Understanding Income Tax for Small Businesses

In the United States, your business, if incorporated, must file and pay federal income taxes, state income taxes in most states, and local income taxes in some areas on the corporate level. Then, in addition, you must pay taxes on any salary or profit that is distributed to yourself. Effectively, you are being taxed twice on any profit that you take out of the business. But you are not being taxed twice on the salary, because for a corporation it is tax deductible. Or, if you pay yourself a salary that the IRS deems excessive, they can recategorize part of it as a distribution of profits.

If your business is incorporated, you may elect to become an “S” corporation (formerly known as Sub-Chapter S) for federal income tax purposes. As an S corporation, your company will not pay direct taxes in most cases. Instead, income and losses are passed on to stockholders. Therefore, the individual stockholders pay the income tax. A limited liability company (LLC) is treated similarly to an S corporation.

Some states treat S corporations the same way the federal government does, and tax the stockholders. Other states do not recognize S corporation status, and thus tax the corporation directly.

Remember that the federal corporation tax returns (regardless of S corporation election) are due one month earlier than individuals’ on the 15th day of the third month after the end of the company’s year. For example, if your fiscal year ends on December 31, your filing date is March 15. The payment for a corporation with an S election is still part of the individual return due on April 15. Be sure to check the section on estimated taxes to know when estimated tax payments are due.

If your business is a sole proprietorship or a partnership, the income is taxed directly to the owner or partners for federal income tax purposes. Most states follow the same rule. However, a few jurisdictions tax the business entity directly. Check with your tax consultant for the rules and regulations that apply to your business.

Remember, you need to file tax returns, and pay a minimum tax in some areas, even if your business has yet to earn a profit.

Estimated Income Taxes

At the beginning of your second year in business, you may be in for a little surprise. Not only do federal—and in some cases, state and local—tax authorities require payment of income taxes on the first year’s earnings, but they also want you to start paying taxes on next year’s earnings. Yes, before the year has ended!

Estimated federal corporation taxes are due when the annual tax is expected to be at least $500. Payments of 25 percent each are due on the 15th day of the fourth, sixth, ninth, and twelfth months of your fiscal year. If you are on a calendar fiscal year, for instance, estimated payments are due on April 15, June 15, September 15, and December 15. Each state has its own minimums and payment schedules, often varying from the federal ones.

If you are self-employed or in a partnership, you will also have to pay income tax estimates. They need to be figured into the total estimated tax the individual owes.

If you are in business that makes sales on a credit basis with a long payment cycle, you could be paying estimated taxes on profits long before you ever see the cash for these sales. That’s because the government taxes your profits, not your cash flow, and they demand you make payments when it is convenient for them, not necessarily when you have the money. That’s the way it is. Get these expected tax payments into your cash flow projections, so you can plan for them and work to avoid running out of money.

About Bob Adams

Bob Adams is a Harvard MBA serial entrepreneur. He has started over a dozen businesses including one that he launched with $1500 and sold for $40 million. He has written 17 books and created 52 online courses for entrepreneurs. Bob also founded BusinessTown, the go-to learning platform for starting and running a business.