How Does Owning a Business Affect Your Personal Taxes?

Owning a business can significantly impact your personal tax situation, influencing how much you owe and how you file. Understanding these effects is essential for maximizing financial benefits and ensuring compliance with tax laws.

This article explores how business ownership affects personal taxes, covering tax structures, self-employment taxes, deductible expenses, loss reporting, and recordkeeping practices.

Types of Tax Structures

Choosing the right tax structure for your business determines how income is reported and taxes are paid. Each structure offers specific benefits and obligations that influence how business earnings affect your personal taxes.

Sole Proprietorship

As a sole proprietor, your business and personal finances are intertwined for tax purposes. Profits and losses are reported on your individual Form 1040 using Schedule C, simplifying tax reporting by eliminating the need for a separate business return. However, this structure does not separate personal assets from business liabilities, placing them at risk. Sole proprietors are also subject to self-employment tax, covering Social Security and Medicare contributions. For 2023, this tax is 15.3% on net earnings, with half deductible when calculating adjusted gross income.

Limited Liability Company

A Limited Liability Company (LLC) provides liability protection while offering flexible taxation. By default, LLC income is reported on owners’ personal tax returns as a pass-through entity. Alternatively, LLCs can elect to be taxed as an S corporation or C corporation, which can offer tax advantages like retaining earnings or benefiting from corporate tax rates. State-specific regulations for forming and maintaining LLCs vary and must be followed.

S Corporation

An S Corporation allows income, losses, deductions, and credits to pass directly to shareholders, avoiding the double taxation faced by C corporations. Shareholders report this income on their personal tax returns, which may result in lower tax rates. To qualify, an S Corporation must meet specific criteria, such as having no more than 100 shareholders, all of whom must be U.S. citizens or residents. Additionally, S Corporations must file an annual tax return on Form 1120S. Shareholder-employees must receive reasonable compensation subject to payroll taxes.

Self-Employment Taxes

Self-employment taxes cover Social Security and Medicare contributions, which would typically be withheld from an employee’s paycheck. For self-employed individuals, this responsibility falls entirely on them. For 2024, the self-employment tax rate remains 15.3%, comprising 12.4% for Social Security and 2.9% for Medicare, applicable to net earnings up to the Social Security wage base.

For earnings above this threshold, only the 2.9% Medicare tax applies, with an additional 0.9% Medicare surtax on income exceeding $200,000 for single filers or $250,000 for married couples filing jointly. Accurate income and expense tracking are crucial for calculating net earnings and ensuring compliance with these tax obligations.

Claiming Business Expenses

Deducting business expenses is a key strategy for reducing taxable income. The IRS allows deductions for ordinary and necessary expenses incurred while running a business, such as office supplies, professional fees, and travel. Travel expenses must directly relate to business activities and cannot be extravagant.

The home office deduction is available to those who use part of their home exclusively and regularly for business. The simplified option offers a deduction of $5 per square foot, up to 300 square feet. Alternatively, actual expenses can be calculated, requiring detailed records of costs like utilities, mortgage interest, and property taxes.

Depreciation also reduces taxable income by spreading the cost of assets like machinery and office equipment over their useful life. The IRS’s Modified Accelerated Cost Recovery System (MACRS) allows for faster depreciation in the early years of an asset’s life.

Reporting Business Losses

Business losses can result from factors like operational inefficiencies or market downturns. The IRS permits the use of net operating losses (NOLs) to offset taxable income in future years. While the CARES Act temporarily allowed losses to fully offset income, the 80% limitation has returned, restricting losses to 80% of taxable income in subsequent years.

The Tax Cuts and Jobs Act of 2017 eliminated the carryback option for most businesses but allows indefinite carryforwards. Partnerships and S corporations pass losses through to individual owners, affecting personal tax liabilities. Owners must understand the at-risk and passive activity loss limitations, which can restrict deductible losses on personal returns.

Recordkeeping Essentials

Accurate recordkeeping is critical for managing taxes. The IRS requires taxpayers to maintain records substantiating income, deductions, and credits reported on their returns. Business owners must track all financial transactions, including receipts, invoices, and bank statements. Effective recordkeeping supports deduction claims and ensures compliance.

For expenses like vehicle costs, detailed logs of mileage, including dates, purposes, and distances, are required. Similarly, meal and entertainment expenses must be documented with receipts showing the amount, date, location, and business purpose. Accounting software like QuickBooks or Xero can streamline this process by automating transaction tracking.

The IRS generally recommends retaining tax-related documents for at least three years, but specific situations may require longer retention. For example, records related to worthless securities or bad debt claims should be kept for seven years. State requirements may differ, so it’s essential to confirm local guidelines. Proper recordkeeping simplifies tax preparation and protects against potential disputes or penalties.