Many new business owners often ask themselves, “What is tax liability?”
In basic terms, tax liability is money business owners must pay to the IRS, state tax collection agencies, and (if applicable) local tax agencies each year. Like personal taxes, business taxes must be paid by specific deadlines.
It’s common for business owners to seek legal ways to reduce their tax liability. One effective way to do this is by looking at deductions and credits they may be eligible to claim. Another way businesses can reduce tax liability is by deferring it.In this post, we’ll dive deep and explore the different types of business tax liability and the steps you can take to reduce them. We’ll also look at the specifics of deferred liability and other important tax factors.
Types of Business Tax Liability
Tax liabilities are a part of life, and obligations must be met, or you can face penalties from tax collecting agencies. Tax liability comes in different forms, and the rate your company is obligated to pay and the type of tax liability you owe directly correlate with your business’s legal structure.
Knowing how to correctly calculate what your business is responsible for paying to the IRS, state, and local tax agencies is vital. Here are common types of business tax liabilities you should know about:
Income taxes
Businesses pay taxes as a “pass-through entity,” while others are subjected to double taxation. How income taxes are calculated will depend upon your company’s legal business structure.
Pass-through entity
In a pass-through entity situation, the business itself isn’t subject to tax because the tax obligation goes through the business owner’s personal taxes and is taxed at individual income tax rates. Companies in this category include sole proprietorships, partnerships, LLCs (these have special rules), and S-Corporations.
Double taxation
Double taxation is when taxes are paid twice on the same income. Businesses structured as C-Corporations are subject to double taxation because taxes are charged at both the business and the individual level.
As you can see, how a business is structured is essential because it has a direct impact on the owner’s tax liability and how much they’ll pay on their income.
Sales taxes
Sales taxes are directly linked to the state where a business sells taxable goods and services. As of April 2024, only a handful of states don’t collect sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon. (If you operate in any of these states, you should familiarize yourself with other obligations you’ll need to meet.)
If your business operates in a state and/or local municipality that does collect sales tax, you will need to collect the tax on each sale you make to a customer and then remit it to your state and/or municipality. Businesses that fail to do this will face penalties.
Employment taxes
Employment taxes are also referred to as “payroll taxes” and involve a series of different taxes all employers must withhold from their employees’ paychecks.
● Federal tax withholding
● State tax withholding
● Any local tax withholding
● Employee’s portion of Social Security and Medicare (FICA)
● Federal unemployment tax (FUTA)
In addition to collecting from employees, your company must also pay its portion of FICA, along with federal and state unemployment taxes. Self-employed business owners will pay both shares of FICA from their company’s net earnings.
Self-employment taxes
A self-employed individual is obligated to pay self-employment tax. This tax also encompasses Social Security and Medicare taxes, so the business owner contributes to the system and is eligible to access retirement, disability, Medicare, and survivor benefits.
Note: Half of the self-employment tax you pay as a self-employed business owner is deductible. Don’t overlook this option!
Excise tax
Not all businesses are required to pay an excise tax. An obligation to pay is directly linked to their operations and the type of products they sell. Common excise taxes include:
● Sales of “sin” goods (e.g., alcohol, vapes, e-cigarettes, and tobacco)
● Use of highways by company trucks
● Fuel and gas
● Gambling and sports betting
● Transporting air and cruise passengers
This is not a comprehensive list of businesses required to pay excise taxes, but these are a few common examples. Read up on excise taxes to see if your business is mandated to pay them so you don’t inadvertently overlook and face penalties. Helpful IRS literature to read up on this topic includes Forms 720, 2290, and 11-C.
Property tax
Businesses that own property must pay property tax. To calculate this tax, take the value of a property and multiply it by the tax jurisdiction’s tax rate percentage. This tax area can become complex since it varies depending on individual situations, so be sure you learn the rules or speak with a tax professional.
Reducing Tax Liability
Tax liabilities are a reality of doing business, but there is some good news. As a business owner, you can seek ways to reduce your tax bill, such as claiming deductions, looking for payroll exemptions, and making charitable donations. These opportunities to lower your tax obligation are perfectly legal.
Often referred to as “write-offs,” you can look to the following as deductions, exemptions, and credits to apply to your tax return. If you qualify for one or more of these (you probably will for many), you can reduce the taxes you owe. Common items you can claim include:
● Rent
● Utilities
● Salaries
● Employee benefits
● Advertising and marketing
● Business insurance
● Home office expenses (if applicable)
● Business-related travel expenses
● Depreciation of certain assets
● Several other qualifying expenses
Additional ways to offset tax liability include contributing to your retirement accounts and investing in your business. This can be tricky, so it’s a good idea to seek the services of a tax professional to help you identify all the legal deductions and credits you can take to reduce the taxes you owe.
Understanding Deferred Tax Liability
The figures on your company’s balance sheet outlining your taxes owed but not due until a later date are called deferred tax liabilities. This means you’re responsible for paying your taxes in the future. To obtain your deferred tax amount:
● Multiply your company’s anticipated tax rate and the difference between your taxable income and accounting earnings (revenue before taxes)
Some examples of deferred tax liabilities include:
● Selling products to customers on credit where they make scheduled payments to you
● Depreciating fixed assets
In a nutshell, deferred tax liability means a company recognizes it owes taxes, but they don’t have to pay them just yet. Deferred tax liability can become complex and is a good topic to discuss with a tax preparer, tax attorney, or accountant to ensure your formulas and calculations are correct.
Obtain your Employer Identification Number (EIN)
Obtaining an EIN is a smart business approach, even if you technically are not required by law to have one, since you can receive many worthwhile benefits. However, the majority of businesses will need to apply for one if they plan to hire employees or open a business bank account.
Having an EIN also helps with taxes because you have a better ability to separate your personal and business tax obligations.
Here’s what you’ll need to do to get your EIN
● Assemble the required information, including your legal business name, what your DBA (“doing business as”) name is (if applicable), business phone number and address, and the date your business was launched or acquired
● Choose the reason why you want to apply for an EIN
● List the name of the individual responsible for your company, along with their SSN (or ITIN) – in most cases, this will be you
● Include the type of business structure you have (e.g., partnership, LLC, S-Corp, etc.) and its tax structure
● Note the number of people you have hired or plan to hire
● Review your application to ensure your information is accurate and free of errors
● Submit your application
After getting an EIN, you can simplify the process of filing your business taxes, obtain better access to business loans (more favorable terms), open business bank accounts, and apply for certain licenses and permits necessary to run your business.
Conclusion
Paying taxes is a necessary part of doing business, and you want to make sure you handle this process right. To help facilitate filing accurate taxes for your business, strive to keep organized records of your expenditures. This way, you know exactly how much you can claim without having to search for your receipts or, worse, missing out on ways to reduce taxes since you don’t have the records. Additionally, always pay your taxes on time. Lateness in paying taxes equates to fines and penalties, negating any tax savings you’ve found.
You can’t avoid paying taxes, but you can take legal approaches to reducing or deferring them. Both options give you the ability to plan for paying taxes so you can mitigate the chance of not having enough cash to make tax payments.