Before You Start a Business, You Must Understand these Tax Basics
Quick question.
If your future business made $50,000 in profit next year… would you know how the taxes work?
Who sends the money to the IRS?
When those payments happen?
How much you should set aside?
Most people who want to start a business have never thought about it.
They assume it works like a normal job with every sorting itself out in April.
That assumption is how people end up paying a bunch of penalties. Or you remember my story about the guy owing the IRS $15,000 he didn’t have?
I see situations like this a lot, unfortunately they are usually coming to me after the fact.
So for you, let’s avoid those problems with some small business tax 101.
When you worked a traditional job, taxes happened quietly behind the scenes.
Your employer withheld money from every paycheck and sent it to the government for you. At the end of the year, you received a W-2 and filed your return.
Most people never had to think about it.
Running a business changes that.
No one is withholding taxes for you anymore. No one is automatically sending money to the IRS.
You are responsible for all of it.
That sounds intimidating at first, but the underlying system is actually straightforward once you understand the basics.
The goal today is not to turn you into a tax expert. It is simply to help you understand how the system works so you do not get surprised later.
The three things every small business owner needs to understand about taxes
If you grasp these three ideas, you will already be ahead of most new entrepreneurs.
- Most small businesses are “pass-through” entities
Most small businesses operate as:
- Sole proprietorships
- Single-member LLCs
- Multi-member LLCs taxed as partnerships
- S-Corporations
These are called pass-through entities.
That means the business itself usually does not pay income tax.
Instead, the profit passes through to the owner’s personal tax return.
Example.
Let’s say your business earns $80,000 in profit.
The IRS treats that $80,000 as your personal income, even if the money stays in the business bank account.
This surprises a lot of people. They assume taxes only apply when they take money out of the business.
But if the business made the profit, the IRS generally expects taxes on it.
- You usually need to make quarterly estimated payments
Remember how your employer used to send taxes to the government throughout the year?
You now have to do that yourself.
Most small business owners make quarterly estimated payments to the IRS.
Typically in:
- April
- June
- September
- January
These payments estimate what you expect to owe for the year.
If you wait until April and try to pay everything at once, two things often happen.
First, the bill is larger than expected.
Second, the IRS may add penalties for underpayment. They call it “interest.” But in reality it is a penalty.
On more than one occasion, I have had people tell me that their CPA told them not to worry about quarterlies. If you get one of those, RUN!
Get in the habit of setting aside a portion of your profits each month (25-30% at first until you figure out a more exact percentage). Have it there waiting for the quarterly payments. I use a separate savings account for this purpose.
- Your taxes are based on profit, not revenue
This is the encouraging part.
Businesses get to deduct legitimate business expenses.
Common examples include:
- Software and tools
• Equipment
• Advertising and marketing
• Professional services (lawyers, accountants)
• Office supplies
• Business insurance - Cell Phone
• Mileage or vehicle expenses used for business
If your business earns $100,000 but spends $40,000 on legitimate expenses, you are usually taxed on the $60,000 profit, not the full $100,000.
But there is one requirement.
You must actually track those expenses.
That is why good bookkeeping matters so much.
Open a separate business bank account. Run business income and expenses through that account. Track them regularly.
You do not need an elaborate system.
Many small businesses do just fine using tools like:
- QuickBooks
• Wave
• Xero
The goal is simply to keep accurate records so you know what your business actually earned and spent.
Weekend Exercise
Spend some time doing three simple pieces of research.
- Choose a bookkeeping tool
Look into options like:
- QuickBooks
• Wave
• Xero
Pick one that feels simple and manageable. The goal is not perfection. The goal is having a system that tracks income and expenses from day one.
- Research what is required to open a business bank account
Most banks will ask for things like:
- Your business formation documents
- Your EIN from the IRS
- Identification for the owner
Look up the requirements for the bank you plan to use so you know what to expect when the time comes.
- Visit the IRS website and explore estimated taxes
Search for “IRS estimated tax payments.”
Look at how the process works and how payments are submitted.
Then ask yourself a simple question.
Would you feel comfortable handling this process yourself, or would you want help from a CPA?
There is no right answer. Plenty of entrepreneurs do it themselves. Plenty hire professionals.
The important thing is understanding the system before the money starts coming in.
That preparation alone puts you ahead of most people starting their first business.