Understanding Small Business Income Tax

If you're like most small business owners, you pay an accountant or other professional adviser to handle your taxes. Even so, understanding your various tax choices is important for running your business.  You'll be able to identify potential tax advantages and traps in time to react.

Planning your taxes and selecting your business form

  • Tax planning. This process evaluates options to determine when, whether, and how to conduct business and personal transactions for minimal taxes. As an individual taxpayer, and as a business owner, you generally can complete a taxable transaction by multiple methods, choosing whichever results in the lowest legal tax liability. While tax avoidance is expected, tax evasion—reducing tax through deceit or concealment—is not.
  • Forming your business. Whether you form a sole proprietorship, a partnership, a limited liability company, or a corporation, there are significant income tax consequences that flow from each. Don't forget to weigh the tax issues against the non-tax issues, such as which form will best help you operate and grow, or which will make it easier for you to pass along the business to your heirs.

Defining your trade or business

To deduct business expenses, you must be engaged in a "trade or business;" an activity carried on for livelihood or profit. According to the IRS, to constitute a trade or business, a profit motive must be present and some type of economic activity conducted. "Profit" means you’re aiming for a real economic profit, not just tax savings.

Choosing tax year and accounting methods

As a small business owner, your decisions often have tax implications - whether or not you realize it. Suppose you buy a car for business use, rather than lease it. You can't deduct the purchase price (as you can a lease payment), but you can deduct a portion of the cost annually as depreciation. Some tax-related choices have a more general effect on your business income, namely:

  • Tax year. This determines the time period for which your taxable income will be computed. All the income received or accrued within a single year is reported on that year's return, along with expenses paid or accrued. The end of the tax year is the cut-off point for many tax-saving strategies.
  • Accounting method. Whether you’re a sole proprietor filing Schedule C or a partnership or LLC filing Form 1065, you must report your accounting method to the IRS. There are two basic methods available to most small businesses: Cash and Accrual. In some cases, you may be able to use a hybrid that combines elements of both. Also, owners of certain types of businesses can use special accounting methods under the tax law.

Determining business income and deductions

Calculating your income tax requires computing your business income.  This means taking your gross business receipts or sales and subtracting your cost of goods sold to arrive at your gross profit, then deducting your other business expenses. Generally, any income you receive connected with your business is "business income" and should be reported on your business tax return. Income is "connected with your business" if the payment would not have been made if you did not have the business. Other considerations:

  • Gross income from sales. In most cases, this will be the bulk of the income you receive from actually operating your business.
  • Miscellaneous business income. This topic can get complicated, since different business-related types of income must be reported on different parts of your tax return.
  • Cost of goods sold. This must be computed if your business uses inventory, in order to complete the business income portion of your tax return.
  • Deductions. Digging up every legitimate deduction is usually your best bet for reducing your taxable income and tax bill. Capital expenditures, start-up, travel (notably vehicles), meal and entertainment expenses, business gifts, compensation, home office deduction, casualty losses and vehicle expenses are all common business deductions.

Capital assets and depreciation

Almost every business must invest in major equipment, vehicles, machinery, or furniture in order to operate. Some require land, a building or franchise rights. Major assets used in your business for more than a year are known as "capital assets" and subject to special tax treatment. You generally can't deduct the entire cost of them in the same year you acquire them, with some notable exceptions for first-year expensing. Here’s how it works:

  • An asset’s cost is deducted over the number of years it will be used, according to the asset’s estimated drop in value each year.  You could subtract all depreciation claimed to date from the cost of the asset, to get the asset's "book value" (theoretically equal to its market value).
  • At the end of the asset's useful life for the business, any un-depreciated portion represents the salvage value.
  • Since the actual drop in value is difficult and time-consuming to compute, accountants use various conventions to standardize the process: the straight-line method assumes assets depreciate by an equal percentage for each year used, while the declining balance method assumes they depreciate more in earlier years.
  • The IRS has specific rules governing how you are allowed to deduct depreciation for tax purposes.

Net profit, loss and self-employment taxes

Once you have computed your gross business income and deducted your cost of goods sold to arrive at your gross profit, subtract your other business expenses for the year to calculate your net business income. This amount is your net profit for tax purposes. There are two important issues to consider when computing your net profit:

  • Self-employment taxes. For sole proprietors, your net business income is the amount on which you must pay self-employment taxes. If your business is a partnership, LLC, or corporation, you must follow somewhat different rules.
  • Net operating losses. Owning a business is full of surprises. Some years your expenses exceed your gross income, translating into a loss for the year. You may be able to deduct this loss against any other income you have, or carry it back to offset prior years' taxable income or carry it over to offset income in future years.

Claiming tax credits

Beyond tax deductions, minimize your income tax bill by claiming tax credits—they are generally preferable because they’re subtracted directly from your tax bill. Deductions, in contrast, are subtracted from the income on which your tax bill is based. As great as tax credits can be, they are only available for certain situations or industries (e.g., research and development, home-buying, car buying, or alternative energy production).  And credits come with a set of very complicated rules, which you or your tax pro must follow in order to claim.

Dealing with the IRS

As a small business owner, be aware of your tax payment obligations and when they are due—even if you use a tax adviser or accountant. There's no worse feeling than watching your cash surplus disappear because of an impending IRS payment. Worse yet is discovering that funds have been spent elsewhere because you didn't realize a tax payment was due. With a good awareness of your filing and payment obligations, you can avoid unexpected payments or penalties.