One of the biggest challenges you will have in your business is handling taxes. Handling taxes as an employee is easy - taxes are deducted before employees
get their paychecks. But businesses have to figure out their profits and have the willpower to save a large portion of it for taxes. Cash is scarce and it is extremely easy to spend it on the owners' living expenses or business operating expenses.
Profits over an above your salary: Shareholders usually must pay between 15 and 25% of net profits in taxes.
Employment taxes: You must have at least 35% above the paychecks you write yourself and other employees
to cover employee taxes.
Sales tax: 100% of sales tax that you collected has to be paid in taxes.
Taxes are so high because you must pay both social security AND income tax. Here's how it adds up:
Social security self-employment tax
Federal income tax
usually between 15 and 25%
California income tax
So, the first thing you need to understand is how to calculate your business profits - and what is tax deductible.
Available cash and profits are NOT the same thing. Warning: If you have inventory, your inventory costs are NOT deductible until
the item is sold. Read the following:
Most of us think of income and expenses in terms of cash received or spent. However,
the IRS requires most businesses which use inventories to use accrual
accounting - where cash is almost irrelevant. We're introducing the two major
accounting methods to you because each can greatly affect your quarterly and annual taxes!
Cash method: for businesses without
The cash accounting method operates almost like your checking account. Record income when
you are paid by your customers and record your expenses as you pay your bills. You have a
profit when you have cash at the end of the month.
One major difference between the cash
accounting system and your checking account is that you have to spread out capital expenditures
over several years
(see Introduction to Tax Deductions). Thus, your cash accounting
records may show you have $15,000 profit, but your actual checking account may be $0 because
you spent a lot of money on capital expenditures (equipment) which can only be expensed over
There is no way to get around this since the accrual system treats capital
expenditures the same way. Note: The IRS has a schedule showing the number of years equipment
and other capital goods must be written off.
Accrual method...required for businesses with inventory
The accrual system doesn't care when cash was paid or received. It tries to track when
obligations were made to pay or receive money. It also tries to match inventory expenses
with the income it generates. For tax purposes, there are three basic things to remember:
When you receive or pay cash doesn't matter. Income is recorded when you sell or
deliver the product (i.e. when the purchaser becomes obligated to pay for it). Expenses are
recorded when you become obligated to pay (i.e. when you sign a contract or receive a product).
The accrual system uses accounts receivable and accounts payable…the cash system does not.
In November 2015, you sell a $400 television on credit. You deliver it in December, but it isn't
paid for until February. You must record the $400 as 2015 income, even though you won't get the
cash until the following year. Bottom line: If you have credit customers at the end of the year,
this can mean higher taxes for you.
You buy and receive $4,000 in supplies on credit in 2015, but don't pay for them until 2016.
Since in 2015 you obligated yourself to pay for these supplies, it is a 2015 business deduction,
even though you never spent cash until 2016! Bottom line: Buying on credit at the end
of the year can lower your taxes.
You cannot deduct the cost of your inventory until you have sold the inventory (or products
containing that inventory).
You buy $40,000 in inventory in 2015. At the end of 2015, $39,500 of the same inventory remains.
You can only deduct $500 as a 2015 business expense!
Capital expenses are treated the same way for cash and accrual accounting.
Unless you're a bookkeeping pro, you'll probably need to hire a CPA, bookkeeper or tax advisor.
However, we also suggest that you learn something about accounting, so you will know what their
numbers mean. Talk to your tax advisor, read a simple accounting book and/or take a community
college class on business accounting.
A simple, basic knowledge of tax and accounting is critical to the success of your business. Businesses
do not fail because of lack of customers or a poor idea - they fail because the owners didn't know
what their costs or taxes were. In addition to seeking competent professionals, we urge you to
take a community college class on business finance and record keeping.
Three basic rules
You cannot deduct an expense unless it meets federal and state rules. Generally, the
expenses must be reasonable and necessary for your type of business.
If you buy something that will be used for more than one year, it must be capitalized ie.
deducted as a business expense over several years. Capitalized expenses include equipment,
buildings, cars, etc.
If you buy an existing business, you can capitalize the purchase price of
the equipment or buildings. However, you may not capitalize (or deduct) the amount you paid for
goodwill. Goodwill is the portion of the business' purchase price that exceeds the book value of the assets (equipment, cash and receivables).
If you start your own business, capitalized expenses include your start-up costs plus
equipment and property that you purchase.
Note: The IRS and accountants call the spread-out
deductions depreciation (on physical items like equipment) and amortization (on non-physical
items, like patent rights).
Inventory can't be deducted as a cost until it is sold.
Because of capitalized expenses and inventory, you may think
you broke even or lost money your first year, but the IRS may
say you actually OWE taxes because those expenses can't fully be deducted the first year.
Start-up costs are expenses you made to investigate and set up your business. Basically,
they are any normally deductible expenses incurred prior to when you began business operations.
If your total start-up costs are $60,000 or less, you can deduct $10,000 as a regular business expense (Section 195 expense) and amortize
the remainder over 15 years. If your start-up costs exceed $60,000, the $10,000 deduction is reduced by the amount such start-up costs exceed $60,000, and the rest must be amortized over 15 years. If your costs exceed $70,000, all costs must be amortized over 15 years. To amortize the costs, use form
form 4952 and include it with your annual business tax return. A separate election letter is no longer required.
Most businesses wait until they have begun business operations (i.e.
opened their doors for business), before purchasing supplies so that these expenses can be deducted
during their first year. Since the date you began business operations can be vague, we suggest
that you talk with your tax advisor about which initial expenses are start-up costs.
For tax purposes, it is often better to delay major purchases until after you have begun
Are these expenses deductible?
Meals and entertainment
50% of reasonable business entertainment and meals with your customers are deductible. If you
reimburse employees on a per diem basis, contact the IRS and request
publication 1542 Per Diem
Rates to determine the allowable per diem rates.
Cars and mileage
You must keep a mileage log of personal versus business use. You can either keep track of all your
car expenses or use a standard mileage rate. The 2018 mileage rate is 54.5 cents a mile, regardless of
the numbers of miles driven. In addition to the standard mileage rate, you can deduct business
parking fees, toll charges and a portion of interest charges on your car. We suggest that you
Publication 917, Business Use of a Car,
for further details. Call the IRS at (800) 829-4933 or visit http://www.irs.gov/Forms-&-Pubs.
Medical InsuranceC-corporations may deduct medical insurance for their employees, as long as the same insurance is
provided to all employees (it is not top-heavy).
S-corporation shareholders: Health insurance premiums for S-corporation shareholders (who own more than 2% of the
corporation's stock) are deductible as a business expense, but must be reported as additional income
for shareholders. Therefore the only time it makes sense is if there are multiple shareholders
where some shareholders are not benefiting from health insurance. See
for further information. This tax deduction is not available if health insurance is available through a spouse
or another job or if the health plan is subsidized.
Club membership is not deductible for federal tax purposes, but it is deductible for state taxes.
Existing furniture and computers now used for new business
If your business uses furniture or computers that you previously owned, you may deduct the value of
these items at the time they were converted to business use. Computers must be depreciated
(deducted) over a 3 year period; furniture over a 5 year period. You can either determine the
fair market value at the time you began using the item for business, or use the depreciated value. Here is an example of calculating the depreciated value:
A $3500 computer was purchased 7 months prior to putting it into a business use. The normal
write-off for equipment is 3 years = 36 months. In this case, $3500/36=97.22 per month. Subtract 97.22 x 7
months ($680.64) from the original $3500 purchase price. The remaining, $2,819 can be deducted as
a business expense over 3 years.
Home Office Expenses
C-corporations generally cannot deduct home office expenses. Theoretically, the corporation can write a
check to yourself for renting
an office, but then you have to report the rental income on your 1040, using
Then you could
deduct actual costs from your rental income.
Another option is to deduct the expense as an employee using Schedule A on IRS 1040. Either way,
it gets very complicated.
S-corporation shareholders: You can deduct home office expenses if you use a part of your
home exclusively and regularly for business either:
As a principal place of the corporation's business;
As a place to meet with your customers in the normal course of business, or
If you are using a separate structure (not attached to your house) for your business.
S-corporations who qualify for the home office deduction do not use a special IRS form. Instead,
just include your home office expenses with your other business expenses on
Home office expenses
All direct expenses (which were incurred for your business only);
A percentage of your indirect expenses (your normal household expenses which indirectly
benefit the business);
The business percentage of your home mortgage (except equity loans which were not used for
Depreciation on a portion of your house (.1% to 3.175% times the percentage of your
home used for business).
Section 179 Equipment Deduction
Since equipment is a capital expense, normally it must be deducted over several years.
However, in 2014 the IRS allows small businesses to fully deduct up to $500,000 per year for newly purchased
equipment or off-the-shelf software. Thus, you can deduct the full cost of a computer, rather than spreading the cost over
several years. This deduction also applies to vehicles, although you may not be able to deduct the entire cost. It does
not apply to purchases of permanent structures. To get this deduction, check with the IRS or your tax advisor to make sure your
equipment qualifies. Then when you complete your annual tax return, check the Section 179 box on
IRS form 4562 (Depreciation). For more
information, visit http://www.irs.gov/instructions/i4562/ch01.html
583 Taxpayers Starting a Business
(shows the records you should keep);
535 Business Expenses;
917 Car Deductions;
587 Business Use of
Your Home; and
334 Tax Guide for Small Business.
If you do not have enough money to pay taxes, it is still critical that you file the tax forms. The fines for not filing tax forms
are much higher than the interest or penalties for late payments - so file your forms on time - EVEN IF YOU DON'T OWE ANY TAXES!
A business with 2 owners that delays filing an IRS 1065 form for 5 months can accumulate $1800 in penalties! So pay attention to due dates.
If you are purchasing items for resale or if you have customers purchasing for resale, they are exempt from sales tax - IF a sales tax exemption certificate
is completed. Below, you will find information about collecting sales tax.
California's sales tax ranges from 7.5% to 10%, depending upon the county or city where
your business operates.
Sales tax is only due when a product is sold to the final user. It is a tax on the retailer
for the privilege of selling tangible personal property in California. It is not a tax
on the purchaser. Therefore, retailers selling taxable goods are responsible for paying
sales tax to the State even if the taxes were never collected from their customers!
Any California business which sells tangible goods (objects) to the final user must pay
sales tax. The key words are:
If your product will be used in someone else's product or will be resold "as is", you
don't collect sales tax. Only the final user pays sales tax, so that objects aren't
taxed over and over again.
Generally, services are not taxed. For example, even though a
CPA gives you a written tax return, the CPA doesn't charge sales tax because
(s)he is really providing you a service (doing your taxes). However, services can
be taxed if state auditors believe that the true purpose of the transaction was to
sell a tangible product, (i.e. disguising sales by calling them services doesn't work).
If this happens, the entire charge, including any services made in connection with the
sale of the goods is taxable.
Oftentimes, part of a job is taxable (tangible good) and the other part isn't (labor).
For example, a car repairman must charge tax on the parts used to fix the car, but
does not charge tax on the labor to install the parts. In order to exempt labor from
sales tax, first verify with the Dept. of Tax and Fee Administration that your particular type of labor is exempt. Then on all invoices, clearly separate those labor charges from the other charges.
There are many "gray" areas...where you may not be sure if something is a service
or a tangible good. Examples include postage, delivery charges, the "breakfast" served at a
bed and breakfast. Usually, there are specific regulations you must follow. If you are
audited by the Dept. of Tax and Fee Administration, YOU will be responsible for the tax, even if you
never collected it from your customers. The Dept. of Tax and Fee Administration has pamphlets
for a wide variety of businesses which help explain the tax laws in simple language.
Included within each pamphlet is a copy of the regulations applicable to that particular
industry. Their pamphlets are available at http://www.boe.ca.gov/sutax/staxpubsa.htm.
How the system works
Anyone who sells tangible goods must register with the State Dept. of Tax and Fee Administration ,
even if they do not sell to the final user. If a business sells to final users, it must
collect sales tax. If the owner of that business had a prior seller's permit with
payment problems, (s)he may have to pay a security deposit with the State.
The actual sales collections are paid quarterly or monthly (if the business is large).
Sales tax exemptions (no sales tax)
Certain groceries, including bottled water.
Sales to the U.S. government
Sales to out-of-state consumers (when the items are delivered or shipped to the
Candy and snack foods are not taxable.
Restaurant food, whether take-out or served, is taxable.
Non-subscription sales of newspapers are generally taxable.
Your purchases can be exempt!
Rule of thumb: If your customer pays sales tax on your product, you don't have to pay
sales tax on items used to make that product. Thus, goods are not double taxed.
The sales tax exemption form shows how to handle sales tax exemptions.
The sales tax exemption only applies to items in your product. Equipment and tools which
you purchase to make your product are taxable since you generally will not resell these
items and you are considered the final user of such items. Remember, the government
wants everything to be taxed once. If your customer isn't paying sales tax on a
specific item, you should be.
Shipping and handling
Shipping and handling are generally taxable. Shipping is not taxable if the final
customer is charged the actual shipping cost, it is separately itemized in an invoice,
and the shipping is done by the U.S. Postal Service or a common carrier (i.e., not the
seller's truck). Contact the Dept. of Tax and Fee Administration for further information.
Providing a service? Pay sales tax
on your supplies
Service businesses cannot get sales tax exemptions for the items they buy to perform
their service (hairdresser's shampoo) - since they are selling the service
(washing hair), not the shampoo. They do not charge sales tax on the service
and thus do not receive a sales tax exemption when they buy the shampoo. Note:
If the hairdresser sells shampoo separately, (s)he is selling a tangible good.
In this case, the hairdresser would receive a sales tax exemption for any
shampoo intended for resale, but would have to charge his customer sales tax on this shampoo.
Remember...all products must be taxed once.
Sales tax rates
Although California has a 7.5% base sales tax, most California counties and many cities
have voted to increase their sales tax beyond the base 7.5%.
Even if you are in a high sales tax area, you may not have to collect the higher
sales tax on all your sales.
Collect MORE THAN 7.5% if
You are in a higher sales tax area and are Sell to people physically
located in that tax area (at the time of the sale). In this case, you should
charge your county's sales tax.
You conduct business and make sales in your customer's tax area. In this case,
you should charge your customer's area sales tax. "Conducting business" means
Any part of your business is located in the county (including storage, showroom, etc.),
You have a canvasser, solicitor, representative, or agent operating in that county,
You receive rental or lease income from that county.
Collect 7.5% if
You are in a 7.5% sales tax area and sell or directly deliver to a 7.5% area.
You are in a higher sales tax area and ship via common carrier (UPS, Postal Service
and other third parties) to any sales tax area in California where you don't conduct
business (see explanation of "conducting business" above).
If you ship your product via common carrier to a higher sales tax area, but don't
conduct business in that area, you do not have to collect their extra sales tax.
You are in San Francisco and a Los Angeles customer orders by mail. If you
don't conduct business in Los Angeles, you charge 7.5% (since the product was sold
in San Francisco, but shipped out of San Francisco's special taxing areas). If you conduct
business in L.A., you must charge Los Angeles' extra sales tax, since that is where
the product will be used. You are only obligated to collect this extra tax
because you conduct business in Los Angeles!
Collect 0% if
If you deliver a product out-of-state or sell to an exempt customer (either someone
who will resell your product or someone buying an exempt product), you do not have to collect
Warning: If you ship products (other than vehicles, vessels, or aircraft)
out-of-state through mail, the Internet, or telephone order sales, you may have to pay that state's sales tax!
If you don't pay the tax, often your customer must declare the purchase and pay a
use tax. Contact each state for their specific requirements.
Special for BART counties
San Francisco, Contra Costa and Alameda counties share the BART taxing area.
If your business is located in any one of these counties, you must charge the extra
BART 1/2% sales tax for any customer in another BART county. If you do not conduct
business in that county (but only ship via common carrier such as UPS or US Postal Service),
you do not have to charge any other special sales tax...so the total sales tax is 7.75%.
If you do conduct business in that county, you must charge that county's full sales tax.
Internet sales and purchases,
out-of-state items, and leasing: use tax
In addition to the sales tax, California has a use tax. The rate for both the sales
and use taxes are the same, but only one of the taxes is collected on a particular item.
The use tax is owed any time you do not pay sales tax on a taxable item that you use,
store or otherwise consume. It is not owed on items that you purchase and then resell prior to
making any use. The use tax normally applies to property purchased from out-of-state and
consumed in California.
The use tax may also be owed on items you lease. A purchaser/lessor has the
option of paying tax on the purchase price of a leased item or on the rental receipts.
If you elect to report on rental receipts, you may collect the use tax from your customers
and remit it to the California Dept. of Tax and Fee Administration.
Be sure to check with the IRS (at click here), the California Franchise Tax Board and California Dept. of Tax and Fee Administration
to make sure that there are no special taxes which affect your business.
Examples of special federal taxes include taxes on sport fishing equipment, bows and
arrows, coal, tires, vaccines, gas guzzling cars, communications, various fuels, air
Keep records for four years of: sales, purchases made for your business and
deductions you declare on your sales tax returns (BT401)
Separate sales tax for each county where you conducted business
File sales tax returns even if you didn't sell anything during the prior period.
You are responsible for sales tax, even if your purchaser didn't pay you.
Don't spend your collected sales tax to meet operating costs!
Contact the Dept. of Tax and Fee Administration if you move, change ownership, discontinue
or sell your business.
This form is used when you buy or sell items intended for resale. These items are
exempt from sales tax. Each certificate must have the purchaser's sellers
permit number and must state that the item will be resold by the purchaser.
You can use this exemption certificate if you are purchasing items
which you plan to re-sell in a tangible product.
Your customers can use it if they are buying items which they will resell.
Sales tax is NOT owed in either case.
Most businesses who use this exemption form should have their own seller's permit number.
Businesses can use this exemption form without a seller's permit if:
The purchaser only sells products which are non-taxable (i.e. groceries); OR
The purchaser does not sell products in California.
If either of these situations apply, put that reason in place of the seller's permit number on the form.
Hal buys paint to finish some rocking horses he has carved and plans to sell.
Since the paint is part of his final product, he can buy the paint with no sales tax,
using an exemption certificate and his seller's permit number.
Mary buys file folders for her office and a machine to assemble her product. Even
though she has a seller's permit, she must pay sales tax on BOTH items,
since neither will be part of the final product she will sell.
Sue (a CPA) buys binders for her tax clients. She must pay sales tax on these binders
because she can't get a sellers permit (she doesn't sell a tangible product).
1 form per customer
If you have repeat customers, they only have to sign the exemption form once.
However, each time you sell them an item, you must ask whether that item is for
resale purposes. If it is, put "resale permit on file" on the invoice. If it isn't,
you must collect sales tax.
Where to send the completed forms
Keep them, in case the Dept. of Tax and Fee Administration audits your business.
Any tangible product (something that can be touched) is subject to either sales tax or use tax.
California is now enforcing the use tax for items purchased from the internet if no sales tax is charged. The purchaser
is responsible for paying the use tax.
How much is the use tax?
The use tax is the same as your local sales tax. See Collecting Sales Tax for the
current sales tax rates.
How is the use tax paid?
The California Franchise Tax Board and the Dept. of Tax and Fee Administration jointly collect the use tax. If you are already
selling tangible items to customers and have a sellers permit, there is a line on your quarterly
BT-401 sales tax return where you
declare any purchases that you made without sales tax, and pay your local sales tax on that amount.
Businesses without a seller's permit must report the use tax
on their annual income tax returns.
(form 100 or 100S).
What's the bottom line?
If you are audited, you will be liable for use tax on any internet purchases of tangible property that you make personally or for your business.
It is not due on services. So, if you download software that cannot be touched, there is no use tax. However, if the company provides you a physical CD with the software,
there is a use tax.
All businesses owe annual property tax on their property. Business property includes your purchased equipment, buildings and supplies, but not inventory.
All businesses with business property exceeding $100,000 are required to file this statement, even if it is not sent to them. The County Assessor has the right to assess all businesses - so if you have business property less than $100,000 and receive a form, you must pay.
The tax rate is the same as other property tax: 1% of the assessed value (plus any extra tax approved after Proposition 13).
The County Assessor will send you a property declaration form in February or March. You must report any business property your business had as of January 1st.
Record business assets you owned as of January 1
Submit the declaration form by March 31 or April 15, depending on your county.
A tax bill will be sent to you in July or July
The tax bill is usually due August 31
How to complete the form
We have included a sample Business Property Declaration form. Your county's form
may vary slightly, but it will ask for the same information. The form usually has 5 parts:
General business information - self explanatory
Declaration of equipment that you own
List the cost of your office furniture, computers, machinery, tools, etc. according
to the date that each was purchased.
Use your annual tax returns for the cost and year purchased.
These items must be put into one of six categories.
Machinery and equipment
Tools, molds, dies
Computers less than $25,000
Computers over $25,000
Declaration of property that you own.
Estimate the value of your:
Construction in process
Equipment out on lease or rented
Add the total equipment calculated on the back of the form and enter it next to Equipment.
Declaration of leased property. If you have leased equipment or other items, you must
show who you leased it from, the year leased, the year it was manufacturered, the annual rent, and the cost to purchase it new.
Even though 2/3 of employment taxes are deducted from an employee's paycheck, the cash still needs to come
from your business. This means that in addition to writing paychecks, you need to have at least 35% in additional funds for taxes.
Before we begin the forms, here is basic information about employer requirements. The state
governments impose 7 employee-related taxes and require workers compensation insurance from either private insurers
or a state affiliated agency. Some of the taxes are paid for by employees. Others are paid by employers.
Some are shared.
Employees pay through withholdings
Federal income tax (FIT)
1/2 social security (FICA)
CA income tax
CA disability insurance
Workers compensation insurance
1/2 social security (FICA)
Federal unemployment (FUTA)
CA Unemployment (UI) & ETT
Prepaid workers compensation
State law requires that employers either prepay their workers compensation
premium or provide the insurance
carrier a deposit. The amount of this prepayment varies by the type of business, but can range
from $100 to $1000+ depending on the type of business you are in.
Employers are responsible for withholding the proper
amount of employee-paid taxes and depositing them and the employer-paid taxes in a timely
manner. This kit shows you when each tax is due, how to pay it, and the reporting
requirements. The taxing agencies have substantial penalties for late deposits or late
report filing. These penalties are not described. Suffice it to say that they
do not waive penalties due to ignorance and are very serious about their deadlines. They
do not want employers to mis-use taxes meant to benefit employees.
Personally liable for taxes
Business owners are personally liable for
employment taxes. This means that if you declare bankruptcy or close down a business, you will still be personally liable for employment taxes owed - even if you formed a corporation or limited liability company.
Required employee records
Keep payroll records, and documents involved in hiring, promotion, performance, and safety training for four years. Do not keep notes or anything that you would not want to see presented in a court of law. If you use independent contractors, do not keep their files with employee records, or use any of the same forms, because they are vendors, not employees.
Identity theft... how to destroy documents
The federal government requires employers to restrict access to personal information that might lead to identity theft. Specifically, any information that can be reported by a consumer reporting agency, such as social security numbers, addresses, and telephone numbers, must be kept confidential. That means that the files (either paper or electronic) should not be available for other employees to see.
This information must be destroyed before discarding it. If it is on a computer, it must be deleted before discarding or donating the computer. If it is on paper, it must be shredded before discarding. Failure to do this may subject you to fines or liability for identity theft.
In addition to payroll taxes, employers have many other responsibilities. While all are required,
their priorities will depend on the business you are in. For example, if you are starting a construction business, the safety requirements are
critical, and should be done before hiring employees. They are less critical to a consulting business. Because of that, we have
put most of these requirements in the "Filling in the Gaps" section of this kit. Please review them and if any are critical to
your business, do them before hiring employees.
Employee classifications are often used to to distinguish which
employees receive certain benefits. For example, a company may develop a policy that only full-time workers and part-time workers
over 30 hours receive vacation benefits. Companies have this flexibility in most areas, except:
Overtime must be paid to any employee who does not meet the "exempt" definition
by the U.S. Department of Labor. So simply calling your employees "exempt" doesn't work.
Employee status does not mean permanent or regular work.
Anyone who works under your direction for even 20 minutes, is an employee. So on-call workers
are not contract help; they are employees.
If your company sets up policies so that only the top management receives the benefits, the IRS will
consider them "top-heavy" and taxes will be owed on those benefits, as if they were monetary pay.