Tax Liability 101: Everything You Should to Know
When it comes to taxes, business owners often have many questions, including, “What is tax liability?” Simply put, tax liability is any money due to the U.S. Internal Revenue Service (IRS), state tax collection agency, or local tax agency by the deadline of each tax year.
Taxpayers, individuals, and businesses alike often try to find legal ways to reduce their tax liability by exploring deductions and credits. In addition to attempting to reduce tax liability, businesses can also defer tax liability. Let’s take a closer look at the types of business tax liability and steps you can take to potentially reduce your tax liability by using these tax preparation tips. We’ll also look at the specifics of deferred liability and other relevant tax-related factors.
Types of Business Tax Liability
To do business, companies must deal with tax liabilities. Tax liability comes in different forms. This is money your company will owe to governing tax collection agencies, and the type and rate of tax liability will depend upon your business’s legal structure.
Correctly calculating the right liabilities to pay the IRS, state, and local tax agencies is essential. Here are common liabilities businesses are responsible for paying for in a timely fashion.
Income taxes
This is one of the tax liabilities that will vary depending on your company’s legal business structure. “Pass-through entities” are business structures linked to the person(s) who owns them. The business itself isn’t subject to tax.
Entities such as Pass-through LLCs are taxed at individual income tax rates and are integrated with the business owner’s personal tax return. Legal business structures in this category include sole proprietorships, partnerships, S-corps, and LLCs (these work a little differently). Federal income tax is pay-as-you-go, and owners pay quarterly estimates based on what they expect to earn. C-corporations are subject to double taxation as they aren’t a pass-through entity.
This way of paying income tax liability is beneficial because it avoids double taxation for owners, and in the event the business suffers a net operating loss, the owner can reduce their personal tax liability.
Employment taxes
Often referred to as “payroll taxes,” if you own a business that has employees working for you, you must withhold a percentage of your employees’ wages to cover their income tax obligations:
● Federal and state tax withholding
● Their portion of Social Security and Medicare (FICA)
● Federal unemployment (FUTA) tax
Your company must also pay its share of FICA, along with federal and state unemployment taxes. If you’re self-employed, you’ll pay both shares of FICA from your business’ net earnings.
Self-employment taxes
Self-employed business owners are required to pay self-employment tax. This tax covers Social Security and Medicare tax for those who do not work for someone else and these payments are contributed to your coverage in the Social Security system, providing retirement benefits, disability benefits, Medicare, and survivor benefits. Half of the self-employment tax you pay is a deductible expense.
Sales taxes
A sales tax liability will depend upon the state where the business sells taxable goods and services. If your state collects sales tax, you are required to collect it from your customers on each transaction and then remit the tax to your state tax collection agency. If you neglect to follow through on this task, you’ll be penalized by your state.
As of April 2024, only five states do not collect state sales tax—Alaska, Delaware, Montana, New Hampshire, and Oregon—but there are other tax obligations as a business owner you need to be aware of if you operate within these states.
Property tax
If your company owns any property, it is subject to a tax liability referred to as property tax. Property tax is usually calculated by taking the value of the property and multiplying it by the percentage of the tax rate for taxation jurisdictions. There is no one-size-fits-all way this is handled, and you should refer to your state and local jurisdictions or speak with a professional tax specialist.
Excise taxes
An excise tax is imposed on certain types of businesses, depending upon their operations and what they sell. Excise taxes usually apply to the following:
● Use of highways by trucks
● Selling “sin” goods, such as tobacco, vaping, e-cigarettes, and alcohol
● Transporting air and cruise ship passengers
● Fuel and gas
● Communications and air transportation taxes
● Tax on first retail sale of heavy trucks, trailers, and tractors
● Gambling and sports betting
This is, by far, not an extensive list of excise taxes. Be sure to fully understand what an excise tax is and to also look at the criteria for IRS Forms 720, 730, Form 2290, and Form 11-C to see if your business qualifies.
Reducing Tax Liability
While no business owner is thrilled by the idea of dealing with tax liabilities, there is an upside to the process that comes in the way of reducing your liability.
By keeping organized records and expenditures, you know exactly what you can claim, making the process much easier since you don’t have to go hunting for your documentation (or miss out on valuable opportunities to reduce tax liability if you don’t remember or have the correct records). Being organized also gives you more time to focus on your company’s operations and other more productive areas of running a business.
You can also look for deductions, exemptions, and credits to help reduce your tax liability. Businesses can reduce their tax liability by “writing off” part or all of certain expenses incurred by the company. This includes but is not limited to:
● Advertising and marketing
● Business insurance
● Depreciation
● Business travel and meals
● Home office expenses
● Rent
● Salaries and benefits
● Utilities
● Many others
Other things to look into include contributions to retirement accounts, making investments in your business, payroll exemptions, and charitable donations – all of which can potentially help offset the taxes you’ll owe. Carefully look into your options and seek the help of a tax professional to make sure you take advantage of all legitimate ways to decrease your tax liability.
Additionally, be sure to always file and pay your taxes on time. This way, you will avoid fines and penalties related to filing late.
Understanding Deferred Tax Liability
Deferred tax liabilities are those listed on your business’s balance sheet that show taxes owed but not due to be immediately paid until a future date.
● Deferred tax status means you’ll have to pay the amount due in the future
● To obtain this amount, you multiply your business’ anticipated tax rate and the difference between your taxable income and accounting earnings (before taxes)
● Examples of deferred tax liability are:
○ Selling a product to a customer on credit, but money owed will be paid off in the future through scheduled equal payments
○ Depreciating fixed assets
Basically, deferred tax liability is recognizing that your company owes taxes, but they are not yet due. This is another tax area where you might want to consult with a tax professional who can guide you through how to properly apply deferred taxes or help calculate any specific tax liability formula relevant to your company’s situation.
Obtain your Employer Identification Number (EIN)
Most businesses are required to have an EIN (often referred to as a “tax ID”), but certain individuals who operate their companies without employees or are independent contractors (technically a business) do not need one. However, it is to their benefit to obtain one.
By applying for and receiving an EIN, it’s easier to organize your business taxes from your personal tax return. Here are the steps involved with obtaining your EIN.
● Gather together all required information, including your legal business name, your DBA designation (if applicable), business address, phone number, and the date you began doing business
● Select the reason why you are applying for an EIN
● Name the person responsible for your business (most likely it’s you), along with your SSN or ITIN
● List your business structure (e.g., sole proprietor, LLC, etc.) and its tax structure
● Note the number of employees you have or an estimation of how many you plan to hire
● Review all information you’ve entered to ensure it’s correct, and submit your application
● Submit your application
Once you obtain your EIN, you can hire employees, simplify the filing of business taxes, open business bank accounts, and gain access to more favorable business loan opportunities, to name a few advantages.
Conclusion
Tax liabilities are not money you can avoid paying, but there are legal approaches your business can take to either a) decrease its tax obligations or b) pay the taxes at a later date. Both options provide you with an opportunity to plan for your payments and reduce the chances of running short on funds come tax deadlines.
Businesses that do not accurately estimate their tax liabilities during the year will eventually run into issues. Always be sure to know what your tax liabilities are, how much you’re expected to pay, and the deadlines associated with your taxes. This way, you’ll never be surprised at your tax bill and easily avoid costly penalties.