Starting an LLC, or a limited liability company, can be daunting and scary. Below are some small business accounting and tax concepts that every small business owner should be familiar with, especially if they plan on growing and expanding their company.
Starting An LLC: Individual Taxes
Individuals file Form 1040 with the IRS. They are due on or around April 15th of every year. You can file for a six month extension, which extends the filing due date to October 15th. However, the IRS may penalize you by charging interest on the taxes that should have been paying but did not, usually because too little was withheld from your income. So Form 1040 may be filed by October 15th, but the taxes paid at that time are still penalized if you’ve been underpaying the entire time.
Above The Line Deductions (And Additions)
These are the items you deduct from (and add to) your gross income to reach your adjusted gross income (AGI). According to the new 2019 Form 1040, they include interest, dividends, retirement distributions (from IRAs, pensions, and annuities), and social security benefits. Other common above the line deductions (and additions) are taxable refunds, business income (or loss), unemployment income, educator expenses, IRA contributions, and student loan interest. These are on Schedule 1.
My hubby and I contribute to our IRAs every year to reduce our AGI, and thus our taxes, as a tax reduction strategy.
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Adjusted Gross Income (AGI)
Your AGI is your gross income less your above the line deductions. So your AGI is the “line”. It’s a completely contrived number that is the basis for many other financial decisions, like what you can deduct on your taxes as itemized deductions, how much financial assistance, public or private, you can get, etc.
Below The Line Deductions
These are the items you deduct from your AGI to reach your taxable income. They include your standard deductions or your itemized deductions. You can take the standard deductions or itemized deductions.
Standard deductions are fixed amounts that you deduct from your AGI to calculate your taxable income. The amount depends on your filing status (single, married filing jointly, married filing separately, or head of household).
Itemized deductions are specific deductions that the IRS allows you to deduct from your AGI to calculate your taxable income. These include medical and dental expenses, state and local taxes, home mortgage interest, and charitable contributions, amongst others. They are on Schedule A, which is the form for itemized deductions.
Business income on Form 1040 is the net income from a sole proprietorship or single member LLC (I’ll explain later) from Schedule C, which is the form for a single owner business. Schedule C lays out the income and expenses of the business and calculates the net income that is transferred to the 1040.
There are 5 major types of companies: a C corporation, a partnership, a limited liability company (LLC) or limited liability partnership (LLP), an S corporation, and a sole proprietorship. Each one has it’s own set of tax rules. Some are similar to each other, some are not.
A C Corporation files Form 1120 with the IRS.
It files and pays taxes just like an individual files and pays taxes. The 1120 is due on April 15th for a calendar year end business or the 15th day of the fourth month for a fiscal year end business (a business whose last day of the year is not December 31st). So if a fiscal year ends on November 30th, the 1120 is due March 15th.
Not every corporation is the size of Target or Apple. Most corporations are not huge and international. But the big corporations make up most of the revenue earned by all corporations as a whole. And not all corporations are public and have millions of shareholders. Most are private whose shareholders are a small group of people, like the executives or employees.
A partnership is a formal agreement between two or more parties to operate and manage a business. The income and liabilities may be split evenly or unevenly amongst the partners. If there are silent partners involved in the business, that means they do not participate in the day to day operations of the business, and thus may receive a smaller share of the income and liabilities due to their lack of participation.
In addition, each partner has personal liability for the debts of the business as well as the actions for all the other partners. And if all the partners but one formally exit the partnership, the business is no longer a partnership and becomes a sole proprietorship until the remaining partner, now the sole owner, formally changes the business entity to an LLC (described below) or closes shop.
A partnership files Form 1065 by March 15th for a calendar year end business or the 15th day of the third month for a fiscal year end business.
So a partnership whose fiscal year end is June 30th must file their 1065 by September 15th.
Limited Liability Company (LLC) and Limited Liability Partnership (LLP)
A limited liability company is similar to a partnership, but it offers the owners protection from liability that a partnership does not. Generally speaking, each owner is liable for the debts of the business to the extent of their personal contribution. And the owners are actually called members, not owners.
There are ways to pierce the veil of liability protection of each member and increase their personal liability past their own personal contributions. They include combining the separation between personal and business, personally guaranteeing a loan, and engaging in fraud or illegal activities, amongst others.
Most LLCs file Form 1065, just like a partnership. However, LLCs with just one member don’t file a 1065 since there is only one member. Those are called single member LLCs. Instead, they file a Schedule C on their 1040 when they file their individual taxes. In that case, single member LLCs must file taxes by April 15th, or October 15th if an extension is filed.
A limited liability partnership is similar to an LLC, except that LLPs are for professional businesses, like accountants, engineers, doctors, etc.
An S corporation is a hybrid of a C corporation and a partnership. They have the benefit of liability protection that a C corporation has but file taxes like a partnership or an LLC. An S corp uses Form 1120S to file with the IRS, which is due by March 15th for a calendar year end business or the 15th day of the third month for a fiscal year end business.
For example, if the fiscal year ends on November 30th for an S corporation, the 1120S is due on February 15th.
Pass Through Entities and K-1s
A pass through entity is a business whose income passes to the owners of the business. It’s also known as a flow through entity, which means the same thing, the income flows to the owners of the business. In plain English, that means the income of the business is reported on the individual tax returns (1040) of the business owners. Income being net income, gross revenue less expenses of the business, like overhead (rent, utilities, telephone, etc), office expenses, advertising, salaries and wages, etc.
When you hear that partnerships, LLCs, LLPs, and S corps are pass through entities, that means those entities don’t pay taxes on their income because the income passes (or flows) through the business to the owners and onto their individual tax returns, the 1040. That income is taxed at the individual tax rate and not a business tax rate.
This is done using a K-1.
When a pass through entity files its tax return (either a 1065 for a partnership, LLC, or LLP, or a 1120s for an S corp), it also includes a K-1 for each owner, which shows each owner’s portion of income (or loss) from the business. That K-1 is needed for each owner to file their own individual taxes, Form 1040.
The purpose of a K-1 is similar to that of a W2. While they look wildly different from each other, both show the income that an individual received from each source, the W2 from an employer, the K-1 from a business that the individual owns. And yes, a person can have multiple W2s and multiple K-1s. That means that the person not only works multiple jobs, but also owns multiple businesses. That is one busy person.
Estimated taxes are quarterly tax payments made to prepay taxes on income that is not subject to withholding, like a paycheck. They are due January 15th (for the previous quarter), April 15th, June 15th, and September 15th. Both corporations and individuals may be subject to estimated tax payments.
Generally speaking, estimated taxes are for those who regularly do not have enough withholdings taken out of their wages during the year. Owners of pass through entities are usually subjected to estimated taxes because the income from the pass through entities are added to their own individual gross wages, if any, to calculate taxable income but have not had taxes withheld from that income.
Corporations must pay estimated taxes if they expect to owe $500 or more when it files its corporate tax return.
Section 179 and Bonus Depreciation
Section 179 and bonus depreciation is basically expedited depreciation that a business can expense when calculating taxable income, thus increasing expenses and decreasing taxable income. In simple terms, bonus depreciation means additional depreciation, hence the word bonus. Section 179 allows a business to expense the entire purchase rather than just depreciation. So the business can deduct the full $50,000 for the pickup truck it just bought rather than just $10,000 (assuming a 5 year life at straight depreciation, $50,000 / 5 years).
For example, if gross income is $100,000 and expenses, including depreciation, is $50,000, then taxable income is $50,000. If bonus depreciation is taken, increasing total expenses (including total depreciation) to $60,000, then total taxable income is now $40,000, thus lowering corporate taxes. If section 179 is taken, where the business can expense the entire purchase of the vehicle rather than just the depreciation amount, thus increasing total expenses with total depreciation to $75,000, taxable income is just $25,000.
Taking section 179 is a way to use new fixed assets purchases, like vehicles and equipment, to lower corporate taxes for the current year. But once section 179 is taken on those fixed assets, those fixed assets cannot be depreciated in future years since they were already fully expensed in the year of the purchase.
When I was studying journal entries in college, I remember thinking “I don’t understand them, but I’ll never need them in the real world, so who cares?” the same way I thought “I’ll never need algebra” in middle school. Well, I use both of them all the time.
Journal entries are the backbone of any accounting transaction.
In simple terms, when you bill a customer, you’re actually debiting accounts receivable and crediting sales. When the customer pays their bill, you’re actually crediting accounts receivable and debiting cash. When using an accounting software, billing the customer by creating and saving an invoice to send to a customer is debiting accounts receivable and crediting sales. You’re just not physically writing a journal entry, with the “T” account and all.
There are times when you will have to physically enter a journal entry. Not all things are perfect, and that goes the same with recording accounting transactions in whichever accounting software is used. That’s when you may enter a journal entry to fix the imperfection.
An adjusting entry is a journal entry used to adjust the current accounting books so that they are accurate. If an accounting transaction is recorded inaccurately, an adjusting entry is used to fix it. They are typically used at year-end to prepare financial statements and tax returns accurately.
Closing entries are journal entries entered at the end of an accounting period, like a month, quarter, or year, to zero out temporary holding accounts and transfer balances to the permanent accounts. They mark the end of one period and the start of the next.
While it’s impossible to learn everything you need to know about starting a small business, the few concepts that I’ve listed here are a step in the right direction. Leave a comment with any questions or comments that you may have about starting or running a small business and I will try to answer them as quickly as I can.
My first accountant job was at a small business construction company in upstate New York.
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