Tax Implications of Starting a New Business

November 17, 2017 : Mike Slack

The launch of a new business comes with many startup tax questions. Let’s review some of the big changes that come with becoming your own boss.

 

1.     Your income is taxable even if you reinvest it into your business.

Any profit your business makes each year will be taxable regardless of whether you withdraw it or reinvest it into growing the business. Luckily, any deductible business expenses can be used to directly offset that income.

This is unlike employees whose non-reimbursed expenses are subject to a threshold based on 2% of their adjusted gross income and are only deductible if they otherwise itemize their deductions.

 

2.     You’ll be subject to self-employment tax.

Your net profit from your business will be subject to the self-employment tax. This tax pays for contributions to both social security and Medicare. Currently, you will pay self-employment tax at a 15.3% rate on your net earnings from self-employment of up to $127,200, and Medicare tax only at a 2.9% rate on the excess.

An additional 0.9% Medicare tax will be imposed on self-employment income in excess of $250,000 for joint returns; $125,000 for married taxpayers filing separate returns; and $200,000 in all other cases. Self-employment tax is imposed in addition to income tax, but you can deduct half of your self-employment tax as an adjustment to income.

Though paying the additional tax may seem burdensome, it actually designed to act the same way as the social security and Medicare taxes that would normally be withheld from the wages of an employed individual. Furthermore, the social security portion of the tax increases your potential social security benefits you may receive at retirement.

If you choose to put your small business into a corporation you will not be subject to self-employment tax on your earnings. However, you will then be subject to payroll taxes as shareholders who perform services for their corporations are required to be paid Form W-2 wages subject to social security and Medicare withholding.

 

3.     Your filing requirements will change.

Normally, individuals with taxable income under specific threshold amounts are not required to file a tax a return for the year. Generally, in 2017 a single individual under age 65 only has to file if their adjusted gross income exceeds $10,400.

However, if you are self-employed you are required to file a tax return if your net income from your business is $400 or more. This is true even if the $400 is your only income and you are thus far below the normal filing threshold.

 

4.     You will be required to make quarterly estimated payments.

Most taxpayers satisfy their tax payment requirements when their employer withholds state and federal taxes from each paycheck. When you’re self-employed, you’re 100% on your own. Most self-employed taxpayers satisfy their tax payment requirements by making estimated tax payments quarterly online or via the mail.

If you also work as an employee for another business in addition to your self-employment, you may be able to satisfy your required tax payments by increasing the amount of withholding from your wages.

Should you fail to make your required payments, you may be subject to an underpayment penalty. The penalty can be avoided if you meet certain specified exceptions or waivers.

Penalty = Interest rate charged by the IRS on deficiencies (X) The amount of underpayment for the period of the underpayment.

 

5.     You’ll be subject to new business tax scrutiny.

Unfortunately, being self-employed will be in one of the IRS’ favorite audit target groups. Though being audited doesn’t mean you’re in trouble unless you’ve actually done something wrong, it is best for you to always be prepared for the possibility. In particular, you should carefully record your income and expenses in order to claim the full amount of the deductions to which you are entitled.

Certain types of expenses, such as automobile, travel, entertainment, meals, and office-at-home expenses, require special attention because they are subject to special record keeping requirements and/or limitations on deduct-ability.

For more advice regarding new business tax responsibilities, schedule an appointment with your nearest H&R Block tax professional.

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Mike Slack

Mike Slack

The Tax Institute, H&R Block

Mike Slack, JD, EA, is a senior tax research analyst at The Tax Institute. Mike leads research teams focused on business and investment tax issues.