Businesses pay five types of taxes:
Income Taxes
Profitable businesses are subjected to federal and potentially state income taxes. A business is profitable when its revenue during the tax year is higher than its operating expenses. Businesses can deduct ordinary, necessary, and reasonable expenses under IRC §162, Trade or Business Expenses, https://www.law.cornell.edu/uscode/text/26/162. However, the IRC does not provide an exhaustive list of all deductible expenses. So, if IRC §162 does not offer a comprehensive list of allowed expenses, how do we determine whether a business can deduct an expense? By assessing whether the expense meets the “ordinary and necessary” requirement of the IRS. The IRS defines ordinary as “one that is common and accepted in your trade or business.” The IRS defines necessary as “one that is helpful and appropriate for your trade or business.” Is there a general rule? A general rule would be to identify the expenses of a business operating in your chosen industry. For example, a restaurant would have the following expenses: food and beverages, wages of cooks and servers, utilities, maintenance, equipment depreciation, dishware, and other costs such as insurance and advertising.
An expense is also only deductible when it is reasonable in amount. For example, let’s assume you want to hire your brother to work in your business. When deciding what you will pay him as an employee, you must ensure that the amount is reasonable for someone with his skill set, education, and experience. Suppose you pay your brother a $60,000 salary, but others in the same industry, with the same background, are only paid $40,000. In this case, the law would not allow you to deduct the additional $20,000 paid over the reasonable compensation. The excess $20,000 would be treated as a gift which is not deductible and may result in the need to file a gift tax return since the amount exceeds the annual gift exclusion limit of $17,000.
A business's profits may be taxed to the business or its owners, depending on the type of business entity structure selected. The profits of a business classified as a partnership, a single member Limited Liability Company (LLC), a sole proprietorship, or a Subchapter S Corporation are taxed at the owner level; thus, they are reported on the owner’s individual income tax returns. In the case of a partnership or a Subchapter S Corporation, the business will file an informational tax return. The informational tax return reports all of the information related to the income and deductions for the business. Still, it does not generally pay tax on the income at the entity level. Partnerships file Form 1065, U.S. Return of Partnership Income. Subchapter C Corporations file for 1120-S, U.S. Income Tax Return for an S Corporation. The partners and shareholders receive a Form K-1. The partners and shareholders use Form K-1 to complete their individual tax returns, Form 1040, U.S. Individual Income Tax Return. The income and deductions of a Subchapter C Corporation are reported at the entity level resulting in the corporation being liable for any tax due; it files a Form 1120, U.S. Corporation Income Tax Return. The income and deductions of a Sole Proprietor or a Single Member LLC are reported directly on Form 1040, U.S. Individual Income Tax Return.
Sales Taxes
Businesses, like individuals, are required to pay sales taxes on purchases of items subject to sales tax. A business may apply for a sales tax exemption certificate when the items purchased are for the inventory of items that will be sold to consumers. In this case, the business is treated as an intermediary, and the consumer becomes responsible for paying the sales tax upon the final purchase. An additional exemption from sales tax applies for businesses registered as non-profit organizations, most notably recognized as 501(c)(3) charitable organizations. Businesses that collect sales taxes must remit the sales taxes collected to the state by a specified timeline which may depend on the amount of sales taxes collected, the business’s years of operations, and other factors which can vary by state. Businesses must comply with the collection and remittance requirements; it is not optional and may subject the business to penalties for noncompliance. The remittance of sales taxes due or collected must follow the procedure required by the specific state or locality; in many cases, online submission is required.
Excise Taxes
Federal excise taxes are a tax imposed on the sale of specific goods or services or on certain uses, https://www.irs.gov/newsroom/an-overview-of-excise-tax. Federal excise tax is usually charged on selling fuel, airline tickets, heavy trucks and highway tractors, indoor tanning, tires, tobacco, and other goods and services. Depending on the type of tax, the responsibility to pay the tax may be held by consumers, retailers, or manufacturers. The rates of each tax vary. Businesses must report excise taxes quarterly by filing Form 702, Quarterly Federal Excise Tax Return. The payment of the excise tax due should be made through the EFTPS (Electronic Federal Tax Payment System) at https://www.eftps.gov/eftps/.
Property Taxes
Businesses are held liable for property taxes. Property taxes include taxes on real estate, including buildings and land. Property taxes may also include personal property taxes. Personal property is defined as property that is tangible or physical. For example, personal propriety would consist of desks and computers in the offices of a company. Personal property does not include intangible property such as stocks or bonds. Most commonly, property taxes are assessed based on the property's fair market value as determined by the city or locality every year; this is not the fair market value as determined by free market factors such as the value of a home placed on the market for sale.
Capital Gains Taxes
Businesses, like individuals, are required to pay capital gain tax when they dispose of or sell capital assets. Businesses receive special tax treatment for this type of transaction under IRC §1231, Property used in the trade or business and involuntary conversions, https://www.law.cornell.edu/uscode/text/26/1231. Capital assets are assets that are not part of the inventory. Inventory represents the merchandise or products that the business sells to its customers. Capital assets include buildings, machinery, and other types used in a trade or business. Capital gains under IRC §1231 are treated as long-term capital gains for tax purposes. This treatment is beneficial as it allows the corporation to capture prior year capital losses which were not deductible in the year of the loss if any; the preceding year's loss is used to offset the amount of capital gain in the current year. This Code section is also beneficial to businesses when the disposal or sale of a capital asset results in a loss because the loss may be used to offset ordinary income, thus reducing the tax liability.
Acronyms Used
1. IRS – Internal Revenue Service
2. IRC – Internal Revenue Code