Expenses

The costs of running a business are largely deductible from a company's profits, thereby reducing its taxable income. Deductible business expenses can include wages, rent, utilities, mileage and travel expenses, office supplies, equipment, advertising, internet and wireless services, and so forth. State and local taxes are generally deductible on businesses' federal taxes as well.

Depreciation

Rather than deduct the cost of certain property in the year of purchase, businesses must in some cases depreciate it over a period of time. That results in tax deductions that can continue for years into the future.

Home Office Deduction

Sole proprietors, in particular, may be able to deduct the cost of a home office that they use "exclusively on a regular basis" to run their business. Based on the square footage of their office relative to the entire home, they can deduct a percentage of their mortgage interest, insurance, utilities, and repairs, as well as take depreciation for that portion of their home.

Tax Credits

Unlike deductions, which reduce businesses' taxable income, tax credits reduce their taxes on a dollar-for-dollar basis. Among the credits available to small businesses are:

• The Work Opportunity Tax Credit (WOTC) provides a tax credit to businesses that hire and employ members of certain "targeted groups," which includes qualified veterans and recipients of various forms of public assistance.
• The Employer-Provided Childcare Credit assists employers with the costs of providing or funding childcare for employees.
• The Small Business Health Care Tax Credit reimburses employers for a portion of their costs in paying health insurance premiums for their employees.
• The Qualified Small Business Payroll Tax Credit for Increasing Research Activities provides a credit based on the company's qualified research activities.

The IRS has a list of other credits and the forms required to claim them on its website.

Tax Planning and Compliance for Small Businesses

While few (if any) small business owners may enjoy paying taxes, the process can be made a little less onerous by planning ahead and keeping good records along the way. Here are a few things to keep in mind:

• Record keeping. Small businesses will want to keep careful records of their income and expenses, ideally as they occur to avoid scrambling to collect paperwork later on. Accounting and tax software programs for small businesses can help. 
• Estimated tax payments. As mentioned above, businesses may need to pay estimated taxes each quarter in order to avoid penalties, not to mention a whopping tax bill at the end of the year. Businesses can pay their estimated taxes by mail, phone, or mobile device as well as online through the IRS's Electronic Federal Tax Payment System (EFTPS). 
• Filing deadlines. Businesses will also want to take note of the deadlines for filing their various tax forms. While individuals may only have to concern themselves with April 15 (or thereabouts) each year, businesses can face an array of deadlines. The IRS spells them out in its Publication 509: Tax Calendars.
• Tax penalties. Small businesses that don't file their taxes on time or fail to pay what they owe can be subject to IRS penalties. In addition, the IRS can charge interest on those penalties until the bill is paid in full. Taxpayers also have a right to dispute any penalties that the IRS imposes.
• Tax audits. The IRS can choose to audit individual or business tax returns for any number of reasons. Sometimes it's simply because the return was chosen at random. In general, the IRS says, most of the returns it audits are no more than two years old, and it rarely audits returns that go back more than six years. The lesson here: Hang on to your returns and all the back-up for them for at least that long.

How to File Small Business Taxes

Filing small business taxes is a three-step process:

1. Collect the information you need (again, preferably on an ongoing rather than last-minute basis).
2. Determine which forms apply to you. You can find a list of small business forms and publications on the IRS website.
3. File by the appropriate deadline.

For example, let's say you're a small business in Washington. The Department of Revenue's monthly B&O tax returns are due on the 25th of the following month, though you may be eligible to file quarterly. To file your taxes, you'll have to be registered with the DoR. You'll then need to have your sales and collection information on hand, and then navigate the DoR site.

Small Business Taxes vs. Large Business Taxes

Small businesses and large businesses face distinct considerations when it comes to taxes due to differences in size, structure, and resources. Here are some key differences.

Tax Filing Requirements

Small businesses generally file taxes using simpler forms, such as Schedule C for sole proprietorships or Form 1120-S for S-corporations. They often make quarterly estimated tax payments to avoid penalties. In contrast, large businesses typically use more complex forms like Form 1120 for C-corporations and may need to file consolidated tax returns for multiple subsidiaries, which requires more detailed reporting and compliance.

Deductions and Credits

Small businesses often benefit from deductions like the home office deduction, startup costs deduction up to $5,000, and Section 179 deduction. Large businesses, on the other hand, can leverage more substantial deductions and credits such as research and development (R&D) credits and foreign tax credits for international operations.

Resources/Expertise

Small businesses usually lack the firepower to put heavy resources behind tax strategy. They usually don't have dedicated tax professionals and have to instead rely on external accountants or tax software. Their limited resources can make it difficult to stay updated on tax law changes and handle complex compliance issues. Meanwhile, large businesses typically have in-house tax departments with specialists who can manage intricate tax matters and implement sophisticated tax planning strategies, especially planning future years.

Entity Structure

Small businesses often choose entity structures like sole proprietorships, partnerships, LLCs, or S-corporations. These structures offer benefits like pass-through taxation but also involve personal liability considerations. Large businesses frequently operate as C-corporations, so they may face double taxation at both the corporate and shareholder levels.

Compliance and Audits

Compliance requirements for small businesses are generally less stringent, though they must still adhere to tax laws and regulations. Large businesses face more rigorous compliance standards and are more prone to audits, especially if they are a public company. They must also comply with additional regulations such as the Sarbanes-Oxley Act.

Resources for Small Business Taxes

The IRS and other taxing authorities provide numerous resources online.

For federal taxes, these IRS links would be good places to start:

• Small Business and Self-Employed Tax Center
• Small Business Forms and Publications
• Publication 334: Tax Guide for Small Business (for Schedule C filers)
• Publication 583: Starting a Business and Keeping Records

Information on state and local taxes can be found on the websites of their tax and revenue departments. As a central starting point, the IRS offers this list of state government websites, including their respective tax offices. Bear in mind that if you're planning to do business in more than one state, you may have to register with several of them.

The Bottom Line

It may sometimes seem as if small businesses are being taxed from every direction. However, understanding the rules can make it easier, and knowing the ins and outs of tax deductions and credits can make it less costly.

If you're a small business owner who's either too busy with other duties or uncomfortable handling these matters yourself, then hiring an accountant who is familiar with your type of business could be money well spent. As a plus, the IRS notes, "Fees charged by accountants and attorneys that are ordinary and necessary expenses directly related to operating your business are deductible as business expenses."