I had a meeting recently with a client who is new to the small business ownership world. He had met with his tax advisor and was confused about the dollar amounts the advisor had estimated would be owed for 2012. We then had a meeting with the client, the advisor and myself to make sure we were all in agreement as to what the business owner would potentially have to pay in income taxes next April and how best to prepare for it.
We always recommend meeting with your tax advisor on a regular basis so there are no surprises come tax time. One area our clients struggle with is understanding how taxes are calculated for a small business owner. It is more complicated that many would think! If your business is an LLC and you are the only member/owner than you are considered a sole proprietor by the IRS. The federal government refers to LLCs as Disregarded Entities as they are really a legal invention, not a tax identity. If your business is an LLC and is owned by two or more people, then your business is usually treated as a partnership. Both single member LLCs and multi-member LLCs have the option to file as an S Corp, but that is a topic for another time.
For both types of LLCs, the focus for taxes is the bottom line: what was the business' net profit or loss for the year. The government does not care about what amount the owner(s) drew out of the business during the year (what they paid themselves). The owners will pay income taxes on the business whether they took all of the money out of the business or none.
In addition to income tax, owner of small businesses also have to pay self employment taxes. This is another area that confuses people. When you are an employee, you pay the government 7.65% of your pay for medicare and social security and your employer pays 7.65%. When you own your own business, you are both employer and employee so you pay both shares or 15.3% of your net income to the federal government to cover your medicare and social security obligations. Unlike an employee who has the 7.65% taken out of every paycheck, a small business owner pays the 15.3% when they file their income taxes every year. This often catches people off guard as it can be a hefty sum if your business enjoyed a profitable year.
Such was the case for my client. He has had a good year so far and the tax advisor had estimated the tax correctly. Fortunately, the client has time to plan for taxes and will have the money available come April.
Next week, I will talk about estimated taxes for small business owners and the pitfalls some encounter.