If you’re getting ready to file your business taxes for the first time, or even if you’ve been in business for a while, you may be wondering why your taxable income is always different from the bottom line showing in your accounting program. It’s time small business tax was explained.
What is showing in your accounting program is your accounting income, and there are a number of adjustments required to convert your accounting net income to your taxable income. Whether you’re a sole proprietor or your business is incorporated, these adjustments happen on your tax return which will be a different IRS form depending on the type of entity you’ve chosen for your business.
Taxes can be complicated, and how they are calculated always depends on your unique situation, but here’s a quick primer; small business tax explained in plain English.
Eligible Business Expenses
If you are a sole proprietor, you will file your business income and expenses on Schedule C as part of your 1040, but even before your taxable income is calculated, certain things are taken into consideration when recording your business income (whether done by you or your accountant).
Mainly: Are these expenses deductible?
You can reduce the amount of adjustments required to go from accounting net income to taxable income by only recording eligible business expenses. A quick and easy way to determine if your expenses are deductible is by asking if the expense is necessary for you to earn income in your business.
Eligible business expenses will vary based on industry, but generally, if you wouldn’t have the expense if you didn’t have the business, then it’s an eligible business expense. For example, a physiotherapist meets with clients in an office outside the home. Any expenses related to that office are deductible because she wouldn’t have them if she wasn’t running that business.
Another type of expense, a capital expense, is incurred when property, vehicles, or equipment are purchased for the business. Capital expenses are deducted over the life of the asset rather than all at once when they are purchased.
If we go back to the physiotherapist in the example above, if she purchased the building where her office is located, then the value of the building would be recorded as an asset on her business’s balance sheet, and only depreciation on the building would be expensed going forward. Accounting and tax rules often differ when it comes to the calculation of depreciation, so if you have capital assets in your business, be sure to consult with your tax professional to determine how much depreciation to claim when calculating taxable income.
The TCJA has changed small business tax preparation when it comes to property improvement expenses, so you’ll also want to check with a tax professional if you have any of these types of expenses. Some property improvement expenses are eligible for a full deduction, subject to restrictions such as the timing of purchase and date of use.
Calculating Taxable Income
Under a marginal tax system like what we have here in the US, multiplying your business income by your tax rate isn’t going to give you an accurate calculation of how much tax you owe. This is because of things like exemptions and deductions.
Further complicating the calculation of taxable income are the different rules for tax and accounting. Your taxable income must be calculated based on tax laws. This is also why you must use IRS approved forms to calculate and file your taxes.
As mentioned above, depreciation is calculated differently for tax and accounting purposes, so this is a common adjustment made when calculating your taxes. This is also why it’s a good idea to have your accountant calculate estimated taxes for you rather than using your accounting income as a basis for your quarterly payment.
Accounting and taxable income can differ substantially depending on the industry you’re in, as well as the credits and deductions available to you.
Credits vs Deductions
There are a number of credits and deductions available to small business owners. Credits and deductions are sometimes used interchangeably, but they are two different things. Both reduce your tax bill, but deductions are items subtracted from taxable income before income tax is calculated, and credits are subtracted from the amount of tax you owe.
The business expenses mentioned above are deductions because they are subtracted from income before tax is calculated. Credits, on the other hand, are deducted after your tax is calculated because they are deducted directly from the amount of tax you owe. For this reason, when credit and a deduction have the same value (say $500), the credit will result in a greater reduction in tax owing.
Let’s say I have a taxable income of $25,000 and my tax rate is 12%, but I forgot to include $500 of office supplies on Schedule C. This will reduce my tax bill by $500 x 12%, which is $60, but a tax credit of $500 will reduce my tax bill by the full $500 because it is subtracted from the tax amount owed rather than my taxable income like the deduction.
By familiarizing yourself with eligible business expenses, adjustments to taxable income, and deductions and credits, you are arming yourself with the tools needed to become more aware of how taxes work. As you increase your awareness of business taxes, you’ll find yourself noticing things you can do to reduce your business tax bill.
Tax laws are complicated, and if this article leaves you with more questions than answers, that’s normal. At Levy | Lauter LLP, we specialize in tax compliance, business advisory, and accounting services for all entities, and we’re here to help. It’s our job to stay up to date on the constantly changing tax laws, so you don’t have to. Fill out this form to schedule a call and learn more about how we can help.