The good news is that you don’t actually have to read any of the tax code in order to do your small business taxes. Because the code as a whole, and the individual tax codes, are written in legal language and difficult to understand, much less apply practically, there are plenty of secondary sources—like the Bench blog—that break the tax code down into more understandable language.
But, for those who want to get an idea of what the tax code covers and what’s in it, we’ve created this overview.
What is the tax code, and how does it affect small businesses?
The tax code and the regulations that follow from it ensure that businesses are properly classified and taxed according to their activities, industry, and structure.
Misclassifying your business—for example, paying taxes as an LLC, instead of a C corporation, when your business does not fit the criteria for an LLC—can lead to a string of negative outcomes, including overpayment, legal consequences, or missed opportunities for deductions and credits.
Common classifications created by the U.S. tax code
The tax code oversees classifications including:
1. Business entity: Different business structures, such as sole proprietorships, partnerships, corporations, and LLCs, have distinct tax regulations and rules. Choosing the right business entity is the first step in ensuring that your business is classified correctly.
2. Industry: Some tax codes are industry-specific, taking into account the unique characteristics and challenges of particular sectors. Some of these industries include agriculture, cannabis, real estate, and industries where tipping is customary. If your business operates in one of these or other specialized fields, it’s important to understand how these regulations apply.
3. Income type: Tax regulations also differentiate between various types of income, including earned income, passive income, capital gains, and more. Accurate classification of income types is vital for determining the correct tax rates and deductions.
Tax code vs. tax rate
The tax code is the entire set of laws that govern the way U.S. taxpayers pay their taxes, while tax rate refers to the percentage of income that a taxpayer owes. The tax rate is determined by your tax bracket, which are classifications based on income.
While we’re at it, other important tax-related terms are deductions and credits. Deductions reduce your taxable income, while credits directly offset tax liabilities. Tax codes influence which credits are applicable to specific income or activities.
Identifying the right tax regulations for your business
The primary criterion that will determine how your business is taxed is your business entity.
Sole Proprietorships
- Sole proprietorships are the simplest form of business structure, where the business is owned and operated by a single individual. In this case, the owner and the business are considered one entity for tax purposes. Profits and losses are reported on the owner's personal tax return, and income is subject to personal income tax rates. Sole proprietors also pay self-employment taxes to cover Social Security and Medicare contributions.
Partnerships
- Partnerships involve two or more individuals sharing the responsibilities and profits of the business. Like sole proprietorships, partnerships are pass-through entities, meaning profits and losses pass through to the individual partners. Each partner reports their share of the income on their personal tax return, and the partnership itself does not pay income taxes. Partnerships file an informational return (Form 1065) to report income, deductions, and credits.
Corporations
- Corporations are separate legal entities from their owners, providing limited liability to shareholders. C corporations are subject to corporate income tax, and the profits distributed to shareholders as dividends are taxed at the individual level. This results in double taxation, as the corporation and its shareholders both pay taxes. However, some corporations, known as S corporations, can elect pass-through taxation, where income passes through to shareholders, avoiding double taxation.
Limited Liability Companies (LLCs)
- LLCs combine characteristics of both partnerships and corporations, offering flexibility in taxation. By default, an LLC is a pass-through entity, and income is reported on the owners' personal tax returns. Alternatively, an LLC can elect to be taxed as a corporation, providing more options for tax planning. The taxation of an LLC will depend on the number of members and the chosen tax classification.
How Bench can help
The safest and best way to identify the regulations that will govern your business, not to mention the deductions and credits that can reduce your tax liability, is to consult with a tax professional.
They will have a thorough understanding of what tax regulations your business needs to comply with, and will handle your entire tax filing process. Bench offers tax advisory and tax filing services for small business owners who want to take the most hands-off approach come tax time.
If you want to DIY your taxes, using tax software can be a less expensive option that still helps you ensure you’re doing everything correctly. If this is the route you choose, Bench provides all our bookkeeping clients with a Year End Financial Package that contains all the information necessary for filing your taxes.
For more, take a look at our Small Business Tax Hub.
What recent changes or updates to the tax code have taken place, and how will they affect small business owners going forward?
A major upcoming change, starting at the end of 2024, is the expiration of certain provisions that were included in the 2017 Tax Cuts and Jobs Act.
Of these, the one that will most affect small business owners is the expiration of the Qualified Business Income Deduction. This deduction allows owners of pass-through businesses to deduct up to 20 percent of their business income from their total taxable income. While you can still use this deduction during the 2024 tax season, it will not apply when you file in 2025.
While understanding the U.S. tax code is most definitely something you can take off your “how to be an entrepreneur” to-do list, knowing the basics of how your business will be taxed, what deductions you qualify for, and any tax credits or regulations specific to your industry, will always be a good investment of your time. By staying on top of your books and working with a tax professional if needed, you’ll make this tax season your easiest one yet.
