Making the leap from employee to business owner is an exciting milestone, but it comes with its own set of tax implications you’ll need to be prepared for. Whether you’re starting your own business or buying into an existing one, understanding how your taxes will change is crucial to avoiding costly tax season surprises.
Understanding how employees are taxed
As an employee, taxes are generally straightforward. Your employer withholds federal and state income taxes, Social Security, and Medicare contributions directly from your paycheck. Your tax filing at the end of the year typically involves reporting your income from your W-2, along with any other deductions or credits that apply.
In addition to these standard withholdings, employees may also be subject to or elect to withhold the following:
- State and local income taxes, depending on where you live.
- Tax-advantaged savings plans, like retirement accounts (e.g., 401(k)).
- Healthcare premiums and benefits that may be deducted from your paycheck.
What changes when you become a business owner?
When you transition to an owner, you'll no longer have income taxes automatically withheld. Instead, you’ll be responsible for calculating and paying your taxes, which means you need to be proactive about your tax planning.
Self-employment tax
As an owner, you may be responsible for paying self-employment tax, which covers both Social Security and Medicare taxes. Unlike an employee, who only pays the employee portion, business owners are required to pay both the employer and employee portions of these taxes, amounting to 15.3% of your income up to a certain threshold.
Business entity structure matters
The structure of your business — whether it’s a sole proprietorship, partnership, LLC, or corporation — greatly impacts how you are taxed.
- Sole proprietors report business income on their personal tax returns and pay self-employment tax on profits.
- LLCs can be taxed as a sole proprietorship, partnership, or corporation, depending on the election you make.
- S corporations allow business owners to take a salary and distribute profits, which may reduce your overall self-employment tax liability. Owners are also required to pay themselves a salary and issue a W-2, so payroll is still required.
Understanding the different business structures and how they affect your taxes is key to minimizing your liabilities.
Deductions and expenses
As a business owner, you may have the opportunity to deduct various business-related expenses, such as:
- Qualified home office expenses
- Business travel costs
- Equipment and supplies
- Professional services, like accounting or legal fees
These deductions can significantly lower your taxable income and reduce the amount of taxes you owe.
Quarterly estimated taxes
Unlike most employees, who have taxes withheld automatically, business owners must pay estimated taxes quarterly if they expect to owe tax with their returns. The IRS requires you to make estimated tax payments on your income, self-employment tax, and any other taxes you might owe. Failing to make these payments on time can result in penalties.
What you need to know for tax season as a new owner
When your first tax season arrives, being prepared is key to making it through. As a business owner, proper recordkeeping is essential for maximizing deductions and ensuring you comply with tax laws. Keep receipts and documents for all business expenses and income. This will not only help you during tax season but will also protect you in the event of an audit.
To avoid confusion and potential issues with the IRS, it’s important to keep your business and personal finances separate. This can be done by opening a separate business bank account and using it exclusively for business transactions.
We’re here to help
By understanding the tax changes that come with becoming an owner, you’ll be in a better position to handle the responsibilities and opportunities that come with it. If you’ve recently made the switch from employee to business owner, talk with your Mowery & Schoenfeld partner to help you understand the complexities of business ownership and ensure that your tax planning is on track.