Small Business and the Impact of Tax Law
Small businesses are the backbone of the American economy. According to the Small Business Administration’s (SBA) Office of Advocacy, there were 31.7 million small businesses in the United States in 2020. With this high number of small businesses, it’s essential to understand the impact of tax law on these entities. The tax code is complicated, but small businesses owners need to understand how it impacts their operations and bottom line. This blog provides an overview of the key tax laws that small businesses need to understand.
Tax Filing Requirements for Small Businesses
All businesses must file a tax return every year. As a small business, you must choose the type of entity that you want to operate, including sole proprietorship, partnership, LLC, S-Corporation, or C-Corporation. Each entity type has different tax rules, and the choice of entity could significantly impact your tax liability.
For example, if you operate a sole proprietorship, your business and personal expenses are not separate, and your income is taxed at your individual tax rate. In contrast, if you establish an S-Corporation, the business’s income is passed through to the shareholders, and the shareholders pay taxes on the income based on their individual tax rate. Choosing the right entity type is critical to ensuring you pay the least amount of tax possible.
Deductible Business Expenses
Small businesses can lower their taxable income by taking advantage of deductible business expenses. These expenses can include rent, equipment, utilities, and travel expenses, among others. To qualify as a business expense, the expense must be ordinary and necessary for your particular type of business. Any expenses that are deemed excessive or lavish are generally not allowed as a deduction.
The Tax Cuts and Jobs Act (TCJA), enacted in December 2017, introduced significant changes to allowable deductions. One notable change was the elimination of the entertainment expense deduction. Under the new law, no deduction is allowed for entertainment expenses, including tickets to sporting events, concerts, and theater performances.
Payroll Taxes
If you have employees, you must withhold payroll taxes from their salaries. You must also match the employee’s social security and Medicare tax contributions. As an employer, you should also be aware of any state and local payroll tax requirements.
Under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) enacted in March 2020, employers were allowed to defer the payment of the employer’s portion of social security taxes. The deferral period was from March 27, 2020, to December 31, 2020. However, the deferred taxes must be paid in two installments in 2021 and 2022, which could impact small businesses’ cash flow.
Sales Taxes
Small businesses must also be aware of any sales tax requirements in the states where they conduct business. Each state has its sales tax rules, and if your business has a physical presence in that state, you must collect and remit sales tax.
The Supreme Court’s 2018 decision in South Dakota v. Wayfair, Inc. significantly impacted small businesses’ sales tax obligations. The court ruled that a state can require an out-of-state seller to collect and remit sales tax on sales to customers in that state, even if the seller has no physical presence in that state. Small businesses must stay up-to-date with the evolving sales tax landscape.
Tax Credits
Small businesses may also qualify for tax credits, which reduce their tax liability. Tax credits typically apply to specific activities, such as hiring employees in designated areas, research and development, and installing energy-efficient equipment.
The CARES Act introduced tax credits for small businesses that were adversely affected by the pandemic. The Employee Retention Credit (ERC) allowed eligible businesses to claim a refundable tax credit for a portion of wages paid to employees during the pandemic. Qualified small businesses can also claim a credit for sick and family leave payments made to employees under the Families First Coronavirus Response Act.
Conclusion
Small businesses are subject to many tax laws and regulations that significantly impact their operations and bottom line. As a small business owner, you must carefully plan and manage your tax obligations to ensure compliance and minimize your tax liability. Understanding the different tax rules for your entity type, deductible expenses, payroll taxes, sales taxes, and tax credits is vital to the success and longevity of your small business. For more information on small business taxes, check out the IRS’s guide for small businesses.