Tax Considerations When Starting a Business

Many people have an interest in starting a business of their own, but do not investigate the tax considerations when starting a business. Starting a business can be a great thing unless all things are considered it could also be a massive headache. Imagine having a business idea that you believe will have awesome financial benefits for you. Then you find out that because you are not properly educated, it turns into a financial burden. This can happen if you do not understand the tax effect of starting a business. The various topics that I will discuss will inform you of the tax considerations when starting a business.

How will starting a business affect my taxes?

First off, starting a business will influence your personal taxes. Business is a for profit endeavor, therefore, there will be income associated with the business. There will also be deductible expenses that are incurred to run the business. Depending on whether there is a net profit or loss from the business is the variable that will determine additional or reduced tax liability created. This is in addition to whatever tax exists on income from other sources.

How do I prepare my business taxes?

When you start a business, decide what type of entity the business will be (i.e. sole proprietorship, partnership, S corporation, or C corporation) because it determines how you will need to prepare your taxes.  There are various forms that must be used to file the business taxes that depend on the entity type.

Below are the forms that must be filed form each entity type.

  • Sole Proprietors – Form schedule C, which is filed with their personal taxes.
  • Partnership – form 1065
  • S Corps – Form 1120 S
  • C Corps – Form 1120

These forms will mostly be used to report the income and expenses of the business to determine if there is any tax liability. In the cases of a C-Corp, the taxes will be filed, and any outcome will remain with the entity. For the other mentioned entity types, any outcome will be passed on to the personal taxes of the individual associated with the business.

How much does it cost to prepare business taxes?

When you start a business, it is important to note that there will be cost incurred outside of the operations of the business. One of those cost is tax preparation. For sole proprietors, the cost of business tax preparation is dependent on the rate charge to do their individual taxes. This cost is generally not significant enough as it will be just a portion of the overall cost or preparation. As it concerns the other business entity types, they file separately from your personal taxes and have their own cost.

The cost for preparation generally ranges from about $500-$2,500. This depends on what it involves in the preparation of the taxes. A business tax return that costs $500 will involve a very minimal amount of work by the advisor. Normally, a business tax return that costs $2,500 will involve a much more considerable amount of work from the tax advisor.

Should I start a business for tax purposes?

When you start a business the main goal should not be for tax purposes. There should always be a profit motive that exists. This is because the IRS requires you to have intentions of making profits. They have guidelines used to measure if there is truly a profit motive.

  • the manner in which the taxpayer carries on the activity,
  • the expertise of the taxpayer or his or her advisers,
  • the time and effort expended by the taxpayer in carrying on the activity,
  • the expectation that the assets used in the activity may appreciate in value,
  • the success of the taxpayer in carrying on other similar or dissimilar activities,
  • the taxpayer’s history of income or loss with respect to the activity,
  • the amount of occasional profits, if any, which are earned,
  • the financial status of the taxpayer, and
  • elements of personal pleasure or recreation.

Do I have to pay taxes on an LLC that made no money?

The answer to this question depends on what state the LLC is set up in. For the great state of Texas, if you have no income, then there will be no tax liability for an LLC. As another example let’s consider the state of California. They require an $800 franchise tax payment due to California whether you have income or not. So, again it just depends on where you have the LLC set up.

Can an LLC get a tax refund?

All types of business entity classifications, for tax purposes, can be structured as an LLC. This includes sole proprietorship’s, partnerships, S Corps, and C Corps. All entities other than C Corporations are flow through entities, which means the income passes through to the members on their personal taxes. the business itself does not pay taxes on the income earned. For this reason, these businesses cannot get a refund either. In the case of C Corporations, these businesses structures report income and pay tax on it, therefore C Corps are the only LLC’s that can receive a tax refund.

What happens if an LLC does not file taxes?

One tax consideration when starting a business, is whether to become an LLC or not. If the decision to do so is yes, then in addition to filing the appropriate income taxes for the business, you will also be required to file franchise tax. Although in Texas, many businesses who are LLC’s never owe franchise tax, it still must be filed or there are penalties and interest assessed. Interest is charged beginning 61 days after the due date if you owe franchise tax.

See below for penalties.

  • A $50 penalty is assessed on each report filed after the due date.
  • If tax is paid 1-30 days after the due date, a 5 percent penalty is assessed.
  • If tax is paid over 30 days after the due date, a 10 percent penalty is assessed.

See link for additional information regarding Texas Franchise Tax.

How do you separate business and personal taxes?

In order to separate your businesses taxes from your personal taxes, you must set up an entity or file an election to be taxes separately. The business types that are handled separately from personal taxes are C Corps, S Corps, and Partnerships. Although S Corps and Partnerships are handled separately from the personal taxes, these are both “pass through” entities. What this means is that the net income or loss computed on the business taxes are added to the personal taxes of the member or member associated with the business. On the other hand, the net income or loss for C Corporations remain with the business.

There are business owners who benefit on their income taxes by taking a loss in certain years, but this cannot become habit because one thing that the IRS considers is how many years in a row a business incurs a loss. This is one way they measure the profit motive of a business.

Now there are tax considerations when starting a business that can benefit you for tax purposes. If someone has a side business that turns out to do well profit wise, at some point rather than being taxed as a sole proprietor, they might look at the tax benefits of choosing a different business structure (i.e. S Corp) to realize a lessor tax burden. See link for further details.

How much can you earn as a hobby before paying tax?

Technically any revenue that you earn as a hobby must be reported as income for tax purposes. Notice that I said “revenue”, this is because expenses for hobbies cannot be deducted. All the income from a hobby must be reported. Considering this, the only way you can avoid paying tax on hobby income is by not having a significant amount of other taxable income (i.e.  wages, interest, dividends, ect…), otherwise the hobby income is added into your total income equation and is taxed as such.

See link for additional information regarding Texas Franchise Tax.

How much can a small business earn before paying tax?

When answering this question there are a few things that we must first consider. The first thing is, any net profit from an unincorporated business (i.e. partnerships, s corporations, sole proprietorship) is included with the non-business income on your personal taxes. So, considering this there is technically no way to avoid paying tax on profits from your business, unless your non-business income is not significant enough to create a tax liability or your business suffers a loss. On the other hand, looking at the unincorporated business income only, a business can earn up to about $400 before having any self-employment tax liability.

Self-Employed Taxes

When starting a business self-employment taxes is a very important variable to be discussed. Most business owners must be aware of self-employment tax unless the business is a C Corp. Sole Proprietors and the pass-through entities (Partnerships and S Corps) will pay self-employment tax on their profit above around $400. Self-employment tax is made up of two components, social security and Medicare. The social security portion is 12.4% while the Medicare portion is 2.9%, this total amount is what we call self-employment tax which is 15.3%

Who Can Help Me?

This blog discusses many of the tax considerations when starting a business. I hope that this is a great guide if you are considering starting a business.  For detailed and more specific information tailored just for you, it is best to consult with a tax adviser. Molen and Associates is always willing and able to help in any way possible. Contact us anytime and we will schedule an appointment to help get you started off on the right foot.

Arthur Harrison III
Tax Advisor, Accounting, EA

The Molen & Associates Difference

Mike Forsyth

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