Businesses are taxed differently than individuals are. Most entrepreneurs know this on some level, but few are aware of the specific differences and best practices that apply to them. As a result, many startups pay too much tax or, worse, get into completely preventable tax problems stemming from poor planning. To avoid the most common entrepreneurial tax headaches (and capitalize on the biggest advantages) consider the following tips.
Choose Your Entity Wisely
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One of the most important tax decisions your startup will make is the legal entity you use. The IRS views your company differently depending on whether you’re a sole proprietor, corporation or partnership. Each of these entities has advantages and disadvantages (some of them totally unrelated to taxes) and there is no “best” entity for every startup. Rather, you need to pick the one that best suits yours.
A C corporation, for instance, is undesirable for many startups because of double-taxation. The company pays a corporate income tax in addition to the taxes each owner pays individually. S corporations and Limited Liability Corporations (LLC) avoid this because they use flow-through taxation. As the name implies, company income “flows through” to the owners, who pay taxes only on what they receive. One key difference: in an LLC, income is allocated by partnership interests (or how much of the company you own.) CNN recommends LLCs for most small businesses.
Determine What Full Tax Compliance Actually Entails
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You also need to determine the entirety of what full tax compliance means for your startup. This is largely a function of your legal entity, but the state and city in which you work can also impose tax obligations of their own. Many large cities (Philadelphia, for instance) levy business privilege taxes on companies operating within city limits. Unlike other taxes (which fall on net profits) business privilege taxes are assessed on gross receipts as well.
In other word: if your company sold $1,000,000 worth of products last year, you owe the city a percentage of that number – no matter what your costs were. Even if you were unprofitable, you still pay. Other requirements of tax compliance apply no matter where you are:
- Obtaining an Employer Identification Number
- Filing corporate tax returns
- Licensing requirements
Separate Finances From Day One
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As an incorporated business of some kind, it’s imperative from a bookkeeping standpoint to keep company finances separate from personal ones. This means (among other things) having:
- A corporate checking account
- A corporate savings account (if you have reserves)
- Income statement & balance sheet
Intermingling corporate and personal finances can have disastrous consequences. If you are sued, the opposing lawyer can argue that you violated corporate form and sue you personally for what they allege your company did. The Secretary of State can also strip your company of its corporate status. An S corporation with over 100 shareholders, for instance, can be ruled a C corporation by the IRS and forced to start paying corporate income tax!
Document All Deductible Expenses
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Startups and entrepreneurs have one key advantage typical employees lack: the ability to deduct all business expenses. Provided the expense was “ordinary and necessary” in your line of work, it is eligible for deduction at tax time. This includes:
- Books or magazines about your field
- Industry training programs or materials
- Work-related travel
- Client entertainment
- Pro-rated portions of rent and utilities (for home offices)
The only catch is that any expense you deduct needs receipts or documentation to back it up. For best results, save all of your receipts as you accumulate them. Then, at tax time, send them all to a companythat will automatically scan and organize the receipts for you online.
Use Reliable Accounting & Tax Preparation Software
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Staying on top of all of this takes a lot of work if you do it manually. Fortunately, in 2011, the most tedious aspects of tax work can be automated by software tools. To ensure minimal time spent on bookkeeping and fewest possible mistakes, invest in capable accounting and tax preparation tools – and learn to use them effectively.
For accounting, we recommend Quickbooks, a handy application that walks business owners through the common bookkeeping tasks they most frequently encounter. For tax prep, TurboTax performs the same function, guiding you through the filing process like a GPS guides you through unfamiliar cities. Used together, these software tools will cut your bookkeeping and tax prep time exponentially.
Consider Paying Quarterly
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Finally, it often makes sense to pay your taxes quarterly – even if you aren’t required to. Many entrepreneurs delay filing until the end of the year, rationalizing all year long that it can wait. The problem with this approach is that it puts you in the position of needing a “hail Mary” pass. Unless you can come out of pocket all at once for an unexpectedly huge tax bill, you’re stuck.
By paying quarterly, you are forced to pay the previous four month’s worth of tax liability in manageable increments. It wont be any more fun sending money to the IRS, but it will spare you the end-of-year scramble to cobble together what you owe.