How Taxation Works
Taxes are a significant part of the financial framework, and they're not always easy to understand. In fact, many people don't fully grasp how taxes work.
So, let's cover the basics of taxation so you can see how it fits into the bigger picture. I'll go into just what you need to know about taxes so that you can maximize your benefits.
WHO MUST PAY TAXES?
Taxation is based on earnings. So, anyone that is making money must pay taxes. This includes:
Individuals that are employees and earn a paycheck.
Individuals that earn an income through sources other than employment like independent contracting, freelancing, self-employed, and digital nomads work online while traveling the world. These individuals receive 1099 from their clients.
Otherwise, you’re likely the owner of a registered business. Your Business earns revenue and must file a tax return to pay its taxes.
HOW MUCH SHOULD YOU PAY?
How much in taxes a business pays largely depends on the type of taxes. There are five major kinds of business taxes:
GROSS RECEIPTS refers to sales. The goal is to reduce sales by taking tax deductions, thereby lowering taxes due.
EMPLOYMENT WITHHOLDING TAX is deducted from employees' wages when payroll is processed. As an employer, you are required to match some of those taxes and pay the employer withholding taxes portion.
CORPORATE FRANCHISE TAXES, also known as privilege tax, is a tax paid by certain companies that wish to conduct business in specific states.
EXCISE TAX is taxation on specific goods and services as you purchase them, like fuel or tobacco or alcohol for example.
VALUE ADDED TAX VAT is a consumption tax on goods and services, or when you the seller add value to those products and services.
Calculate corporate tax based on the legal business structure.
(Sole Proprietor, Partnership, LP, LLP, LLC, C-Corp, S-Corp)
HOW TO LOWER YOUR TAXES
The process is the same for both personal and business. However, the type of deductions and other factors vary. For example,
INCOME TAX (personal wages) - the goal is to reduce income earned by taking deductions, credits, and allowances to lower the Gross income down to a Net Income amount. This lower amount (net income) is what is used to determine your tax liability based on your household. Theoretically, a single person with a $ 5,000 net income should pay more taxes than a family of four with the same net income. The same net income with more people means less taxes owed.
GROSS RECEIPTS, GROSS SALES – refers to business sales. The goal is to reduce Gross Sales down to the lowest possible Net Profit or Loss. The first step is to deduct COGS (direct expenses) from Gross Sales. This will give you the Gross Profit. Next, from the Gross Profit amount, deduct overhead and other business expenses to get the Net Profit amount. A Net profit means you have money left after deductions. A Net Loss means you spent more than you earned in a given period (the month, or the year). This is very possible to do especially when you have outstanding bills that need to be paid.
Businesses are allowed to deduct expenses, fancy “allowances”, depreciate assets, or make extraordinary purchases for example. This may seem suspect, but the fact is these are legitimate business practices and exactly how the business savvy and wealthy can move the billions they earn into lower tax brackets ~ oftentimes, paying less taxes than you!
Make “NOBOSS Moves”
Now that you know how taxation works, you can take advantage of tax deductions and allowances too. But bear in mind that you're not operating on the same financial level as the wealthy. You must make every dollar count.
That being said, spending money just to take a deduction is NOT smart. There is a commercial showing a group of entrepreneurs fighting over the restaurant check because they can take a business deduction. This is highly misleading, and I'll give you two reasons why:
You’re spending money now so you can get it back later. What’s the benefit of that? This concept does nothing more than disrupt your cash flow.
Not all deductions are 100% deductible, specifically Food and Drink (Meals Exp) is only 50% deductible!
You want to make some “NOBOSS moves” by investing your money into income-generating opportunities. Depending on the type of “NOBOSS moves” you make you might be able to reduce your net income, reduce your taxes, and make money too!
KEEPING GOOD RECORDS
When you start your new business, you should also set up your bookkeeping system. One of the biggest mistakes a new business can make is waiting to set up its bookkeeping system. This is a dangerous financial mistake that happens far too often.
Keeping good records is the foundation of financial management. Documenting your business activity from the first expense is critical to building your business and minimizing taxes.
Start with a bookkeeping system that is simple and easy to update on a regular basis. No law says you must have a bookkeeper, accountant, or CPA when you start your business, so you have a few options to consider who will maintain your records properly:
Do your own bookkeeping.
Hire a bookkeeper.
Outsource to a bookkeeping service. We offer accounting implementation, monthly bookkeeping, and training services to new business owners.
Considering you are required to pay taxes, you will ultimately make a decision by year-end so that your Tax Preparer or CPA can review your records, lower your taxes, and file business tax returns.
This information is part of the Should You Incorporate series. Dig deeper For more information about Legal Biz Structures, How Taxation Works, How to Pay Yourself, Starting a Business, or NOBOSS tools and resources for entrepreneurs.
