Whether you just became self-employed or you’ve owned a business for years, your taxes work differently than they do for most other people. Many entrepreneurs often don’t fully understand their tax situation for both themselves and their business. Especially as companies grow and change, your tax situation can vary widely from year to year. That can create some headaches when your accountant calls and says you owe a big tax bill. Alternatively, knowing how changes in your business affect your taxes can help you prepare for both the growth and the tax bills.
Key Takeaways
- Taxes are not calculated based on the amount in your business account, but on your business’s profit (i.e., the sales of goods or services minus your expenses).
- Most small business owners with an LLC have a pass-through structure or own a sole proprietorship, partnership, or an S-Corporation; for these structures, all income, expenses, deductions, profits, etc. flow through the company to the owner’s personal tax situation.
- The biggest taxable item for pass-through entities is self-employment tax (SE tax), which is a 15.3% tax on business income in addition to the federal income tax requirements. Those who are eligible may be able to create an S-Corp to minimize SE tax.
What Actually Gets Taxed?
One very common misconception is that self-employed business owners think they have to “take home” their money for it to be taxed. They think that unless they put the cash into their personal family checking account, it isn’t taxed yet. Over the years, I’ve had many clients who were fearful of moving money around, worried they would trigger a giant tax bill without knowing it.
This can be confusing because, in our day-to-day work on the business, all we see is the current cash flow in the bank accounts. That is where the cash comes in from customers and the expenses go out. Makes sense. But taxes are not calculated based on the amount in your business account. Simply moving money out of the business doesn’t determine how much tax you owe.
For most small business owners, the trigger for taxes is the moment you sell your good or service, and/or receive the cash. Once you receive that revenue, it can be taxable to you. If you receive the revenue and spend it all the next day, taxes are still affected based on how much came in initially. Alternatively, if you never take another penny out, you still may owe taxes based on the revenue. Now, how much you pay in taxes will depend on how many expenses, deductions, etc. are involved.
So, your current bank account balance isn’t the best indicator of how much profit the company has. In reality, you pay expenses at different times, revenue comes in at different times, and you likely distribute money to pay yourself at different times, too. So, if we can better control when taxes occur in our business, we can be more flexible without accidentally creating a big tax bill.
What Can Business Owners Actually Control?
In chronological order, most businesses start by spending money to bring in revenue. As revenue comes in, you start paying more in expenses, taxes, and so on. Finally, as both revenue and costs keep seesawing, you pull some money out of the bank to pay yourself.
While that is generally what we see, it may be more helpful to think of it as a linear progression, if you can excuse the brief accounting lesson. A business starts with the “top line” revenue that comes in. Then you deduct expenses and business costs to get the company’s profit. Finally, you can use the profit however you want, either reinvest it in the company or distribute it to the owners.
This is the simplified version of an Income Statement or P&L Statement for the business, which can be helpful to see and make changes to. The formula is basically Revenue – Expenses = Profit. Within these three buckets are dozens of ways to alter your tax situation, but ultimately, you pay tax on profit. Managing revenue, the expenses it takes to generate that revenue, how and when you pay taxes, how you pay yourself, and how much you leave in the business can all affect what profits get taxed.
The key is that controlling the company with taxes in mind is less about your bank account and more about the business’s metrics. Just because cash flow is going well and there is extra in the bank account this month doesn’t necessarily mean it is okay to distribute more to yourself. Many business owners operate this way, and it is not necessarily wrong. But without a deeper understanding of what you should control first, you are likely still flying blind before knowing how much the next tax bill is.
How Does the Business Itself Change Your Taxes?
For now, I have been assuming most who read this own a pass-through business. This generally means someone who owns a sole proprietorship, partnership, or an S-Corporation. Those who own an LLC are generally, whether they know it or not, electing to be taxed as one of these entity designations. While they certainly have their differences, there is one key similarity between them: all income, expenses, deductions, profits, etc. flow through the company to the owner’s personal tax situation.
These companies generally pay no corporate income tax, unlike larger C-corporations that trade on the stock market. However, the biggest taxable question for pass-through entities is the possible requirement for the owner to pay self-employment tax (SE Tax). This is a 15.3% tax on business income in addition to the federal income tax requirements you have. The calculation for SE Tax is more complicated than this, but is essentially based on business profits, not on how much money you distribute from the company (except for S-Corps, see below). Distributions are extremely important for our families’ cash flow, but tax-wise they are not as related as you might think.
That said, based on how your business is structured, it may be possible to change the way you pay yourself to affect the SE Tax required. A common example is when owners distribute money from a pass-through company that elects to be taxed as an S-Corp. It is possible to pay yourself a salary, and while subject to payroll taxes, it would reduce your company profits that flow through to your personal taxes. That is why it is critical to review your tax situation with your accountant. There are always exceptions, and many business owners pay too much in taxes simply because they do the same thing they always have and don’t take the time to learn what options they can control.
Clarity Before Change?
For now, I have been assuming most who read this own a pass-through business. This generally means someone who owns a sole proprietorship, partnership, or an S-Corporation. Those who own an LLC are generally, whether they know it or not, electing to be taxed as one of these entity designations. While they certainly have their differences, there is one key similarity between them: all income, expenses, deductions, profits, etc. flow through the company to the owner’s personal tax situation.
These companies generally pay no corporate income tax, unlike larger C-corporations that trade on the stock market. However, the biggest taxable question for pass-through entities is the possible requirement for the owner to pay self-employment tax (SE Tax). This is a
