When it comes time to file taxes for your business, the stakes are high, and you want to save as much money as possible. To do this, you’ll need a solid understanding of your startup's tax liability.
Imagine that your startup takes off in the second quarter of the year. Amidst the sudden success and expansion, it’s hard to keep track of escalating federal tax liability, especially as your profits push you quickly through different tax brackets.
Come tax time, your Q3 and Q4 taxes could be under-collected, leaving you with a bigger bill from the IRS than you’re prepared to handle. This may force you to pull from your cash reserves and could potentially jeopardize your other business ventures.
Your tax liability directly impacts everything from your choice of business structure to compliance, budgeting, and cash flow. Armed with knowledge, you can identify opportunities, manage risk, and make strategic decisions.
Here's what to know about startup taxes and how to maximize tax benefits for your startup.
What Is Tax Liability?
Tax liability is the total tax debt your business owes to the government. The Internal Revenue Service (IRS) calculates this amount based on your taxable income and the deductions, credits, or exemptions you qualify for.
You need to know your tax liability to comply with tax laws and make informed business decisions that help your company's bottom line.
Why Is Tax Liability Important For Startups?
Accurately calculating your tax liability is crucial. Miscalculated taxes can lead to fines and extended payment plans. If this occurs in the early years of your company, you may find yourself playing catch-up on payments during a critical growth period. The sooner you pay what you owe, the better.
Types Of Taxes And Their Impact On Startups
Different taxes have different impacts on your startup. Here are three common tax types and how they play into your company's tax liability.
Federal Income Taxes
The federal government collects taxes on the income your company makes. Whatever your company earns, you must pay taxes on this profit according to your federal income tax bracket.
The higher your tax rate, the more your tax liability cuts into your profits. Fortunately, you may be able to reduce your federal tax liabilities with strategic deductions and credits.
Depending on where you operate, you'll likely need to collect sales tax on each sale you make.
Generally, your customers pay this when they purchase your product, and a state government regulates and collects these. If you sell products online to multiple locations, you must be able to collect and pay sales tax to each state as needed.
You and your employees are also responsible for paying payroll taxes on wages.
These taxes support Social Security and Medicare programs. Both you and your employees contribute to payroll taxes, splitting the 15.3% tax down the middle.
Factors Influencing Tax Liability For Startups
A variety of factors influence tax liability for startups. Working with a startup tax advisor can help you develop the best tax strategy for your company.
Details to consider include your business structure, tax deductions, credits, and tax planning strategies to lower your tax liability.
The corporate entity you choose for your startup may impact how much you pay in taxes. Consider the following options when structuring your business:
- C Corporation: This business type means your company's income is taxed twice. Your business pays taxes on the income it earns. Any capital gains your shareholders earn are also taxed.
- S Corporation: If this is your business structure, your company isn't responsible for paying a corporate income tax. As a result, your business earnings aren't double-taxed. Your shareholders are the liable party.
- Limited Liability Company (LLC): These types of businesses may pay taxes as a corporation, or each member may pay self-employment taxes on their earnings.
Choosing the right entity structure for your company also helps reduce your tax liability if you ever take your company public.
Tax Deductions And Credits For Startups
Many startups qualify for tax deductions and credits designed to help growing companies. Tax deductions are any business-related expenses that are subtracted from your overall tax liability.
For example, if your tax liability is $50,000 for the year but you purchased $2,000 worth of computers for your employees, you can deduct this expense. After this deduction, your tax liability is only $48,000.
You get an automatic deduction on your taxable income called a standard deduction. However, if you have specific deductions that could lower your taxes even more, it might be better to choose itemized deductions.
In addition, some of the startup tax credits you may be able to use include:
- State R&D tax credit
- Tax credits for retirement plans
- Tax credits for work opportunities
- Tax credits for healthcare
- Employment Zone (EZ) employment credit
Timing And Tax Planning Strategies
The timing and planning related to your tax strategies can make a huge difference in finalized tax liability. Working on your tax preparation throughout the fiscal tax year can help. Consider the following tax planning strategies:
- Close your books monthly: Account for all your records regularly so you don’t have to scramble when tax season approaches.
- Meet with a tax advisor frequently: Stay in compliance with tax codes at all times by regularly working with an advisor.
- Create an action plan for deadlines: An action plan can help you track expenses, receipts, tax credit opportunities, accounting reconciliations, and tax deadlines.
- Take advantage of depreciation: Reduce your tax liability by claiming losses due to depreciation on company equipment. As property loses value over time, you may reduce your tax burden by claiming this.
How To Calculate And Report Tax Liability
During the tax year, it's important to keep an eye on your income regularly. This way, you can calculate your tax liability on a regular basis. By staying on top of it throughout the year, you make tax season easier and get an idea of how much money you owe in taxes.
To calculate your tax liability, multiply your income by the appropriate tax rate according to each revenue department you owe, such as federal taxes to the IRS or state taxes to your home state.
Enter these calculations into your tax forms to report to the revenue departments. The form will vary based on the department and your business structure but may include documents like Form 1120-S for S corps or a Schedule C as part of your common 1040 for small business income.
Once you add up your tax liability, you report it on your income tax return. You have likely been paying federal taxes or payroll taxes throughout the year. If you have overpaid, you'll receive a tax refund.
A startup tax advisor can help you prepare to meet your business tax deadline by calculating your total tax liability. Based on your taxable income bracket and federal income tax rate, your advisor can help you determine your federal income tax liability. They'll also find ways to lower the amount you owe through eligible startup tax deductions and credits.
Navigating Tax Liability For Startup Success
To optimize your tax liability strategy, establish a quality tax process early in your startup formation. It pays to track your income and apply your tax calculations throughout the year, as it saves you from being hit with surprise bills come tax season.
If you're not sure where to start, an experienced tax preparation expert can help you develop a solid tax strategy that won't eat into your profits.
Partner with a finance concierge to learn more about tax brackets, tax liability, and startup taxes before your returns are due.