As a tax advisor to entrepreneurs and executives, I’m regularly chatting with folks who are starting a business. As I focus on working with small, service-based businesses, these conversations are typically with professionals who have a specific expertise – think marketing, law, IT – that they plan on turning into a full or part-time business. They’re often either tired of working for someone else or semi-retired and not ready to read and practice yoga all day.
Every time – seriously, every time – I’m chatting with a current or prospective client who’s considering starting a company, they ask me the same three questions. I’ve repeated myself so much that I’m memorializing the answers in this article. Although not bespoke advice for any particular situation, what you will find here is a baseline education for a better understanding of these three concerns so you can have a higher-level conversation when you speak with your tax advisor.
Question 1: Do I need an LLC and/or do I need an S Corporation?
First, let’s address what an “LLC” is and what an “S Corporation” is.
LLC stands for Limited Liability Company. When creating a business, you make numerous choices about the business’ formation such as who will own it, in what proportion will owners have ownership, who is responsible for decision making, etc. You also choose how the business will be structured for legal purposes under state law. A Limited Liability Company is one structure option. Alternatives are sole proprietorships, partnerships, and corporations. Different structures, or combinations of structures in the case of multiple businesses, result in different legal protections and obligations under applicable state law. For example, while an LLC or a corporation may shield its owners’ assets from a lawsuit against the company, a sole proprietorship may not afford such protection.
An S Corporation, by contrast, is a function of federal tax law. Think of an S Corporation as a federal tax saran wrap that you can use to cover a business, such as an LLC or corporation, to obtain a certain federal income tax treatment for the company owner(s). Explained this way, we can understand that the terms “LLC” and “S Corporation” are not mutually exclusive and that you can, in fact, have the same business be both an LLC and an S Corp at the same time. We can also understand that knowing that a business is an LLC, in and of itself, tells us nothing about the company’s federal income tax status. What folks find attractive about S Corporations is that their profits are not subject to self-employment tax. This can be a significant source of tax savings for the right fact pattern. Note that I said right fact pattern and not all fact patterns. Sometimes an S Corporation is not the best move as I have previously discussed in this article.
Now you can look at the questions “do I need an LLC?” and/or “do I need an S Corporation?” and see that it will actually be more helpful to step back and ask a broader question: “Does my business need some sort of special legal and/or tax structure?”
The first question is a legal one and your optimal answer is going to depend on a variety of inputs that I won’t cover because I’m not a lawyer. How your business can best be structured for legal purposes is a question for you and your corporate attorney. The second question is definitely in my wheelhouse, but unfortunately not something that can be answered for you in an article you read online. For best results, speak with your tax advisor who will want to know things like what type of business you’re going to run, what your exit strategy is, who the owners will be, what profit levels you expect and how quickly you expect to reach them, your appetite for administrative inconvenience to obtain tax efficiency, etc. Because so many factors are involved in how best to operate a business from a tax perspective, if someone who doesn’t know your tax situation has advised you that you should be in an S Corporation, my best advice is to run away.
Question 2: Should I make estimated tax payments?
After we’ve chatted about legal and tax structure, the next question in the conversation is, “Should I make estimated tax payments?” Many new and aspiring small business owners are accustomed to having the bulk of their income come from earnings as an employee. These earnings typically have an appropriate federal and state income tax withheld. Most of these folks are not accustomed to earning significant income that has no associated taxes withheld and remitted on their behalf. Naturally, there can be questions, sometimes even anxiety, about how all this works without an employer behind the scenes taking care of things.
I’ve written previously about making estimated tax payments. Read that article here so what I say next will have a place to land.
You’re back! In addition to the explanation and guidance in the previous article, let me say a few things here that are specific to the intersection of new small business owners + estimated taxes:
- The first year of transitioning into the role of small business owner from being an employee can be challenging to pin down from a tax perspective. With the occasional exception, most of my clients who are in this situation truly have no idea how their business will do in the first year or two. If you don’t know how much money you’ll make, then you don’t know what your related tax liability will be and so how can you plan for it, right? For these folks, I generally say to set aside 1/3 of revenue less expenses (a/k/a “profit” or “net income”) monthly to cover taxes. You’ll either be over or under, but hopefully in the right ballpark.
- What your spouse is doing impacts you. As most married couples file one joint tax return, your spouse’s earnings and withholdings will impact your decision of whether to make estimated tax payments and to what extent. Many of my clients initially find it confusing that this is the case. Let me give you an example: You started a new business last year and had taxable profit of $30,000 for the year. Using my previous rule of thumb, you had set aside $10,000 for taxes which you expected to owe with the filing of your tax return. Additionally, your spouse has a W-2 job and earned $250,000 last year with $100,000 of this withheld for taxes. Putting all this together, your tax return reports $280,000 of total income and $100,000 of taxes withheld. However, your tax return also reports a total tax liability of only $85,000 resulting in a refund of $15,000. How did you go from expecting to owe $10,000 to being overpaid by $15,000?! It’s because your spouse had enough withheld to not only cover their earnings, but also your business income. So, would making estimated tax payments have helped you for the first year of your new business? Probably not in that particular situation. But what if you’re expecting profit of $70,000 this year? Or what is your spouse is starting a new job where they may earn significantly more or less than the prior year? Again, what your spouse is doing impacts your joint tax situation and will inform if, and to what extent, you make estimated taxes.
- Be cautious when using next year’s profits to pay last year’s taxes. As you read in the other article, I’m indifferent as to whether my clients pay estimated tax payments. I’m more interested in tax minimization and cash flow management than I am with complying with estimated tax payment rules that have no relationship to your businesses’ cash position. What I do want my clients to do, however, is to at least be setting aside for taxes as the money is being earned. I promise you do not want to file your tax returns in April only to find you need to generate new cash flows to pay last year’s taxes. Not only do you have to cover old taxes, now it’s hard to set aside for the current year. This strategy is a house of cards that crumbles the first year you have a downward trend. Can you come back from it? Absolutely you can. But it’s hard and it can take several years. I don’t want that for you.
Question 3: What can I deduct?
Now we’re at the last, but definitely not least, question of the conversation. This answer will depend based on what type of business you’re operating, but I’ll cover the more common ones here.
Common tax-deductible small business expenses include:
- Business use of your vehicle. I have an article on how that works here. At the very least, keep a log of your mileage.
- Other travel expenses such as Uber/taxis, hotels, tolls.
- Furniture, office equipment, office supplies.
- Most meals for business purposes are typically 50% tax-deductible, although for 2021 they are 100% tax-deductible.
- Business use of your home to the extent you have a place in your home that you use for business regularly and
- Internet and cell phone.
- Marketing, business association dues, state licenses, professional fees.
- Compensation to others for services performed. This would be either independent contractors to whom you issue a 1099 at the end of the year or employees to whom you’ll issue a W-2 and may also provide benefits.
- Rent and repairs for your office space.
- Depreciation on long-lived assets such as vehicles, more expensive furniture & office equipment.
- If you deal in inventory, you can generally deduct the cost of product sold or available for sale, i.e., Cost of Goods Sold
- There are retirement plans available to small businesses that also can be tax-deductible.
Common small business expenses that typically are not tax-deductible include:
- Entertainment, social club dues – even if these lead to revenue generation.
- Owner personal expenses such as clothes and personal use of your vehicle or home.
- Most gifts in excess of $25 per recipient.
If you’re in a service-based business, you’re not going to have the same level of expenses as, say, a restaurant would. With higher margins, there are less tax benefits available to you. Missed expenses are expensive. I encourage you to keep track of all your business expenses by establishing a business-only bank account (even if you operate as a sole proprietorship) and using an accounting software/app. Go one step further by outsourcing your bookkeeping function for oversite and increased confidence that all your business activity is properly recorded. For more information on what tax-related records such as receipts, filings, etc. you’re required to keep and for how long the IRS has details here.
Sidebar: I have spoken with numerous aspiring business owners who are under the false impression that an LLC they wholly own (we say Single Member LLC and write it as “SMLLC”) somehow has more tax benefits available to it than if they operate their business as a sole proprietor. This idea predates cringeworthy TikTok tax advice so I’m unsure of its source. In some cases, the same transaction will be treated differently for tax purposes by businesses with different legal/tax structures. For example, certain owner fringe benefits are deducted differently for tax purposes among corporations, partnerships, etc. However, the difference in federal tax treatment between operating your business as a sole proprietor vs a SMLLC is nadda, zip, zero. All the deductions available to your SMLLC are also available to you as a sole proprietor. If you are paying self-employment taxes on your sole proprietorship profits, you would continue to do so if you did business as a SMLLC. (Do check for state-level differences, though, such as state-level annual LLC fees and taxes.)
TL;DR: If you’re starting a new business, you have several options regarding your company’s legal and tax structure. An LLC and an S Corporation are not an either-or proposition, and it’s possible that both or neither are optimal solutions for you. Consulting your corporate attorney and tax advisor is a must when starting a new business. You may want to make estimated tax payments, but you at least want to be budgeting for taxes. Keep impeccable financial records to substantiate as many tax deductions as possible.
Congratulations and best of luck!
Account – A general ledger record that holds financial transactions of a similar type; examples include Fees (a revenue account) and Distributions (an equity account); accounts and their balances (for a particular period or as of a particular date) are found on the company’s financial statements.
Accounting – The process of recording and summarizing financial transactions, maintaining financial accounts and generating related insights.
Accounts Payable (A/P) – A liability account that reflects funds owed by the business to its creditors/suppliers. Reported on accrual-basis financial statements.
Accounts Receivable (A/R) – An asset account that reflects funds owed to the business for services performed. Reported on accrual-basis financial statements.
Accrual-Basis Method of Accounting – Financial transactions are reflected in financial reports when revenue is earned, and expenses are incurred regardless of when cash changed hands.
Assets – What the company owns, what the company has a right to. Examples includes bank accounts, accounts receivable, fixed assets.
Balance – The amount in an account as of a specific date or for a specific period.
Balance Sheet – A financial statement that shows the assets, liabilities and owners’ equity of a company on a given date.
C Corporation – A business with one or more owners operating as a C Corporation pursuant to federal income tax rules; the underlying legal entity can take various forms pursuant to state law such as a corporation or an LLC. C Corporations file federal Form 1120 to report the company’s tax activity, as well as to pay tax on that activity. Owners do not report tax activity of a C Corporation on their personal tax returns.
Capital Contributions – Money that business owners have put into the business. Typically, this is “seed money” to get the business started.
Cash-Basis Method of Accounting – Financial transactions are reflected in financial reports when revenue is received and expenses are paid.
Cash Flow Management – Involves tracking money coming into and leaving a company by amount, type of activity, and timing for purposes of effectively responding to cash position ebbs and flows, allocating company resources, positioning for growth and profitability and other uses.
Depreciation – Deducting the cost of a physical asset used in a business over time rather than all at once. This is both an accounting and a tax concept.
Estimated Tax Payments – Income taxes (and self-employment taxes) that taxpayers remit directly to government taxing authorities during the year in advance of tax return filings.
Financial Statements – Reports that show the historical financial performance of a business.
General Ledger (G/L) – A financial report that details a company’s financial transactions for a given period; transactions in the general ledger are grouped by account.
Income Statement – Same as Profit & Loss Report.
Indicator – A metric, observation, activity, etc. that provides insight into the past (lagging), current (coincident), or future (predictive/leading) financial health of a business. Examples include shrinking profit margins over several periods (lagging indicator), healthy Accounts Receivable balance with a high likelihood of collectability (coincident indicator), development of a new referral source (predictive/leading indicator).
Liabilities – What a company owes to others. Examples include accounts payable, credit card balances and bank lines of credit.
Owners’ Equity – Assets minus liabilities; comprised of cumulative profits, losses and amounts owners have contributed to and taken out of the company since company inception.
Owners’ Draws/Distributions – Company profits that owners have taken out of the company.
Partnership – A company with two or more owners operating as a partnership pursuant to federal income tax rules. Partnerships file federal Form 1065 to report the company’s tax activity. Each owner receives Schedule K1 from Form 1065 to report their share of the company’s activity on their respective personal tax returns, Form 1040.
Pay-As-You-Go – Rather than paying income taxes only when tax returns are filed, taxpayers are required to make tax payments throughout the year using mechanisms such as withholding and/or estimated tax payments to avoid underpayment penalties.
Payroll Taxes – Include federal income taxes, state income taxes, Social Security tax, Medicare tax and various other types of taxes that are withheld from an employee’s paycheck and remitted by the employer to government taxing authorities and similar agencies. Social Security tax and Medicare tax are typically matched by the employer. Some payroll taxes, such as unemployment taxes may be paid entirely be the employer.
Profit & Loss Report (P&L Report) – A financial statement that shows a company’s revenues and expenses for a given time period resulting in either a profit or a loss for the period.
Profit Margin – Profit divided by revenue. For example, if profit for the month is $4,500 and client fees for the same month are $10,000, the profit margin is 45%.
Qualified Business Income (QBI) Deduction – Created by the Tax Cuts and Jobs Act of 2017, the QBI deduction is a federal income tax deduction calculated very roughly as 20% of a pass-through business owner’s taxable profits from the business. The QBI deduction is subject to numerous restrictions such that many otherwise eligible taxpayers may claim a reduced deduction or none at all.
Ratio Analysis – Dividing one number in a financial report/statement into another number in a financial report/statement for purposes of generating data that is comparable within a given report, over a given period, against an industry benchmark, etc. Examples include profit margins.
S Corporation – A company with one or more owner operating as an S Corporation pursuant to federal income tax rules; the underlying legal entity can take various forms pursuant to state law such as a corporation or an LLC. S Corporations file federal Form 1120-S to report the company’s tax activity. Each owner receives Schedule K1 from Form 1120-S to report their share of the company’s activity on their respective personal tax returns, Form 1040.
Self-Employment Taxes – The self-employed person’s equivalent of Social Security and Medicare taxes; self-employment taxes include both the “employee” portion and the “employer” match.
Single Member Limited Liability Company (SMLLC) – A company with only one owner operating under a Limited Liability Company umbrella pursuant to state law. This structure is not recognized as a tax entity for federal income tax purposes. Company tax activity is reported directly on the owner’s Schedule C of personal tax return, Form 1040, just as if the company were a sole proprietorship.
Sole Proprietorship – An unincorporated business with only one owner; this structure is not recognized as a tax entity for federal income tax purposes. Business tax activity is reported directly on Schedule C of personal tax return, Form 1040.
Underpayment Tax Penalties/Underestimated Tax Penalties – Assessments in addition to taxes owed that government taxing authorities charge for missed or reduced estimated tax payments and/or withholdings.
Withholdings – Income taxes (and payroll taxes) that employers keep from employee paychecks and remit to government taxing authorities on the employee’s behalf.