A knowledge of federal tax brackets is important to small business owners since the income from businesses is likely to impact the amount of taxes one has to pay. The way a company is run will determine whether income from the firm will be included in the personal tax bracket or not.
The process of tax planning will involve more than just figuring out the annual revenues. Other concepts such as taxable income, marginal rate of taxation, deductions and estimates are also important.
Understanding Business Taxable Income
It is essential first to figure out the income that can be taxed in the business. The income here refers to the income that the business makes, but there are times when the business does not make taxes on such income.
In most cases, the business is allowed to deduct the operating costs from the income that it makes in order to come up with the income that is subject to tax. Such costs are normally different depending on the nature of the business and they may include things like rent, salaries, professional services, insurances, advertisements, equipment and supplies among others.
To illustrate, if a business makes an income of $250,000 and the allowable expenses are $150,000, then the net income of the business is $100,000.
Bookkeeping is essential because it will enable one to track the income and expenses.
How Tax Brackets Can Affect Business Owners
Federal income tax brackets operate progressively, implying that a fraction of a person’s taxable income can be subject to different tax rates. Entering a new tax bracket does not imply that all taxable income is now subject to taxation at the higher rate.
This aspect is especially crucial for the owners of those businesses where any profit is added to their own tax filing.
For instance, an owner will generate additional income, making it necessary for him/her to be in a higher marginal tax bracket. Yet, the income will be subjected to the higher tax rate only to the extent that it falls within this bracket.
Comprehension of marginal tax rates can assist business owners when assessing tax implications of any additional income earned.
Business Structure Can Change Tax Treatment
The business entity structure used by a business organization may influence significantly the manner in which the business income is reported and taxed.
Sole Proprietorships
The income earned from a sole proprietorship business organization may be reported in the individual’s tax return. Additional tax may also apply such as the self-employment tax apart from the normal federal income tax that is charged to the business.
Partnerships
In partnership businesses, the income is generally passed onto the partners with each of them filing his/her share of the business income in his/her individual tax returns.
LLCs
The taxation of the business will depend on how the business is categorized for federal tax purposes. The LLC may be classified as a sole proprietorship and/or partnership or the LLC may choose corporate taxation.
Corporations
C corporations may be separate tax entities such that they report their own income taxes. Additionally, shareholders may face some additional taxes when certain types of dividends or other distributions are made.
Marginal Tax Rate vs. Effective Tax Rate
Two tax concepts which tend to be quite confusing include the marginal tax rate and the effective tax rate.
The marginal tax rate is the highest federal income tax rate applicable on the income of the taxpayer. The concept becomes useful in determining the effects of increasing income levels.
The effective tax rate is the average percentage of income paid in terms of taxes.
For business people having pass-through income, knowledge of both concepts will make it simpler to assess the implications of increasing income levels on taxes.
Business Deductions Can Reduce Taxable Income
Taxable business income could be lowered by eligible deductions made from business income. Examples of deductible costs could include:
- Office rent and some operating costs
- Salaries and some benefits
- Advertising
- Accounting fees and other professional fees
- Insurance
- Supplies and equipment
- Some business travel costs
- Other ordinary and necessary business expenses
Deduction rules vary from one expense to another as well as from one business situation to another. Having your receipts, invoices, bank statements, and other forms of supporting documents will help you prove that your expenses are eligible.
It is essential for entrepreneurs to differentiate between their business and personal expenses because wrong classification of personal expenses as business expenses may lead to tax issues.
Tax Credits Can Also Affect Tax Liability
Tax credits and deductions are two different things. While deductions help reduce taxable income, the tax credit will help lower the tax obligation directly.
Depending on the eligibility of the organization, various types of tax credits related to certain activities, like employing employees or research and development activities, can be claimed by companies.
Since there are certain criteria for claiming a tax credit, it is important that business owners check the eligibility before filing taxes.
Estimated Tax Payments for Business Owners
Not all self-employed people or entrepreneurs are required to have federal income taxes withheld from their income generated from businesses as it is done for the employees’ incomes.
In such a case, certain business owners can find themselves required to pay estimated taxes on a quarterly basis.
Paying estimated taxes will ensure that one does not end up with a surprise tax bill during tax time. This will ensure smooth cash flows in the course of the year, instead of having to save money during the tax season.
There are some factors that affect one’s estimated tax needs.
Why Bookkeeping Matters for Tax Planning
Accurate financial information forms the basis for tax planning. If records are not precise, then it will be hard for an entrepreneur to determine profits, know the deductible amount and forecast future tax liability.
The process of keeping books of account regularly will assist in monitoring income, expenses, payroll, invoices and other financial transactions in the year.
It will also be easier for one to be able to notice when profitability changes prior to making tax payments. This is because in case of any changes in the level of income in the year, an entrepreneur will be able to examine the projected taxable income and formulate tax planning strategy.
Planning for Changes in Business Income
Income of a business organization can vary greatly on a year-to-year basis. There could be variations in terms of seasons, new contracts, expansion expenditures, staff-related changes, etc.
These variations may influence the taxable income of the organization as well as place its owner in a different marginal tax bracket.
It is always useful for business organizations to look at their financial statements and expected income on a regular basis rather than waiting for an annual tax season. It will help them plan their estimated taxes as well as consider the tax deductions available to them.
Tax Planning Should Be Part of Business Financial Management
Federal taxes alone do not define all aspects of operating a successful and financially stable company. The owner must think about various other things such as payroll, taxes at the state and local level, cash management, retirement, insurances, and investments.
Knowledge of federal tax brackets, however, will be a good starting point for the analysis of how a change in business profits will influence the overall tax burden.
Instead of trying to minimize taxes, the goal of planning should be financial organization and preparedness of the company.
Conclusion
Federal tax brackets could be vital for small business owners if business income is subjected to taxation as if it is the personal income of the business owner. The knowledge about taxable income, tax brackets, effective tax rate, tax deductions and credits, and tax estimates may be useful in making sound financial decisions.
The structure of the business, income level, deductibles, and other personal matters will define the amount of tax payable. The accounting process and the analysis of the income earned throughout the year could help you plan your taxes well and be ready for the required payments.
Since the rules and personal conditions are different, small business owners need to seek advice from the tax adviser concerning tax and entity structuring.
FAQs
Generally, federal income tax is based on taxable income rather than simply total business revenue. Eligible business expenses and other applicable adjustments can affect the amount ultimately subject to tax.
No. Under the progressive federal income tax system, different portions of taxable income are generally taxed at different rates.
A marginal tax rate is the highest federal income tax rate that applies to a taxpayer’s taxable income. It can be particularly useful when evaluating the potential tax impact of additional income.
Accurate bookkeeping helps businesses track income and expenses, monitor profitability, identify potentially deductible expenses, maintain supporting records, and prepare more accurate tax information.
