10 Tax Terms All Small Business Owners Should Know

by | Mar 8, 2022 | Taxes

As you begin to collect your tax documents, you will find terminology can quickly overwhelm even the most experienced business owner. Some of these key terms you will regularly hear throughout the year when handling accounting or bookkeeping tasks. However, some of these terms only come up when it is time to file your return.

No matter the case it is important to have a clear understanding of what these terms mean and how they can affect your business.

Be sure to save this post to easily refer to these key terms.

Accrual Basis

When it comes to bookkeeping there are two ways to record your transactions: accrual basis and cash basis. Accrual basis is the process of reporting revenues when they are earned and expenses when they are incurred. 

For example if you were to pay for an annual subscription you would divide that payment over the 12 months you have the subscription.

Accrual basis requires a significant amount of work but the process can provide management with important information on operations.

Bad Debt

Depending on how your payment schedule is set up, you may be performing work prior to receiving payment. In these cases, you can sometimes be at risk for bad debt. This is when work is performed or goods are provided without payment.

When this happens, the accounts receivable is written off as a bad debt expense. Bad debt is tax deductible and so it is appropriate to use the specific amount that you were unable to collect.

Business Expenses

A myth we hear often is any expense paid by your business is a tax write off. While partly true, there are boundaries around what the IRS considers a business expense.

For a business expense to be written off it must be both ordinary and necessary. What this means is that if you were to make a purchase, it must be seen as both ordinary and necessary for the course of your operations. Could you reasonably expect a business similar to yours to be making the same purchase?

For example if you owned a cake bakery and purchased an oven, this expense would be considered ordinary and necessary for other cake bakeries. However if you were to purchase a lawn mower and recorded it as a business expense, this would not be considered ordinary and necessary for a cake bakery. Therefore it would not be deductible.

Cash Basis

As mentioned above, there are two different ways to record bookkeeping transactions: one of those ways is accrual basis, the other is cash basis. Cash basis is the process of recording income and expenses when they hit your bank account.

This is regardless of when revenue is earned or expenses are incurred. Cash basis is required for tax reporting purposes.

Form 1099-NEC

The Form 1099-NEC is required by independent contractors who receive income during the taxable year. Typically this income was reported on a Form 1099-MISC, however, the increase in independent contractor work has led the IRS to create a separate form for this specific type of income.

Form 1099-MISC

Prior to 2020, independent contractor income was reported on Form 1099-MISC but with the increase in independent contractor work a separate form has been created, see Form 1099-NEC. Now the 1099-MISC Form is used to report other payments and income such as rental payments, financial rewards, and legal fees paid.

Independent Contractor

There are employees and there are independent contractors. As an employer it is important to understand the difference and how each can affect your budgeting and operations. When you hire an independent contractor you may save a bit on tax withholdings but you give up more control over the worker.

For example, independent contractors have say over the hours they work, how the work is performed, and where they work. There are many other factors that determine whether someone is an independent contractor or an employee. To learn more visit the IRS website here

Self-Employment Tax

There are many pros to being self-employed, however, paying self-employment tax is not one of them. The self-employment tax is to cover social security and Medicare taxes traditionally taken out of a W-2 paycheck. Since these taxes are not taken out of self-employment income received, it is paid along with the individual’s annual return.

Tax Credit

A tax credit reduces the tax liability an individual or business owes to the IRS. Once your tax liability has been calculated, tax credits are applied to further reduce your tax payment. There are all kinds of tax credits and new ones can be added. Which is why it is always important to be working with a tax accountant who can provide you with the most up to date tax information.

Understanding these basic tax terms can help make filing your return less stressful, whether you are working with an accountant or not. Many of these terms can be misunderstood, like independent contractor and business expense. So developing an understanding can help ensure you are always in compliance with the IRS.