Small businesses, of which there are thousands in California, spend the highest percentage of time of any business entity preparing and submitting taxes. Federal, state, and local tax requirements are extremely complex and change every year.
Multiple agencies administer different taxes, and each has its own set of rules and methods of payment. It is no wonder that small business owners often have common tax issues and outcomes of inadvertent noncompliance.
Business Ownership and Tax Considerations
The taxes a business owner files and pays depends on the classification of the business itself.
Corporations are subject to corporate income tax, which tends to be a flat tax. In other words, the tax rate does not change with the amount of money earned. A sample rate is 4% to 9%.
A “pass-through” entity, meaning S-corporations, limited liability companies (LLCs), and sole proprietorships, are subject to the tax on personal income. In this case, the amount earned determines the tax rate. It can be as low as 0% and go up from there in tiers.
If you are sell goods, you must pay sales and use tax. While most retailers and other merchants pass along this tax to the customer, you must still pay it along to the Franchise Tax Board (in California) or other state taxing entity. If you spend it, you have a big tax bill ahead of you.
Speaking of the Franchise Tax Board (FTB), this is one of three tax agencies you must deal with in the state of California. The Franchise Tax Board administers the personal income tax and corporate taxes. Another agency, the Board of Equalization (BOE) administers and collects the sales and use tax plus other taxes and programs. The Employee Development Department (EDD) administers payroll taxes, Social Security, Medicare, disability insurance, and unemployment insurance among other programs.
Common Tax Issues for Small Businesses
Underpayment of Taxes and Poor Record-Keeping
The most common tax problems vexing small business owners are the underpayment of taxes and poor record-keeping.
The business owner collects sales tax from customers but neglects to pass it along to the state, thereby underpaying the sales and use tax obligation. Collected sales tax is mean to pay for that; if it does not get paid through the business, the BOE holds certain “responsible persons” liable for the sales and use tax debt. Responsible persons can include the business owner(s), employees, and anyone else involved in business operations.
Small business owners may also underpay their personal income tax. Maybe they think estimated quarterly tax is optional. It is not. Estimated tax payments are mandatory, and if you do not pay on time and in full, you will be subject to penalties and interest on the unpaid amount.
Nonpayment of estimated taxes hurts more than your pocketbook. It can inflate your end-of-year taxes and slow business growth as well as take a chunk out of your bank account. Unfortunately, interest on unpaid taxes accrues at an extremely high rate and the penalties for not filing are even higher.
Another problem with failing to file quarterly estimated taxes is if you don’t estimate them, the government auditors will. Then you will owe the tax liability estimated by the auditors and, tying in with poor record-keeping, if you have not kept accurate documentation you will have a difficult time challenging that estimate.
Poor record-keeping can create problems when it is time to file your taxes and in the event you are audited. For example, you will not be able to defend your deductions if you have not kept receipts.
Some underpayment is inadvertent and is generally due to the complexity of the tax code. It can seem expensive to retain tax help, but you probably don't have the expertise to do it effectively on your own either. Other underpayment is done on purpose for illegal gain.
Misclassification of the Business and Related Issues
Doing business in California means paying a franchise tax to the state for the privilege of transacting business in that state. What form and how much tax is owed depends on the type of business entity.
Typically, corporations do not pay franchise tax.
California franchise tax applies to limited liability companies (LLCs), limited partnerships, limited liability partnerships, and S-corporations. In instances when a corporation or an LLC elects to be treated as a corporation, then those businesses do not pay franchise tax. They are subject to corporate taxes instead.
On a related note, if you buy a business or a stock of goods, you may find yourself responsible for the seller’s unpaid taxes, interest, and penalties up to the purchase price of the business or stock goods. This is known as “successor liability” and could be an unexpected expense if it is not on your radar.
If you misclassify an independent contractor as an employee, at worst you will withhold payroll and income taxes unnecessarily. However, if you misclassify an employee as an independent contractor, whether inadvertently or willfully, you will be guilty of tax fraud. The Employee Development Department can uncover this issue in an audit that is triggered by lower than expected tax remittances from you.
Another common mistake of those who are self-employed is pricing your goods as if an employer is withholding payroll taxes. However, as the business owner, you are responsible for both parts of the payroll tax. At the end of the year, you may have a larger tax liability than you expect.
An Ounce of Prevention
The issues discussed above, and other tax problems commonly suffered by small businesses are completely preventable.
First of all, hire a professional to make sure you follow all the regulations to the letter. Tax preparation software will not provide enough help and may not be updated appropriately as tax law changes. It also may not be able to identify all the legal ways you can reduce your tax bill.
Keep excruciatingly correct records. Keep receipts for all deductions, which typically require additional substantiation. Save all tax files and workbooks, and save everything you used to calculate those taxes. The BOE suggests maintaining records for at least four years. The FTB suggests keeping them for up to twelve years. This is a circumstance where software can help you keep all this organized.
Review your statements on a regular basis and be sure you have a proper estimation of your payments. If you are not sure if you owe sales or use tax, ask the BOE for written advice on specific tax questions; it can provide protection from owing tax, interest, or penalties later. Verbal advice does not offer that.
Fill out all the paperwork and submit it and the payments on time and in full. The BOE recommends keeping tax collected from customers in a separate account so it will be easy to retrieve.
Small business owners can do a lot to keep themselves out of hot water with the tax agencies. Hiring a tax professional is one of them. It will cost less in the long run.