Why income tax is such a big deal for business owners
Everyone likes to gripe about income tax and the related hassles in figuring it out each year. But for small business owners, your income tax computation has a much greater result on your lifestyle and the future of your company than it has for employed people.
By contrast, taxes are easy for people with jobs.
Although people with jobs may whine about how difficult taxes are -- they’d keep quiet if they had any idea how easy they have it compared to people who work for themselves.
When you have a job, your taxes are basically paid automatically for you, since your employer withholds an appropriate amount from each paycheck. The employer pays this withheld amount directly to the government. So the employed person could practically do nothing further except sign and turn in their Form 1040 U.S. Individual Income Tax Return each April 15.
Naturally many employed people don’t want to just stop at that -- they want to look around and see if there are some deductions they could be taking in order to reduce their tax. They’ll check the head count in their household to see just how many dependents they are supporting. And they’ll dig further for unusual expenses that could be deductions, such as educational expenses, extraordinary medical expenses and whatever else they can find.
Employed people don’t have to worry much about creating tax penalties for themselves -- their taxes were already paid via withholding and they just don’t have access to much opportunity to mess up.
The self-employed tax picture is entirely different!
Now that you work for yourself instead of accepting a regular paycheck from an employer, you are responsible for paying your own taxes. You’ve got periodic deadlines for doing so throughout the year, which you have to take the initiative to meet.
And if you employ people in your business, then you’re responsible for withholding their taxes and this must be done on time and 100% correct. For now, we’ll focus on issues regarding your own income tax and return to your dealing with employee taxes later.
In addition to meeting the deadlines, you have to figure out how much tax you need to pay!
In order for a small business owner to figure out how much income tax to pay, you have to keep records. Records of all money that comes in to the business and all money the business pays out.
Records must be precisely categorized, because how they’re categorized determines your taxability.
It’s not enough to track just the total money that came in minus the total money you paid out. You have to assign each transaction to a descriptive category. Different categories will affect your net tax picture in different ways.
If you try to keep it simple by just tracking total income minus total outgo, you will either be paying way more than you need to in taxes, OR putting yourself in a risky situation because you didn’t classify certain transactions correctly OR both. So, although it’s very tempting to make your business recordkeeping as broad brush as possible, it’s usually a dangerous idea.
Your responsibility for your own taxes gives you more opportunity for “reward” -- and for risk!
Unlike an employee, who only gets what’s left after withholding is taken out, a small business receives the whole amount that comes in. Then, the owner determines how much of that whole needs to be paid out for business-related expenses including taxes and, ultimately, how much the owner will be able to keep personally.
The financial decisions the owner makes and how he or she categorizes individual transactions result in the amount of tax that must be paid. Two small businesses can show numbers that are identical -- they each have the same dollar amount of gross income and show equal total outgo. But one owner must pay hefty income tax while the other has a tiny tax bill. Wouldn’t you rather be the owner who pays less in tax, so you can have more of what you earned left to reinvest in the business and support your family?
Since you’re entrusted with tax decision-making, you are open to more scrutiny for possible errors.
The IRS and its relatives -- state income tax bureaus -- trust you as a small business owner, to compute, report and pay your own taxes. So they are going to need to check up on you more, to be sure you followed the rules correctly.
This is where confusion starts to set in. You are trying to understand the rules to follow, but what seems perfectly logical to the IRS may be totally incomprehensible to you and vice-versa.
Why your federal tax decisions affect your working capital so crucially
As an owner, the decisions you make that affect how much income tax you pay determine what’s left for your owner’s “take home” more than other types of taxes, such as sales taxes, franchise taxes, etc.
Whatever amount you paid in income tax no longer is available as money in the bank. And -- even more importantly -- what you pay one year pre-determines what you’ll probably pay throughout the next year in estimated quarterly taxes. Since you have to have the estimated amounts available when due, you have to factor these payments into your future cash-flow planning.
Unlike employed people who get all excited a tax refund, for you, as a business owner, that’s the last thing you want! A refund means you made a zero-interest loan to the government with money you should have been using in your business.