As a CPA who works with creative entrepreneurs, I’ve seen firsthand how overwhelming taxes can feel when you’re focused on your craft.
The good news is that you don’t need to become a tax expert to succeed in the business world. But you should take a few minutes to make sure you understand some key tax terminology.
Today I’m breaking down the top 20 tax terms that every small business owner should know, and I’ve organized them into 3 sections:
Knowing these tax concepts can help you and your business get ahead and stay ahead when it comes to your finances, so let’s get down to business!
Tax and Accounting Terms
- Audit
An IRS audit is a review of your tax return. You’re more likely to avoid an audit if you keep accurate business records. Even though “audit” sounds scary, it doesn’t always end in heartache and financial ruin, especially if you consult an accountant for help with the process.
- Bookkeeping
Bookkeeping is what we call it when you track your income and expenses. Software like QuickBooks, Wave, or even spreadsheets can be used for bookkeeping, or you can hire a bookkeeper to do all of the things for you.
- Business Expenses
Business expenses are what you pay to run your business. These costs are for things like equipment, marketing, and travel. The IRS defines business expenses as “ordinary and necessary” costs. The good news is that most of them can be tax deductions!
- Capital Gains
Capital gains are a type of unearned income that refers to the profits you make from selling an asset at a higher price than what you paid for it. Typical assets that may result in a capital gain (or loss) when you sell them could be stocks, bonds, real estate, or other types of investments.
- Credit
A tax credit is an amount subtracted from your tax bill. Some credits can even result in a refund.
- Deduction
A tax deduction reduces your taxable income. While it’s not a dollar-for-dollar refund, it does lower your tax bill.
- Depreciation
If your company makes an expensive purchase (the IRS says over $2,500) on something your business will use for a long period of time, then you don’t have to deduct the full cost of the expense right away.
Instead, you can depreciate the asset so that it doesn’t have such a big effect on your books and so it doesn’t skew your profit numbers. For instance, if you purchase a new computer or office furniture that you plan to use for many years to come, you can depreciate the cost of those items over however many years you think it will be used.
- Earned Income
Earned income, which can also be called active income, generally refers to any income that you bring in for services you perform or goods your business sells. It includes wages, tips, and commissions.
Antonym: On the other hand, unearned income, or passive income, includes money you earn from investments through interest, dividends, and capital gains. Unearned income can also include income from things like pension or Social Security benefits.
- Estimated Taxes
Instead of having taxes withheld from a paycheck, the self-employed pay taxes quarterly. These payments are known as estimated tax payments.
To determine how much you may owe, use this formula: Subtract your expenses from your income and multiply what’s left by 20% to get your estimated federal tax and 10% to get your estimated state tax.
For instance, if you’re a photographer pulling in $60,000 per year with $10,000 in expenses for the year, you’ll take $50,000 and multiply that by 30%. This will tell you that you should set aside $15,000 in taxes for the year. Then, you can divide that number by 4 to figure that you’ll pay about $3,750 in self-employment taxes (total between state and federal taxes) each quarter.
- Gross Income
Your business’ gross income is the total amount you make before expenses are taken out. Your gross income includes client payments, tips, and any other income from your business.
- Net Income
Your business’ net income is what’s left after you subtract your business expenses from your gross income. This is the amount you’ll pay taxes on.
- Operating Income
Your business’ operating income is what’s left after you subtract your normal, day-to-day business expenses like rent, wages, and software subscriptions. You don’t include larger one-off or once-in-a-while expenses in the calculation so that your operating income gives you a more realistic and average picture of your business’ income.
- Self-Employment Tax
If you’re self-employed, you pay both the employer and employee shares of Social Security and Medicare (FICA) taxes; this is often referred to as self-employment tax.
Typically, if you earn more than $400 in a year through self-employment, you’ll owe self-employment tax. It’s important to determine how much you will likely owe and to make sure you have enough money in the bank when the tax is due.
- W-2 Employee
If you’re on a payroll somewhere, you’ll get a W-2, and your taxes will be automatically taken out of your paycheck.
Anotonym-ish: On the other hand, a 1099 employee is a freelancer or independent contractor whose taxes are not automatically taken out of any pay they receive.
Tax Forms
- 1099-NEC
The 1099-NEC is a tax form that business owners issue to independent contractors to report the total amount they’ve paid the contractor in that tax year. A 1099-NEC is issued if the business has paid $600 or more during the year to the contractor for services (not goods).
As a business owner, you’ll need to create and send a 1099-NEC to contractors who’ve done work for you, and depending on the type of work you do, you may also receive 1099-NECs from other businesses who’ve used your services.
- Schedule C
A Schedule C is the IRS form that you’ll use to report your income and expenses if your business is set up as a sole proprietor or a single-member LLC.
- W-9 Form
A Form W-9 is a tax form that you should collect from all contractors and vendors you use for your business. It has the contractor’s taxpayer information that you will need when you create their Form 1099-NEC at the end of the year.
If you haven’t collected a W-9 from a contractor or vendor, then you should request it. If they refuse to give you the information, there is a process to follow since you still need to complete a 1099-NEC for them.
Business Entity Types
- Limited Liability Company (LLC)
A limited liability company (LLC) is a business structure that can help protect your personal assets if your business is sued. Switching from a sole proprietorship to an LLC won’t change how you pay taxes (on a Schedule C).
- Pass-Through Entity
The term pass-through entity means that a business’ income passes through to the owner/shareholder’s personal tax return. Sole proprietorships, limited liability companies (LLCs), and S-Corporations are all pass-through entities.
- S-Corporation
An S-Corporation, or S-Corp, is a tax election that can help you save on self-employment taxes once you’re making a consistent profit. It allows you to elect to be a pass-through entity which means you’ll only be taxed at the individual level rather than both the corporate and individual level.
To be a legitimate S-Corp and avoid tax problems, there is paperwork and a fee involved. You’ll also need to pay yourself reasonable compensation which takes careful consideration. I recommend working with an accountant if you’re ready to make this move.
Abridged by Amy
As an entrepreneur, your time is best spent doing what you love, but understanding your business’ finances is what will help you keep doing what you love. If taxes feel overwhelming to you, you don’t have to go it alone! Consider working with a CPA who is experienced in helping small business owners like you.
And if you’re ready to take charge of your business’ finances and devote time to learning how to set your business up for success, sign up for my Know Your Worth course to get started today!
