By Justin Smith
For the Opelika
Do you own a small business, either as your full-time job or as a side hustle? If so, taxes for your business are generally covered under self-employment tax laws. The IRS defines a trade or business as an activity carried out with the objective of making a profit. You do not actually have to make a profit in order to be in a trade or business as long as there is a profit motive, with the reasonable expectations of profits at some point in the future.
Several types of self-employment options exist. The simplest form is a sole proprietorship. Business owners do not have to file incorporation or organization documents with the state, apply for a Federal Employer ID Number (FEIN), or report self-employment taxes using a separate tax return. You can start out small and grow your business with minimal administrative overhead. All you really need to do is track and categorize your income and expenses. While many people rely on bank statements or credit card statements, this isn’t really the best option – you should always retain evidence of your income and expenses, preferably in the form of receipts, invoices, etc. Preparing a basic income statement (profit and loss) will also help keep your accounting fees low if you engage a professional tax preparer.
Your sole proprietorship taxes will be filed on Schedule C, which is an extra form on your individual income tax return. Income typically includes sales or commission revenues (but not personal contributions to start the business), and expenses often include advertising, business licenses, materials and supplies, insurance, rent, home office expenses, cell phone/internet costs and mileage. When you own and operate a small business, most expenses directly related to operating the business will be deductible. It’s not unusual to lose money in your first year or two, which can actually save you money on your personal taxes.
Many individuals desire to organize a Limited Liability Company (LLC) and obtain a FEIN as part of their business startup. While this is valuable in shielding you from legal liability and protects your Social Security Number, there is no actual tax benefit to creating the LLC. The IRS considers LLCs to be “disregarded entities,” which simply means the income and expenses will be taxed to the individual taxpayer and not to the company. Additionally, most states (including Alabama) charge a fee for creating an LLC, along with an annual franchise tax (in Alabama, this is referred to as the Business Privilege Tax, with a minimum $100 annual payment to keep your LLC in force).
Simplicity is one of the key benefits for sole proprietorships, but self-employment tax is one of the key costs. Specifically, self-employed individuals must pay 15.3 percent of their profits as self-employment tax to cover Social Security and Medicare. Employees who work for a company only pay half of this through payroll deductions, and the employer pays the other half. This tax is on top of federal and state income taxes, and often results in sticker shock for first-timers who are unprepared to pay the tax. I often advise self-employed individuals to set aside approximately 30 percent of their profits for taxes. The amount sounds high and is actually often less, but it helps to avoid a massive tax bill. It’s also very important to pay estimated taxes throughout the year to minimize penalties, interest, and massive tax bills in the spring.
Other forms of small business structures include Partnerships (often established as multi-member LLC businesses) and S Corporations (which provide tax benefits including passing through income both in wage form and in dividend form – which reduces your overall tax liability). However, both Partnerships and S Corporations required completely separate tax returns and add complexity to your business, which may negate the value of any tax savings. These are more complicated topics and should be discussed with a professional tax preparer.
As I have often heard, your tax is your tax – so minimize it!
Justin Smith is a licensed certified public accountant in Opelika, specializing in individual and small business tax and accounting. He can be contacted at 251-209-2579 or Justin@JSmithCPA.net. His website is www.jsmithcpa.net.