Taxes and Your New Business: Part 1

By Dan Caplinger

09/08/2006

Starting a business involves many details that you have to monitor. Before you even get that far, you have to pick what type of business entity you want, and you may need to register with the Secretary of State in the state where the business will operate. Depending on the industry, you may also need to get approval from a separate state regulatory agency to begin operations. Everywhere you turn, new rules seem to appear from nowhere, each requiring you to jump through a hoop, and usually to pay a fee.

Like individuals, businesses face a host of taxes that get imposed at every level of government, from the federal Internal Revenue Service to state departments of revenue to county and city tax assessors. Before you get too far into your business, you need to understand the numerous ways in which these taxes affect your business. Not only will you have to pay taxes on your business profits, but you may also have responsibilities for withholding, collecting, and remitting certain other taxes, such as payroll and sales taxes, to the appropriate authorities. Although rules specific to your state and city may have special quirks, we can still cover some general issues about which you should remain aware.

Federal income taxes

If your business makes a profit, it will probably incur an income-tax liability. However, the way in which the government will tax your business depends on the form of business entity you choose. If you operate your business as a sole proprietorship, partnership, or limited-liability company, then the income tax is usually not imposed on the business entity itself but on the owners, who then each include their respective shares of the total profit on their individual tax returns, usually by filing Schedule C to Form 1040. If you operate a partnership with one other person and the business makes $1,000, then if you have agreed to split profits equally, each of you will report income of $500 on your individual income tax returns. Businesses set up in this fashion are sometimes referred to as pass-through entities. For partnerships and LLCs with more than one member, your business will generally need to file an information return with the IRS to report the overall profits of the business and to allow the IRS to make sure the various individual owners report all of their income.

If you choose to incorporate your business, you will have a choice to make. Most small businesses can qualify to be treated as a subchapter S corporation, the name referring to the part of the Internal Revenue Code that governs such companies. By electing S-corporation status, your business will be treated as a pass-through entity that needs to provide only an information return. However, if you choose not to elect this status, then your corporation will be an entirely separate business entity, requiring a separate income tax return and incurring its own tax liability. If the corporation makes payments to you, you may have to treat those payments as income; you therefore will either have to find a corresponding corporate deduction, or end up paying tax twice. The potential for double taxation leads many small-business owners to choose S-corporation treatment, if they form a corporation at all.

State taxes

Every state has some tax rules unique to itself. That can make it harder for businesses operating in multiple states to calculate tax liability and conduct proper tax planning. Business taxes at the state level come in many different varieties, and it's crucial for you to understand the way your state works so that you are prepared when you have to pay.

For the most part, states tend to tax businesses using one of two different figures as a tax base: the net taxable income of the business or the total revenue of the business. For states that use a tax on net income, the rules often closely resemble those for individual income taxes -- the business reports income and deductible expenses and pays tax on the net taxable income using a rate schedule that the state legislature sets. States that base their tax on the total revenue of the business, however, use rules that more closely resemble sales-tax rules -- a tax rate is applied to the gross receipts of the business without regard to whether the business made a profit. As a result, you may well owe tax to your state despite having no federal tax liability and even though your business may have lost money during that year.

In addition, if your business owns inventory, equipment, or other property, you may need to pay property tax. Again, the specific aspects differ greatly from place to place. Some jurisdictions impose property taxes on even small amounts of property, while others impose no tax unless the business owns property with a value above a certain amount.

Most states have excellent resources for new business owners, available either on the state's website or by getting in touch with the state agency responsible for collecting tax. In reviewing a state's materials, you should especially consider a few important issues: If your state imposes business taxes, determine whether they apply to the type of business entity you have chosen. Some states impose taxes only on corporations but allow pass-through entities to follow federal income-tax rules and collect individual income tax from the owners of the business. Find out whether your state follows federal income-tax rules for calculating deductible expenses. While some states have self-adjusting laws that automatically incorporate changes in federal tax law, other states use the federal law in effect on a certain date in the past, and still other states have their own special rules that may differ completely from federal tax rules. Speak to your taxing authority to get more information about anything you don't understand. It's far better to spend time now than to wait until an unexpected tax notice arrives in the mail.

Federal and state taxes imposed directly on new businesses can be extremely complicated. But even once you get a handle on them, you will still face other tax responsibilities as a business owner. The next part of this article discusses your responsibility for payroll taxes, the need for you to collect sales taxes, and other tax-related issues.

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Fool contributor Dan Caplinger prefers taxes to death but tries to stay away from both. He doesn't hold shares of any of the companies mentioned in this article. The Fool's disclosure policy is always working for you.