As April 15 approaches, businesses are faced with a major challenge: They not only need to communicate their tax returns to the IRS, but also their previous year’s profits. Small businesses, self-employed individuals, and freelancers need to take the cash inflow and outflow principle into account when calculating their profit. But what exactly does this mean? This guide will help you through this...
It can be difficult for entrepreneurs to keep a clear view of things when it comes to bookkeeping and taxes. To break it down, every business is subject to sales tax, which means that you are obligated to pay taxes on your annual income. However, you also have the right to claim input tax deductions. Ultimately, this means that you don’t have to pay every penny of sales tax; consumers can alleviate some of the burden.
The terms ‘input tax’, ‘corporate tax’, and ‘sales tax’often cause a great deal of confusion, as they are often used in tandem or even interchangeably. But what exactly are these concepts? How do you calculate input tax and what should you keep in mind when making a claim? Read on for an explanation of how the input tax process works.
Sales tax, corporate tax, and input tax: definitions
Input tax, corporate tax, and sales tax all basically refer to the same taxation system. We use different terms to distinguish between the different standpoints in the system. But it’s not as confusing as it seems; when you understand the principle, you’ll have no problem remembering the different terms.
In principle, input tax is no different to the sales tax you pay when purchasing goods or raw materials, but it can be deducted from your annual taxes if you make a claim. But why is this and how does this process work?
Profit from claiming sales tax
As an entrepreneur, you usually need to purchase goods, raw materials, and/or make use of services. These operating expenses might include the purchase of wares and commissioned repairs. For these kinds of expenses, sales tax is paid at the normal rate (between 1 and 10%, depending on your state). By doing this, you are making a refundable input tax payment but without claiming a profit.
However, the additional money spent on input tax does not go on to benefit the business who sold the goods or services. The company must then transfer the amount to the tax office at the end of the tax year. The tax office then claims this as corporate tax.
This method ensures that consumers – not companies – ultimately pay via the sales tax added to products or services. The tax burden, therefore, has no influence over a company’s profits or losses.
Input tax may only be deducted from operating expenses that are deductible. To this end, operating expenses must be recognized as necessary expenses for operational purposes. Non-deductible expenses include, for example, household and lifestyle expenses, gifts, income tax and other personal taxes, fines, legal fees, and other criminal charges.
How to calculate input tax: an example
A carpenter in Maine needs materials in order to construct a garden shed, so she buys the raw materials from Company X. They sell her wooden panels with a total value of $1000. With the additional sales tax of 5.5% (the average in Maine), the selling price becomes $1055 gross. If the carpenter purchases the product at the named price, Company X owes the tax office the $55 of sales tax. Company X does not make a loss because the amount was paid by the consumer during the initial transaction process; the carpenter essentially paid the input tax.
The carpenter can now complete her shed with the parts she has acquired. The shed has a value of $2000, and with the added sales tax of 5.5%, the selling price has become $2110 gross. When the shed is sold, the customer pays the $119 sales tax. The carpenter is then refunded the original $55 so that she no longer carries the cost of the input tax of the raw materials. All this simply means that ultimately, the carpenter only pays $55 of sales tax, rather than $119.
Input tax surplus occurs when the input tax is higher than the sales tax. However, when it’s lower, it’s known as sales tax payable. At the end of the tax year, you will either be refunded or need to pay the difference, depending on the how much is paid in input tax and sales tax.
For another detailed explanation of how to calculate input tax, check out the example given in this video:
How do you claim sales tax?
In order to claim a rebate on sales tax, you first need to fill out the Schedule A tax form to establish whether or not you are eligible to itemize deductions. A repayment is only available if you are eligible. You can determine your eligibility by calculating the sum of all the expenses to be itemized (including sales tax). If this amount is greater than the standard deduction amount, you may claim the sales tax deduction.
As a business, you should have all of your receipts, statements, and invoices archived as part of your bookkeeping measures. If you are eligible to claim deductions, you must gather these receipts and calculate the amount of sales tax that you have paid during the year.
The Schedule A form includes sales tax tables for each state. Find your state and determine the allowable sales tax deduction for your income. Compare this figure to the amount of sales tax you have paid. Choose the one that allows you to receive the larger deduction and report that in the Schedule A form. Don’t forget to check the box indicating your decision to deduct sales tax under the title, ‘Taxes You Paid’ and then enter the amount.
Very small businesses (with under $5000 in business expenses) and self-employed workers should complete Schedule C in order to declare their profits and losses. Schedule C is also available for business owners that are not registered as a specific type of business entity, or sole proprietors.
Be aware that since 2013, there are now two methods of calculating home office expenses using Schedule C. The method introduced in 2013 has been simplified, although the original, more complicated calculation sometimes results in a larger deduction. To complete your Schedule C for, you need:
- a profit and loss statement
- a balance sheet
- statements and receipts of all business expenses
- if your business sells products, a list of inventory
- details on other expenses, such as travel, entertainment, and home business expenses
Using these documents, you can calculate your gross income under the section entitled ‘Cost of goods sold’. You can then list your allowable deductions, which are subtracted from gross income to calculate net income. This figure is used to determine your total adjusted gross income tax liability. Self-employed people should also calculate their self-employment tax, which is based on the net income figure.
More types of deductible taxes and expenses
As a business, most of the taxes you pay are deductible but how and when they are deducted depends on the type of tax. In addition to sales tax, you could be entitled to claim deductions on:
- gross receipts tax
- telephone tax
- license tax
- state unincorporated business tax
- fuel tax
- payroll tax
- business travel and entertainment expenses
- real estate tax as well as the cost of maintenance and repairs
- depending on your business type, state income tax may count as an itemized deduction, but federal income tax is never deductible.
These deductible taxes are subject to state regulations. Please check the legislation in your state before completing Schedule A or C.