Understanding income taxes as an entrepreneur can be a real headache, and many online resources like to assume you already have a basic knowledge of how taxes work when they explain concepts. In this post, I'm breaking down the BARE BASICS of how income taxes work (without the accountant jargon).
This is Part 3 of the Tax Prep Series!
Disclaimer: This information is intended for a general audience and does not constitute direct financial advice for your personal situation. Additionally, this post is based on United States tax law and may not be as applicable to businesses based in other countries. If you have financial questions relating to your individual business or situation, please reach out to a trusted CPA or tax preparer.
What Is Income Tax?
The federal government (and many state governments) tax a portion of the income you earn throughout the year in order to generate revenue. This tax revenue is what funds the government services and programs that shape our communities and society.
While many people tend to complain about having to pay taxes, it can be a nice perspective shift to remember that paying taxes is a part of our civic duty to contribute to the financial wellbeing of our states and country. H&R Block wrote, “it’s like you’re chipping in to pay your part of a larger bill for shared resources.”
Try to think of it as a necessary duty for being a part of a functional society that granted you the opportunity to have that job or run that business and earn money in the first place. (Easier said than done, I know. 😜)
When and How Do I Pay My Taxes?
Technically speaking, income taxes are due annually. During tax season (about end of January through mid-April), you’ll hear people talk about needing to “file their tax returns.” Note that you’ll be doing this for the PRIOR calendar year. (So in March of 2023, you’re likely filing your 2022 taxes.)
A tax return is the FORM that you file to the Internal Revenue Service (IRS), the United States’ tax authority, that reports your income, expenses, and other relevant tax details. While this was once an actual set of paperwork to be filled out, in the digital age you’re now able to fill out online forms in a more user-friendly way to do this (I use TurboTax, but I recommend entrepreneurs always find a tax preparer they can trust to save them from making common and costly mistakes!).
Note: A tax return is not the same thing as a tax refund. The “return” is the FORM, a “refund” is an actual amount of MONEY you may receive from the IRS. More on this in a moment!
The tax return form for your individual tax return (known as Form 1040) is how you’re able to calculate how much money you earned and ultimately, how much in taxes you have to pay, which I’ll break down in the next section.
How Is Income Tax Calculated?
Income tax calculations can get very complicated as your financial situation grows more complex — that’s what accountants are for! And frankly, most of you don’t need to be able to run the calculation yourself, so I’m going to keep this simple.
We’re going to use some tax terms here, but all we’re really saying is that your tax is calculated as:
What I Earned
- What It Costs
- Special Considerations for My Financial Situation
- How Much I Already Paid in Taxes
= How Much I Still Owe (or How Much I Get Back)
Gross Income: This is essentially the total of all income that you earn. Note that there are some types of income that you can generate that you do not have to pay taxes on.
Minus Deductions: There are some expenses you may have that can reduce the amount of income you have to pay taxes on. There are several kinds of “deductions” out there, and your tax preparer or tax software should help you identify the ones you qualify for. There is even a “standard deduction” that everybody gets automatically, to act as a catch-all for the expenses most of us have. Consider this a way the government says, “We know that just because you earned X amount, that doesn’t mean you HAVE that amount on you because you have costs. So to be fair, we won’t charge you on the full amount.”
Equals Taxable Income: You’ll be left with the final net amount that you’ll get taxed on. The percentage that you’re taxed depends on how big or small this number is! (Note: The U.S. has a “progressive” tax system, which means that your income isn’t just taxed at one flat percentage.)
Once the amount of tax you owe is calculated off of your taxable income, that tells you your income tax liability. As in, the amount that you now owe the government based on how much money you earned last year.
But that’s not where it ends! This number can still be reduced by two things: credits and pre-payments.
Minus Tax Credits: Tax credits are additional special case scenarios you may qualify for that can reduce your final tax bill. These are more valuable than tax deductions (which reduce the income you pay tax on) because they cut into your actual taxes owed, dollar-for-dollar. However, you do have to match the criteria to qualify for these, which is where your tax preparer comes in handy.
Minus Pre-Payments: This is how much you’ve already paid. Think back or even pull up your last employee pay stub you received - see the line item for “federal withholding”? (Sometimes abbreviated FWH.) Withholding is when your employer sends the IRS a portion of your income as you earn it to contribute towards your tax bill, kind of like forced savings. The amount they withhold depends on the information you gave them on your W-4 form when you were first hired (and you can typically change this by contacting your boss or HR department). Note that there are other ways to pre-pay taxes, which we’ll talk about in a couple of sections.
If your tax credits and pre-payments end up being MORE than you actually ended up owing, you’ll get a refund from the IRS. If they weren’t enough, then you will have taxes due and you’ll have to write a check when you go to file your tax return.
How Is My Business Income Different?
If you are a sole proprietor (you just started doing business without filing any special paperwork to make your business in its own legal entity) or you are an LLC, your business activity is reported on your personal tax return just like any other income you might have.
Specifically, it goes onto a special part of the Form 1040 called “Schedule C”. All you’re doing is reporting your total business income earned minus your business expenses (deductions). That’s because you’re only going to be taxed on the Net Profit. This is what people mean when they say things like “claim your business expenses.” Just like we talked about above, you’re simply deducting your costs from your gross income to arrive at a more fair number for your taxable income.
The main difference when you have business profits to report on your income tax return is that you will also have to pay self-employment taxes. When you are an employee, part of your income taxes taken out of your paycheck (in addition to the federal income tax withholding) are for Social Security and Medicare. If you have self-employment income, those taxes haven’t been taken out throughout the year, so you’ll pay them with your annual return.
However, as an employee, you and your employer both pay half of the total amount due. If you’re self-employed, then you have to pay both halves. This is where self-employment tax (SE Tax) gets its bad reputation from, as it can hit hard if you’re not ready for it.
What About Quarterly Estimated Taxes?
Diving into the world of self-employment income, you’ve probably come across the idea of “paying taxes quarterly” or making “estimated payments.” What does this mean?
This does NOT mean you’re filing quarterly tax returns. This is simply another method of prepaying your taxes that you think you’ll owe when you go to file next year.
As a business owner, you generally are expected to make estimated tax payments on a quarterly basis. Again, this is a pre-payment of what you’re expected to owe when you go to file your taxes next year. So estimated payments made in 2023 are for 2024’s tax return.
Technically, you don’t have to pay these by the quarterly deadlines, or even at all. However, if you owe a balance on your tax return and you didn’t make your estimated payments, you’ll owe an additional penalty - so it’s best to make your payments on time.
Read more about Estimated Taxes and other tax responsibilities you have throughout the year here!
Where to Go From Here?
Hopefully now you’re able to better understand exactly what’s happening each year when you go to file your taxes and find out if you owe or get a refund!
To learn more about the practical action steps you should be taken to stay up-to-date with your tax responsibilities (especially as a business owner), check out the other posts in this Tax Prep Series:
US Tax Checklist for Business Owners: Throughout the Year (Part 1)
US Tax Checklist for Business Owners: End of Year (Part 2)
Are you ready to take your financial journey to the next level? Then you may be ready to check out the More With Money Academy!
This ever-growing collection of online courses and trainings are specially designed to support entrepreneurs like you on your path to financial wellness. The Academy contains carefully designed courses that are easy to understand and implement so that you can be empowered with the practical concepts, streamlined systems, and powerful mindset to transform your business and personal finances.
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I'd love to continue the conversation in the comments! Feel free to share your thoughts.
Until next time!
Business Money Management
Katie Scott
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