What E-commerce Business Owners Need To Know About Their Tax Responsibilities
Running your own e-commerce store is quite an adventure. From the thrill of making your first sale to the excitement of watching your business grow, there's always something new and challenging around the corner. But with all that excitement, there’s the not-so-thrilling side of taxes. A common mistake that new business owners often make is not understanding the tax responsibilities that come with starting and running a business. But don’t worry—I’ve got your back.
Properly managing your tax responsibilities helps you avoid penalties, maximize your deductions, and maintain a clear financial picture of your business. This not only ensures compliance with federal regulations but also gives you peace of mind, allowing you to focus on growing your business.
By the end of this article, you’ll understand your tax responsibilities as an e-commerce business owner. We’ll cover everything from choosing the right business structure to recordkeeping and deductions. Think of this as your go-to guide for staying on the right side of the IRS.
Summary List of Tax Responsibilities
Before we dive into the details, here’s a quick list of the questions you need to answer and understand as an e-commerce business owner:
Which form of business will I use?
Will I need an Employer Identification Number (EIN)?
Do I have to start my tax year in January, or may I start it in any other month?
What method can I use to account for my income and expenses?
What kinds of federal taxes will I have to pay? How should I pay my taxes?
What must I do if I have employees?
Which forms must I file?
Are there penalties if I do not pay my taxes or file my returns?
What business expenses can I deduct on my federal income tax return?
What records must I keep? How long must I keep them?
Now, let’s dive into each one.
Choosing Your Business Structure
Which form of business will I use?
First things first, you need to decide which form of business you’ll use. The structure you select will determine how much you pay in taxes, the paperwork you need to file, the personal liability you face, and your ability to raise capital. Making an informed decision can save you money, reduce your risk, and provide a solid foundation for growth.
Here are your main options:
Sole Proprietorship: This is the simplest structure, where you and your business are legally the same. It’s easy to set up and has straightforward tax reporting, but you’re personally liable for all business debts and obligations. This structure is often chosen by individuals starting a small business on their own.
Partnership: If you’re starting your business with one or more partners, a partnership might be right for you. It’s relatively simple to set up, and profits pass through to partners’ personal tax returns. However, like sole proprietorships, partners are personally liable for business debts, which means personal assets are at risk.
Limited Liability Company (LLC): An LLC offers liability protection without the complexity of a corporation. Profits can be passed through to your personal tax return, avoiding double taxation. This is often recommended for e-commerce businesses due to its flexibility, protection of personal assets, and potential tax benefits. LLCs can have one or multiple members, providing flexibility in ownership.
Corporation (C Corp or S Corp): Corporations offer the most liability protection but come with more regulations and tax requirements. A C Corporation is taxed separately from its owners, which can lead to double taxation on profits. An S Corporation allows profits to pass through to shareholders’ personal tax returns, avoiding double taxation, but it has more restrictions on the number and type of shareholders.
Each business structure has its own advantages and disadvantages, so it's important to consider your specific business needs, goals, and future plans when making your decision. For e-commerce businesses, the LLC is often recommended because it combines liability protection with tax flexibility, making it easier to manage your finances and protect your personal assets. Additionally, it allows for simpler tax filing compared to a corporation while still offering significant benefits.
Getting an Employer Identification Number (EIN)
An Employer Identification Number (EIN) is a unique nine-digit number assigned by the IRS to businesses for tax identification purposes. It functions similarly to a Social Security Number for individuals but is used specifically for business activities.
Will I need an Employer Identification Number (EIN)?
Yes, if you have employees, operate as a corporation or partnership, withhold taxes on income (other than wages) paid to a non-resident alien, or have a Keogh plan.
No, if: You’re a sole proprietor with no employees, though getting an EIN can still be beneficial for opening a business bank account and maintaining privacy.
You can apply for an EIN online through the IRS website—it’s free! Here’s the link to apply.
Designating a Tax Year
Do I have to start my tax year in January, or may I start it in any other month?
Designating a tax year means choosing the 12-month period that will be used for accounting purposes and tax filings. This is important because it sets the time frame for when you report your income and expenses. In simple terms, it helps you organize your financial records and ensures you file your taxes correctly and on time. Most businesses use January to December, but you can choose a different 12-month period that better aligns with your business cycle. This decision affects when you prepare your financial statements and pay your taxes. There are two main options:
Calendar Year: This runs from January 1 to December 31 and is the most common choice for small businesses.
Fiscal Year: This is any 12-month period ending on the last day of any month except December. For example, a fiscal year could run from July 1 to June 30.
For e-commerce businesses, the calendar year is often the preferred choice as it aligns with the standard reporting period for tax purposes and simplifies the process of tracking annual financial performance. The IRS generally requires you to stick with your chosen tax year unless you get approval to change it.
Choosing an Accounting Method
What method can I use to account for my income and expenses?
Choosing an accounting method determines how you record your income and expenses. This choice is important because it affects how you track your money and report your financial performance. In simple terms, it impacts how you see your business’s cash flow and profitability
Cash Method: Income is recorded when it is received, and expenses are recorded when they are paid. This method is simpler and often used by small businesses.
Accrual Method: Income is recorded when it is earned, and expenses are recorded when they are incurred, regardless of when the money is actually received or paid. This method provides a more accurate picture of your business’s financial health and is required if you have inventory or average gross receipts over $25 million.
For e-commerce sellers, the accrual method is often recommended as it provides a clearer view of your financial status by matching income and expenses to the time periods in which they are incurred.
Understanding Business Taxes
What kinds of federal taxes will I have to pay?
As a business owner, there are certain taxes you may have to pay to stay compliant with federal regulations. Here's a brief overview:
Income Tax: All businesses, except partnerships, must file an annual income tax return. The form you use depends on your business structure.
Estimated Taxes: If you expect to owe $1,000 or more in tax when your return is filed, you generally have to make quarterly estimated tax payments. This helps cover your tax liability throughout the year. For a detailed guide on how to calculate and pay estimated taxes, check out my blog article on estimated taxes.
Self-Employment Tax: This covers Social Security and Medicare taxes for individuals who work for themselves. The current self-employment tax rate is 15.3%.
Employment Taxes: If you have employees, you’ll need to withhold and pay federal income tax, Social Security and Medicare taxes, and federal unemployment tax (FUTA). See more on employment taxes in the next section.
Excise Tax: Depending on the type of products you sell, you may be required to pay excise taxes.
These taxes ensure that you are contributing your fair share to federal programs and staying within legal requirements. You can pay these taxes online through the IRS Electronic Federal Tax Payment System (EFTPS), which makes it easy to manage your tax payments.
Employment Taxes
What must I do if I have employees?
If you have employees, there are additional tax responsibilities you need to manage. They are as follows:
Federal Income Tax Withholding: You must withhold federal income tax from your employees’ wages. The amount withheld is based on the information provided by the employee on Form W-4.
Social Security and Medicare Taxes: Both you and your employees contribute to Social Security and Medicare taxes. You’re responsible for withholding your employees' share from their wages and paying both shares.
Federal Unemployment Tax (FUTA): This tax provides funds for paying unemployment compensation to workers who have lost their jobs. You pay FUTA taxes only from your own funds, not by withholding from your employees' wages.
State Employment Taxes: Depending on your state, you may also need to pay state unemployment tax and possibly other state-specific employment taxes.
It’s crucial to file the necessary forms on time, such as Form 941 (Employer’s Quarterly Federal Tax Return) and Form W-2 (Wage and Tax Statement). Properly managing employment taxes ensures compliance and helps you avoid penalties. For more details on managing employment taxes, consult the IRS guidelines or speak with a tax professional.
Filing Information Returns
Which forms must I file?
As a business owner, you need to file certain forms to report information about your business activities to the IRS. These forms are known as information returns and are essential for staying compliant with tax laws. Here are some key forms you may need to file:
Form 1099-MISC/1099-NEC: If you paid $600 or more to a non-employee, such as an independent contractor, you must file Form 1099-NEC. Use Form 1099-MISC for other types of miscellaneous income.
Form W-2: This form reports wages, tips, and other compensation paid to employees, as well as the taxes withheld from those payments. You need to provide copies to both your employees and the Social Security Administration.
Form 941: This is the Employer’s Quarterly Federal Tax Return, which you file to report income taxes, Social Security tax, and Medicare tax withheld from employees’ paychecks, as well as your own share of Social Security and Medicare taxes.
Form 940: This form is used to report your annual Federal Unemployment Tax Act (FUTA) tax.
Form 1120 or 1120S: If you operate as a corporation, you’ll need to file either Form 1120 (C corporation) or Form 1120S (S corporation) to report income, gains, losses, deductions, and credits.
Form 1065: If your business is a partnership, file Form 1065 to report the partnership’s income, deductions, gains, losses, etc.
Filing the right forms on time is critical to maintaining compliance and avoiding penalties. Make sure you understand which forms apply to your business and stay on top of filing deadlines.
Tax Penalties
Are there penalties if I do not pay my taxes or file my returns?
Yes, failing to pay your taxes or file your returns on time can result in significant penalties. These can include late filing and late payment penalties, as well as interest on unpaid taxes. Ensuring you meet all tax deadlines and obligations is crucial to avoid these costly penalties and maintain compliance with federal tax regulations.
Here’s a brief overview:
Failure to File Tax Returns: If you do not file your tax return by the due date, you may have to pay a penalty based on the tax not paid by the due date.
Failure to Pay Taxes: If you do not pay your taxes by the due date, you will incur a penalty for each month, or part of a month, that your taxes remain unpaid.
Failure to Withhold, Deposit, or Pay Employment Taxes: If you do not properly withhold income, Social Security, or Medicare taxes from employees or withhold but do not deposit them, you may face penalties and interest on the unpaid tax. Late deposits may also incur penalties.
Failure to Follow Information Reporting Requirements: Penalties apply for failing to file information returns, not including all required information, or reporting incorrect information. This includes penalties for not furnishing correct payee statements on time.
Failure to Supply Taxpayer Identification Number: A penalty of $50 applies for each instance where you fail to include your taxpayer identification number (SSN or EIN) or that of another person where required on a return, statement, or other document.
These penalties highlight the importance of timely and accurate tax filing and payment. Waivers may be available if you can show that the failures were due to reasonable cause and not willful neglect. For detailed information on penalties, refer to your tax return instructions and relevant IRS publications.
Deducting Business Expenses
What business expenses can I deduct on my federal income tax return?
According to the IRS, for a business expense to be deductible, it must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your business. These expenses must be directly related to your business operations and should not include personal, living, or family expenses. For example, purchasing inventory is considered an ordinary and necessary expense for an e-commerce business, while buying groceries for personal use is not.
Common deductible expenses for e-commerce businesses include the cost of goods sold (COGS), which covers inventory, shipping fees, and packaging materials. Operating expenses such as rent for your office or warehouse, utilities, internet service, and office supplies are also deductible. Marketing and advertising costs, including online ads and influencer fees, can be written off as well. Additionally, you can deduct expenses for professional services like accounting and legal fees, as well as business-related travel and meals. Understanding and utilizing these deductions can significantly lower your tax bill and improve your business's financial health.
Tracking your expenses accurately is crucial to taking full advantage of these deductions. Using a spreadsheet or accounting software can help you keep detailed records, which is essential not only for maximizing deductions but also for maintaining compliance with IRS requirements. This brings us to our next important topic: recordkeeping.
Keeping Accurate Records
What records must I keep? How long must I keep them?
Finally, keeping accurate and organized records is essential for managing your e-commerce business and ensuring compliance with tax laws.
Maintaining detailed records of all your business transactions helps you track your income and expenses, prepare accurate financial statements, and support the deductions you claim on your tax return. For example, keep receipts, invoices, bank statements, and credit card statements to document your business purchases and sales. This includes digital records, as the IRS accepts electronic documentation.
You should also keep copies of your filed tax returns and any supporting documents, such as payroll records if you have employees and records of assets like inventory, property, and equipment. These records will be invaluable in the event of an audit or if you need to amend previous returns.
The IRS generally recommends that you keep business records for at least three years from the date you file your tax return. However, if you underreport your income by more than 25%, you should keep records for at least six years. For records related to employment taxes, keep them for at least four years after the date that the tax becomes due or is paid, whichever is later. Proper recordkeeping not only helps you stay compliant but also provides a clear financial picture of your business, aiding in better decision-making and financial planning.
In Conclusion
Understanding and managing your tax responsibilities is essential for the success and growth of your e-commerce business. From choosing the right business structure to deducting expenses and keeping accurate records, staying informed and organized will help you avoid costly penalties and maximize your tax savings. By following the guidelines outlined in this article, you can ensure compliance with federal regulations and maintain a clear financial picture of your business.
If you have specific questions or need personalized guidance on your tax situation, I invite you to schedule an advisory call with me. Let's discuss your unique needs and ensure you're on the right track to achieving your business goals. Click here to book your session today!
Disclaimer: The content on this blog is for informational purposes only and does not constitute professional financial advice. While I am an accountant and tax professional, the information here should not be relied upon without seeking advice from a professional tailored to your individual circumstances. I disclaim any liability for actions taken based on the content of this blog.
