Startup Tax Issues: What You Need to Know
The success of a startup rests on the decisions its entrepreneurs make at its founding, many of which could be affected by tax issues. These include obtaining an Employer Identification Number (EIN) and gaining an understanding of tax obligations on the federal level such as income, sales and excise taxes and employee withholdings. Many states have their own income and employee taxes, and some localities may levy income property taxes, too.
The organization of the company makes a difference in the way the taxes are applied, and so does the choice to hire independent contractors or employees. Proper documentation of income and expenses, operating losses and deductions is essential, both to keep from paying unnecessary taxes and to prevent trouble from an audit.
Employer Identification Number (EIN)
The EIN is the same as the taxpayer identification number, and other than a sole proprietorship, all companies must have one. However, a sole proprietor is not exempt if pension or excise tax returns are filed. If the organization of the startup changes, the sole proprietor must apply for an EIN. When a company already has an EIN and the organization changes, the owner must apply for a new number. A new EIN is also necessary if ownership changes.
Federal Tax Issues Related to Organization
Whether the startup is a limited liability company (LLC) or a corporation affects what federal tax regulations are relevant. An LLC can be a sole proprietorship or a partnership, and the owners are called members. If it is a sole proprietorship, the owner simply pays income tax on the business but does not file a separate return for the business itself. When there are two or more members, the members each pay personal income tax based on their shares of the company’s profits and losses.
A corporation that qualifies for S status has stockholders who are responsible for reporting the incomes and losses on their own tax returns. A C corporation is a for-profit organization that is taxed as an entity in itself.
Federal Payroll Tax Issues
Companies must pay federal payroll taxes on the earnings of their employees. These include FICA taxes, which are Social Security and Medicare, as well as federal income taxes, and they are withheld from the employees’ wages. An employer is responsible for paying a federal unemployment tax and state workers’ compensation insurance, which are not tied to employee withholdings.
Independent contractors pay their own taxes, so the company that uses them does not have the tax burden that is part of hiring employees. Hiring independent contractors may save the startup quite a bit of money and responsibility. However, if workers are misclassified, there can be serious legal ramifications.
Business Taxes at the State and Local Level
Income taxes at the state level are paid during the year as the business earns the income. While all states have business income taxes, the regulations are not the same. In some cases, companies must pay estimated yearly taxes every quarter. Other locations may require the businesses to pay the taxes at the end of the year.
In some states, employers must obtain a tax identification number that is similar to the federal EIN that the IRS requires. Employment taxes also vary from state to state. An employer may be required to pay state workers’ compensation insurance and unemployment taxes in addition to those the federal government requires. Withholdings may include a state income tax as well.
Some counties and municipalities levy additional taxes, such as property and operating taxes, sales tax and income tax.
Tips for Thorough Recordkeeping
The IRS advises that small businesses keep records of purchases, expenses, assets and gross receipts. The system that the company uses should maintain precise documentation of the income and all expenses that are deductible to ensure that the appropriate amount of tax is paid and avoid legal trouble in an audit.
Purchase, income and expense records must be meticulous. Gross receipts, cash register tapes, credit card statements and invoices are examples of documentation that must be kept. Businesses typically require furniture, machinery and other property to run the business. These must be documented as well to show changes in worth and whether there is a gain or loss when they are sold. The purchase price, how the asset is used, any expenses related to its improvement and how much it was sold for should be documented. Deductions may be taken for losses and depreciation.
Federal, state and local tax issues that are applicable to startups vary, but thorough recordkeeping is necessary regardless of which regulations apply. Owners may benefit from acquiring a basic knowledge of business tax laws before making some of the decisions that will shape their company.
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