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This article was fact-checked by our editors and Christina Taylor, MBA, senior manager of tax operations for Credit Karma Tax®. It has been updated for the 2020 tax year.
People go into business for themselves for a lot of reasons — including a desire to make money.
Of course, making money usually means paying taxes, too. Whether you’re starting a new business or side hustle, having a tax plan in place can help you make the most of your entrepreneurial endeavors.
Here are some tax tips for new business owners.
- Pick the business entity that’s right for you
- Choose an accounting method and stick to it
- Be aware of self-employment taxes
- Know what tax breaks are available to you
- Start preparing for tax season now
1. Pick the business entity that’s right for you
For legal and tax purposes, you can structure your business in different ways. Choosing the right one can impact how you file and how much you owe at tax time. Here’s a quick summary of the most popular business-structure options.
You own an unincorporated business on your own, and there is no distinction between you and the business. You get all the profits of the business, but also all its expenses, debts and risk.
In a partnership, you share ownership of the business with one or more people. The three main types of partnership — general partnerships, limited partnerships and joint ventures — have varying legal liabilities for the partners.
Limited liability company
With this business structure, you can generally own the business by yourself or share ownership with others. However, because state statutes govern how LLCs can be formed and managed, you should check your state’s requirements before starting one. An LLC typically protects members from personal liability related to the business’s debts or legal actions. Profits and losses of the LLC pass through to your personal income without being subject to corporate taxes — although you will have to pay self-employment taxes.Need to know more about how to file taxes for a side gig?
An S corporation, frequently called an S corp, is a special type of corporation that allows for profits and losses to pass through to the shareholders rather than the business itself, avoiding double taxation. This also means that income from an S corp is not subject to corporate tax rates, and can pass through to your personal tax return as a shareholder.
Also known as a C corporation, this is a separate legal entity owned by shareholders. With this structure, only the business has legal liability and debt. While corporations may offer the greatest protection from personal liability, they’re also generally more expensive to establish.
No single business structure is right for everyone. And you don’t necessarily have to incorporate or create a partnership or LLC to maximize your tax benefits.
Not sure which business structure to choose?
“Talk to your accountant,” says Janis Orel, a CPA and owner of Orel and Associates CPAs. “Look at what your business is projecting in the future, where you want to go with it, your business plan, and then sit down with your accountant and try to strategize the best way to get there.”
The U.S. Small Business Administration is also a good resource for learning more about business structures and launching a business.
2. Choose an accounting method and stick to it
Even if your business is entirely digital, you’ll still need to keep records and account for your income and expenses. There are different types of accounting methods, but cash and accrual are the main two. Here’s a breakdown of each.
The cash method is the most common accounting method for individuals and small businesses, generally because it’s more straightforward for accounting and tax purposes.
Essentially, you account for income for the tax year in which you received it, and expenses are accounted for the tax year in which you actually paid them.
Under this method, you account for income for the tax year in which you earned the right to receive it, and you can determine the amount owed with reasonable accuracy. For example, if you’re a freelance graphic designer and finish a job in December 2020 but don’t get paid until January 2021, you’d still report the income on your 2020 tax return.
The same goes for expenses. If an individual or vendor has done work for you or provided you with a service, and you can be reasonably sure of an accurate cost (for example, you signed off on an estimate or purchase order), then you count the expense in the year the work or service was done — even if you don’t get billed or pay for it until a later year.
Depending on your business, you may also be able to employ special methods of accounting for specific income and expense items, or a hybrid of all three. But because they can make things more complex, you may want to enlist an accountant to help.
3. Be aware of self-employment taxes
Depending on how you structure your business, you could be on the hook for self-employment taxes on your business income.
Self-employment tax consists of Social Security and Medicare taxes, and it’s similar to the taxes employers withhold from their employees’ paychecks.
The tax rate is 15.3% of net earnings — 12.4% Social Security tax plus 2.9% Medicare tax. Up to $137,700 of your net self-employment earnings will be subject to the Social Security portion of the tax, but there’s no limit for the Medicare portion.
In fact, if your net earnings exceed a certain amount, you may also be subject to an additional Medicare tax at a rate of 0.9%.
Threshold amounts are as follows:
- Single, head of household or qualifying widow(er): $200,000
- Married filing jointly: $250,000
- Married filing separately: $125,000
As you’re forecasting your income and expenses and considering how much money you’ll personally take from the business, keep these taxes in mind. You may even want to make estimated tax payments to avoid a huge tax bill and maybe even penalties at the end of the year.
4. Know what tax breaks are available to you
The tax code offers a number of tax credits for businesses, and you may be able to take advantage of some the first time you file your business taxes, provided you qualify.
You can find a full list of business tax credits on the IRS website, but here are a few to consider.
- Work opportunity credit — If you’ll be hiring employees for your business, hiring workers from certain target groups that typically have a hard time gaining employment may qualify you for this credit.
- Disabled access credit — If you have a storefront or office that’s open to the public, you might be able to qualify for this credit if you incur expenses to provide access to your business for people with disabilities.
- Alternative motor vehicle credit — This credit could reward you for driving green if your business purchases a new car, SUV or truck that runs by combining oxygen and hydrogen fuel to produce electricity. To qualify, you must be the owner of the vehicle who originally used it and placed it in service during the tax year. And the vehicle can’t be a two-wheeler, is primarily used in the U.S., and isn’t intended for resale.
In addition to these and other tax credits, you can generally deduct business expenses that are ordinary and necessary. Plus you may be able to qualify for a deduction of up to 20% of qualified business income if you have a pass-through business structure (e.g., a sole proprietorship).
To make the most of the credits and deductions available to you, consider working with an accountant who can lead you in the right direction.
5. Start preparing for tax season now
Starting a business can make filing your taxes more complicated, so the sooner you start organizing your finances, the better.
“Start a separate checking account for your business, and have a separate credit card for your business,” says Orel. “That way you have a statement for everything and nothing is lost.”
Also, keep meticulous records of your receipts and the miles you drive for your business.
“There are many apps that are great for tracking your travel,” says Orel. “A lot of deductions are lost because people don’t keep mileage logs.”
Be aware that self-employment often means making estimated income tax payments throughout the year if you expect to owe a $1,000 or more in taxes when you file your federal income tax return. Payments are generally quarterly and can be paid online, by phone or by mail. Underpaying your taxes throughout the year could result in a penalty when you file.
You can learn more about estimating tax in IRS Publication 505.
Starting a business is an exciting adventure, and it’s important to be aware of the tax implications of entrepreneurship. While you may be more interested in developing your product or service, take some time to learn how business taxes work and how you can make the most of yours.
Understanding what taxes you need to pay, when to pay them, and what business tax credits and deductions are available may help make it easier to focus on your core business — and long-term success — throughout the year.
Christina Taylor is senior manager of tax operations for Credit Karma Tax®. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.