The start of the year is always a busy time for us accountants, especially in the small business world. January is 1099 crunch time, and we are in the midst of preparing everything for our tax clients. It is also a busy time for tax payers, whether they own a business or not. As due dates creep closer, the stress levels amplify, and the questions start rolling in. Recently, we addressed two of our most popular tax FAQs that ring true for a lot of tax DIY-ers. To help ease a little tax time stress and help you be better prepared for next year, here is your income tax prep FAQ roundup.
So this is the thought that runs through pretty much every taxpayer’s head at least once, if not multiple times throughout the year. This gets really stressful for business owners fresh out of the W2 world. They may still be in reactive mode, just paying bills and getting more business; not necessarily thinking about the tax implications of that income coming in. We filtered things as well as we could to help you understand the answer for your situation.
You must understand that the yes or no answer to this question is very circumstantial, so you need to consult a tax CPA for a precise answer. Outside of that disclaimer, the best way to better understand your situation is to get to know the general concept of income tax, so we will start there.
You're not going to pay income taxes on the revenues you bring in, you're going to pay income taxes on revenues, less expenses, and what's leftover. If it's profitable above zero, you'll owe taxes on it. If it's below zero, you won't owe taxes on it - from an income tax standpoint. That's the simplest way to describe it.
There are a lot of nuances when it comes to deductions, depreciation and loss, carry forwards, etc, which is why having a tax pro in your life is very helpful. They will understand the intricacies of these items, how they apply to you, and be aware of any updates to tax laws.
As a business owner, taxes don’t just stop at income tax, especially if you sell products. Things like franchise tax and sales tax need to be considered. There is also payroll tax, if you have W2 employees.
Depending on your state’s regulations, you may or may not owe income taxes, but will have to pay other fees associated with running a business in that state. For example, the state of Tennessee does not have state income tax. If you are a passthrough entity, (go here to read up on what that is, if it matches your situation) you won't owe state income taxes. However, they do require you to pay a franchise and excise tax (another form of tax) based on either your revenues or profits. So you will likely be dealing with multiple tax scenarios either way as a business.
Some localities require income taxes, like some big cities do, but also a lot of locations require business licenses. Every city in town could have different ways of calculating the amount of money that you owe. Some of them are based upon gross receipts; your gross revenue, basically, where you have to pay a 3%, 5%, .005% number of that. That's basically a tax, right? It’s called a business license, but it's a tax to support local operations of that jurisdiction.
So to bring things back to the question of “will I owe income taxes?" It is a much bigger conversation at the base level, as you can see, but in the traditional sense of the income tax conversation, you owe income tax on the profits of your company revenue, less expenses. You don't owe income taxes on the revenues of your company. This is at the federal level and in most states. Be conscious of other taxes that exist, that mirror income taxes like business licenses, franchise taxes, excise taxes, etc. so you can better understand what your specific tax scenario looks like.
This question ranks in the top two tax time freak out FAQs we hear, which is exactly why we are addressing it again. It’s a pretty common situation: you bill a large chunk of money, the year end passes and you haven’t received that money yet. How does that hit the tax bill? Are you now on the hook for the tax amount on money you don’t have? In short - no, depending on how you file.
When you file taxes, you will select cash based or accrual based – it all starts here. As a business, you need to select one or the other when you file.
What cash basis means from a tax perspective is that you only get taxed on monies you receive from your customers, and monies you pay out to your vendors. If you do a cash basis tax return, you wouldn't get taxed until the year you actually received the money. We see a lot of businesses; small businesses, specifically service providers, where they're invoicing customers on terms and getting paid at a later date to do a cash basis tax return.
Accrual basis is different. You essentially get taxed when the services were provided by either the customer or vendor. If you invoice the customer for December services for $10,000 on December 31, and you don't get paid until the next calendar year, that ten grand would be included on the accrual basis tax return - the exact scenario the FAQ's owner worries about.
There are a ton of benefits to Accrual based accounting, so it makes sense to apply this to our outsourced accounting practices for clients. This method allows for proper management of your business to understand things from a CFO level perspective. Things like understanding your profitability, managing cash flow, and your breakeven point. From the business management and internal reporting side, we are all Accrual, but when we file our client’s taxes, we go with the cash method. The majority of our clients are smaller businesses and can’t front the taxes owed on payments they haven't received yet. Some clients will take advantage of deductions opportunities when they can, maximizing that cash based accounting. For example, they may pay the next three months of rent on their office space ahead of time in December, and apply that to the previous year’s taxes.
Sometimes a small business can benefit more from the Accrual based option, but it depends what type of business you are in. Let's say that you take deposits from customers that are refundable, (or even not refundable), like event companies? You get a deposit up front this year, but the actual event doesn't happen until next year. At some point you may have to deposit, or refund that money back to them beforehand, for whatever reason. You may not want to get taxed on that portion of money that you just haven't deposited or escrowed until next year.
To sum things up, it depends on how you file your taxes whether or not you would owe on money not received yet. Most likely, no, you will not owe them. This depends on which selection you make when you file; accrual basis or cash basis accounting. Cash basis taxes you when you receive money and when you pay money out. Accrual basis taxes you on when services are rendered. However, that doesn’t mean you can’t reap the business management and reporting benefits of doing accrual based accounting through the year.
For the best results in your situation, make sure to work with a solid tax CPA so you're on the correct tax basis to minimize your taxes and to support your business and personal situation long term. The cool part is you can adjust which method works best for your unique situation as your business evolves and grows.
If navigating taxes is not your, thing, we've got you. Take a moment to tell us about your business and we will set up a time to chat through how outsourcing your accounting can help your unique needs.